Non Agency Primer

Understanding Nonagency Mortgage Security Credit 197 Journal of Housing Research Volume 6, Issue 2 197
Fannie Mae 1995. All Rights Reserved.

Understanding Nonagency Mortgage Security Credit
Nancy DeLiban and Brian P. Lancaster*
Abstract
This article traces the evolution of credit enhancement techniques in the nonagency mortgage
security market from its primitive private placement beginnings in the 1970s, through the
explosive Resolution Trust Corporation growth period, up to the sophisticated present of the re-
REMIC (repackaged Real Estate Mortgage Investment Conduit). We explain how these techniques
work and the forces in the market and regulatory environment that brought them about. We then
analyze how some techniques can have unintended impacts on the financial characteristics of
securities they are designed to credit-enhance, how to monitor low-quality high-yield collateral,
and the different approaches of major credit agencies.
While different nonagency securities may bear the same credit ratings, the structuring techniques
used to achieve those ratings can play a critical role in the securities ultimate performance. In
general, the lower the credit quality of the collateral, the more that structure will affect
performance.
Keywords: mortgage security; credit enhancement; mortgage collateral
Introduction
In the 1980s and into the 1990s, securitization replaced traditional borrowing and
became the chief funding mechanism for many financial institutions. By securitizing and
selling assets, a financial institution decreases capital requirements, raises money, and
reduces credit and interest rate risk.
Of all asset classes, mortgage debt has been the most frequently securitized. U.S.
mortgage debt outstanding at the end of 1993 totaled more than $4.2 trillion, about $1.7
trillion of which has been securitized. By contrast, at the end of March $800 billion of
consumer installment debt was outstanding, $116 billion of which was securitized.
To date, most mortgage-backed securities (MBS)about $1.3 trillionhave been insured
by a government agency or a government-affiliated agency such as the Government
National Mortgage Association, Freddie Mac, or Fannie Mae. To be eligible for inclusion
in an agency securitization program, the underlying mortgage assets must meet certain
guidelines, such as not exceeding a current balance limit (currently $203,150), having no
delinquencies in the past 12 months, and having full and complete documentation.
Underlying mortgages passing these tests are referred to as conforming mortgages.
However, house price inflation during the 1980s, the creation of a plethora of mortgages
by originators jockeying for market share, and the Resolution Trust Corporations need
to quickly securitize the unusual mortgage assets of bankrupt thrifts led to massive
* Nancy DeLiban and Brian P. Lancaster are Managing Directors in the Financial Analytics & Structured
Transactions Group (F.A.S.T.) of Bear, Stearns & Co., Inc.
198 Nancy DeLiban and Brian P. Lancaster
growth in the nonconforming or nonagency market and the creation of the credit
enhancement techniques examined in this article. Although we focus on the techniques
used in the single-family market, most are also used in the burgeoning commercial and
multifamily markets.
Evolution of Credit Enhancement Techniques
Credit enhancement techniques in the nonagency mortgage security market have
evolved along with the growth in the markets size and sophistication. Before 1991, only
a few nonconforming or whole-loan mortgages were securitized. Lacking a government
agency guarantee, most whole-loan MBS were credit-enhanced by corporate guarantees,
letters of credit, surety bonds, pool insurance, spread accounts, or reserve funds instead
of the subordinate classes common today. After their introduction in 1986, the senior-
subordinate transactions gained a small share of the market. However, under then-
prevailing regulations, it was difficult for investors, outside of banks and insurance
companies, to purchase the credit risk associated with subordinate tranches. More
important, the lack of performance information, liquidity, familiarity, and ratings made
the purchase of subordinates unappealing for most investors, thereby forcing issuers to
retain the first-loss position or obtain some form of insurance. In addition, because most
transactions were sold privately during the 1970s and early 1980s, revealing and
accurate long-term performance information has become available only recently.
