Could US forbearance initiatives be replicated in European MBS?

The non-agency mortgage principal forbearance initiatives currently underway in the US are being seen as useful templates for stressed European residential mortgage markets, such as Ireland and Spain. However, some believe that principal forgiveness will ultimately play a greater role in resolving problems in the region's commercial mortgage markets.

"Both Ireland and Spain have witnessed mortgage debt rescheduling initiatives of sorts in the past couple of years, led mostly by lender delinquency management practices," says Ganesh Rajendra, head of EMEA asset and mortgage-backed strategy at RBS. "But employing a more comprehensive approach to loan modification seems to us like a logical next step in order to help ameliorate some of the stress in the mortgage market, given the extent of mortgage debt outstanding and the sharp decline in house prices in both countries."

He adds: "The idea of a bold and comprehensive loan modification programme in Europe is only of course conjecture at present, but we wouldn't rule it out over the next two or three years, should the housing market recovery prove lacklustre - especially if the impact of the US programmes is deemed economically beneficial."

Overall arrears trends in many European RMBS markets continue to stabilise or improve, but it is too early for this to have permeated through to loss rates or - in countries with long repossession times - late-stage delinquencies. As a case in point, S&P last week downgraded the class A3, B and C notes of both the Celtic Residential Irish Mortgage 12 and 13 deals due to more pessimistic WALS and WAFF assumptions, driven by house price declines and deterioration in arrears.

Asset-backed analysts at RBS note in a report that Ireland has so far seen relatively few repossessions. "We remain concerned that foreclosures, which have been delayed to some degree by lender forbearance and the relatively slow repossession process, could ultimately climb significantly and crystallise outsized losses in light of the collapse in house prices. A comprehensive loan modification initiative in Ireland could serve to either stave off or indeed accelerate - through debt forgiveness - some of the pent-up loss risks," they say.

Crucial details would obviously have to be worked out in terms of the sharing of any forbearance-based losses among borrowers, lenders and investors - for instance, around how a securitisation structure should be compensated for the dilution in cashflow caused by principal forgiveness - before any proposal could be implemented. Such issues are still being thrashed out in the US, for example.

However, one ABS investor points out that any measure that isn't voluntary will be extremely difficult to implement from a legal perspective, due to concerns about overriding contract law. "Anything a lender does on a one-to-one basis with their customer is fine," he explains. "Even the Bank of America forbearance programme in the US is voluntary - anything that isn't will end up straight in the Supreme Court. The US appears to be willing to go further than other jurisdictions with respect to loan modifications, but lenders still aren't being forced to forgive principal."

The investor adds that if forced principal forbearance was a realistic prospect, mezz RMBS tranches would typically be trading at zero in the secondary market, given that 10%-20% write-downs on positions could be expected.

The recent implementation of NAMA has brought some clarity around stress in the Irish mortgage sector, with banks being forced to take write-downs and then be recapitalised. But it appears that Spanish banks, in contrast, are trying to stretch their loss reporting out over a number of years.

Indeed, the Spanish government would rather merge weaker banks together than force them into bankruptcy. "The process is being supported by a state-backed fund, but it is still taking longer than expected. A bankruptcy doesn't serve bank customers well, yet the uncertainty is discouraging investors from entering the market and slowing the country's recovery," the investor notes.

He suggests that principal forgiveness is more likely to be implemented in the commercial real estate sector - at the CMBS SPV or development company subsidiary level - than in residential mortgages in Europe. "Investors would rather reduce the debt and keep the borrower paying than be left holding a property. Banks are doing their best to avoid becoming landlords on a wide scale."

Furthermore, most investors are pleasantly surprised about how little litigation has occurred in the European CMBS market. "It seems that investors prefer to see consensual workouts and voluntary restructurings - for example, through maturity extensions - for distressed CMBS. The majority of European deals are held by banks, which are reluctant to be associated with the publicity of a court case and certainly wouldn't claim to have not understood the structure properly from the outset," the investor concludes.

CS