To examine the possible effects of a slowdown in home price appreciation, Citigroup Global Markets researchers recently studied a sample portfolio consisting of 75% 2/28 hybrids and 25% fixed rate MBS, with home price appreciation in 2.5% increments varying from a 10% increase to a 2.5% decrease.

After several years of accelerating home price growth, U.S. home prices are poised for more modest price gains in 2005, and short interest rates are seen expected to continue moving upward. Citigroup feels that if prepayments on hybrids were to slow down, these three combined effects would generally lead to higher losses in subprime mortgage ABS, as the majority of subprime hybrid loans reset to a higher monthly payment on the first reset.

Industry-wide hybrid cumulative losses to date are 2.3% for 1997 originations, 3.2% for 1998 originations, 3.5% for 1999 originations, 4% for 2000 originations, 2.4% for 2001 originations, 1% for 2002 originations and 0.4% for 2003 originations. For seasoned deals from specific issuers, the losses vary from 2% to over 6%. Baseline losses are below the average historical experience for 1998 to 2000 originations, and are predicted for a collateral pool with higher FICO scores and higher loan balances than the average 1998 to 2000 pools.

Citigroup found that cumulative losses would increase by 13% if home price growth slowed down to 5% and losses would increase by 22% if appreciation slowed to 2.5%. Additionally, researchers found that a 2.5% decline in home price growth would trigger a 42% increase in cumulative losses.

Citigroup emphasizes the relationship between home price growth rate and prepayment speeds. As the slowdown in home prices is coupled with a slowdown of prepayments, the increase in losses becomes more profound. Assuming 7.5% home price growth, a slowdown of speeds increases cumulative losses by 22%. By contrast, maintaining the 7.5% appreciation rate, a pickup in speeds decreases losses by 18%. Based on Citigroup's figures, the worst-case scenario involving a decline in refinance activity, coupled with a 2.5% home price deflation rate, and a 100bp rise in the fixed month Libor forward curve would result in an 89% spike in cumulative losses.

For slower speeds, losses grow by 52% as home price appreciation slows from 7.5% to negative 2.5%. For fast speeds, losses grow by just 34% under the same home price depreciation scenario. The more seasoned the collateral, the greater the cumulative effect of home price appreciation, researchers added.

The effect of coupon reset on delinquencies following the resets is significant, however its net effect of cumulative losses is relatively small. Although the first coupon resets vary between 62 and 297 basis points between the three interest rate scenarios, the variation is 4% or less for all prepayment speeds and home appreciation rates they examined. Citigroup says one possible reason for the small effect is that its model accounts only for the first reset, but it could not identify a significant effect of subsequent resets on credit performance. Another reason is that the increase in delinquencies occurs after a significant fraction of the pool has paid down.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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