The sharp decline in short-term interest rates has encouraged subprime mortgage lenders to include more fixed-rate collateral in floaters during the past two years, and investors have lately begun to balk at the embedded cap costs in mixed deals. However, changes made to the structure and collateral during the past year appear to have effectively offset the risk of declining WACs, according to recent research from UBS.

Going into 2003, some mixed deals included more than 40% fixed-rate collateral, the report found. "The more fixed, then the greater the basis risk, and hence, the larger the cap costs," analysts wrote.

While investors were initially unaware of the embedded cap costs, the drop in WAC throughout last year - and the consequent reduction in excess interest in these deals - got the market talking. Prompted by these concerns, Moody's Investors Service issued a new set of guidelines for rating subprime deals in April, which included a new set of interest rate stress scenarios.

"A main consequence of Moody's new approach was an increase in the amount of OC [overcollateralization] needed to secure a specific rating," UBS analysts said in the report. "In fact, it looks as if the average OC amount has risen from 75 basis points up to 150 basis points, in a typical deal."

The new model, combined with increased pressure from analysts, has caused investors to reduce the amount of fixed-rate loans in their new deals. Another outgrowth has been a small flurry of deals without a Moody's rating. Most CMO managers will not purchase non-Moody's rated subprime bonds, the report noted. However, the end result remains to be seen. "If the non-Moody's bonds carry sufficient spread, some may be inclined to step up to the plate and buy them . . . there is a lot of questioning and experimentation going on with respect to ratings on subprime mezz and subordinate securities," analysts wrote. (see story, p. 1)

In addition to cutting back on the amount of fixed-rate loans in mixed deals, issuers sought to assuage investors' fears by adding hedge caps or corridors into their deals. Recent deals may contain caps or corridors protecting all, or most, of the tranches and for an extended period of time.

After running stress tests on the triple-B-rated bonds of three major issuers from mid-2003 and mid-2004, UBS analysts concluded that new deals can withstand at least the level of stresses as could bonds issued before last year.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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