[By Doug French, with Frank Raiter, Susan Barnes, Gail McDermott, Terry Osterweil, Michael Stock, and Thomas Warrack, analysts, residential mortgages group, structured finance ratings, Standard & Poor's Ratings Services]
The U.S. residential mortgage-backed securities (RMBS) market is expected to remain healthy throughout 2000, but it is unlikely to revisit the record loan origination levels achieved in 1998. The prospect of more interest rate hikes by the Federal Reserve in 2000 will continue to pressure these originations, which will probably not reach the US$1 trillion mark for the first time since 1997.
On the agency front, the two major government-sponsored enterprises (GSEs) are expected to increase their subprime and "alternate A" origination volumes, assisted by the continued deployment of their automated underwriting systems and their push for partnering with major originators. Higher conforming balances will also spur on more activity for the GSEs, especially in the prime arena.
The chief culprit for this falloff in originations was the gradual rise in interest rates, which climbed steadily throughout 1999. The 30-year fixed mortgage rate, for example, began 1999 at 6.83% and finished the year at 8.05%. Higher rates have caused refinancing demand to dwindle; as recently as 1998, refinancings accounted for over 60% of all mortgage volume, but as of January 2000, that level hovered at approximately 25%.
A Word About Y2K
The RMBS market typically witnesses frenzied activity during the last month of the year. As expected, though, the fourth quarter of 1999 was one of the slowest quarters ever, and much of this can be attributed to computer-related concerns and the year 2000 turnover. The fourth-quarter inertia was offset, however, by increased activity in October and November. In addition, January 2000 securitization volume was normal, indicating that issuers did not wait until after the new year to securitize.
The market was seized by a hibernation factor. Issuers seemed to display an urgency to get their product to market by Thanksgiving and then laid low until the effects of Y2K played themselves out.
Prime Securitization Market Braces
For Encroachment By GSEs
Because the refinancing boom is over, prime RMBS volume will taper off in 2000. Securitizations will also shrink, in the wake of the federal government's announcement that the GSE ceiling for 2000 has been increased by 5.29%, to $252,700. This latest jump is the third consecutive increase of 5% or more. Published reports estimate that approximately 82,000 loans, worth in the neighborhood of $21 billion, will fall below this new mark. Most of this activity will probably be absorbed by Fannie Mae and Freddie Mac.
As the loan limit for the GSEs continues to increase, the percentage of loans securitized in the private-label market will keep eroding. Though $92 billion is a healthy number, the decline is a point of concern.
The demand for refinancing is projected to remain low throughout 2000. The prime market would probably withstand an increase in the prime lending rate of 25 or 50 basis points, but a steeper rate hike could send origination levels down dramatically and greatly reduce profitability.
As rates ratchet higher and origination volume continues its moderate descent, Standard & Poor's will pay special attention in 2000 to underwriting guidelines, which may become more lenient as banks seek to attract business.
Prime mortgage securitizations began 1999 in robust fashion, on the heels of 1998's records. But volume dropped dramatically in the third quarter, and the fourth quarter proved to be one of the quietest ever - again, mostly related to Y2K concerns.
In total, securitization volume fell to $92 billion, down from its record level of $134 billion in 1998. Much of this year-over-year shortfall was due to aggressive purchasing by FNMA and FHLMC, for which the maximum conforming balance was raised in 1999 to $240,000, a 5.66% increase over 1998's level of $227,150.
Most of the critical data involved in prime transactions remained virtually unchanged in 1999. The weighted average loan-to-value (LTV) ratio for 30-year, fixed-rate transactions crept up to 73.73% from the previous year's level of 73.56%, and the weighted average FICO score in 1999 was only fractionally higher at 718.08. Despite these consistent numbers, however, Standard & Poor's AAA' credit enhancement levels surged from 4.29% in 1998 to 4.52% last year. This increase came about because of rising rates, which translated into greater loss severity. In addition, higher house prices enhanced risk by increasing the likelihood of cash-out refinancing, and the number of loans with less-than-full documentation continued to rise.
Subprime Volumes Expected to Hold Course
Credit will become a bigger issue in the subprime market in 2000. As many of the subprime deals issued during the high-volume period of 1996-98 begin to season, each issuer's tier ranking will depend as much on the performance of its outstanding transactions as on the capitalization it holds. Standard & Poor's will continue to hone its subprime ratings model by tracking the pool characteristics and performance of these transactions.
Securitization volume in the subprime mortgage sector in 1999, excluding home improvement and high combined loan-to-value (CLTV) transactions, dropped to approximately $60.9 billion from 1998's level of $69.3 billion, though home equity loans (HELs) are still the most popular asset class among all ABS. Subprime issuers continued to consolidate in 1999, and fewer monoline specialty finance companies are hanging on. Firms may continue this trend in 2000, but the diminished number of merger candidates dictates that the consolidation pace will slow, and that competition among the richest and largest issuers will become much more intense.
More Comfort Among
High CLTV Investors
The control shift from FirstPlus Financial Inc., which declared bankruptcy in 1999, to more heavily capitalized and better known high CLTV issuers such as Residential Funding Corp. and Conseco Finance Corp. (formerly Green Tree Financial Corp.) has inspired greater investor confidence. Residential Funding alone, in fact, now issues approximately half of all high CLTV transactions.
Investor interest in high CLTV product in 2000 will depend heavily on the health of the economy and the stability of interest rates. As performance trends become more clear, high CLTV securitizations should increase in size and frequency in 2000, especially as Residential Funding and Conseco continue to lend legitimacy to the sector.
Though there was still strong consumer demand for high CLTV loans in 1999, investors were somewhat skeptical toward second-lien mortgage product with a CLTV ratio of greater than 100%. In 1999 originations remained steady, but the aggregate value of securitizations dropped to $4.3 billion, down from $8.9 billion in 1998. This suggests that many midsize banks are offering loans to customers and holding these loans on their balance sheets as portfolio investments. Spreads also remain wide, making securitization in this market a less profitable exit strategy.
More Growth Ahead in
Securitization of New Collateral
As the subprime market matures, the market for securitized non- and reperforming loans will expand moderately in 2000. Given the counter-cyclical nature of these loans, a sharp downturn in the economy would bring many more non- and reperforming loans to market. Standard & Poor's saw more non- and reperforming transactions backed by former subprime collateral with higher coupons in 1999. As a result, the senior/subordinate structure, coupled with overcollateralization, was introduced. This segment of RMBS remains concentrated among a select few players, such as Credit-Based Asset Servicing & Securitization LLC (C-BASS), Residential Funding, and Bayview Financial Trading Group LP.
Standard & Poor's sees also growth potential in the reverse mortgage market. The first such transaction closed in April 1999, and the market seems poised to accept many more deals of this nature. The first impediment is the lack of reverse mortgage volume, as long-term mortgagors have shown a reluctance to go back into debt. When more mortgagors are made aware of the benefits of a reverse mortgage, however, more transactions will follow. The second concern involves the prospect of more scrutiny from the government, which could result in more legislation geared toward consumer protection.
The securitization of tax liens is also poised to grow in the near term, as more of these issues, which have typically been restricted to liens in single municipalities, involve liens from several states at once. Standard & Poor's anticipates that this asset class will receive more attention, as large financial companies continue to purchase these multistate bulk transactions. A key factor that will influence the course of future tax lien securitization investments will be the new legislation that Standard & Poor's expects to be enacted in 2000 or soon thereafter. Though some purchasers suffered losses last year, and therefore decided to discontinue their investments in tax lien securitizations, each of the transactions that Standard & Poor's has rated is performing up to or better than expectations.