By Marjan Riggi Vice President/Senior Analyst, Moody's Investors Service
Home equity securitizations structured with step-down triggers to preserve the credit enhancement of all rated classes may be rated higher than transactions without these investor protections. In particular, Moody's uses two different tests - the delinquency test and the cumulative loss test - to ensure that investors at all levels are adequately protected.
The tests should be used in conjunction with one another. Because the delinquency test is usually calibrated to the senior class enhancement level, it may leave subordinated classes exposed. And the cumulative loss test is not as forward-looking as the delinquency test but it does protect the senior and rated subordinate noteholders in cases where the delinquency test fails to preserve credit enhancement for all rated tranches. The inclusion of both delinquency and cumulative loss tests before reducing overcollateralization and releasing credit enhancement can help to protect rated tranches before losses trend high enough to erode the classes' credit protection.
Lock-Out and Step-Down Provisions
The ratings of the different tranches in subprime home equity deals reflect the credit risk borne by investors and the amount of protection available through credit enhancement. Analyzing anticipated collateral performance relative to available credit support is the best way to assess the credit risk of a transaction.
Initial enhancement levels for senior classes are calibrated to sizes that protect those classes from large variances from a "mean loss," which essentially reflects the mortgage pool's expected performance for the life of the transaction. Therefore, if the pool's performance does not trail expectations, the original credit support may lead to a surplus of credit enhancement for the finite life of a transaction. In such a case, the typical deal structure will allow a reduction in credit enhancement after a period of usually three years (consistent with having reached peak loss rates) if certain performance criteria are met.
This is accomplished by modifying a mechanism known as the "lock out," whereby subordinate tranches are locked out of all principal payments for a fixed period of time (usually three years), with "step-down" provisions. The increase in the relative subordinate percentage in the remaining pool due to the lock out protects the senior classes from credit losses during peak loss years. After the step-down date, however, if the pool passes certain performance tests or "triggers," the subordinate tranches could begin to receive principal payments. In this way, current credit enhancement after the step-down date will more accurately reflect the performance and risks of a transaction until its final payment.
Loss and delinquency triggers protect deals in different ways. Deal performance measures used for the step-down test vary from deal to deal. Typically, subprime deals have a delinquency test, where current credit enhancement levels are measured against seriously delinquent loans. Less typical are loss tests, where cumulative losses are measured relative to credit enhancement or initial loss expectations. Moody's has been proactive in distinguishing the credit risks of deals with solid loss and delinquency triggers from those with merely the traditional senior class delinquency test.
The Delinquency Test
For typical subprime structures (fixed-rated mortgages and adjustable-rate mortgages), a pool passes the delinquency test if total delinquencies (60+ days delinquencies, real estate-owned, and foreclosures) are less than roughly half of the total current enhancement. This feature could extend the three-year lock-out period, protecting rated classes from the possibility of higher losses to the extent they can be predicted in advance from the trend in serious delinquencies. However, as the following example illustrates, this form of delinquency test is usually calibrated to the senior class enhancement level so, while it protects the senior classes, it may not always be beneficial for the subordinates.
Case 1: Deal Structure at Closing
Column 1 is the base case, where a Aaa rated class of $80 is issued against a pool of $100 in mortgages.
Case 2: Step Down Appropriate for Seniors and Subordinates
Column 2 is the base case at the step-down date, where $60 of prepayments have reduced the size of the Aaa rated class to $20, and $1 of cumulative loss has reduced the unrated class to $4. The serious delinquencies at this stage are $8. In this case, because the total Aaa rated enhancement is greater than double the amount of delinquencies (8 x 2 15 + 4), the Aaa rated class is amply protected from future losses because it now has nearly 49% of credit enhancement behind it. Therefore, the deal can now afford to allocate principal payments to subordinate tranches as long as the delinquency test ratio is maintained. The Baa class is also reasonably well protected because its share of enhancement has also doubled to 10% from 5%, although its subordinate tranche has suffered a $1 loss.
Case 3: Delinquency Test Protects Seniors, Not Effective for Subordinates
Column 3 illustrates the same prepayment and delinquency amounts but with higher cumulative losses ($4). In this case, although the delinquency test will pass (8 x 2 = 15 + 1) and the Aaa rated class is still well protected, the mezzanine class is left with only an inadequate $1 of protection to sustain $8 of pipeline delinquencies.
In addition, in certain structures where delinquencies are charged off at 180 days, the delinquency test is not meaningful because there is never enough build-up of delinquencies to predict anticipated performance. This usually applies to deals backed by home equity lines of credit or closed-end second loans.
The Cumulative Loss Test
Moody's proactively makes positive rating distinctions for deals with cumulative loss tests. These require that principal can only be released to subordinate tranches as part of a step down if certain cumulative loss levels have not been reached. These tests work better at protecting the subordinated tranches by preventing subordination leakage if losses trend high enough to erode protection behind the lowest rated class.
The loss test triggers are generally linked to the subordination levels for the lowest-rated class, the level of losses experienced, and the timing relative to the anticipated loss curve. Currently, the most common way to do this is to have the step-down test fail if cumulative losses trend higher than required loss coverage levels for the lowest rated tranche, perhaps with an additional cushion. In this way, the lowest rated tranche is better protected if losses drift higher than expectations.
In Case 3 of the example above, the cumulative loss test will ensure that at least the $1 protection left behind for the mezzanine class is not released. If that deal only had the delinquency test, the mezzanine class would be in a worse position.
While the cumulative loss test is not as forward-looking as the delinquency test, it does serve to protect the holders of both the senior and rated subordinate notes from instances where the delinquency test fails to preserve credit enhancement for all rated tranches. The loss test is also beneficial for transactions where misreported delinquencies or extensions could lead to inappropriate step-downs. By having both the delinquency and the cumulative loss tests in transactions, all rated classes are better protected from worse-than-expected performance.