July 2011
Vol. 3 No. 2

Overlooked Advances:
Valuing Subprime Mortgages after the Crisis

THE MARKET FOR U.S. residential

Although the supply pressures stemming from the prospect

mortgage-backed securities (RMBS) has taken aof Maiden Lane II auctions, as well as potential sales byturn for the worse in recent months, with prices

European banks and other holders of legacy positions, havecontinuing to fall, particularly in the subprime

clearly caused prices to fall, we believe other less widelysegment. After subprime securities sank by 20–

recognized factors also may be creating pricing havoc in the25% during May–June of this year, the financial press andoften erratic and opaque market for mortgage cash flows.

other market watchers were quick to associate these priceThis brief Market Insights seeks to bring some clarity to thisdeclines with the Federal Reserve Bank of New York’s Marchcorner of the capital markets by focusing on two overlooked

decision to auction assets from its Maiden Lane II LLC facility,

dynamics: loan servicer behavior and the negative duration

which was formed to hold more than $20 billion in RMBSof subprime floaters.

once owned by American International Group, Inc.

Tocomplete the circle, the New York Fed cited adverse market
conditions when announcing at the end of June that it would
postpone those subprime asset sales.

Overlooked Advances
Security Valuation: The Old Tools
Are No Longer Sufficient
The 2007–08 financial crisis significantly altered several
aspects of borrower and loan servicer behavior. In the past,
analysts would typically focus on the following variables
when valuing credit-sensitive RMBS:
 borrower prepayment activity (i.e., the likelihood that aborrower will refinance or move); borrower default probability; and loss severity in the event of a default.
An investor could make assumptions about these various
factors and then run them through bond cash-flow analysis
software to derive a value for a given security.
Since the financial crisis, however, other variables that havehistorically received less attention are increasingly playing
an important role in security analysis. These factors include: liquidation timelines;
 post-modification loan behavior; and loan servicer behavior.
In the case of certain RMBS, these new variables havebecome more relevant in bond analysis than traditional

factors such as prepayments or defaults. The nuanced
nature of the new variables means that they may cause theprices of certain securities to rise and others to fall evenwhen held in the same trust. 1Servicers Matter
By way of example, let’s focus on loan servicers. In thenormal course of business, servicers collect loan paymentson behalf of the noteholder, make generally modest total
advance payments to trusts if borrowers miss a scheduled
payment, collect and pay taxes and insurance premiums,
and maintain records, among other functions. However,during periods of financial stress, particularly when centeredon credit markets, servicers can take on a much larger andmore important role. Because servicers are contractually
obligated to make advances on unpaid principal andinterest payments, the sheer number of post-crisis
delinquencies may mean that servicers pay considerable
sums of money to trusts funding the assets. In this way,
servicers end up effectively “banking” trusts by makingadvances on delinquent payments and recovering the funds
as loans liquidate.
In the aftermath of the recent credit crisis, delinquency
rates have increased and liquidation timelines have beenextended. Under these conditions, the servicers’ advancepayment function has morphed from a relatively minor

Declining Servicer Advances
100

Servicer Advances as aPercentage of Missed Payments

90
80
70
60
50
40
1/1/06

9/5/06

Figure 1

5/10/07

1/12/08

Large Cap Servicers

9/15/08

5/20/09

Small Cap Servicers

1/22/10

9/26/10

6/1/11

Ocwen Financial

1

Securitized residential mortgage loans are typically pooled andtransferred to a special purpose vehicle formed as a trust for purposes ofcreating bankruptcy remoteness, among other considerations.

MARKET INSIGHTS

July 2011 | Vol. 3 No. 2 | Page 2 of 6

Overlooked Advances
administrative role to a substantial asset on their balance
sheet with an increasingly long tenor. Servicers have thus
reassessed their contractual duties and obligations
regarding advances and taken a more aggressive stancewhen interpreting legal agreements because funding theassets has become financially burdensome, particularly fornon-bank servicers.
Figure 1 (above) shows servicer advancing behavior,highlighting that of a single servicer, Ocwen Financial
Corporation. 2 Ocwen Financial is a pure-play loan servicer
that is widely followed in the industry by virtue of being
publicly traded. The “large cap” servicer universe shown in
Figure 1 principally includes firms owned by the largest
chartered banks which are able to fund servicing advances
using relatively low-cost liabilities such as deposits or othershort-term borrowings. The “small cap” servicer universe
mainly comprises firms that are or were owned byinvestment banks or are privately held, resulting in a higher
cost of capital.
The trend lines show that servicers have been advancing
less money (as a percentage of missed payments) to RMBS
trusts, and the amount advanced has been decreasing at anaccelerating rate. Bond investors who traditionally would
not have analyzed this effect must now make assumptions
about the future behavior of various servicers whenattempting to forecast RMBS prices. In addition to theaccelerating decline in servicer advances, the market has
seen several large servicing transfers as servicing companies
either sell some of their servicing rights to other firms orexit the home loan servicing business altogether.
The steep decline in Ocwen advances that occurred at thebeginning of 2011 was caused primarily by a large transferof assets from HomeEq Servicing, a unit of Barclays PLC, toOcwen. After reviewing HomeEq’s servicing practices,Ocwen determined that a portion of that firm’s advances
should not have been made, and they thus reclaimed assets
from the trusts. Because the amount of reclaimed advances
was greater than the current cash generated by loans in thetrusts, no payments were remitted to the trusts. This
resulted in the complete cessation of cash flows to certain
trusts. Investors who did not understand the short-term
catalyst or long-term implications of this behavior may have

