NEW YORK - At the Bond Market Association's annual meeting held here last week, rating agency representatives discussed how both prime and subprime borrowers are increasingly moving into alternative mortgage products that have a future payment adjustment such as hybrid mortgages, IO loans and option ARMs - innovations that have thus far supported the housing market, but have some negative credit implications. Attendees also gave their outlook on the housing and commercial real estate sectors.

With little history backing these new affordability products, panelists said that it has become a challenge to model or predict borrower behavior. However, they also acknowledged that these products are starting to become a significant part of the housing market.

Rating agency analysts said that the housing industry is driven by supply and demand fundamentals. Jay Siegel, managing director at Moody's Investor Service, said that affordability products such as 100% LTV, hybrid ARM, IO, negative amortization, and no income verification loans, qualifies borrowers for mortgages they previously couldn't. The market has also seen more credit-impaired borrowers fuelling housing demand. In this market, even first-time homebuyers are entering the Jumbo sector, as many of them actually qualify for half-million dollar loans. He also noted the looser guidelines for investor-owned properties, which can comprise up to 20% of certain mortgage pools or even 100% of some sub pools. The risk, Siegel added, is that some pools could have multiple loans to the same borrower, increasing exposure to a single borrower default.

Siegel said the challenge in looking at many of the affordability products is the limited performance history, thus, estimating the credit risk for pools containing affordability products is, "part art, part science," he said. For instance, in projecting IO loan performance over time, Moody's has synthetically re-created the behavior of non-amortizing loans, and applied a payment shock to it in different scenarios.

Scott Seewald, managing director at Fitch Ratings, stated that since there is very limited data on IO loans, to approximate the borrower behavior for this product, Fitch has drawn parallels with the way hybrid ARM borrowers react to interest-rate payment shock. Fitch also looks at the criteria by which lenders qualify borrowers. Fitch looks to see if lenders qualify borrowers based on the teaser rate alone, or the full principal and interest payment on their mortgage. Fitch also determines whether the loans have a two-, three-, five- or ten- year interest only period. The rating agency perceives additional risk associated with loans that match up the interest rate reset and the end of the interest only period. In that scenario, the borrower experiences both interest rate and principal payment shock. This is typically seen in the two- and three- year IO loans. Analysts look at the margins on these loans to determine how much interest the borrower has to pay and the parameters under which the loans were underwritten in terms of LTV and FICO scores.

The discussion also touched upon the credit outlook for both the RMBS and CMBS markets, specifically in a rising rate environment. Expectations are for a gradual slowing of the housing market although nobody thinks that there would be a national housing bubble bursting, but merely anticipate regional weakness.

Seewald discussed Fitch's general outlook for the housing market based on a 100 to 150 basis point rate hike and stable employment picture. Seewald said that under this scenario, coastal housing markets would likely outperform the national average while interior regions would underperform. In 2006, there will be a convergence of house price appreciation across regions with 3% to 4% growth rate. In 2007, Fitch expects the national numbers to be slightly positive at 1% to 2% with coastal regions underperforming the interiors. However, Seewald clarified that Fitch bases its market value decline assumptions on the worse case scenario, specifically interest rates rising greater than 150 basis points and severe economic conditions. Fitch analyzes historical price movements in each region, considering how volatile the markets are and whether a region is overheated or not. Triple-A enhancement levels for tri-state area housing would range from a 55% to 76% market value decline while Midwest regions - where there is less market volatility - would probably be set at the 35% level.

In terms of the CMBS market, the rating analysts warned that although the sector has enjoyed a good run so far, they said that the looser underwriting standards, increased leverage and refinancing risk in recent deals are prompting them to urge caution on the sector.

Copyright 2005 Thomson Media Inc. All Rights Reserved.

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