Standard & Poor's placed 1,196 tranches in 129 re-REMIC transactions on watch for possible downgrade.

The reason for placing deals on watch stems from S&P improperly structuring interest cash flows in deals that pay interest on a pro-rata versus sequential basis. According to a report from Barclays Capital analysts, the action was motivated not by a rise in loss expectations, but were mostly a result of the potential for interest shortfalls.

Around 70% of the bonds were re-REMICs from 2010, 15% from 2009 and the rest from earlier vintages, Barclays reproted. A big majority — around 90% — of these are backed by prime or Alt-A, with small percentages (roughly 6% each) backed by option ARM and subprime.

"The impact on prices will depend on how many bonds are downgraded and how steep the downgrades are," explained Scott Buchta, head of investment strategy at Braver Stern Securities. "Many of these bonds are rated only by S&P so the impact could be significant if the cuts are severe enough."

Barclays Capital analysts examined whether investors should be concerned with the rating agency's action. According to analysts, the bulk of the ratings watch negatives related to 2010 re-REMICs. They said that it is extremely hard to break 2010 re-REMIC super seniors looking at it from a credit perspective.

The same is true, analysts said, for many of the second half 2009 re-REMICs. There will be a number of downgrades on 2008 and even early 2009 super seniors just as a result rating agency changes in loss assumptions since issuance.

But, Barclays analysts said that yesterday's list did not raise any questions in terms of the bonds' credit-worthiness from the point of view of principal payments. Instead, it zeroed in on the potential for interest shortfalls. It is not clear, Barclays said, how S&P will stress these bonds for interest shortfalls and what the stresses applied for each rating category will be, they said.

In the report, analysts looked at ways where the interest shortfalls can happen for super senior re-REMICs as well as the factors that lessen the risk somewhat.

According to Barclays analysts, the significant rate reduction modifications on loans in underlying pools can lessen the interest cash flow over time. Modification rates have been much higher in weaker credit sectors including subprime. But, the bulk of re-REMICs are on Jumbo/Alt-A underlyings, for which modification rates have been much less and are not likely to pick up considerably.

Additionally, they said that the P&I is commingled on many of the fixed-rate underlying bonds. Any reduction in interest cash flows, they said, will have a negligible impact on them, as some principal from the pool will get diverted to make up for any interest shortfall on the underlying super-senior.

Barclays said that another reason for potential interest shortfalls could be stop advances on delinquent borrowers by the servicer. Like modifications, this would impact the weaker credit sectors more, as advances are a bigger part of their cash flows. Jumbo and Alt-A, on the other hand, are less likely to experience stop advancing and should be less affected.

To the extent P&I is commingled, there should be a negligible effect on re-REMICs of fixed rates and even hybrid WAC pass-through underlyings.

In terms of the massive rate spikes that could cause shortfalls on floater re-REMICs, analysts said that a spike in short rates could cause a problem. They expect that most of these will be backed by floating rate underlying bonds that would lessen some of the risk. In cases where the underlying has high modifications levels, particularly from subprime and option ARMs, analysts could still expect shortfalls.

In other words, Barclays analysts said it is hard to predict the eventual downgrades unless S&P's methodology to stress interest cash flows becomes apparent.

That said, they said that to the extent downgrades happen and cause meaningful downward pressure on prices, analysts suggested buying super senior re-REMICs. On a fundamental basis, at 175 to 200 basis points over swaps, these are still more attractive compared with much more negatively convex agency MBS/new issue triple-As, analysts said.

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