Part of an agreement with regulators that could result in principal reductions planned for 200,000 residential mortgages owned or serviced by Bank of America as could benefit the bank but could be neutral to negative for some residential mortgage-backed securities bondholders, according to a recent Fitch report.
The agreement, which is expected to affect the legacy portfolio Bank of America obtained from Countrywide, is likely to provide for an average principal reduction amount in excess of $100,000 for each borrower 60 days overdue.
The agreement does not include mortgages owned or backed by the Federal Housing Authority or the U.S. Department of Veterans Affairs.
Fitch considers the most likely loans to qualify for this principal reduction those originated between 2005 and 2007.
“The principal amounts ultimately reduced and the impact on those trusts will vary based on the loan origination year, current loan-to-value ratio, and delinquency rate,” said the ratings agency. “Those originated during peak house price years will likely see the largest reduction, as the plan calls for a balance cut to bring the loan amount down to the property's current value.”
Fitch said that although it has taken into account higher market value declines for the peak vintage collateral in its current ratings, “the potential for increased defaults among currently paying borrowers that are marginally underwater could increase total losses to the trusts, particularly if the principal reductions are not effective in reducing defaults.”
However, the agreement could be potentially beneficial for Bank of America, “because the bank has already reserved for penalties” and Fitch believes “any reversals could help BAC's income going forward.
“While the agreement will help the bank reduce the amount of penalties it owes over time, the aggregate best case benefit is moderate from a financial perspective,” Fitch said, noting that it will “continue to monitor the details of the settlement and their impact on the large lending institutions and RMBS bondholders.”
As previously noted on this website, Fitch has found that principal reductions perform better than restructurings involving a rate or payment cut. But default rates for principal reduction modifications with deep payment cuts are still higher than 20%.
“There are other risk factors that you can't address with a principal cut,” Fitch senior director Suzanne Mistretta previously told this publication, noting among these are other non-mortgage consumer debts that tend to be a key driver in re-defaults. She also noted that reducing mortgage principal tends to sometimes result in a situation where the first-lien mortgage debtholder perhaps unwittingly subsidizes these other consumer obligations. This could in some circumstances create a moral hazard as it might encourage other leveraged/underwater borrowers to default in hopes they get similar payment reductions, Fitch has said.
