Bracing for the deepening recession on the horizon, MBS market players have started to scrutinize credit enhancement levels in jumbo mortgage deals. Are subordination levels too low?

Some market participants have suggested that rating agencies are still lowering levels - despite rising delinquencies - in order to compete for market share, thus increasing the risk to those investors who are in the first line of attack: the single-B buyers.

ASR spoke to all three rating agencies, investigating why, despite the surrounding gloom and doom, subordination levels are still coming down.


"What you don't see when simply looking at the deal levels is how consistent the rating agency has been in determining credit enhancement levels," said Susan Kulakowski, senior director at Fitch.

To exemplify this, one should look at how Fitch has viewed RFC's 30-year fixed jumbo deals. For all deals that Fitch has looked at since 1999, the rating agency has given RFC very consistent credit enhancement levels, averaging 21 basis points at single-B, with 36 of the 42 deals at 20 basis points. At the same time, Fitch's AAA' requirement ranged from approximately 3.50% at the beginning of 1999 to 3.00% on RFC's securitizations during 2001. Deal levels-the levels that investors see, based on all involved rating agencies-fell from more than 4.00% during that same time period down to 3.00%. The deal levels represent a decrease of 27% versus 14% for Fitch's levels.

Fitch's methodology for determining credit risk in MBS has not changed during this period. The improvement in risk profiles in pools is due to better characteristics such as LTV ratios decreasing and FICO scores improving. In addition Fitch has seen improvements in the servicing capabilities of RFC and other issuers which is incorporated into the rating analysis.

According to Kulakowski, Fitch looks at the characteristics of each loan in a particular pool to determine the credit enhancement requirement. For each loan, Fitch looks at two components: the likelihood of default and the loss severity.

In terms of loss severity, what drives the loss on a mortgage is primarily the decline on the value of the property, which is about 55% of the loss on the mortgage.

"What we do when we forecast the market-value declines for each rating category is to basically take the underlying drivers of property values and to make them progressively worse as we go up the rating scale from single-B to triple-A," said Kulakowski.

Fitch also considers the location of the property. For each of the 79 regions, Fitch projects different sets of housing price paths. Basically, Fitch looks at the underlying economic strength or weakness in a local market and uses that to determine housing prices going forward.

The rating agency is focusing on regions located on the coasts, particularly California, because it has one of the largest contributions to MBS.

Fitch says that the location of the property, the issuer, the underwriter of mortgages as well as the servicers are the factors that matter in determining credit enhancement levels.

Moody's Investors Service

There are three main reasons why Moody's has reduced its subordination levels on RMBS deals.

According to managing director Pramila Gupta, the riskier portion of jumbo product has been segregated - Alt-A collateral has been going into Alt-A pools. This has enabled Moody's to assign lower enhancement levels to the portion that is composed of pure Jumbo collateral.

Aside from this, more originators are observing best-business practices. This is largely because many of these originators would like to build a better mouse trap to cull out and differentiate the better borrowers such as through improvements to their automated unerwriting systems.

Moody's is also more able to quantify the benefit of better FICO scores.

The rating agency's subordination levels have not dropped considerably in recent times, but have followed a gradual drift over time. In fact, for single-B, which is the lowest-rated class, it still requires at least 20 basis points to 35 basis points in credit enhancement depending on the pool.

"A single-B rating does not mean that there is not going to be a loss of principal," said Gupta. "There is potentially some loss of yield at the single-B rating which is built in the credit support. We don't necessarily say that single-B should be able to withstand a recession. That's the unfortunate thing. People think that since it's rated single-B, it should behave like a Baa2, and that's really not the case."

Standard & Poor's

According to S&P, there are two main reasons why they had reduced subordination levels in 2001.

One had to do with S&P changing its rating criteria in June of this year.

The rating agency had looked at the performance of the base-case prime loan. After an extensive review of hundred of thousands of these types of loans, S&P determined that the base foreclosure frequency that it had been assuming was too high, so they had lowered that base case frequency for single-B.

Since S&P changed its base-case foreclosure frequency assumption as well the multiples that lead up to the other rating categories, this has had the effect of reducing the subordination levels for everything below triple-A.

Aside from adjusting its base-case foreclosure frequency assumption, there has also been an increase in the quality of the underlying collateral as well the reduction in LTVs and the rise in FICO scores. Analysts said there are now better quality pools partially because of the high refinancing volume.

A combination of these factors has led to lower enhancement levels.

Though the rating agency looks at many other factors and characteristics to determine a loan's default and severity potential, it mainly looks at LTV and FICO characteristics.

Some analysts have stated that LTV might not be a good determinant of the true risk of the underlying loans in MBS because low LTV assumes continued home price appreciation (see story on p. 11) S&P said, however, that there is a component of its model that actually forecasts the probability of home price decline in 180 Metropolitan Statistical Areas (MSA's).

If there is a higher probability of home prices declining, the market-value decline assumption is adjusted upward in S&P's model. This would, in turn, lower the value that the property, affecting the loss severity on the loan and therefore affecting the credit enhancement needed for that particular loan as well.

S&P said that the subordination levels that it gives out to specific issuer pools are based solely on its loan-level model.

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