With the current recessionary environment, people on the Street are starting to question the lowering of subordination levels by the three rating agencies on jumbo RMBS deals.

In a recent UBS Warburg report, analysts studied whether the reduced subordination levels in the jumbo arena are still appropriate given the higher level of losses expected, especially in light of the recent statement from the Mortgage Bankers Association that total mortgage delinquencies in the third quater went up to 4.87%, which is the highest it has been since the third quarter of 1991.

The article pointed to the irony that just as the economy is slipping into a recession, rating agencies still continue to lower credit enhancement levels. Analysts said that though BBB and BB classes seem relatively safe despite the decrease in the levels, the yields for B and unrated pieces might be adversely affected in a recessionary scenario.

UBS said that the rating agencies have given sound reasons for lowering the levels, such as the current superior underwriting standards and the fact that Alt-A loans are starting to be put into separate Alt-A pools.

They added, however, that the lowering of subordination levels may actually be driven by rating agency competition.

Through a chart, they showed that through the mid- to late- 1990s Moody's Investor's Service had a smaller share of the jumbo market compared to Fitch and Standard and Poor's. But a shift was seen this year, as Moody's market share started to rise. This is probably because last year Moody's changed its RMBS rating approach and became more aggressive in its pricing.

According to an MBS analyst who is not from UBS, "There has been some rating agency competition driven basically by two rating agencies up at the top but only one on the subs." (See story on p. 1)

Are LTVs and FICO

scores reliable?

Separately, a report from Nomura Securities stated that, "We believe that the reductions in credit enhancement levels are difficult to justify based on the reportedly improving credit characteristics of the underlying mortgage loans."

According to Nomura, the decline in triple-A subordination levels was apparently largely based on lower loan-to-value ratios (LTVs) as well as higher FICO scores.

However, the problem is these measures might not reflect the true risk in rated RMBS deals.

Nomura said that lower LTVs would suggest lower risk. But this is usually associated with a spate of rapid home price appreciation. Nomura stated that this makes an argument for taking the numbers "with a grain of salt" because only time will tell whether home prices will continue to trend up.

Analysts added that rapid refinancing activity warrants another grain of salt. The spike in refinancing, they said, means that the basis for determining the value of LTVs would be appraisals - which is not really an exact science - as opposed to arms-length trasactions.

Aside from these, analysts pointed out that the relationship between credit risk to LTV is not linear.

They concluded that the continued decline of credit enhancement levels has made newer MBSs more risky than older MBS. This is why it becomes more important to distinguish between issuers nowadays. Nomura cited Cendant and Wells Fargo as examples of issuers who consistently produce good deals.

"The nugget of our argument is, consistency matters here," said Mark Adelson, a director at Nomura. "Sticking with the players who can produce consistently good performance with no surprises is what investors should focus on."

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