Deal performance in the Australian structured finance market had been less favorable in the second quarter of 2003 then the first quarter, according to Standard & Poor's in reviewing the methodology. In fact, in the second quarter the market experienced 10 downgrades. S&P mainly attributed these to rating actions on four counterparties, adding that the underlying collateral performance remains strong.

The basis for the seven residential mortgage-backed securities downgrades in the second quarter was attributable to the exposure to Royal & Sun Alliance Lenders Mortgage insurance Ltd (RSALMI). Following the financial strength and counterparty ratings downgrade of RSALMI to A-' from A+' on May 22, 2003, the RAMS Mortgage Corp Ltd Series 6E, 7E, 8,9,10,11 and RMS Trust 2002-1 subordinated bonds were lowered to A-' from AA-' on June 3.

In August, a ratings review on RMBS deals insured by GE Mortgage Insurance Pty (GEMI) concluded with S&P affirming the ratings on the senior and subordinated tranches of RMBS deals with exposure to GEMI. These RMBS deals were put on review after S&P placed GEMI on CreditWatch in late June. GEMI has a AAA' financial strength and counterparty credit rating.

The type of insurance provided by RSALMI and GEMI is referred to as lenders mortgage insurance (LMI), which was introduced in Australia in 1965 to cover lenders against losses on loans secured by mortgages. The ratings on Australian RMBS have taken into account the credit enhancement provided through LMI.

Transactions also usually require further enhancement to reach a AAA' rating

on the senior securities, usually achieved through a subordinated class of notes. Consequently, the standard prime RMBS structure in Australia consists of two classes of securities, senior-ranking securities rated AAA' and subordinated securities rated either AA-' or AA' (depending on the rating of the mortgage insurers).

However, as a result of the rating action taken on the tranches of RMBS with exposure to RSALMI, S&P will no longer automatically downgrade a RMBS subordinated tranche on the basis that a mortgage insurer is downgraded by S&P.

In the case of the Australian RMBS affected by the rating action on GEMI, S&P recalculated the credit support for the AAA' rated securities based on the current loan pool characteristics to assess the amount of additional credit support needed to avoid placing them on CreditWatch negative. S&P gave 75% credit at the AAA' rating level to the mortgage insurance provided by GEMI, rather than the 100% assumed at the time the securities were issued.

The review of the RMBS transactions with exposure to RSALMI came to the conclusion that there was no effect on the senior tranches of Australian RMBS with exposure to RSALMI. But for the subordinated tranches, S&P recalculated the level of credit enhancement required to support the AA -' ratings. S&P gave the A-' rated RSALMI policies 75% credit at the AA-' rating level.

"The rating action on two mortgage insurers Royal & Sun Alliance (RSA) and GE Mortgage Insurance (GEMI) prompted a review of RMBS deals that were insured by those entities," said Gary Tucker at Standard & Poor's. "We therefore went through a loan-by-loan analysis of the pool characteristics of the transactions, and looked at the credit support required for the securities. We looked at the percentage of the loans in the mortgage pool that were insured by either RSA or GEMI. We assessed the status of each loan in the pool including the loan-to value ratios and seasoning of each loan in the pool for each transaction. As we went through this credit assessment of determining the level of credit support available in the RMBS tranches, including the level of excess spread available in the transaction, and if excess spread of at least 25 basis points was flowing in the transaction, then we came to the conclusion that this would be able to support the securities."

"We also took account of the additional credit support present on some of the deals, such as the cash reserves already present in the transaction," Tucker further explained. "Further, in some cases, additional cash injections or guarantees were made available."

The result was that, for each RMBS transaction insured by GEMI, a combination of one or more of the factors discussed above provided sufficient credit support to avoid placing any AAA' rated Australian RMBS on credit watch negative.

While in the case of Royal & Sun Alliance, (as already mentioned) all deals were affirmed, aside from the RAMS Mortgage Corp Ltd series 6E, 7E,8,9,10,11 and RMS Trust 2002-1 class B bonds which were downgraded from AA-' to A-'.

Following the downgrade of the mortgage insurer RSALMI, there was some concern in the market that all the subordinated RMBS bonds with exposure to RSALMI would also be downgraded. However, in the end, the only subordinated bonds that were downgraded were those under the RAMS program. "Nevertheless, the uncertainty surrounding RSALMI and the potential pressure on the sector did cause the subordinated debt to widen. Spreads moved from the lows of the beginning of the year of around 70 basis points over Bills to the current levels of 90 basis points over Bills," said Ben Metcalfe, director, credit and ABS trading, at ABN AMRO.

In a research report, ABN AMRO concluded that the recent revision to the ratings methodology would be a positive for RMBS, and, among other things, pointed to reduced ratings volatility, providing additional support and further tiering.

One market participant commented that this methodology change could indicate a move away for S&P from the weakest link approach, but Tucker at S&P said, "While the weakest link rating approach underpins our methodology, we also look at the transaction for what it is, and recognize all the features of the transaction."

"In this case, it was giving credit to the excess spread present in the deal," he added.

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