The home equity loan sector back in the early part of the millennia - along with other segments of the capital markets - grew comfortable with a historically low interest rate environment, structuring their deals accordingly. Fast forward to the present, in the face of rising interest rates, some of those deals might face interest shortfalls that hit their available funds caps thus exposing them to greater basis risk, JPMorgan Securities analysts say.
"For seasoned 2003 and 1H04 subordinates in particular, hitting the AFC is no longer a remote possibility," JPMorgan analysts wrote recently in the bank's ABS Monitor. "Cash flow from excess spread may be insufficient to cover shortfalls due to high losses."
The bank also said that certain embedded interest rate derivative contracts might not effectively hedge against the credit risks tied to those tranches, depending on the contracts' terms. Caps might not provide cash flow if the strikes are too high, or if the contract covers too short a time frame, JPMorgan analysts say.
The 2003 and first-half 2004 vintages are particularly worrisome, because while bond coupons are increasing along with Libor, asset yields are not resetting as quickly. This sets up a situation where the vintages might experience a shortfall on interest payments. In particular, the bank identified about 300 classes where the collateral WAC is less than the estimated bond coupon by an average of about 80 basis points. In some cases the interest shortfall reached 240 basis points. Although excess spread and cash flow from derivatives contracts might hedge against shortfalls, the bank says the list of bonds that fall into this cautionary zone "demands a closer examination by investors."
Other market sources see the cause for concern, too.
When rating agencies assessed the HEL ABS transactions from late 2003 and early 2004, the bonds were sized using more optimistic interest rate assumptions than the deals that closed after that period. Deals done in the second half of 2004 and beyond were structured to sustain a more rapidly rising interest rate environment, said Grant Bailey, a director in Fitch Ratings' RMBS group.
"They were structured with more cushion, in the form of subordination," said Bailey.
In any case, says Bailey, rating agencies do not rate HEL securities based directly on AFC shortfalls. While rating agencies assess the amount of available excess spread in a deal, and lower excess spreads can lower the credit rating, the credit rating does not directly consider the risk of an AFC, said Bailey. In general, transactions that are doing well will be able to cover their shortfalls, he said.
Still, according to JPMorgan researchers, investors might want to closely scrutinize monthly statements on the vintages it questioned. Normally, interest rate shortfalls and derivative cashflows should be reported monthly. "However, we have found that the information is not necessarily clear or consistent across transactions (even from the same issuer/trustee), and in a few instances, simply wrong," JPMorgan analysts say.
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