With mortgage origination processes changing markedly even compared to just a few years back, the definition of credit has evolved. One sector, in particular, that has been affected by these changes is Alt-A collateral, where history can no longer provide a good basis of predicting future performance, analysts said. Finding new ways of defining the product becomes crucial at this juncture.

In a recent report, Fitch Ratings said it "believes the Alt-A sector can no longer be defined under one definition but requires a few definitions." These sectors, said the rating agency, can be distinguished from one another by looking at differences in credit risk. Analysts separated the Alt-A collateral into three subsectors: Prime Alt-A, Alt-A-, and Alt-B, often called subprime Alt-A.

In a related report, Bear Stearns said that innovation in Alt-A mortgages has "spawned" a distinct category called the "near prime" sector. What's more, analysts said that within this new segment, issuers have developed diverse ways of looking at the various loan attributes such as LTV, FICO and documentation. "With no single play book' for near prime underwriting and a nearly infinite number of possible attribute combinations, predicting credit performance can be more challenging in the near prime sector than it is in more homogenous sectors such as prime jumbo, " researchers wrote.

With the array of possible combination of such loan attributes, Bear Stearns said that the level of documentation is becoming less indicative of credit performance especially for the "limited documentation" category. This category applies to a large percentage of loans in many Alt-A transactions and provides many different options in terms of underwriting.

Risks in the sector

Fitch said that changes in performance in Alt-A product could be attributed to three different factors: credit quality, risk layering and issuer intangibles. Because of these factors, analysts said that the bonds that are issued by many sellers today might carry unprotected risk. "As credit changes along with the combination of the risk, we think the risk to investors is magnified substantially," said Cheryl Glory, managing director from Fitch's RMBS group. And while prime Alt-A might perform better, Alt-A- and Alt-B are expected to face higher default rates.

In its study, Fitch compared Alt-A securitizations from the first half of 2004 with the performance of the 1999 and 2000 vintages of loans underlying Residential Funding Corp.'s Residential Accredit Loans Inc. (RALI) and Indy Mac Mortgage Corp.'s Residential Asset Securities Trust (RAST) securities issuances.

In studying the RALI and RAST deals, Fitch found that there are factors aside from visible loan attributes - or the intangibles in the origination process - that impact performance. The report said that in a nonhomogenous product like Alt-A, lender-specific intangibles (eg., underwriting process and controls or valuation procedures) play a very important role in discerning differences in embedded risks and credit performance. The report explained that these intangibles manifest themselves via performance measures including delinquency status and pool losses, even though there are no obvious differences in the underlying risk characteristics of the collateral pool.

Fitch believes that the understanding of a lender's origination practices is crucial in knowing the risks associated in an evolving sector like Alt-A. "Knowing the lenders processes is a fundamental part, outside of the visible attributes, of assessing the risk investors are undertaking in buying their bonds," said Glory.

Going forward

Analysts said that additional research is needed to understand the Alt-A sector and its corresponding risks better. Fitch added that comparing various Alt-A lender pools with the performance of the sector in aggregate is misleading and does not really reflect all the risks in the collateral pools. Analysts said that to understand the credit risk of today's pools better, it is important to look at the sector in terms of the three subsectors and concentrate on the subsector to which that particular pool most closely matches.

Separately, Bear Stearns indicated that the distinction of subprime and prime is indeed blurring - as evidenced by the evolution of "near prime" and by subprime lenders moving higher and prime lenders moving lower in FICO. Due to this, analysts said that it becomes a question whether historical sector performance taken alone is less important as a predictor of future mortgage credit performance in each sector. Analysts added that those who have concerns about the negative impact of higher mortgage rates on the subprime sector could use near prime product to shift credit exposure into longer reset loans. This delays the rate shock and allows for more time for borrower income to catch up.

Analysts from the firm also advocated the disclosure of additional borrower attributes including disposable income. This would help market participants to better segment and price risk in new and developing mortgage sectors, noting that FICO scores, though useful, do not always tell the real story.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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