In the wake of last week's launch of a $176 million reperforming-loan securitization by C-BASS and underwriters Merrill Lynch, market observers are saying that improved credit enhancement levels and a robust economy are making such "scratch and dent" collateral increasingly attractive to investors - possibly setting the stage for a year where reperforming and nonperforming deals finally solidify their visibility in the marketplace.

Sources say that the history of poorly performing credit-sensitive deals from the last several years have been factored into the market recently, allowing current issuers to add the proper credit enhancement - such as excess cash or a monoline insurance wrap - in order to get the sort of attention that they have been looking for with these transactions.

"In previous deals from the 1996 to 1998 era, companies such as Ocwen have realized losses that were higher than most people would have anticipated," said Michael Hoeh, head portfolio manager at Dreyfus Corp. "On those old deals, there was not a lot of history in terms of what the credit enhancement needed to be for the rating agencies to evaluate these things. A lot of it was based on normalized assumptions. But there was not a lot of history in terms of what the losses and delinquencies were going to look like."

Now, that history has been factored into new securities, Hoeh said. Therefore, securities such as those just issued by C-BASS are expected to be perceived much more favorably by both the rating agencies and investors, mainly because such agencies are becoming less conservative about their assumptions regarding reperforming securitizations.

"The credit enhancement levels have definitely gone up on the product, and that has been driven by the performance of those Ocwen deals," said Diane Westerback, senior analyst and vice president at Moody's Investors Service.

"When we evaluate pools, we do give a certain amount of credit to the fact that an increase in housing price appreciation is going on, and that is certainly reflected in the credit enhancement levels for those deals," added Thomas Albertson, vice president at Duff & Phelps Credit Rating Co. "Each deal requires a strong servicer to perform well."

The five Ocwen deals were backed by reperforming loans from the Department of Housing and Urban Development, sources say, and they were managed by Bear, Stearns & Co. and Blackrock. However, there have been very low recovery rates on the loans in these deals, which many observers find surprising, especially considering the current strength of the U.S. economy.

"You'd hope that with housing prices appreciating so much, borrowers would not continue to go delinquent. But there have been higher losses than expected with these deals," said Dreyfus' Hoeh.

Part of the reason for that, however, was HUD's policy of "arrearage," wherein a delinquent Ginnie Mae loan causes the borrower to be put on a payment plan which frequently does not cover the full interest and principal on the loan. In this case, the arrearage builds up. Additionally, these deals performed rather poorly because of the length of time it takes to foreclose on a government loan. But even during times of strong housing appreciation, loss severity is still over 40% for some of these deals.

All of that might be changing, however. The last Ocwen deal, led by Greenwich, had subordination levels that were substantially higher. Additionally, the current reperforming securitization from C-BASS is expected to do well, especially because of the company's impressive reputation as a special servicer and default manager.

"With this back-up in rates and slowdown in refinancing activity, reperforming deals are going to receive a lot more attention," said Duff & Phelps' Albertson.

More Reperforming Deals This Year

In fact, the current robust economy and the trend toward using MBIA wraps for these reperforming deals leads observers to believe that they will be priced very aggressively and will show up more often in the marketplace in 2000.

"We anticipate that we will continue to see a growing supply of credit-sensitive product, including scratch-and-dent', impaired deals, and deals that are unable to meet traditional prime or subprime guidelines," said James Schneider, a director at C-BASS. "We intend to increase the size and frequency of our securitizations in 2000, relative to years prior."

According to Schneider, as the institutional investor base has a growing awareness of the capabilities of special servicers, they will have a growing understanding of these types of deals and of how a company like C-BASS controls loss severity and loss mitigation.

C-BASS, which is 48% owned by MGIC and 48% owned by a large reinsurance company named Enhance, got the highest rating as a special servicer for subprime from Fitch IBCA. Schneider says that the performance of these deals is directly related to the reputation of the servicer.

"Various agencies come up with firm opinions about servicing capabilities, and they decide who can manage it more effectively from a timeline perspective, and also in terms of loss severity and alternatives to foreclosure," Schneider commented.

"C-BASS has an excellent reputation as a special servicer, and that certainly helps," added Dreyfus' Hoeh.

Additionally, C-BASS reportedly conducts more thorough due diligence and truly examines loan-level data, including property valuation. "We can securitize the accurate value from the get-go, giving investors more comfort. We nail due diligence up front, and your expectations of performance are that much more accurate as well."

Frequency of Defaults is Key

With the growth of the subprime market, there are loans being made to borrowers with worse and worse credit, despite the current economic cycle and the excellent job market. Because of this, issuers are naturally going to move toward securitizing more reperforming product, sources predict.

"As long as housing prices don't deteriorate, the U.S. job market is at full employment and delinquency rates for residential mortgage-backed securities should remain at low levels," said Hoeh.

"But as the market matures I think interest in these deals just becomes a natural by-product," added Moody's' Westerback. "Investors are going to continue to have a better understanding of the different kinds of product that are available out there."

"As regular-flow business tends to go away, securitizations naturally move to other types of product," said Duff & Phelps' Albertson.

Most importantly, however, is the fact that the frequency of defaults in reperforming deals become the most important factor when evaluating performance - not the loss- severity data.

"Frequency is the key issue, and what drives that?," Westerback added. "What do you look to? Payment patterns? Dollars paid? A very wide range of products go into the reperforming nomenclature."

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