Moody's Investors Service this week will release a report suggesting home equity ABS deals incorporate more effective triggers. Analysts at the rating agency last week stressed they were not aiming to "dictate" the type of triggers used in home equity deals, but did say lower-rated tranches would likely receive a more favorable rating through the use of one of two alternative triggers it outlines in its report, in addition to standard cumulative loss and delinquency triggers.
Moody's solicited comment on a number of the alternative triggers at its annual investor conference last year. The favorite among them has emerged as the so-called pipeline loss trigger, which was found to make deals the "most robust" and exhibit less ratings volatility. A second to the pipeline loss trigger was a hybrid version of the cumulative loss trigger that accounts for prepayment speed.
"There has been discussion on these triggers for the last couple of years. We are sort of surprised that people didn't move forward in terms of putting some more robust triggers into transactions, so we decided to go ahead and suggest this," said Warren Kornfeld, a managing director at Moody's. Introduction of new triggers was not purposely correlated with an expected decline in the home equity lending market. In fact, the old set of triggers seem to show their faults more in good economic times, when high prepayments tend to make them less effective, said Navneet Agarwal, a vice president at Moody's.
As far as how much use of the triggers - or versions of them - will influence ratings: "Moody's will continue to make a credit rating distinction between deals with more robust triggers and deals without," the rating agency writes in its report. Generally only bonds at the lower end of the capital structure can be expected to gain a ratings boost from favorable loss triggers. "For example, a Baa2' bond without either of the two additional triggers could potentially be rated Baa1' if the transaction employed either of these two more robust triggers," the report states.
Trigger happy
Triggers are intended to ensure cash flows infuse the appropriate tranche, based on a given deal's performance. Since roughly 2002, most home equity deals have incorporated both a delinquency and cumulative loss trigger. Delinquency triggers typically measure serious delinquencies, while cumulative loss triggers are based on a threshold of cumulative losses. In its analysis, Moody's found the commonly used soft delinquency triggers were helpful primarily to higher-rated tranches. On the other hand, cumulative loss triggers were found to be weak when it came to ail end losses. As a result of the inadequacies, the rating agency analyzed the performance of a crop of alternative triggers, including pipeline loss, CPR-based cumulative loss, hard delinquency and net excess spread.
Unlike a typical cumulative loss trigger, the pipeline loss trigger predicts a pool's future losses based on its level of current delinquencies. The forward-looking trigger compares expected losses with available credit enhancement at a given rating level. The most important aspect of the trigger, according to Moody's, is its ability to incorporate both delinquencies and losses. The trigger assigns a lifetime default probability, or roll rate, to each loan in the pool, then multiplies the rate by the loss given default, or severity assumption - the roll rate being determined by the loan's current delinquency status and rating stresses. The pipeline loss trigger is the ratio of available credit enhancement to pipeline loss.
The CPR-based cumulative loss trigger was found to be a step-up from the vanilla cumulative loss trigger because it factors in the rate of prepayments, effectively delaying a step-down in the event of higher-than-expected prepayments. The trigger was designed to help cure the problem of "back-end" losses, when weaker borrowers are left behind in pools as stronger borrowers prepay. The CPR-based threshold is achieved by multiplying the ratio of the actual pool factor to the expected pool factor by the standard cumulative loss threshold.
The remaining triggers tested by the agency seemed somewhat less impressive. The hard delinquency trigger calculates a given pool's percent of 60-day plus delinquencies, foreclosures, REO and bankruptcy. The trigger was found to do a good job of preventing downgrades from stepping down, but it inhibited the step-down of upgrades. The net excess spread trigger, based on net excess spread after losses, was found to be relatively volatile.
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