RMBS Performance, Outlook

Standard & Poor’s announced that it expects RMBS issuance of between $900 billion to $950 billion in 2007, about 10 percent to 15 percent below last year’s level though the third-largest year in history.

“In 2006, the inevitable downturn gained momentum as record-breaking growth and strong credit performance began to disappoint,” the ratings agency said in the announcement. “Evidence of this was found in home price appreciation, diminished profitability of mortgage lenders, widening credit spreads — particularly toward the bottom of the credit stack — and an acceleration of negative rating actions.”

Last year held the first annual decline in overall rating activity since 2001 — there were 250 more downgrades than in 2005, but the number of upgrades was 401 below the previous year’s number.

“We expect this trend of lower upgrade percentages and higher downgrade percentages to continue as the residential mortgage market undergoes a modest transition,” S&P added.

The annual upgrade-to-downgrade ratio last year was 2.5 to 1. Of the 1,016 upgrades last year, the majority — 628 — came from prime-jumbo loans, although this number continued to decline from a peak of 1,006 in 2003. These loans backed approximately one-fifth of the RMBS transactions issued in 2006 and about 23 percent of the total rated RMBS outstanding. Alt-A loans also saw more upgrades than downgrades last year.

“Fast principal prepayments, seasoning of the underlying mortgage loans, shifting interest features of the transactions, market value appreciation, moderate delinquencies, and low losses continued to serve as catalysts for the positive rating activity,” S&P said in an announcement.

In the home equity sector, the 10 upgrades and 88 downgrades that occurred in the fourth quarter, pushing its annual number of ratings changes to 427, affected transactions backed by subprime, second-lien high CLTV, and closed-end second-lien collateral.

Subprime transactions shifted to predominantly negative rating activity from primarily positive in 2005 — a trend the sector is expected to continue this year, but the downgrades represented only 1.53 percent of all outstanding subprime.

While Standard & Poor’s expects more upgrades than downgrades this year, fewer rating changes overall will further compress the upgrade-to-downgrade ratio. Much of the rating activity will continue to be driven by transactions backed by subprime collateral, Alt-A and prime jumbo. Fewer upgrades are expected overall because there are less outstanding transactions collateralized by prime mortgage loans, and the recent trend in securitization leans toward structures with fewer speculative-grade ratings.

“We do expect losses, and therefore negative rating actions, to increase in the near term relative to previous years,” the agency said in a report. “Our simulations, however, reveal that as long as interest rates and unemployment remain historically low and income growth continues to be positive, the majority of investment-grade bonds, and certainly those rated ‘BBB+’ and higher, should perform well.'”

In another report about RMBS trends, S&P cited the market consolidation that occurred as a result of diminishing net interest margins, the rise of early payment defaults, and reduced demand for mortgaged credit.

To keep production levels high, lenders accelerated focus on innovative affordability products, further pushing the boundaries of risk-layering. Around mid-2006, S&P adjusted criteria to require additional credit enhancement for loans with riskier profiles to reflect higher default expectations for loans with piggyback second liens, extended terms, low FICO credit scores and/or high loan-to-value ratios, and layered risks.

“Profitability levels of mortgage originators took a hit as whole-loan prices declined and conduits and other whole-loan buyers enforced buyback provisions contained in sales agreements,” S&P said. “That forced lenders to repurchase loans with early payment defaults.”

The cash drain forced several subprime lenders, such as Ownit Mortgage and Sebring Capital, to shut down, got others to strategically merge with Wall Street firms, such as First Franklin with Merrill Lynch, while others, such as Option One and Ameriquest are still on the block, the ratings agency added.

Reports continue to warn of a significant increase in early payment defaults for most product types in the 2006 vintage. Of particular concern, S&P added, are purchase money loans to stated income borrowers accessing high combined loan-to-value piggyback loans, which “have become the poster child for poor lending decisions and caused an acceleration of early payment defaults and delinquencies” in the vintage.

“We expect 2006 originations to underperform other recent vintages and for negative rating actions on ‘B’ through ‘BBB’ rated bonds to be up modestly relative to the past few years, particularly in the subprime sector,” S&P said.

Other trends that unfolded last year include the tiering of credit spreads for low-investment-grade bonds; a significant interest in new products such as covered bonds, reverse mortgages, hybrid pay option ARMs, extended-term mortgages, earned-appreciation mortgages, and synthetic risk transfers; and a controversy over triggers in structures that employ excess spread as credit, as the triggers work effectively in the goal of protecting ‘AAA’ and ‘AA’ rated securities, but current investors in first-loss and speculative-grade securities are demanding similar protection, according to the report.

“Originators that succeed in this difficult environment will be the ones that have learned their lessons with ‘stretched’ guidelines and layered risks,” S&P said. “A combination of increased focus on the profile of early payment defaults and the potential tightening of underwriting guidelines could result in a better-performing 2007 vintage.”