2The data presented in Figure 1 are based on computations madeinternally by the D. E. Shaw group and may differ from other sources.

MARKET INSIGHTS

chosen to dump affected bonds. This created a buying
opportunity for those with a more complete understandingof the often volatile cash-flow movements in these trusts.
For certain assets, the assumptions made about servicer
advancing behavior can materially affect bond pricing.
Consider the pricing on the ABX.HE A 06-1, an RMBS index
tranche that is actively traded and closely watched by theindustry. 3 We simulated the impact of servicer advance rates
on that tranche of securities by using the current averageadvance rate for the tranche as a base rate that is held
constant over time and comparing price changes for thecurrent servicer advance rates shown in Figure 1 (holdingthose constant as well). Table 1 outlines the results of thedata run.
Table 1: Price Sensitivity of ABX.HE A 06-1 Index
Tranche to Servicer Advances
Current Servicer
Advance Rate

Price Change Relative
to Base Advance Rate
for ABX.HE A 06-1

Large Cap Servicers

84.8%

4.6%

Small Cap Servicers

65.1%

-6.3%

Ocwen Financial

48.4%-14.3%

Servicer Category

The data clearly show the considerable impact that servicer
advance rates can have on the pricing of subprime RMBS.
Servicer-specific developments continued to dominate theheadlines in July with Bank of America, N.A.’s $8.5 billion
proposed settlement with investors regarding mortgages
originated by Countrywide Financial Corporation. As partof the settlement, BofA has agreed to comply with industry
timelines in processing delinquent borrowers. As theservicer of approximately 28% of the loans in private-label
securitizations, BofA services approximately 36% of thedelinquent loans in the private-label universe (see Figure 2below). The higher percentage of delinquent loans in
BofA’s servicing portfolio is partly a function of its inaction
on processing delinquent loans relative to other servicers.
Figure 3 (below) shows the annualized transition rate at
which loans that had been delinquent for at least 90 days
entered foreclosure or liquidation. The data show thatservicers in aggregate have slowed down the process by

3

The ABX.HE is a synthetic index that references a basket of 20 subprime
RMBS, and the A 06-1 tranche represents home equity loans originallygiven an A credit rating that were underwritten in the second half of 2005.

July 2011 | Vol. 3 No. 2 | Page 3 of 6Overlooked Advances
which loans are moved along in the resolution process, butthat collateral serviced by Bank of America has transitioned

stop and move BofA closer to the rest of the market.
However, unlike prepayment or default risk or loss

Bank of America-Serviced Loans

Percentage of Loans Serviced

40
35
30
25
20
15
10
50
1/1/08

6/4/08

11/7/08

Figure 2

4/12/09

9/15/09

Delinquent Loans

2/18/10

7/24/10

12/27/10

6/1/11

All Loansat a meaningfully slower rate than the rest of the market.
These dynamics create new challenges for investors. Inaddition to the complexities created by having to measureand forecast industry liquidation timelines and servicerspecific timelines, investors in BofA-serviced assets must
now forecast the most likely resolution and timing of theproposed settlement with RMBS investors. In particular,
investors who purchase RMBS serviced by BofA that haverelatively high delinquency rates are implicitly taking a viewthat behaviors which impede the liquidation process willcontinue or that other factors will cause those behaviors toseverity, it’s much more difficult to model idiosyncratic
variables such as servicing behaviors and their effects onsecurity prices. Because some investors have devoted
little or no attention to the nuanced behaviors ofservicers, they may have been quick to sell assets orincrease their risk-premium assumptions when faced withuncertain outcomes and a lack of transparency as to theforces that caused cash flows to change.
Such investor missteps may stem from two features of theRMBS market. First, the industry has not standardized theRate of Loans Delinquent for At Least 90 Days Entering Foreclosure or Liquidation

