This year may prove to be the strongest year yet in the last decade for upgrades in residential mortgage-backed securities ratings, according to a study issued last week by Standard & Poor's Ratings Group, which examined the changes it made to its ratings on RMBS for the 10- and one-half-year period from Jan. 1, 1989, through June 30, 1999.

The study, which analyzed ratings changes such as upgrades and downgrades, reported that for the first six months of 1999, there were already 94 upgrades and only 11 downgrades for the MBS that S&P looked at.

"So, percentage-wise, if that ratio continues for the full year, 1999 may be the strongest yet," said Robert Pollsen, one of the authors of the study. The upgrades occurred in 79 public ratings and 15 confidential ratings. "We've had upgrades outnumbering downgrades since 1994. Part of the reason for that is that the upgrades generally correspond to a strong U.S. economy."

Most of the rating changes in the study were the result of the mortgage pool collateral performance, as opposed to a letter-of-credit provider or a limited guarantee, or other outside credit support, Pollsen said.

According to the study, several factors may help to explain the strong performance of residential MBS. First, due to the declines in interest rates over the last decade and increased movement of people in the U.S., mortgage pools have been experiencing high prepayment rates. This has often resulted in mortgage pools paying down to levels wherein the remaining credit support increases to a much higher percentage of the remaining mortgage pool.

Second, losses are more likely to occur early in a mortgage loan, before the mortgagor has increased the equity in the home. Otherwise, even if the mortgagor encounters financial difficulty, the property may be sold at a price sufficiently high enough to pay off the mortgage loan balance in full.

"As the older securities are seasoned, and because of the shifting interest structure embedded in a lot of them, this allows for some upward movement in the rating," said Ernestine Warner, an S&P analyst and co-author of the study. "Also, S&P makes a continuing effort to refine and perfect the criteria used in the ratings of transactions."

Refinancing Patterns

The year 1994 began a trend of more residential MBS upgrades outnumbering downgrades, which has lasted through the third quarter of 1999. So far, 1994 holds the record for the most upgrades, with rating upgrades more than doubling the number of downgrades, 133 to 64.

Although 1999 seems to be on its way to beating the record, swings in interest rates might alter refinancing patterns, making it difficult to predict whether the trend in upgrades will continue into 2000.

"Because interest rates have possibly bottomed, or at least may temporarily go higher, this could mean a difference in the actions of the people refinancing their mortgages," Pollsen said. "If we don't see as much refinancing as we've seen up until this point, then that could result in pools and existing mortgages staying out longer, which may slow down the trend in rating upgrades."

But the fact that the loan pools themselves may change could be counteracted by the fact that pools issued in the mid-90s are becoming more and more seasoned.

"We have seen lots of pools that were seasoned," noted Pollsen. "As those become more seasoned, there could be more ratings upgrades also."

Their study also mentioned that all 11 downgrades for 1999 were based on performance, and nine of them were seasoned for five years or less.

Prepayment Models

While recent prepayment history - which has included premium coupons prepaying faster than expected - has caused certain investment companies to alter their prepayment outlooks recently, S&P's model is not going to be changed in regard to loss coverage requirements, the analysts said.

"The model we use tries to be conservative and uses the way that hits the credit support the most," Pollsen said. However, the portion that S&P allows banks to claim from excess credit could change, so less excess spread credit on a particular deal may cause them to look at prepayments more closely.

"Prepayments would be more of an emphasis on those pools where you rely on excess interest," Warner said. "If you shrink the available excess interest in the pool, which is truly the credit support, the prepayment phenomenon, of course, would be given more consideration."

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