Why does the treatment of modified loans in a nonagency RMBS deal impact the bond classes?

What will be an ideal response?

A modified loan is one in which the terms have been altered in order to help the borrower satisfy the monthly mortgage obligation. Prior to the problems in the market, deal transactions gave the servicer the right to modify a loan but typically did not address how the modification of a loan should be handled. Loan modification programs were established by several government agencies, along with monetary incentives to modify loans with a primary goal being to reduce the monthly mortgage payments of borrowers with proven hardship. This is to be accomplished by a combination of interest rate reduction, term extension, and payment deferral.

The key issue is how servicers treat the modified loans because that impacts the senior and subordinated transactions. As an example, consider a loan in a pool where the principal has been modified such that the principal has been deferred. The question is whether such a loan should be written off immediately as a loss and as a result, this would benefit the senior bond classes. On the other hand, if the deferred principal is not recognized until the point where principal losses are realized by the trust, this would result in more interest payments made to the subordinate bond classes that would have had their principal written down.