Flood of Subprime RMBS Downgrades

The New York-based ratings agency announced today that credit ratings on 612 RMBS classes backed by subprime mortgages have been placed on CreditWatch with negative implications. The securities total $12.1 billion and represent 2.13 percent of the $565.3 billion in transactions rated by S&P between the fourth quarter 2005 and the fourth quarter 2006.

The ratings will be downgraded in the next few days to CCC on any class expected to experience a writedown during the next 12 months, and to B, BB or BBB on any classes expected to fail this stress test within 13 to 24 months, 25 to 30 months or 31 to 36 months, respectively, S&P stated.

On average, between 75 percent and 80 percent of the loans backing the affected classes are subject to some type of payment adjustment during the next 18 months, S&P said. These loans are 20 percent more likely to default than fixed-rate borrowers.

“The CreditWatch actions are being taken at this time because of poor collateral performance, our expectation of increasing losses on the underlying collateral pools, the consequent reduction of credit support, and changes that will be implemented with respect to the methodology for rating new transactions,” the announcement said. “Many of the classes issued in late 2005 and much of 2006 now have sufficient seasoning to evidence delinquency, default, and loss trend lines that are indicative of weak future credit performance. The levels of loss continue to exceed historical precedents and our initial expectations.”

Following S&P’s actions, Moody’s Investors Service announced it downgraded 399 subprime RMBS securitized last year — citing higher than anticipated delinquency.

While the 2000 subprime vintage, which had been the worst-performing vintage until this year, had aggregate total losses of 7 basis points, RMBS issued since the fourth quarter 2005 have had aggregate losses of 29 BPS, S&P reported. Loans delinquent 90 days or more from the recent vintages are also exceeding the 2000 vintage. And even some loans issued this year may share some of the of the same risks.

“When recent transactions with the same seasoning are compared on a quarterly basis with similar transactions issued in 2000, we find that both mean losses and standard deviations are running in excess of the 2000 book,” the agency added.

The agency said it sees no improvement in the poor performance of these securities — which has exceeded initial assumptions. Also, further evidence of lower underwriting standards and mortgage fraud is being uncovered on the 2006 vintage.

As a result, property values are expected to decline an average of 8 percent between 2006 and 2008 — when the market bottoms out, S&P Chief Economist David Wyss said in the statement.

“We expect that the U.S. housing market, especially the subprime sector, will continue to decline before it improves,” S&P projected. “Furthermore, we expect losses will continue to increase, as borrowers experience rising loan payments due to the resetting terms of their adjustable-rate loans and principal amortization that occurs after the interest-only period ends for both adjustable-rate and fixed-rate loans.”

The agency said it revised its methodology by increasing loss severity assumptions to 40 percent. In addition, if the class immediately subordinate to a senior class is downgraded, the senior class will have to demonstrate a higher level of protection. Default expectations have been raised to 21 percent for loans with 2/28 hybrid ARM terms.

S&P said it will also begin considering the lenders’ capacity to minimize mortgage fraud in its ratings. Among factors considered here are executive experience, the broker approval process and internal controls.

But S&P, as well as Fitch Ratings and Moody’s Investor Service, has been accused in a recent report of doing too little too late.

The agencies have lagged behind market movements when reassessing RMBS and CDO ratings, said the authors, Joseph R. Mason, associate professor of finance at Drexel University’s LeBow College of Business and a visiting scholar at the FDIC, and Graham Fisher & Co. Managing Director Joshua Rosner. An even greater concern is that the process of creating MBS and CDOs requires the ratings agencies to become part of the underwriting team, leading to legal risks and even more conflicts because of the routine use of “the rating agencies publicly available models to pre-structure deals.”

The agencies have failed to re-rate MBS tranches as frequently as they should, according to the authors, who pointed out that, in the short term, asset ratings adjust more slowly than market prices. The agencies also were criticized for relying primarily or solely on the information provided by issuers during the ratings process.

Late Tuesday, apparently spooked by revelations from the ratings agencies, the Dow Jones Industrial Average was down more than 150 points.

Sam Garcia worked in mortgage lending for twenty years prior to becoming publisher of MortgageDaily.com.

e-mail: mtgsam@aol.com