From the foreclosure freeze, to the tranche warfare.
The foreclosure freeze rather turns the traditional waterfall of benefits between Mortgage-Backed Securities (MBS) investors on its head. Junior bondholders sitting at the bottom of the MBS payment structure, could actually benefit from the freeze, while senior bondholders sitting at the top could lose out. Perverse but true.
You can see why in the below simulation from Moody’s.
These are deals from the Markit ABX 2006-2 index (remember that?). Moody’s has estimated principal recovery and discounted net present value (NPV) — a basic measure of cashflow — for senior and junior noteholders in a base case scenario, and one where the liquidation period is extended by 18 months.
Under the extended scenario then, NPVs for junior bondholders increase rather substantially, while NPVs for seniors drop. Average principal recovery also decreases by about two percentage points for senior bondholders.
There are two things happening here.
For a start, extended foreclosure timelines tend to increase servicing costs/payments on the underlying loans — which hits the RMBS mortgage pool. But they also tend to transfer reserve money from senior principal to junior interest.
It’s rather morbidly ironic to note that one of the theories behind the foreclosure scandal itself — from MERS to Robo-Signing — is the idea of servicers cutting corners in an attempt to minimise servicing costs, or simply being overwhelmed by a rising tide of foreclosures. MERS was one way of reducing paperwork and expense, while Robo-Signing was one method of quickly tackling foreclosures.
In any case — expect an almighty junior/senior/servicer struggle to come.