2009-02-10 17:46:04 -

Many U.S. RMBS servicers are expanding their use of principal forgiveness to avoid high re-default rates and provide delinquent borrowers with an incentive to stay current on the modified plan. While principal reductions help lower the modified payment, initial limited data for modifications with large balance reductions (20% or more) exhibited higher re-default rates than loans with principal and interest (P&I) payment reductions of 20% or more, according to Fitch Ratings.


Fitch believes that servicers must determine the borrower's actual level of income, and craft a modification suitable to that income level, if possible. "Some combination of payment reduction and either principal forbearance or forgiveness may be the most effective approach to mortgage modification as it may increase

borrower ability and willingness to re-pay the modified amounts," said Diane Pendley, Managing Director and Head of Fitch's Operation Risk Group. "However, when principal forgiveness is used, as opposed to forbearance where a portion of principal is ballooned to the end of the term, it should be carefully considered and tied to the current value of the home."


Fitch's analysis of 60+ delinquency data obtained from First American Loan Performance (LP) shows that the amount of the principal reduction has not made a great deal of difference to date in the success of the modification. For loans that had a principal reduction of 20% or more, roughly 28% had re-defaulted six months later. Loans with a principal reduction by up to 10% had a similar re-default rate of about 30%. This compares to a 30% re-default rate for loans that had their principal balance increased by up to 10%. Modifications may increase a loan's principal balance due to capitalization of past due interest and other costs.


P&I payment decreases appear to have had a more direct impact on the percentage of loans that later re-default. The data for these loans show a greater range of re-default percentages. Loans modified to include a 20% or greater reduction in P&I experienced a 21% re-default rate within six months. That compares to a 49% re-default rate for loans with 10-20% increases in P&I. The data indicates that decreases in P&I at modification cause distinct decreases in re-default rates six months later.


This suggests that a strategy that focuses on a borrower's cash flow and reduces their payment-to-income ratio to an affordable level has been more effective, to date, at helping borrowers stay current with the modified payment than a principal reduction, according to Group Managing Director and U.S. RMBS group head Huxley Somerville.


"Servicers are likely to use a combination of interest rate reductions, extended amortization, forgiveness of delinquent amounts, and/or principal forbearance or forgiveness as part of their loan workout strategy," said Pendley. "In addition, several servicers have announced reducing targeted post-modification payment-to-income percentages in order to lower re-default rates as these calculations typically omit other debt, such as second liens and consumer loans."


Looking forward and based on the data from servicers and LP, Fitch expects 60+ re-defaults on modifications to remain at elevated levels, in the range of 60% to 70% after 12 months. Fitch's projection is based on the use of aggressive or streamlined strategies where income is not documented or verified, as well as the impact of continued home price declines and rising unemployment. However, as servicers shift their strategy to focus on DTI ratios and payment sustainability, the re-default rates may be lower than Fitch's expectation. As changes are made to the types and terms of modifications given and more data is collected, Fitch will update its projection.


"When properly designed, modifications can benefit both U.S. homeowners and residential mortgage backed securities (RMBS) investors," said Somerville. The key to a successful loan modification program is that the modification is sustainable. Thus, reductions in principal balances creating greater borrower equity may improve a loans' performance. But, just as important, is providing a payment that reflects the borrower's long term ability to pay. Although principal reductions have not yet been used to an extent which allows a clear determination on their success, Fitch believes that both features may be needed in order for a modification to be sustainable and therefore, reduce re-default rates.


Fitch will be publishing a report in the coming weeks that will describe loss mitigation strategies and the results of Fitch's findings.


Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.








Fitch Ratings, New York

Huxley Somerville, +1-212-908-0381

Diane Pendley, +1-212-908-0777

Sandro Scenga, +1-212-908-0278 (Media Relations)

sandro.scenga@fitchratings.com