60

Annualized Percentage50403020
100
1/1/08

6/4/08Figure 3

MARKET INSIGHTS

11/7/08

4/12/09

9/15/09

Non-Bank of America

2/18/10

7/24/10

12/27/10

6/1/11

Bank of America

July 2011 | Vol. 3 No. 2 | Page 4 of 6

Overlooked Advances
reporting and tracking of advances. Even investors who
understand the relevance of servicer advances on bondperformance need to build their own analytic tools to trackand forecast this behavior. In addition, understanding
outlier behavior, such as that exhibited by Ocwen, often
involves detailed discussions with, and potential site visits
to, servicer firms. The average RMBS investor may not be
accustomed to doing this kind of “shoe-leather” research,having become overly reliant on commoditized data.
Second, liquidation timelines can play a significant part indetermining performance on individual RMBS. Investors
need to estimate whether recovery timelines will continue
to extend and how specific servicer behaviors may varyfrom averages and thus influence those timelines. Market
events such as the Bank of America settlement make thiseven harder by raising new questions about investor cash
flows, further complicating the job of a bond analyst.

Subprime Floaters: The Impact ofNegative Duration
Let’s now shift from market fundamentals to thecharacteristics of subprime bonds. Most subprime bonds
are distressed securities that have floating-rate coupons anda six- to nine-year modified duration. As such, they
commonly exhibit negative interest-rate duration. Thismeans that the bond yield-to-price relationship is reversed:
the security’s price increases as interest rates rise, anddecreases as rates fall. As a result, a great deal of theexpected cash flows from these bonds depends on theinterest rate prevailing over the life of the deal.
Market convention prices these subprime bonds as thepresent value of expected cash flows based on current
interest-rate forwards. Consequently, as interest-rate
forwards rally (i.e., decrease), expected cash flows fromthese RMBS decline, with the inverse being true if forward
rates go up. (This negative-duration characteristic would
not apply if investors priced subprime RMBS using a spreadover a risk-free rate, as is typically the case with nondistressed securities.) Consider the example presented inTable 2 in which the market prices subprime RMBS bonds
at a constant 8% yield.

MARKET INSIGHTS

Table 2: Price Sensitivity of Subprime RMBS toChanges in Interest-Rate Forwards
Present Value of Subprime RMBS
Assuming 8% Yield Based On:

Price ofBond

Change in
Price

Current Interest-Rate Forwards$33.10N/A+100 bps Move in Interest-Rate
Forwards (Parallel Shift)$38.0014.7%-100 bps Move in Interest-Rate
Forwards (Parallel Shift)$27.90-15.8%

This example illustrates that the combination of a static
discount factor and dynamic moves in interest-rate
forwards means that the prices of subprime bonds can bedirectly influenced by changes in interest rates, althoughmost investors would not hedge this exposure. Market
participants who do not take negative duration into
account for localized movements in interest rates when
pricing subprime bonds may be embedding implicit
distortions in their forecasts and effectively misvaluing
those securities.

Conclusion
The RMBS market is more nuanced and complicated than may
appear at first blush, and analyst research and forecasting tools
in many instances have failed to adapt. The prices ofmortgage-backed securities have been affected not only by acombination of fairly obvious technical supply pressures, butalso by the vagaries and complexities of fundamental forces
such as mortgage servicer behavior and their resultant impact
on cash flow timing and security characteristics such as
negative duration. Investors may leave money on the table orsubject themselves to unnecessary risk by overlooking them.

July 2011 | Vol. 3 No. 2 | Page 5 of 6

Overlooked Advances

The views expressed in this commentary are solely those of the D. E. Shaw group as of the date of this commentary. The
views expressed in this commentary are subject to change without notice, and may not reflect the criteria employed by any
company in the D. E. Shaw group to evaluate investments or investment strategies. This commentary is provided to you for
informational purposes only. This commentary does not and is not intended to constitute investment advice, nor does it
constitute an offer to sell or provide or a solicitation of an offer to buy any security, investment product, or service. This
commentary does not take into account any particular investor’s investment objectives or tolerance for risk. The
information contained in this commentary is presented solely with respect to the date of the preparation of thiscommentary, or as of such earlier date specified in this commentary, and may be changed or updated at any time without
notice to any of the recipients of this commentary (whether or not some other recipients receive changes or updates to theinformation in this commentary).
No assurances can be made that any aims, assumptions, expectations, and/or objectives described in this commentary
would be realized or that the investment strategies described in this commentary would meet their objectives. None of thecompanies in the D. E. Shaw group; nor their affiliates; nor any shareholders, partners, members, managers, directors,principals, personnel, trustees, or agents of any of the foregoing shall be liable for any errors (to the fullest extent permitted
by law and in the absence of willful misconduct) in the information, beliefs, and/or opinions included in this commentary,or for the consequences of relying on such information, beliefs, and/or opinions.

MARKET INSIGHTS

July 2011 | Vol. 3 No. 2 | Page 6 of 6