Tougher Rating Criteria May Impact Issuers


Changes to Standard & Poor's (S&P) rating criteria will require greater credit enhancements for some nonagency residential mortgage-backed pools.

Those beefed-up enhancements, which were effective July 1, may increase subordination levels of some pools and put pricing pressure on lower-quality loan issuances, according to industry observers. Issuers typically use credit enhancements, such as overcollateralization or third-party credit enhancement, to improve ratings of their pools. Indy mac

S&P's new tool for modeling securities, Levels 5.7, takes a stricter view of house price trends, first liens with simultaneous seconds and borrowers with lower FICO scores.

In addition, Fitch Ratings is redoing its mortgage model to take into account projected losses of nontraditional mortgage products. In addition to improving Fitch's analysis of affordability products, the ‘soup to nuts’ recalibration will increase its precision with regard to economic factors, such as area unemployment rates, according to Suzanne Mistretta, senior director at Fitch.

Fitch's model is already taking into account higher foreclosure frequencies of products with longer amortizations, Mistretta says. Those longer amortizations require higher subordinations or other credit enhancements because of higher foreclosure frequencies, as well as higher loss severities due to their higher loan balances.

Volatile house prices

According to S&P, changes to its housing volatility index (HVI) will have ‘a substantial impact’ on its credit enhancement requirements.

The index, which calculates the volatility of home prices in 379 metropolitan statistical areas (MSAs) covered by the Office of Federal Housing Enterprise Oversight's house price index, determines the probability of home price declines in an economic downturn. The Levels model uses those probabilities to adjust the assumed market value decline (MVD) of property values by rating class.

Home price appreciation is considerably more likely to slow than previously believed. ‘The shift in HVI adjustment is dramatic,’ the rating agency states. ‘The standard MVDs for substantially more MSAs will increase.’

New research shows that loans with simultaneous seconds are more likely to default and that borrowers with low FICO scores are more likely to default than previously thought.

Since loans have become seasoned enough for meaningful conclusions, the rating agency decided to review its simultaneous second lien criteria. Analyzing 639,981 loans originated in 2002 with simultaneous seconds, it found that borrowers with those loans are at least 43% more likely to default than stand-alone, first-lien borrowers, with other factors being equal. The size of the second loan does not significantly impact the chances of defaulting.

Poor performance falls notably when seconds are combined with lower FICO scores. For instance, a borrower with a piggyback loan and a FICO score under 660 is about 50% more likely to default. That finding prompted a loan-level adjustment of 50% into S&P's model for loans with credit scores under 660.

With the earlier model, Levels 5.6, loan pools did not receive a simultaneous second-lien penalty if the percentage of loans with seconds was below 20% for prime pools or 30% for subprime pools, the rating agency notes. While low-FICO score borrowers are more likely to default than previously believed, high-scoring borrowers are less likely to default than formerly thought. Indy mac

To compare differences between the previous and updated model, S&P ran identical pools of 1,800 loans through both tools. Loans with either high FICO scores or low loan-to-values (LTVs) saw little difference, but loans with low scores and high LTVs are more likely to need additional credit enhancement. For instance, while the two computations produced identical predictions for LTVs of 75% across a range of credit scores, the differences increased as borrowers' equity and credit quality dropped. The earlier model predicted a foreclosure frequency of 7.89% for 700 FICOs and 95% LTV, but the new tool predicted 8.24% foreclosures for the same loans.

The difference between the models was most pronounced for credit scores of 550 and LTVs of 95. The new model predicted a foreclosure frequency for those loans of 29.52% – almost twice as high as its predecessor.

The tougher rating criteria come as reports of slowing house price appreciation proliferate and concerns about affordability products increase.

Banking regulators are studying simultaneous seconds and subprime lending as part of their review of nontraditional mortgage products. Those regulators are expected to release new guidelines for nontraditional mortgage products – such as reduced documentation requirements, nonowner-occupied properties, below-market introductory rates and risk layering – this summer.

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