Recent trends in the mortgage sector of the ABS market have had positive impacts to date, but presenters at last week's Moody's Investors Service RBMS Investor Briefing raised red flags over recent vintage transactions. In particular, the increase in interest-only products and modified loans, combined with the decline in applicant documentation, may spell trouble for the sector going forward, Moody's analysts said.
There have been some positive developments in the sector, primarily the increased due diligence in home appraisal valuations resulting from investment bank shelf deals. Of the record-breaking first-quarter supply, two-thirds was issued by investment bank loan acquisition shelves.
The negatives outweigh the potential positives from increased due diligence, according to the rating agency. However, competitive pressures between originators for originations has led to a proliferation of I-O, zero equity and reduced documentation mortgage product in securitization pools.
The decline in refinance activity seemingly has been compensated for by the offering by originators of more alternative loan product to down-in-credit borrowers, thus boosting purchase-loan activity. Moody's fears that should interest rates rise as expected, many of these borrowers would be left unprepared to handle the payment shock expected once the amortizing period begins and monthly payments step up.
Hypertranching, or the carving of cashflows into more rating-specific classes, can potentially increase loss severity in the now-smaller subordinated tranches. As a result, "smaller tranches may receive lower ratings or need increased credit enhancement," noted analyst Karin Kelner.
While these are not new concerns, Moody's believes that a combination of these factors in recent and future vintages may be an issue for them, unless enhancement increases. Kelner indicated that as a result of these factors, and the likelihood of them converging simultaneously, enhancement in mortgage ABS may be increased by up to 20% in some transactions.
Another area of concern for Moody's is loan modification activity. In his presentation, analyst Joe Grohotolski cited the relative lack of reporting for modified loans in securitized pools. Grohotolski believes servicers could manage performance triggers by modifying loan terms and making the delinquency status of the loan current based solely on the new modified loan term, potentially causing credit support to leak out of a transaction prematurely. These modified loans within securitizations are not identified to investors on a deal-level basis, making it difficult to size the impact.
Citing the aforementioned concerns over economic fundamentals, Grohotolski believes that modifications could be used more frequently, masking delinquent loans as ones with cashflow as interest rates rise. These modified loans, in turn, may lead to an unanticipated rise in defaults that otherwise would be spotted by rising delinquencies.
"The increase in loan modifications, with virtually no transparency, means that a delinquent borrower could start cashflowing only to default at a later date," Grohotolski said, therefore potentially undermining the purpose of delinquency triggers. He suggests that there is a need for more loan-modification transparency. In addition, modified loans and other loss mitigation techniques should be tracked in monthly investor remittance reports.
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