Cramdowns Unlikely to Trigger Immediate RMBS Downgrades
Allowing bankruptcy judges to alter the terms of mortgages should not have any immediate impact on the ratings of securities backed by the affected mortgages, according to Fitch Ratings:
While there are still many unknowns to be determined before U.S. RMBS market participants can gauge the effect of proposed bankruptcy cramdown legislation on outstanding transactions, passage of such provisions are not likely to trigger immediate rating downgrades of transactions.
However, “Due to varying deal language, about 31% of Fitch rated Prime and Alt-A transactions have a greater risk of senior bond downgrades with the remaining 69% having limited risk.”
The Bankruptcy Reform Act of 1994 eliminated the risk of bankruptcy cramdowns on first mortgages secured solely by the debtor’s principal residence and, since then, Fitch has considered the risk of losses due to borrower bankruptcy filings as small. With the potential change in law that risk could become a more material one. The current proposed cramdown legislation provides a bankruptcy judge the ability to reduce the mortgage by a significant amount; the difference between the mortgage amount and today’s ‘market value’ of the property.
The rating implications of bankruptcy cramdown risk are amplified in certain existing Prime and Alt A RMBS transactions where bankruptcy losses are not allocated as typical credit losses. In these Prime and Alt-A transaction documents, the amount of bankruptcy loss that is to be allocated to the bonds in reverse sequential order is limited to a very small total, on the order of $100,000 to $300,000. Bankruptcy losses in excess of this limit are then allocated, pro rata, across the capital structure, Fitch said in a release.
“With regard to new ratings, given the level of uncertainty that would be introduced by the proposed law, Fitch would likely only assign ‘AAA’ ratings if all the losses from cramdowns were allocated as other losses are assigned, in reverse sequential order, as is the case for many current Prime and Alt A transactions. That decision would only be made definitively when an understanding of the final language of any proposed cramdown legislation was obtained.”
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