Nonprime to be Hardest Hit

Despite that the performance of residential mortgage-backed securities has been strong relative to historical performance, delinquencies and losses have begun to trend upward and are expected to rise further this year, Fitch Ratings said in a recent asset performance outlook report for global structured finance for 2007.

“Although this is directly attributable to slower house price growth and a higher interest rate environment, the deterioration is also due to a noticeable shift towards more risky collateral attributes,” the ratings agency wrote.

Long-term rates rose by roughly 100 basis points in the first half of 2006 from the low in 2005 and, in addition to borrowers taking on more debt to keep up with house prices in recent years, the popularity of “affordability” loans, such as interest-only loans, option ARMs and 40-year mortgages, went from next-to-nothing in 2001 to over 50 percent of the non-agency loans originated in 2006, according to the report.

For the entire non-agency sector, the increase in combined loan-to-values to 83 percent through the first three quarters in 2006 from 73 percent in 2002 was driven by the growing number of “combination” first and second liens. Meanwhile, since 2002, debt-to-income ratios were up on average from 37 percent to 41 percent and were likely understated — as the percentage of borrowers in “stated-income” programs increased to 60 percent from 37 percent in the four-year period. And, it is likely the trend of increased leverage will continue through this year, the report said.

“Borrowers who had stretched to afford the higher house prices are now showing signs of strain, as serious delinquencies have increased in the prime, Alt-A and, particularly, the subprime sectors,” Fitch said.

The potential impact of the housing correction will be more acute in the subprime mortgage sector, where serious delinquencies have increased almost 50 percent year-over-year and the number of downgrades has jumped in recent months.

Unlike earlier vintages of subprime hybrid ARM and IO borrowers that “have demonstrated minimal sensitivity since low interest rates and high homeowner equity allowed even the most highly levered borrowers to refinance prior to the rate adjustment,” slow home price growth will likely lessen the availability of refinancing options next year and there is a large number of borrowers facing scheduled payment increases in 2007.

“The largest challenge of the 2005 and 2006 vintages still lies ahead when roughly three-quarters of those borrowers are required to make a higher monthly payment with the scheduled rate adjustment at month 24,” Fitch said, adding that 2/28 hybrid ARMs originated in these years are scheduled to face a rate increase of several hundred basis points.

Additionally, the number of subprime borrowers with reported subordinate second liens has almost doubled since 2004, the weighted-average DTI ratio (42%) and the percentage of non-full doc loans (44%) in 2006 were both at a record level.

According to the outlook, the asset performance of subprime, home equity and specialty products will decline next year and ratings environment will be negative. Fitch expects delinquencies to rise by at least an additional 50 percent from current levels throughout the next year and for the general ratings environment to be negative, as the number of downgrades is expected to outnumber the number of upgrades.

“Upward rate adjustments for seasoned loans will result in continued collateral performance deterioration,” Fitch said. “While negative rating pressure will be primarily concentrated in seasoned transactions after the step-down, an increase in pre-step-down negative rating actions is likely.”

The increase in bond credit risk has been modest in prime and Alt-A, where delinquencies have increased approximately 10 percent to 15 percent from the unusually strong performance experienced in recent years, the ratings agency reported.

Credit characteristics of prime loans originated in 2006 continued the trend in recent years of weakening risk attributes as risk increased every year since 2003 in almost every major category, except the FICO score. The 70.6 percent weighted-average LTV ratio in 2006 is the highest since 2001. Meanwhile, the DTI ratio (37%), non-owner occupied property (9%) and non-full documentation loans (55%) are all at the highest levels on record, and hybrid ARM IO loans made up the greatest share of new originations, according to the report.

For the Alt-A sector, although reported LTV ratios of loans securitized have remained relatively stable, the percentage of loans reporting a subordinate second lien has more than doubled since 2002, the weighted-average DTI ratio (37%) and the percentage of borrowers using non-full documentation (82%) are both at all-time highs. Almost 90 percent of option ARM borrowers chose non-full documentation last year and approximately 75 percent he Alt-A loan originations were affordability loans.

But prime and, to a lesser degree — Alt-A transactions, can sustain increases in losses from the levels experienced in the past several years without resulting in a notable increase in downgrades. Thereby, Fitch expects to see delinquencies and losses rise, but also expects to continue to see upgrades outnumber downgrades in these sectors and for the ratings environment to remain positive this year.

“Slower prepayments and higher delinquencies will reduce the number of upgrades from the unusually strong levels of recent years,” but “higher credit enhancement for recently issued transactions should help mitigate higher credit risk,” Fitch said. Plus, “regulatory attention may result in a reduction of option ARM volume.”

The performance of outstanding manufactured housing securitizations continues to stabilize. A significant reduction in the supply of new units in recent years helped support demand for repossessed units and market participants noted a recent general increase in demand for manufactured homes as rapid rates of appreciation caused site-built house prices to become unaffordable for many borrowers. The positive collateral and market trends have resulted in an improvement in the relationship between upgrades and downgrades. Fitch expects it to remain fairly even and the ratings environment to remain stable.

For scratch and dent and reperforming sectors, delinquencies and roll-rates appear to be deteriorating as the slowdown in the housing market is providing fewer options for borrowers. The combination of declining asset performance, approaching rate resets and the potential for adverse selection resulting from previously rapid prepayments in seasoned transactions will likely increase negative ratings, Fitch reported.

In the net interest margin securities sector, Fitch sees the asset performance declining in 2007 and the ratings outlook as negative, as “reduced excess spread and the deteriorating performance of underlying collateral will increase risk for seasoned” securities.

Overall, across all sectors of global structured finance, Fitch sees the asset performance of 38 sectors as stable, 25 as declining and only 10 improving. The global rating outlook picture is more optimistic with 18 positive, 10 negative and 44 stable sectors, Fitch said, adding that the United States is roughly balanced with seven positive sectors and six negative.