By Erkan Erturk, Ph.D., Director, Kelly Luo, Ratings Specialist, Monica Perelmuter, Associate Director, and Mark Risi, Ratings Specialist, Standard & Poor's Ratings Services

U.S. manufactured housing ABS ratings experienced significant volatility in terms of downgrades and defaults during the past several years. The downward pressure on the sector began in early 2002 and continued through the end of June 2004, affecting all vintage years from 1995 through 2002.

Many factors have contributed to this adverse performance; these include the effect of low interest rates making site-built housing and apartment rentals more affordable to potential MH borrowers, thus squeezing MH sales; weaker underwriting standards due primarily to competition in the MH industry; the underwriting of MH chattel products with significantly longer loan terms; and the overall slowdown in the U.S. economy during early 2000 through the middle of 2003. In the end, the combination of subprime borrowers with a subprime asset class has resulted in heavy loan losses that exceeded Standard & Poor's expectations, which then translated into unfavorable behavior for the MH ABS ratings. Looking ahead, Standard & Poor's expects additional downgrades in this industry as MH loan losses continue to increase.

Standard & Poor's Ratings Services has observed the following behavior of MH ABS ratings:

MH ABS has been one of the poorest performing asset types with significant rating volatility in recent years.

The Chapter 11 bankruptcy filings of two lending giants, Oakwood Homes Corp. and Conseco Finance Corp., contributed to the deteriorating performance of MH loans, and, as a result, the MH ABS ratings.

About 50% of the MH ABS ratings across all vintages experienced downgrades since issuance; for several vintages (such as the 1999 issuance year), this downgrade rate reached a record high of as much as 83%.

Credit quality changes in terms of the average number of notches were significantly worse than the levels observed in both global ABS and overall structured finance ratings.

The MH downgrade rates have been very sensitive to the actual level of collateral losses across most vintages. The regression slope suggests that a 1% increase in the overall collateral losses results in about a 5% to 7% increase in the downgrade rates for most vintages, and about a 10% increase in the 2002 vintage downgrade rate. Conversely, the 1994 vintage downgrade rate has less sensitivity (0.5%) to the overall collateral losses.

This report accompanies a recent article titled "U.S. Manufactured Housing ABS Continues to Struggle," published Aug. 2, 2004 by Standard & Poor's. That piece discusses the steep decline in the MH loan market and the accompanying slump in MH ABS performance and volume. This report documents the long-term rating behavior of U.S. MH ABS transactions rated by Standard & Poor's. It presents the overall MH ABS rating behavior and describes the performance from a number of perspectives, such as original-to-last ratings, vintage performance, MH loan loss rates and MH ABS downgrade rates.

This article examines the historical trailing 12-month change in the credit quality of MH ABS ratings and compares the rating behaviors of MH to global ABS and overall structured finance. It also discusses the frequency as well as the magnitude of the MH original-to-last rating transitions by vintage years. Furthermore, the impact of cumulative MH collateral losses on the lifetime downgrade rates is investigated. The results show that the MH ABS ratings experienced significant volatility, suggesting an overall decline in the credit quality of MH securities.

Manufactured Housing Sector's Steep Decline

The recent low interest rate environment allowed some renters to purchase homes, thereby increasing apartment vacancy rates in certain areas and lowering the related rental rates. Hence, some park communities faced competition from apartment buildings for prospective tenants; in certain instances, apartment rents were lower than combined payments for lot rentals and chattel contracts. Traditional MH competitors, namely site-built housing and apartment rentals, have benefited from the lower interest rate environment, thereby squeezing MH sales. However, as house prices continue to escalate and interest rates begin to rise, MH sales should benefit.

During the mid-to-late 1990s, the MH industry found itself in the midst of a boom, with many new lenders entering the originations business. This influx of new lenders increased competition for market share, leading to a loosening of underwriting standards. Some of these liberalized underwriting standards included 5% down programs, an extension of the borrower credit spectrum to which originators would lend, and significantly longer loan terms for chattel paper financing. As a result, a large number of subprime borrowers turned to the rapidly expanding market. Also, some manufacturers built new plants and opened new retail sale centers to meet the growing demand for originations.

