The credit ratings of RMBS continued their stalwart performance during the first half of 2002, with a stunning 362 upgrades and only 15 downgrades. An overwhelming 88% of the upgrades originated from investment-grade credit classes, which experienced only three downgrades. Strong collateral performance contributed to all but one of the upgrades.

To compare 2002's first six-month rating performance with the one-year performance of prior years, its rating transition ratio matrix is annualized. To annualize, the matrix of six-month transition ratios by major rating category is squared; that is, multiplied by itself. The implicit assumption of squaring the six-month matrix is that the rating transition pattern of the first six months will continue for the remainder of the year.

The matrix of six-month RMBS transition ratios for 2002 is shown in Table 1. The annualized 2002 RMBS rating transition ratios are shown in Table 2.

Despite the substantial number of upgrades during the first six months, the annualized 2002 RMBS rating transition ratios were still modestly outdone by the one-year ratios of 2001. The relative underperformance of 2002 was only because all of its investment-grade credit classes experienced less frequent upgrades than 2001 did. For example, while the AA' rating in 2002 had an impressive 19.61% upgrade frequency to AAA' with no downgrades (Table 2), its 2001 counterpart enjoyed a 6.02%, or 602 basis points (bps), higher frequency of upgrades with no downgrades.

Similarly, 2002's A' ratings exhibited 369 bps (-3.93% plus 0.24%) less frequent upgrades, even though it also had 140 bps (-1.00% plus -0.20% plus -0.20%) less frequent downgrades than A' ratings in 2001. Again, the BBB' ratings underperformed in 2002 compared with 2001 with a consistently lower frequency of upgrades (-0.06% plus -5.22% plus 0.79%) and higher downgrade frequency (-0.63% plus -0.68% plus -0.23%). The performance of BB' and B' ratings in 2002 was mixed, but at least they outperformed those in 2001 by having, respectively, 70 bps and 290 bps lower default frequencies.

The annualized 2002 performance, however, was far superior to the one-year average of the 1978-2000 period. Not only did the AAA' ratings in 2002 experience no downgrades versus 23 bps of downgrades in the 1978-2000 period, but they also suffered no defaults versus the one-basis-point incidence in the 1978-2000 period. For all other ratings, 2002 generally enjoyed more frequent upgrades and endured less frequent downgrades than their counterparts did during the 1978-2000 period.

CMBS: Downgrades,

amid many upgrades

With 92 downgrades and 63 upgrades during the first half of 2002, CMBS credit ratings for the first time experienced more downgrades than upgrades. Many of 2002's year-to-date downgrades were due to the lowering of the corporate credit rating of Kmart Corp. and the resultant impact on dependent credit-tenant lease transactions as well as the deteriorating performance of the underlying real estate collateral in the lodging and health care sectors. Conversely, amortization and loan payoffs accounted for the bulk of this year's upgrades

Despite the higher frequency of downgrades, 2002's annualized CMBS transition ratios were only slightly outdistanced by those of 2001, when credit ratings performed strongly amid an economic downturn. In particular, the AAA' through A' credit classes continued to exhibit resiliency by significantly maintaining their stability or upgrade potential. As shown in Tables 3 and 4, the AAA' ratings continued to exhibit a perfect 100% rating stability. The AA' ratings showed a greater frequency of upgrades than downgrades (7.20% versus 0.60% plus 0.60%) with no defaults. Similarly, the A' ratings also exhibited a higher frequency of upgrades (0.60% plus 4.55%) than downgrades (2.04% plus 0.50% plus 0.01% plus 0.01%). Additionally, the respectable performance of the top three credit ratings in 2002 was not very far behind their strong showing in 2001.

The BBB' ratings, however, exhibited accelerating deterioration in 2002 in the upgrade-downgrade frequency compared with 2001, though with only a modest six-basis-point default ratio. Furthermore, the BB' and B' ratings fared worse in 2002 compared with 2001. Marked increases in defaults during the first six months raised their default ratios to 2.23% and 5.04%, respectively. These ratios exceeded those in 2001 by 223 and 395 bps. They were also 213 and 432 bps higher than the one-year average of the 1990-2000 period.

Securitization markets: Heightened defaults

One of the most significant credit events in structured finance securities during the first half of 2002 was the sharp increase in defaults. The ABS sector experienced an unprecedented 15 defaults, slightly more than half the total of 29 defaults recorded between inception and 2001. Similarly, CMBS witnessed a sharply increased 15 defaults, only two shy of the total defaults between 1990 and 2001. Further, RMBS recorded eight defaults (there were 94 defaults between 1978 and 2001).

While the incidences of default are unusually high for a short period, their patterns are unique. This uniqueness may ease the sense of alarm in the minds of investors. First of all, 13 of the 15 ABS defaults came from three issuers of franchise loans. The economic downturn of last year coupled with the tragic event of September 11 has devastated the businesses of franchise operators (such as national chain fast foods and gas station convenience restaurants). The other two ABS defaults came from a single retail credit card issuer that went bankrupt in 2001.

All 15 CMBS defaults had speculative-grade original credit ratings. Two of them suffered principal erosion, and the rest, interest shortfalls. Interest shortfalls were usually caused by significant declines in property value and the resultant appraisal reductions of the underlying collateral. Similarly, all but one of the eight RMBS defaults were originally rated BB' or B'. The one investment-grade default had an original rating of BBB'.

Excerpted from "Rating Transitions, First Half of 2002: Mixed Performance of U.S. Structured Finance Securities."

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