The existence of incurred, but not yet properly allocated losses is a major problem.
For example, until the losses are properly allocated, junior tranches of the RMBS securities continue to receive cash distributions that they would not be entitled to if the losses were allocated as incurred.
Regular readers know that your humble blogger has been pushing since before the financial crisis for a master database that would have all of the underlying asset performance data on an observable event basis for each transaction.
If this database existed, losses would be allocated as they are incurred and each tranche of a deal would get the cash it was entitled to.
On the securities performing at December 2011, a universe of approximately $1.42 trillion, R&R estimate the amount of additional losses likely to materialize is $300 billion, with one-third concentrated in ten arranger names, including Countrywide, Morgan Stanley and JP Morgan. About 17,000 tranches, or 34% of the universe analyzed by R&R, may lose up to 83% of their remaining principal.
In addition, R&R estimates that approximately $175 billion of losses already incurred on the loans have not yet been allocated to the bonds in the related transactions. Failure to allocate realized loan losses could distort the valuation of related RMBS tranches....
In the course of conducting valuations on RMBS, the R&R analytics team discovered widespread, serious, repeated data discrepancies. Ann Rutledge, a founding principal, asked the team to measure the magnitude of the discrepancy on the RMBS universe.
To do this, R&R subtracted cumulative losses allocated to the tranches from unallocated, expected losses, calculated as the sum of defaults, bankruptcies, foreclosures and REOs minus recoveries. “The results were very disturbing: $175 billion of unallocated current losses and $300 billion of imminent losses,” Rutledge said.
Rutledge commented that she was not clear why these losses are being held in limbo instead of being properly allocated, since the data used by R&R in the calculations were included in the servicer reports. She cautioned, “Investors should be concerned about receiving inaccurate bond performance information and paying unnecessary fees.”
The implication for bond holders in RMBS is significant with respect to both estimates.
Subordinated securities in the RMBS with probable future losses ought to be written down by such losses but instead may be continuing to receive interest owed to more senior tranches. It could also mean that servicers are earning fees against loans that have already been liquidated, which also reduces the amount of cash to pay senior bond holders.
For example, in one month, servicers could generate $75 million or more in inappropriate fees against the $175 billion in unallocated losses.
Rutledge also noted that R&R has observed a steady increase in amount of limbo losses, raising the prospect that a significant amount of funds are still being misallocated for bond investors.
“The system for MBS is still fundamentally broken,” she said. “All the loose ends need to be identified and knit together into a well-functioning system before investors can feel comfortable investing in RMBS once more.”