DBRS, Inc. (DBRS Morningstar) assigned ratings to the following NRZ Excess Spread Collateralized Notes, Series 2018-PLS2 (the Notes) issued jointly by HLSS Holdings, LLC and HLS MSR-EBO Acquisition LLC. The trend on the ratings is Negative.
The ratings of the Notes reflect the guarantee provided by New Residential Investment Corp. (NRZ or the Company) and the ultimate recourse to NRZ, as well as the expected recovery on the Notes due to the Notes benefiting from a first priority, perfected security interest on specific pools of mortgage servicing rights (MSRs).
The ratings on the Notes are financial institution ratings, not structured finance (sf) ratings.
These Notes are currently also rated by our affiliated rating agency, Morningstar Credit Ratings, LLC (MCR). In connection with the ongoing consolidation of DBRS Morningstar and MCR, MCR previously announced that it had placed its outstanding ratings of these Notes Under Review–Analytical Integration Review and that MCR intended to withdraw its outstanding ratings; such withdrawal will occur on or about September 30, 2020. In accordance with MCR’s engagement letter covering these Notes, upon withdrawal of MCR’s outstanding ratings, the DBRS Morningstar ratings will become the successor ratings to the withdrawn MCR ratings. Information about the MCR ratings, including the history of the MCR ratings, can be found at www.morningstarcreditratings.com.
On June 30, 2020, DBRS Morningstar provided notification on methodology decisions for the U.S. MSR asset class. Following the notification period that closed on July 31, 2020, new engagements in this asset class would be rated and monitored by DBRS Morningstar using a combination of the following methodologies (collectively, the Applicable MSR Methodologies):
(1) “Global Methodology for Rating Non-Bank Financial Institutions”
(2) “Legal Criteria for U.S. Structured Finance”
(3) “Rating U.S. Structured Finance Transactions”
In analyzing the NRZ Excess Spread-Collateralized Notes, Series 2018-PLS2 transaction, DBRS Morningstar applied the “Global Methodology for Rating Non-Bank Financial Institutions” to assess the corporate credit risk of the MSR servicer (or guarantor) who guarantees the full repayment of principal and interest to noteholders at maturity. This methodology also provides the basis for assessing the limitations on the MSR ratings from the servicer’s financial institutions rating (Issuer Rating).
“Legal Criteria for U.S. Structured Finance,” which, specifically in the True Sale and Non-Consolidation sections, considers the legal separation (or the lack of as in this transaction) of the MSR assets from the servicer. It further discusses limitations on the security ratings where a potential linkage is recognized to a counterparty (servicer).
The “Rating U.S Structured Finance Transactions” methodology recognizes that collections of mortgage servicing fees are generally senior to other security obligations in the cash flow waterfall, and considers the potential linkage to the MSR servicer (or guarantor). This methodology was not used in the analysis of NRZ Excess Spread-Collateralized Notes, Series 2018-PLS2, as the ratings assigned are not structured finance (sf) ratings.
For transactions where the MSR noteholders must rely on cash flow from the servicer, either under direct obligations or through a corporate guarantee, the Long-Term Issuer Rating is the starting point in the rating analysis. Given the guarantee from and the ultimate recourse to NRZ in this transaction, DBRS Morningstar’s rating analysis for the Notes starts with the B (high) Long-Term Issuer Rating of NRZ issued by DBRS Morningstar (https://www.dbrsmorningstar.com/research/367513/dbrs-morningstar-assigns-b-high-lt-issuer-rating-to-new-residential-investment-corp-trend-neg), and reflecting the negative trend of NRZ.
For ratings of certain classes in NRZ Excess Spread Collateralized Notes, Series 2018-PLS2, the Long-Term Issuer Rating may then be notched upward due to the secured nature of the Notes. The number of notches of uplift is a function of DBRS Morningstar’s expected recovery for noteholders from the liquidation of the MSR assets upon the occurrence of a credit event and the priority claim on those liquidation proceeds to the more senior class of notes. In other words, DBRS Morningstar gives considerations to the level of seniority and overcollateralization of each class of MSR notes when assigning the uplift from the Issuer Rating. See “DBRS Global Methodology for Rating Non-Bank Financial Institutions”, Exhibit 5. Determining Recovery Amounts and Assigning Notch Uplift.
The ratings of the Notes also consider the legal structure of the issuance including the first priority perfected security interest on the Aggregate Excess Servicing Fees (ESF) assets. However, the lack of bankruptcy remoteness given the absence of a true-sale or safe harbor opinion in legally separating the MSR assets from NRZ constrains the rating uplift for certain classes of Notes and prevents DBRS Morningstar from analyzing this transaction as a structured finance securitization.
KEY CREDIT CONSIDERATIONS
Credit Profile of the Servicer and Operational Risk
When cash flows to MSR noteholders have linkage to the servicer, the credit risk profile of the servicer is a key consideration, along with the collateral valuation. DBRS Morningstar performed an operational risk review to assess the quality of the servicer’s operations and its ability to comply with servicing standards.
