Abridged from Market TABS by Rod Dubitsky and Neil McPherson, of the securitized assets research group at Credit Suisse First Boston
In the first quarter of 1997 ContiMortgage ushered in a new era in the subprime home equity market by issuing the first senior/sub deal backed by subprime home equity loans. Most subprime home equity deals issued before Conti 1997-1 were insured and did not have any rated subordinated classes. Furthermore, the structure of Conti 1997-1 largely served as the template for many future subprime deals to come. One of the key features of Conti 1997-1 as well as most other senior/sub subprime deals is that credit enhancement may be reduced or "step down" if certain tests are satisfied. The ability of a deal to step down depends on the satisfaction of certain performance tests or triggers. Stepdown rules can have a significant impact on the average lives of subprime home equity bonds.
Many of these deals have or will soon reach their stepdown dates. While the stepdown criteria is fairly similar in most of these deals, subtle and not-so-subtle variations render comparisons difficult. The purpose of this article is to describe how the triggers for the 1997 senior/sub deals work, the impact of the triggers on the cash flow allocation and the average life of the bonds and finally to discuss the status of the stepdowns for a number of 1997 deals.
Structural Overview of Senior/Sub Deals
While there are many variations across deals, the following basic elements are part of nearly all senior/sub subprime home equity deals:
Excess Spread: the difference between the coupon on the loans and the coupon to the bondholders, is available for credit support. Most subprime transactions use excess spread to create overcollateralization and to absorb losses. Overcollateralization is created by paying excess interest as principal to the senior bondholders (this is also known as "turboing"). The excess interest payments result in a faster decline in the balance of the bonds relative to the balance of the underlying loans. This causes the balance of the loans to exceed the balance of the bonds. This excess is overcollateralization.
Overcollateralization: Overcollateralization (OC) typically builds to a specified level, after which excess spread that is not used to absorb losses will be paid out to the most junior class, typically the residual holder (usually, but not always, the issuer).
Principal payments before stepdown date: All principal payments are paid only to the senior bondholders until the "stepdown date".
Stepdown Date: Subprime deals may generally step down the later of (1) 36 months of seasoning and (2) the date by which the current senior credit support percentage has doubled relative to the original credit support percentage.
Principal payments after the stepdown date: Once the stepdown criteria have been satisfied, principal is allocated in a manner that provides 2x the original credit support percentage. The satisfaction of other performance triggers will also determine whether credit support can be reduced.
Performance Triggers: Performance triggers are typically based on 60+ delinquencies and, less commonly, losses. Failing performance triggers will result in the diversion of cash flow from junior certificateholders to more senior certificateholders. Generally, the failure of a trigger will result in scheduled and unscheduled principal payments going to the senior bondholders until the trigger is cured.
Key Elements Of Subprime Home Equity Stepdown
Stepdowns are typically subject to three types of criteria: (1) aging criteria, (2) credit enhancement requirements and (3) performance triggers. Each of these will be discussed in turn.
Minimum Aging Criteria
Most senior/sub subprime deals require at least 36 months of seasoning prior to stepping down. The rationale behind the 36-month stepdown relates to the seasoning pattern of subprime mortgages. The 36-month period reflects a period of time sufficient to observe the performance of the underlying mortgages. Loss and delinquency curves for subprime home equity loans generally peak around three years of seasoning. If the stepdown date were to occur too early in the loss curve, credit support may be prematurely released.
Credit Enhancement Requirement
Before a deal can step down, the credit enhancement percentage is typically required to be a multiple of the original credit support. The multiple is generally 2x the original credit enhancement percentage. In addition, credit enhancement criteria are applied individually to all classes, grouped by rating level (e.g., they apply to all triple-As, double-As, etc. as a group) - before any class will receive principal, the more senior classes need to have their own required subordination.
Performance triggers serve a role not unlike that of traffic cop: they determine when it is safe to step down, i.e. reduce the amount of credit enhancement. Performance triggers are typically based on losses and delinquencies. While delinquencies and losses are both used in performance triggers, delinquency triggers are far more common in senior/sub subprime home equity deals. In addition, loss triggers, where present have a secondary impact on the cash flow allocation (see below). It is important to note that triggers can oscillate between passing and failing from month to month as performance and credit support levels change.
What Are Typical Performance Triggers?
The following are the most common trigger events:
* 60+ delinquencies exceed 50% of the senior credit enhancement for fixed-rate mortgages. Put another way, in order to pass a trigger test, credit enhancement must be at least 2x 60+ delinquencies.
* 60+ delinquencies exceed 40% of the senior credit enhancement for adjustable-rate mortgages. (i.e. credit enhancement must be at least 2.5x 60+ delinquencies).
