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2nds, Stated Drive Delinquency

Fitch conference call on CDOs

April 10, 2007


photo of Coco Salazar

The performance of subprime loans backing 2006 vintage residential mortgage-backed securities has deteriorated with striking speed, according to a recent ratings agency conference call. Dominant among the worst performers are limited documentation loans and loans with junior liens.

While subprime delinquencies in the 2005 vintage originations have risen, the level of delinquency on the 2006 vintage is similar to that seen in the 2000 and 2001 vintages -- which were impacted by the recessionary environment, according to a Fitch Ratings conference call reviewed by MortgageDaily.com. Cumulative losses as a percentage of initial pool balance is also trending higher for the 2006 vintage, according to the call.

"The 2006 vintage will prove to be a poor vintage," Fitch said in the call. "Early defaults combined with ongoing low home price appreciation and ARM reset risks will drive losses higher than recent vintages, and, in many instances, higher than initial expectations."

When following a comparison with earlier vintages, Fitch forecast the ultimate cumulative loss in subprime RMBS will be 6 percent to 8 percent, given current conditions.

Among notable subprime trends was that over time, the FICO scores of loans which defaulted by month 12 in the 2006 vintage was 615, rising from 589 in the 2003 vintage, Fitch said. FICOs rose for performing loans as well, but the increase has been quicker in non-performing loans because some of the high FICO loans in these cohorts are very highly correlated with some of the other drivers of risk.

The rise in piggyback second lien lending and low or no documentation loans are amongst the drivers of early defaults, Fitch said. In the 2006 vintage, 54 percent of early default loans had low or no documentation versus 43 percent of the performing loans.

Clearly, loans with second liens are clearly under performing those without them and no doc loans are performing worse than full doc loans, but the 2006 vintage is under performing the vintage of 2005 even among those loans without these high risk attributes, Fitch continued.

Fitch also noted the share of purchase loans has been growing and become much more over represented among the defaults. Layered risks such as purchasers, particularly in high price areas, taking on piggyback seconds and opting for stated income loans, or first-time buyers, who are susceptible to early defaults, are contributing to the defaults.

Beyond loan characteristics, an additional driver for the under performance is home price appreciation. The concentration of California loans has been falling, but their concentration within defaulted loans has been rising dramatically now that the market no longer carries the high home price appreciation of previous vintages. Appreciation changed rapidly for loans originated in 2006 to the point where those originated in the third quarter are showing outright deflation after the first quarter.

"Our concern today is that a lower home price appreciation environment is going to make it more difficult for borrowers to refinance," a Fitch executive said. "Also, potential regulatory changes in loan products may make it harder for borrowers to qualify for a mortgage."

The large majority of subprime ARM resets are due to occur in 2007. About 32 percent of subprime outstanding loans are to reset this year. Many of the 2005 and 2006 borrowers of 2/28 hybrid ARMs face a substantial rate reset -- potentially up 300 basis points from the initial rate as many caps typically limit the amount of the first adjustment to that amount, according to the corresponding slide presentation of the call.

Within structured finance CDOs, mezzanine structured finance CDOs have the highest exposure to subprime RMBS. About 80 to 90 percent of the product in mezzanine structured finance CDOs are subprime RMBS bonds, according to the call. RMBS have always been the largest sector exposure of CDOs, but the growth in the RMBS market from 2003 to present is reflective to the increased exposure to the subprime market, as 2000 and 2001 vintages have significant exposure to manufactured housing bonds.

In the call, Fitch said it was too early too tell which CDOs are exposed to troubled bonds, but its preliminary analysis was that the impact on CDOs with exposure to subprime RMBS would be primarily contained to the below-investment grade tranches of the CDOs.

A report following the call projected performance of structured finance CDOs if and/or when the stress materializes in the RMBS market.

More than 220 Fitch-rated structured finance CDOs globally, including all high grade and mezzanine, have exposure to U.S. subprime RMBS bonds. Across all U.S. structure finance CDOs, the average exposure to U.S. subprime RMBS as a percentage of the par value of the portfolio is nearly 45 percent, according to the report.

Fitch-rated structured finance CDOs with exposure to mezzanine subprime RMBS number 137, of which 95 were issued in 2003 or after. The average exposure to subprime RMBS for 2003 to 2006 vintage mezzanine structured finance CDOs ranges from about 43 percent to 71 percent. Furthermore, about 3 percent of 2003 to 2006 vintage mezzanine structured finance CDO portfolios are comprised of below investment grade subprime RMBS, and 16 percent 'BBB–' assets -- which are the most at risk for default or downgrade due to their position in the capital structure.

"Although 2006 vintage subprime RMBS is expected to be very poor, Fitch believes any near-term ratings volatility will arise from earlier vintage subprime RMBS, where negative selection among borrowers due to prepayments is occurring simultaneously with the release of credit enhancement due to RMBS performance triggers passing, against the backdrop of a slowdown in the U.S. housing market," Fitch wrote in the report.

Fitch does not expect material negative rating actions for 2005 and 2006 subprime RMBS bonds to come until the second half of this year. Slower prepayments and failing triggers should help mezzanine tranches in 2005 and 2006 subprime RMBS transactions to retain credit enhancement mitigating the weaker loan performance, the report said.

"Ratings volatility arising from later vintage subprime RMBS will likely be experienced in 12–18 months as the actual loss experience becomes more clear," Fitch said in the report. "That said, under our more severe stress the 2006 vintage of mezzanine SF CDOs appears most vulnerable to wholesale ratings changes given their greater exposure to subprime RMBS."

Nonetheless, three stressful scenarios in the report all resulted in modest to moderate challenges to ratings stability in 2007 for a sample of 2003 to 2006 mezzanine structured finance CDOs.

"It is positive to see that even these unlikely stressful scenarios point to a moderate rating volatility in mezzanine SF CDO liabilities in response to a severe deterioration in the subprime RMBS sector," the report said.

"Fitch expects that, barring deterioration in other sectors, downgrades in the subprime RMBS sector will translate to moderate, one- to two-notch, negative rating migration for 2003–2006 mezzanine SF CDOs in 2007."

Coco Salazar is an associate editor and staff writer for MortgageDaily.com.

e-mail: [email protected]

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