Fitch Ratings has finalized its new criteria for projecting losses on prime RMBS.
The framework's main principle is the interaction between borrower equity and drops in market value as ways to determine what the expected losses are for each loan. Additionally, the methodology looks at both loan level attributes and macroeconomic factors to determine what the loss expectations are.
The new model framework has several key updates and improvements. Among them is the application of a proprietary regional home price model to calculate the sustainable value of the property. The new sustainable home price model also gauges a borrower's effective or sustainable LTV.
The performance in the recent downturn, according to Fitch analysts, only emphasized the strong correlation between borrower equity and default behavior. The new framework acknowledges this relationship by looking closely at the borrower equity as a key driver of both probability of default and loss severity.
Its new model also shows more countercyclicality. By focusing on sustainable home prices, Fitch is able to take a countercyclical view on the potential for negative equity when projecting defaults and losses. Because of this, credit enhancement levels will show improved sensitivity.
The credit protection will rise significantly in housing booms accompanied by unsustainable home prices. Conversely, credit protection will drop as 'bubbles deflate' and housing market risk neutralizes, the rating agency stated.
The core methodology has not materially changed since Fitch introduced the model in its Feb. 1 exposure draft. However, Fitch has made several key enhancements to address some of the risk factors that drive the agency's default and loss expectations better.
The biggest among them is the application of a two-step process to achieve a stressed market value decline environment. In this instance, home prices are initially reduced to their 'sustainable value' and then subjected to more of a stressed market value decline assumption at each rating category. This approach from Fitch gives more transparency into the rating agency's perspective on 'sustainable prices' and the amount of home price stress that the loss protection levels can cover.
Fitch has also brought together two separate default probability variables into a new variable. The sustainable market value decline and original combined LTV ratio (CLTV) are now known as sustainable LTV ratio (SLTV), which is now the most predictive borrower default variable.
Other changes made include the inclusion of Fitch's roll-rate methodology. This is used to know the expected defaults on recent vintage collateral. It also added separate loan-level probability of default adjustments for seasoned loans and made changes to several default and loss variables.
Fitch will apply the new model to examine new and existing ratings for prime RMBS deals.
According to the rating agency, the new model should have a moderate effect on existing ratings considering the more conservative stress scenarios. Fitch expects the review of existing prime RMBS ratings probably impacted the implementation of the new model, which will be completed within 90 days.