If mortgage rates do begin to steadily rise - as most of the Street predicts - lenders could look down in credit to maintain origination volume, an effect that could trickle into all tiers of the market, as, for example, prime lenders skim the cream from the nonprime crop.

Such is reminiscent of the subprime lending and investing community's concern a few years back when the GSEs began exploring lower-credit borrowers to maintain volume, although the interest rate phenomena and subsequent unprecedented refinancing boom solved the volume problem ten times over.

Still, the 2000 vintage of mortgages across the spectrum was a sour one, as it, like next year's mortgages, followed a refi cycle. But where to now, as this boom dries up?

The current sentiment, that adverse selection could once again become an issue for the subprime sector, particularly if rates rise suddenly, was expressed at the recent ABS East conference in Boca Raton. Further, according to a conference writeup from Nomura Securities, some panelists predict a vintage of tainted MBS.

Nomura does not necessarily share this view. "Mortgage lending is a consummately scalable business," said Mark Adelson, head of ABS research at Nomura. "It's all labor. You don't have to build a factory, and it's not unionized."

Others note an opposing trend: subprime originators actually moving up in credit. In fact, when rates spiked in August, jumbo and Alt-A origination slowed dramatically, while subprime origination went the other way. Because subprime rates move less drastically and with a lag, the differential between Alt-A and subprime rates narrowed. Borrowers might have chosen the slightly more expensive product to capture a higher LTV or other relaxations in a non-prime loan, noted Tom Zimmerman, researcher at UBS.

Down in credit for a premium?

Meanwhile, a recent phenomenon is blooming: the development of the Alt-B credit tier. Some argue that the Alt-A credit tier has never been quite defined, though most agree that there is a gap between what is sold as Alt-A and what is sold as subprime.

Deutsche Bank, for example, recently closed a $300 million Alt-B transaction via its Deutsche Bank Alt-A Loan shelf. The deal, DBALT 2003-2XS, was backed by collateral picked from various whole loan pools from originators such as First National Bank of Nevada, Homestar Mortgage Services and Greenpoint.

The weighted average coupon on the 2XS series, which priced on Sept. 29, is 6.917%, while the net coupon is 6.59%, versus the Alt-A marketed DBALT 2003-1, which priced on Aug. 25 with a WAC of 6.197% and a net coupon of 5.93%, according to Bloomberg.

So far, Alt-B deals have primarily come to market through bank issuance vehicles such as DBALT, though only a few banks have actively pushed the product.

The collateral may be best described as Alt-A loans with one or two more strikes against them, though just shy of falling in the subprime sector. Alt-A borrowers are typically prime by some measures - such as income - but may be document-impaired.

Typically these borrowers were either slipping into Alt-A pools or subprime.

What's interesting, moreover, is that the growth in this carve-out is investor- driven. Alt-A has proven that, after a year or so of seasoning, it prepays in line with jumbo MBS. Alt-B, however, has convexity characteristics similar to non-prime pools, with credit characteristics similar to prime, noted Eric Londa, head of private label MBS at Deutsche.

"What you're doing is attracting your traditional mortgage market investor who normally wouldn't go into the ABS market, and you're attracting your traditional ABS investor, who wouldn't normally invest in the MBS market," Londa said.

For the mortgage investor, this type of product would be most popular when prepayment risk is at its worst. However, as rates creep, mortgage investors are already starting to monitor extension risk, though Alt-B probably offers a spread pickup, since it's essentially a credit product.

Tiered differentiation

While the Alt-B carve-out may lose some of its steam for MBS investors when prepayment risk becomes less of a concern, there's a simultaneous drive for borrowers to target this credit tier, as competition collateral heats up.

As mentioned, some analysts argue that Alt-A needs to be better defined, and that a new Alt-B product "is just muddying the water a little bit more."

For example, Impac Mortgage has an Alt-A program that is arguably a different credit/performance profile than what most people consider Alt-A.

Sources at GMAC-Residential Funding Corp. noted that, instead of vintage underperformance as a result of lenders moving down in credit, there might be a trend of "shelf differentiation" by issuers. GMAC is pretty much the king of shelves, with at least five different programs that specify collateral even further via postfixes tacked on to series numbers.

Nonetheless, if lenders do loosen their underwriting standards, it's likely to be detected fairly early on, given the 2000 experience. According to UBS' Zimmerman, industry players are already watching for collateral statistics to shift, and it's possible that rating agencies will apply more scrutiny if they suspect underwriting standards are loosening.

"The risk is not that the LTVs slip; the risk is that originators put a little bit more pressure on the appraiser to make the LTV fit," said Nomura's Adelson. "If there's declining origination volume, there might be too many appraisers out there, too."


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