During 1999 and the first half of 2000, the ABS market has grappled with severe credit difficulties among issuers of subprime residential mortgages. Not only have senior-subordinated deals issued by the weakest firms suffered from genuinely higher credit risk, but even senior tranches of "wrapped" (insured) deals have seen their spreads widen due to the market's judgment of "guilt-by-association." Tiering among various issuers has become pronounced: triple-A-rated tranches of deals issued by financially distressed companies trade roughly 20 basis points behind similar tranches from financially strong issuers, such as Equicredit Corp. and Saxon Mortgage Corp. Nonetheless, within the wide variety of available issues, good investment values can be found.

Higher defaults rates by weaker mortgagors and faster prepayment rates by stronger mortgagors in subprime pools than had been expected at issuance set off this turmoil in the subprime market. With the debt service burden of all consumers at a 12-year high in the first quarter, it is not surprising that the more marginal customers of these subprime lenders have had trouble meeting repayment schedules. At the same time, borrowers who do maintain their payment schedules are often offered the opportunity to refinance at a lower rate. While this is attractive for the borrower, it reduces issuers' cash flow, forcing some to file for bankruptcy protection. The bankruptcy itself causes further deterioration in servicing performance as staff morale and commitment decline, diminishing efforts at collection on slow-paying loans and worsening the default rates. In other instances, troubled issuers have been taken over by healthier institutions.

The performance of distressed subprime issuers varies considerably. The United Companies Financial Corp. (UCFC) and ContiMortgage deals experienced much higher delinquencies and larger default losses over the past year than has been normal for the subprime sector. Other distressed issuers such as Conseco Finance Corp. and Delta Funding have experienced milder losses, although still higher than the strongest issuers, like Saxon and Equicredit.

The weakest performing issuers, including UCFC and Conti, are transferring their servicing to stronger firms as part of the bankruptcy resolution process, UCFC to EMC Mortgage Corp., a subsidiary of Bear Stearns, and Conti to Fairbanks Capital Corp. Rating agencies have commented favorably on both these sales. In each case, the sales are likely to improve the long-run credit performance of UCFC and Conti deals. In the next six months, however, the large volume of severely delinquent loans is likely to accelerate credit losses. Even the strongest servicing performance is not usually sufficient to make severely delinquent subprime mortgagors current on their loans. In fact, the best subprime servicers often speed the foreclosure process in order to maximize recoveries net of expenses.

The risks to investors in subprime deals issued by distressed firms depends on both servicer performance and deal structure. With the unexpectedly high default and prepayment rates, spreads have widened, especially for deals of the most financially distressed firms. However, it also seems to us that ABS market participants have over-reacted in marking down deals of distressed issuers backed ("wrapped") by bond insurance.

No matter how poor the credit performance of the collateral, insurance guarantees timely payment of interest and ultimate payment of principal for wrapped securities. For insured securities, the ratings depend primarily on the rating of the insurer. Only if the bond insurer is downgraded does the credit performance of the collateral matter. Thus, senior tranches of wrapped deals do not represent significant credit risk to investors. Indeed, all of the credit downgrades and other recent expressions of rating agency concern have been directed at senior-subordinated rather than insured deals. For example, as ContiMortgage's 97-1, 97-2, and 97-3 deals were downgraded, the rating update made clear that there was no threat to the credit quality of the senior tranches of similarly performing but insured deals, such as Conti 97-4.

Since the beginning of 1997, about 55% of subprime issuance has been structured with bond insurance rather than senior-subordinated, so there is a substantial supply of insured bonds issued by distressed entities.

Summary

The insured tranches of deals with weak collateral performance and financially distressed issuers have cheapened as the ABS market turned negative on the distressed names generally. These tranches are offered roughly 20 basis points wider than comparable bonds of strong issuers, such as Saxon and EquiCredit. Given the financial strength of the bond insurers and the solidity of their triple-A ratings, these wrapped tranches represent excellent long-term value. By contrast, the wide spreads on senior-subordinated tranches of similar deals represent approximately fair compensation for the heightened credit risk of these securities relative to their better performing counterparts.

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