Fitch Ratings has responded to the subprime market turmoil by revising its criteria for measuring mortgage default and loss risk for newer vintages. The methodology now takes into account current credit risks that have sent the U.S. RMBS market into a tailspin, including high-risk loans, significant changes in adjustable-rate mortgages and declining home prices in certain regions.
"I think a lot of the risks have been surfaced around products, but the home price environment could continue to worsen," said Glenn Costello, Fitch managing director and RMBS co-head. "That's certainly the single largest risk to additional deterioration of performance versus what we've already seen." The rating agency's estimates of regional home price declines are based on forecasts provided by University Financial Associates that are incorporated into Fitch's ResiLogic default and loss model. "If home prices continue to decline, the borrower who may find themselves with little or no equity will increase so if they get into trouble in terms of making their payments they won't be able to work out of that," Costello added.
The subprime fiasco has also led Fitch to create a new "low" documentation category for ResiLogic, which carries a 43% higher expected default rate than for "full" documentation loans. Default expectations for short-term and hybrid ARM products have spiked because of the decision by many large originators to cease distribution of these mortgages. Expected default rate multipliers for 2/28 ARMs are up 22% and 3/27 ARMs have been increased by 12%. In addition, expected default rates for ARMs with adjustment terms below two years have been increased by 30%.
"The high-risk loan products, in what appears to be substantial evidence of loose underwriting and borrower broker fraud, have driven early delinquencies to very high levels," Costello said. "This substantial secular change in performance shows no sign of abating and we are letting it drive our longer-term forecast to a substantial degree."
On July 12, Fitch placed 170 U.S. subprime RMBS transactions under analysis and began taking formal ratings actions on Aug. 1. The agency has affirmed 850 classes with an outstanding balance of $740 billion and downgraded 491 classes with an outstanding balance of $9 billion. The ratings action reflects changes to surveillance methodology, specifically involving loan from the 2005 and 2006 vintages.
A few months ago, the rating agency placed the 2006 vintage loss expectation between 6% and 8% but the crumbling subprime market could change the outlook. "Eight percent could still prove to be a good estimate but that bias has to be higher given the rapid deterioration of the market," he said. "But more important than the projected loss is the ability of individual bonds to withstand loss."
Determining the risk of bonds to loss involves modeling cash flows. Thus, the agency's updated methodology is giving weight to the slow prepayment speed that is currently being experienced in the market. Fitch forecasts an uncharacteristic plunge in prepayment speeds for 2006 transactions, followed by an upswing. "We do predict a spike in prepayment rates as we approach the ARM adjustment rate, but the magnitude of that spike is far lower than what has been observed in any vintage in recent history," Costello said.
The agency focuses on the break loss/loss coverage ratio to develop its cash flow modeling process. Any bond class that cannot demonstrate an LCR of 1.1 will be subject to a ratings adjustment, but while the stressed environment has raised expected losses, Fitch does not foresee an increase in extreme losses to the same degree.
"We do think we have a solid, conservative expected forecast now so we certainly don't anticipate any near term changes to those ratings, but the market can continue to surprise to the downside so we will do what we need to do if things change," Costello said.
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