These weaker underwriting standards led to a large increase in defaults and delinquencies for MH loans and to an increase in repossessed unit inventory. As the U.S. economy moved into the most recent recession, these delinquency and default rates began to rise even more rapidly. Some of the participants were forced to exit the origination business, as deteriorating portfolio performance severely affected their profits. With the exit of several lenders, the remaining lenders began to tighten their underwriting standards, thus causing a decrease in the total number of approved applicants. Fewer approved MH buyers, along with competition from repossessed unit inventory, translated into a decrease in demand for both new and used units. This prompted many companies to close some of their manufacturing plants and sale centers.

The Chapter 11 bankruptcy filings of two lending giants, Oakwood Homes Corp. and Conseco Finance Corp., also contributed to the deteriorating performance of MH loans. Historically, when a seller/servicer exits the MH originations business or declares bankruptcy, the seller/servicer's dealer relationships may be negatively impacted and, consequently, its ability to liquidate repossession inventory at maximum recovery rates may also become more difficult. This may increase the loss severity experienced by the pool supporting the transaction.

As expected, performance of MH ABS has suffered severely as delinquency and default rates rose to record levels. In addition, as fewer servicers were utilizing retail dealer channels to dispose of repossessed units, instead moving to wholesale channels, loss severities have increased. During the past few years, severities that traditionally remained in the 40% to 50% range increased to the 80% to 100% range.

Deterioration in MH ABS Credit Quality

MH ABS ratings have experienced significant volatility in recent years. This rating volatility refers not only to the frequency but also to the magnitude of rating transitions. The combined effect of magnitude and frequency is represented by the average credit quality, and measured by the average number of notches changed during trailing 12-month periods, giving equal weight to each rating outstanding at the beginning of each 12-month period.

Chart 1 shows the trailing 12-month changes in the credit quality of MH ABS ratings in terms of average number of notches. During the 12-month period ended June 30, 2004, MH ABS securities experienced a downgrade of about 3 notches in credit quality. The average downgrade rate was 4.5 notches for each MH security during the 12-month period ended in March 2004. Chart 1 also compares the rating behaviors of MH ABS with those of global ABS and all structured finance securities. The difference in rating behavior is enormous among global ABS, SF and MH and underscores the unfavorable behavior of MH ABS ratings since late 2000.

Overall, the ratings and the average change in credit quality are highly correlated: lower ratings tend to be associated with higher average declines in credit quality, while higher ratings tend to experience lower average changes in credit quality.

Standard & Poor's also found that 82% of the MH securities originally rated BB' were downgraded and 64% of the BB' ratings defaulted as of June 30, 2004. The cumulative downgrade and default rates tend to decline for higher-rated securities. For example, the original AAA', AA', A' and BBB' ratings experienced downgrade rates of 33%, 40%, 54%, and 62%, respectively. Similarly, the default rates for those ratings were zero, 0.7%, 23%, and 30%, respectively.

Loan Losses, Downgrades,

and Timeliness

Analysis of cumulative MH loan losses, MH ABS downgrade rates, and the explanatory power of the loan losses on the volatility of downgrades may provide insight into the timeliness of Standard & Poor's MH rating actions. In particular, transactions issued in the 1998 and later vintages displayed steep deterioration in terms of net losses relative to transactions issued before the 1998 vintage. While the older vintage securitized loans benefited from higher loan recovery rates during their peak loss period (which typically ranged between 24 and 48 months of performance), both the lower recovery rates and the

earlier loss frequency affected recent vintage securitizations.

The deterioration in losses in securitized MH loans is further reflected in the rating volatility seen on MH ABS ratings in recent years. On average, more than 60% of the ratings for transactions issued in 1998 through 2002 were lowered since issuance. The cumulative downgrade rates for 1994 through 1997 were 6%, 30%, 58%, and 54%, respectively. In addition, approximately 18% of the ratings issued in 1998 and later have defaulted, while about 12% of the ratings issued prior to 1998 have defaulted. Furthermore, about 25% of the MH ABS ratings on transactions issued before 1998 were raised, while less than 1% of the ratings on transactions issued after 1998 were raised.

In conclusion, the overall results, as expected, suggest that the changes in the MH loan losses and MH ABS downgrade rates were significantly and positively correlated. High r-squared as well as the significantly positive slopes, calculated when the loss rates were regressed on the downgrade rates for each vintage year, show the high sensitivity of the loan loss rates to MH ABS downgrades.

Abridged from "Adverse Behavior of U.S. Manufactured Housing ABS Ratings Highlights the Sector's Challenges", available on: www.ratingsdirect.com

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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