Loss triggers are less common in the 1997 senior/sub home equity deals and typically only affect the stepdown of the residual class. Relative to delinquency-based triggers, loss triggers have a secondary impact on senior/sub home equity deals. Specifically, the failure of a loss test generally results in the freezing of the overcollateralization and/or the stepup in overcollateralization.
Senior Credit Support Defined In Multiple Ways
As mentioned, a trigger test fails if delinquencies exceed a specified percentage of senior credit support. While relatively simple on the surface, the definition of "senior credit support" can vary from deal to deal. The definition of senior credit enhancement can take on two general forms:
Senior Specified Enhancement (SSE) %: Credit enhancement is sometimes specified as a multiple of original credit enhancement - generally 2x (original subordination percentage plus original OC target percentage). In this variation, for example, if the initial subordination is 10% and the OC Target is 2%, the SSE would be 24%. In this example, a delinquency test for fixed-rate collateral would fail if 60+ delinquencies exceeded 12%.
Senior Enhancement (SE) %: In this variation, delinquency triggers are expressed as a function of actual senior support at the time of the stepdown.
The distinction between these two triggers is most relevant at the first stepdown date. This is because actual support (SE) may be much higher than the specified support (SSE) at the stepdown date. After a deal has completely stepped down, the SSE will be equal to the SE. This results from the paydown rules, which allocate principal in a manner that reduces the actual senior credit support (SE) to an amount equal to the SSE.
Delinquency triggers based on SSE will fail at a lower level of delinquencies than triggers based on SE. This is the case since credit support needs to be at least equal to SSE before a deal can step down. Therefore the only time a delinquency test would come into play is when the credit enhancement criteria is satisfied. Therefore the SE must always be greater than or equal to SSE - otherwise the deal can't stepdown anyway and the delinquency test is irrelevant.
Where Have All The Seniors Gone?
For some deals, if the senior bonds have paid off, the performance tests are ignored and principal is allocated as if the trigger tests are satisfied. For other deals, the trigger test may still be in effect, but the importance of the triggers may be diluted depending on the definitions used. Many of the 1997 deals, for example, define senior credit support as equaling the "subordinated bonds" divided by the collateral balance. Very often the subordinated bonds are defined based on the deal structure at closing. If this is the case, once the senior bonds have paid off, the senior credit enhancement formula will equal 100%. This results from the fact that after the senior bonds have paid off, the subordinated bonds, as defined, will equal the collateral balance.
Impact at the Deal Level
One part of the equation in analyzing stepdowns and triggers is how they are measured. The other part of the equation is: what happens when the stepdown occurs or a trigger fails. What we mean here is: how do the triggers and stepdowns affect the cash flow distribution?
The general impact of failing a trigger or stepdown test is to divert cash flow from junior bondholders to more senior bondholders. The effect of failing a trigger in most subprime deals is to divert all principal payments to the senior bondholders, thus shortening the average lives of the seniors and lengthening the average lives of the junior bonds vs. the expected case. However, many subprime deals have multiple triggers. While evaluating these triggers can get confusing, two general rules apply:
1. Most delinquency triggers will result in all principal being allocated to the senior bonds.
2. Most loss triggers will result in an increase or freezing of the OC requirements.
Impact at the Tranche Level
While it is interesting to see the impact that triggers have at the deal level, investors buy specific classes not deals. Therefore the impact of stepdowns and triggers on particular tranches is where the rubber meets the road. While the impact of triggers on individual classes varies by deal the general rule of thumb is that failing a performance trigger will shorten the senior bonds while at the same time lengthening subordinated classes.
Status and Description of 1997 Deals
Credit Suisse First Boston reviewed the status of 41 separate pools from 1997-senior/sub subprime home equity transactions. Though most of the 1997 deals reviewed are currently passing their triggers, many deals may not step down completely as the triggers are likely to be hit before the deal fully steps down.
The following observations can be gleaned from the analysis:
* Nearly all of the 41 separate loan groups we reviewed (about 95%) are satisfying their credit enhancement criteria.
* About 85% by number of deals we evaluated are currently passing the primary delinquency trigger tests.
* About 65% of the deals we evaluated are expected to pass the triggers throughout the stepdown, down from the 85% that is currently passing. In other words, the delinquency trigger is expected to fail before the transaction steps down the maximum permitted amount.
One of the more challenging aspects of analyzing subprime mortgage deals is the evaluation of triggers and stepdown criteria. While the presence of triggers is a zero sum game to all securityholders, the confusion relating to the understanding of the triggers detracts from the liquidity of the sector as a whole - this hurts all participants. By outlining the specific components of triggers and stepdowns, this article provides a framework for analyzing and understanding structure in senior/sub subprime home equity deals.