Despite significant tightening over last few weeks, many banks still see relative value in subordinate and mezzanine home equity ABS.

According to Morgan Stanley, secondary market triple-B home equity bonds tightened as much as 70 basis points during the first week of November. That said, investors could pick up roughly 400 basis points moving from triple-B to triple-B minus, versus the 25- range gap seen last year. Morgan researchers also like the double-A to single-A trade, which offers about 100 basis point in spread, but does not see incremental benefit moving to single-A minus, which only pays 25 basis points over single-A.

In last week's research, MS stressed three prepayment scenarios - fast, base and slow - in a "spiking Libor" environment, defined as the forward Libor curve, which assumes a 1% rise annually, plus an additional 300 basis point spike over the next 12 months. Under a spiking Libor, fast CPR scenario, triple-B minus home equity suffers first-dollar loss at 3.7% cumulative losses, researchers found. This is compared with the 5.2% breaking point for the fast-paying triple-B minus, and 6.8% in base case CPR, in a non-spiking forward Libor environment.

"Bonds would really suffer from accelerating prepayment speeds and rising interest rates, but we consider that scenario unlikely," researchers write, noting that

rising rates tend to slow prepayments.

Collateral underlying

In the new-issue home equity market, FICO scores and LTVs rose in unison during the third quarter, noted Peter DiMartino of RBS Greenwich Capital in last week's research. Using S&P data, in part, DiMartino breaks down the market into fixed-rate, adjustable-rate and mixed pools.

According to the report, average FICO scores in both fixed- and adjustable-rate pools increased by 7 basis points, while mixed pools showed a marginal gain.

The improvement in FICO score, however, was offset by higher LTVs. Average LTVs increased 60 basis points for adjustable rate pools, and a whopping 170 basis points for fixed-rate pools.

Because rating agency credit models are sensitive to LTVs, says DiMartino, it is not surprising to see that credit enhancement levels also increased in the third quarter. S&P's triple-A credit enhancement for adjustable-rate mortgage transactions increased on average by 27 basis points to 22.47%, while credit enhancement for fixed-rate triple-A subprime MBS spiked 224 basis points to 16.39% in the third quarter.

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