Zoe (Jinyang) Wang, analyst; Julia Tung, vice president and senior analyst, Moody's Investors Service

There were 261 rating changes between January 1, 2005 and March 31, 2005, affecting roughly $9.0 billion in securities issued. Overall rating change activity decreased more than 27% from the previous quarter due to a 51% decline in the number of downgrades (135 for $6.5 billion).

Meanwhile, the number of upgrades (126 for $2.5 billion) increased by 53% from the previous quarter. This is the first time since the third quarter of 2003 that the total number of rating changes in a quarter fell below 300, and the first time since the fourth quarter 2001 that the ratio of downgrades to upgrades was roughly one.

CDOs Regain Lead in Downgrades

The CDO sector regained the lead in downgrades for the first time in two years and accounted for 54% of all asset-backed downgrades in the first quarter of 2005. In terms of absolute number, however, CDO downgrade activity actually decreased from 82 downgrades in fourth quarter 2004 to 73 in first quarter 2005 and remains well below the peak number of quarterly CDO downgrades (260) reached in second quarter 2002. As in the past, the CDO downgrades were generally associated with deterioration in the credit quality of the underlying portfolios.

The home equity sector, which has appeared frequently on the downgrade list, claimed the second-largest share of downgrades (25%) in the first quarter. The 34 downgrades were all caused by weaker than expected performance of the underlying loans.

There were ten downgrades of securities backed by small business loans in the first quarter. Prior to 2005, there had been only 29 downgrades in this sector. All of the affected securitizations were originally sponsored by First International Bank, now renamed UPS Capital Business Credit.

Similarly, all five downgrades in the equipment lease sector involved transactions from one issuer, DVI Financial Services, Inc. Since DVI's filing for Chapter 11 bankruptcy protection in August 2003, Moody's has downgraded these deals several times. The latest rating actions reflect under-collateralization of the outstanding notes, high obligor concentrations and lower obligor credit quality in the remaining asset pool, and uncertainty regarding future recoveries on defaulted receivables.

There were five downgrades in the manufactured housing sector in the first quarter, more than 95% below the previous quarter's figure and the lowest number of manufactured housing downgrades since the first quarter of 2001. The significant drop in manufactured housing downgrades is the main reason for the reduced asset-backed security downgrade activity in the first quarter.

Three classes of notes from Scotia Pacific Company were downgraded due to concern over continued weak cash flow from timber operations. This marks the first time a timber collateralized transaction has appeared on the downgrade list.

Rounding out the downgrade list were four downgrades of securities backed by aircraft leases and one downgrade of a security backed by floorplan receivables. The floorplan downgrade was not performance related and will be discussed in the next section.

Through December 2004, downgrade activity, excluding tobacco-related deals, was concentrated in the CDO (40.1%) and manufactured housing (27.5%) sectors.

Weak Performance Drives Downgrades

All but 3 of the 135 downgrades (97.8%) in the first quarter were caused by poor performance of the underlying collateral. This compares to prior experience when weak performance was a factor in 81.4% of non-tobacco downgrades.

Moody's downgraded two Class B Notes issued by Cypress Tree Investment Partners II, Ltd. following commencement of a liquidation of the transaction initiated by the Class B investors after the senior class of notes was retired. While a significant proportion of the collateral pool has already been liquidated and used to partially pay down the Class B Notes, the liquidation exposed the remaining balance owed to the Class B Note holders to increased risk.

The downgrade of the Class A Notes from MMCA Wholesale Master Owner Trust II, Series 2003-2 was prompted by the continued uncertainty surrounding Mitsubishi Motors Corporation's (MMC) franchise in the U.S. Because the floorplan receivable notes, which finance MMC dealer inventories, are ultimately repaid from the proceeds of vehicle sales, the strength of MMC's franchise in the U.S. is important to the credit quality of the transaction.

Manufactured Housing Sector Tops Upgrade Activity

There were 126 upgrades in the first quarter of 2005, up more than 50% from the previous quarter. The increase in upgrades can be attributed to activity in the manufactured housing sector, which had the most upgrades of any asset type in the first quarter.

The last time the manufactured housing sector led upgrade activity was in fourth quarter 1999. All 62 upgrades were related to securities issued by Vanderbilt Mortgage and Finance Inc. and none were related to collateral performance. Slightly more than half of the upgrades occurred in February 2005 and were prompted by Moody's upgrade of Clayton Homes, Inc., the corporate parent of Vanderbilt, which provides corporate guarantees to the certificates affected by the upgrades.

In March, another group of Vanderbilt certificates that are backed by adjustable rate mortgages were upgraded as a result of a build-up in credit enhancement. These securities have benefited from the low interest environment.

The home equity sector was also a large contributor to the upgrade list with 50 upgrades in the first quarter. Together with the manufactured housing sector, these two sectors accounted for more than 85% of all upgrades from January to March.

Unlike the manufactured housing upgrades, the home equity upgrades were spread across a number of different issuers. All of these rating actions were due to a build-up in credit support.

Upgrade activity in the CDO sector continues to be limited. There were six CDO upgrades in the first quarter, one fewer than the seven that occurred last quarter. Five of the six CDO upgrades were due to a build-up in credit enhancement.

There were eight upgrades in the "other" category, including seven equipment lease/loan deals and one truck deal. All but one of the securities in the "other" category were upgraded because of better than expected performance of the underlying collateral.

Most upgrades through December 2004 occurred in the home equity (21.3%), auto (20.7%) and manufactured housing (15.9%) sectors. Prior to January 2005, a build-up of credit enhancement was the leading cause of asset-backed upgrades (49.5%) with strong performance as the second major contributor (25.8%).

Outlook: Rating Activity Dependent On Securities Under Review

Upgrade activity has been increasing since 2003 and it will be interesting to see if this trend continues for a third year. Already, the number of upgrades in the first quarter of 2005 equals more than 50% of the total number of upgrades in 2004.

Meanwhile, the first quarter of 2005 was a quiet one in terms of downgrades, helped by a slowdown in downgrade activity in the manufactured housing sector and the lack of new developments in the legal case surrounding the tobacco settlement-related securitizations. However, this trend may reverse itself later in the year should rating actions be taken against the numerous credit card securities currently under review.

On April 13, 2005, Moody's placed 48 classes of certificates issued by the Discover Card Trust under review for possible downgrade following the announcement by Morgan Stanley that it may pursue a spin-off of its subsidiary, Discover Financial Services.

In addition, all the municipal tobacco-related transactions remain under review with direction uncertain. As a result, the level of future downgrade activity is uncertain and will depend on actions taken on the asset-backed securities currently under review.

Copyright 2005 Thomson Media Inc. All Rights Reserved.

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