Through qualitative analysis, DBRS Morningstar assessed the reasonableness of the third-party estimate of the collateral value. DBRS Morningstar RMBS analysts reviewed the valuation agent’s logic or analytical approach employed to derive the net present value (NPV) of the MSR and ESF cash flows, as well as the critical assumptions used as inputs to the valuation cash flow model. The key inputs used in the valuation of MSRs by the valuation agent include the contractual gross servicing fee; ancillary income (late fees, float and escrows); remaining mortgage portfolio maturity; interest rates; involuntary and voluntary mortgage prepayment speeds; the cost of servicing the mortgage loans; and the discount rate applied to the cash flows to derive the NPV of the MSRs.
DBRS Morningstar expects the collateral valuation to be performed by an independent third party and to be updated frequently given the impact interest rate movements may have on prepayments (there are no restrictions or penalties when prepaying Agency mortgage loans) and related MSR values. DBRS Morningstar expects collateral valuation reports to be provided on a periodic basis and monitors changes in collateral valuations, noteholder credit enhancement and, as applicable, compliance with covenants and advance rates, as well as other important aspects of the transaction agreements.
When estimating recovery values, DBRS applied a haircut to the MSR fair market valuation. In general, a facility with lower advance rates will create more overcollateralization for noteholders, potentially generating higher DBRS recovery rates, which may translate into a greater uplift (e.g., more notches) from the Long-Term Issuer Rating.
On June 30, 2020, there was $232.5 million of note principal outstanding across the four classes of notes. The Notes are collateralized by the aggregate excess servicing fees and by any float and any real estate (REO) owned fees received by the Issuers under their agreements with the servicers relating to such MSRs on a certain pool of private-label residential mortgages. On June 30, 2020, the fair value of the MSR assets as set by the third-party Valuation Agent was $466.7 million. This resulted in a sound level of overcollateralization and an LTV for the transaction of 49.8%.
DBRS Morningstar’s recovery analysis for the Notes assumes that an Event of Default has occurred and that the Sequential Pay Trigger Event is in effect resulting in principal payment on the notes to be paid sequentially to the most senior class of notes then outstanding until the notes are repaid in full. Three scenarios were developed by DBRS Morningstar that included haircuts to the June 30, 2020, fair values of the MSR collateral, with ranges from 40% to 60%. A uniformed distribution of these scenarios was assumed. The results of these scenarios were then averaged to determine a final expected recovery for each class of the Notes. The recoveries led to uplift of four notches from the Long-Term Issuer Rating for the three most senior classes of the Notes, and a two notch uplift for the Class D Notes. DBRS Morningstar also conducted a sensitivity analysis to the distribution of weightings of the three scenarios and found no material impact to the notching uplift.
Transactions with linkage to the servicer typically contain covenants that require the servicer to cure any borrowing base deficiencies. This covenant is intended to mitigate the impact of any sudden and steep increases in prepayment speeds on MSR collateral valuations where the noteholders become undercollateralized.
There are often other covenants that are tied to the financial condition of the servicer that, when breached, may cause an early amortization of the notes or a servicing transfer unless the breach is cured within the specified resolution period. Typically, the covenants require the servicer to maintain compliance with Agency liquidity, debt ratio and tangible net worth requirements.
The Negative trend on the Notes reflects that of NRZ, which considers the heightened uncertainty as to the future credit performance of the Company’s residential mortgage loans given the Coronavirus Disease (COVID-19) induced recession. While forbearance levels have declined steadily since May 2020, DBRS Morningstar continues to be concerned that performance could deteriorate should U.S. labor markets remain challenged while government support programs and stimulus expire.
Given that the ratings of the Notes are inherently linked to the Long-Term Issuer Rating of NRZ, should NRZ’s Long-Term Issuer Rating be downgraded, the rating of the Notes would be downgraded. Additional material financial losses as a result of the challenging operating environment would lead to the ratings being downgraded. Weakening of the Company’s liquidity position or an increase in the composition of funding from short-term funding facilities would lead to the ratings being downgraded. A material reduction in the cushion to covenants, including minimum tangible net worth and leverage, would also result in the ratings being downgraded. Additionally, a decline in the expected recovery on the Notes from the MSR assets would result in the rating uplift from the Long-Term Issuer Rating to narrow.
Given the Negative trend an upgrade of the ratings is unlikely. The trend on the ratings could be moved to Stable should the Company continue to make progress in strengthening its funding and liquidity position while also stabilizing its financial performance. An improvement in the expected recovery from the MSR assets for the Class D Notes would lead to a wider uplift of the rating of the Class D Notes from the Long-Term Issuer Rating of NRZ.
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.
All figures are in U.S. dollars unless otherwise noted.
The principal methodologies are the Global Methodology for Rating Non-Bank Financial Institutions (September 24, 2019): https://www.dbrsmorningstar.com/research/350802/global-methodology-for-rating-non-bank-financial-institutions, and DBRS Morningstar Criteria: Guarantees and Other Forms of Support (January 22, 2020): https://www.dbrsmorningstar.com/research/355780/dbrs-morningstar-criteria-guarantees-and-other-forms-of-support.
For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.
The primary sources of information used for this rating include Company Documents and the Collateral Agent report. DBRS Morningstar considers the information available to it for the purposes of providing this rating was of satisfactory quality.
The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.
Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.
For more information on this credit or on this industry, visit www.dbrsmorningstar.com.
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