In examining the link between the rate of home price inflation and residential mortgage default rates for subprime loans, Fitch Ratings demonstrates the strong negative correlation between the two. In short, high rates of home price inflation (HPI) helps keep subprime default rates low. Conversely, slow home price growth and home price deflation drives defaults higher as is the case with the 2006 subprime vintage. In California, home prices based on the weighted average of the loans' geographic concentration are relatively flat, growing by a meager 0.2% between 4Q05 and 4Q06.

With stalling home price inflation, borrowers experiencing difficulty making payments are less able to resolve their problems through a profitable sale or refinancing, leading to rising defaults. 2006 vintage mortgage pools were composed of loans that were mostly originated in late 2005 or 2006, when the trend of home price appreciation started to slow down or even reverse. Default rates for the 2006 vintage are significantly higher than those of other vintages with similar age.

Fitch analyzed the default rates, defined as the sum of 90 day+ delinquency, foreclosure, REO and bankruptcy rates, of loans originated in 2002 through 2006 and the cumulative HPI rate following origination. Fitch conducted its analysis at the Metropolitan Statistical Area (MSA) level, rather than using state or national numbers. By weighting the home prices based on the amount of subprime loans in each MSA, Fitch was able to create a more accurate picture of home price inflation levels in the areas where subprime mortgages are concentrated.

The analysis showed that subprime loans originated in the first quarter-2006 have experienced only 0.5% HPI after 12 months, but that defaults have jumped to 8.3% of outstanding mortgage balances. This contrasts starkly to 2005 full-year originations that experienced average HPI of 17% after 12 months and very low defaults of 1.7%.

Fitch examined the sensitivity of subprime borrowers to home price appreciation by observing the default rates of loans in various HPI 'buckets'. The analysis showed that default rates for the MSAs that experienced less than 5% HPI were the highest of all the loans in the data sample. In addition, in areas with an HPI of 5%-24.9%, the number of loans in default reached 13% by month 24, only slightly lower than that for loans located in areas that had less than 5% HPI. In contrast, loans in default located in areas that have HPI of 25% to 49.9% were much lower and those in areas of 50% or more HPI were a fraction of those in the 5% to 24.9% bucket.

Fitch has previously discussed certain collateral attributes, such as stated income loans and piggyback second liens that were contributing to the high level of early payment defaults for the 2006 subprime vintage. The low HPI is exacerbating the increased risk associated with these loan attributes. Some of these borrowers are probably experiencing outright home price declines.

Fitch's ResiLogic default and loss model generates expected loss scenarios that reflect substantial declines in home prices. Fitch's investment-grade loss coverage requirements are designed to withstand substantial home price declines. Fitch will continue to track the status of home price inflation and its impact on performance, and in upcoming research, illustrate the impact of more severe home price declines on loss rates and bond ratings.

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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