Early Problems Hindering Growth of the Market
These early credit enhancement structures faced many problems, most of which resulted
from the cost of achieving a AAA or AA rating and the risk associated with a potential
downgrading. At the time, few corporations, financial institutions, or insurers had a AAA
rating. As a result, the elite few could charge high premiums, and therefore most deals
were structured with only a AA rating, limiting the potential investor base for whole-
loan-backed securities. In addition, the market for senior-subordinate securities was not
yet developed, so the cost of selling the subordinate tranches could be quite high, thereby
raising the overall cost of the transaction. Securities enhanced by reserve funds and
spread accounts also faced problems. Reserve funds require that cash flows be reinvested
at low rates similar to Federal Reserve funds while still covering the cost of a higher
yielding bond, resulting in a high cost of carry. The rating agencies did not (and still do
not) give much credit for spread accounts, so such accounts were very expensive. As a
result, issuers retained some portion or all of the subordinates that they thought were
undervalued by the market, found an insurance company to buy some or all of the
subordinate bonds (usually as a private placement), or paid up for an insurance policy.
Growth of the Market
By 1991, the continual bull market and the active solicitation of refinancings by highly
competitive mortgage bankers led to an explosion in prepayments and issuance. Nonagency
mortgage securitization hit new highs in 1991 and continued at a record pace through
1993 (see figure 1).
Understanding Nonagency Mortgage Security Credit 199
Figure 1. Growth of the Whole-Loan Market
Source: Bear, Stearns & Co., Inc.
* Annualized from first three quarters.
It was not until 1991 that the market saw a dramatic increase in the economic and
structural efficiency of credit-enhanced transactions. At that time, most deals used
either General Electric Mortgage Insurance Corporation (GEMICO) pool insurance or a
senior-subordinate structure, since the price execution of these alternatives was very
similar.
Rise of the Super-Senior Structure
As with most developing markets, as the structural efficiency of the transactions
increased, so did the popularity of senior-subordinate structures. Senior-subordinate
structures are designed to protect the senior bonds at the expense of the subordinates.
Each structure is divided into two parts: a senior and a subordinate tranche. The amount
of each tranche is determined by the rating agencies. Losses are first allocated to the
subordinates. In addition, the cash due the subordinates is often used to maintain the
liquidity of the seniors.
The most common form of senior-subordinate structure is one with shifting of prepay-
ments (also called a shifting interest structure). Shifting of prepayments occurs from
taking the pro rata share of prepayments due the subordinates and applying it to
accelerate the amortization of the seniors. The prepayment lockouts to the subordinates
follow a schedule derived by the rating agency that depends on the extent of subordina-
tion and the credit quality of the collateral. The typical schedule for a fixed-rate single-
family mortgage is a 100 percent prepayment lockout to the subordinates for five years,
declining to 70, 60, 40, and 20 percent, respectively, for each year thereafter (see table 1).
Because of the greater credit risk of adjustable-rate mortgages, prepayments are locked
out 100 percent for 10 years or until the original percentage doubles, only shifting to the
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1987 1988 1989 1990 1991 1992 1993 1994*
Table 1. Prepayment Lockout Schedules for Fixed-Rate and Adjustable-Rate
Mortgages
Fixed-Rate Mortgages Adjustable-Rate Mortgages
% of % of
Prepayments Prepayments
Locked Out Number of Years Locked Out Number of Years
100 5 100 10
70 1 80 1
60 1 60 1
40 1 40 1
20 1 20 1
0 maturity 0 maturity
subordinate investors according to the slower schedule. The prepayment lockouts may be
affected by delinquencies or losses. After this, the prepayment lockout diminishes and
the subordinates receive their pro rata share of prepayments. By shifting prepayments
in this manner, the ratio of the subordinate part to the senior bond is increased, initially
corresponding to the early typical rise in losses and delinquencies as mortgage collateral
seasons. However, as time passes and loss levels begin to stabilize, the subordinate
tranches can begin to be paid down. Thus shifting of prepayments requires less upfront
subordination, making the deal more economically efficient while protecting the investor
in the senior bonds.
However, in 1991 there were still many investors who did not feel comfortable with the
credit risk of nonagency mortgage securities and believed the rating agency require-
ments might be insufficient. This belief gave rise to the super-senior structure, in which
an additional credit layer was stripped from the senior tranches and used as subordina-
tion (see figure 2). Since the remaining, regular AAA senior bonds retained the original
subordination behind them, they generally maintained their rating. Clearly, a case can
be made that these mezzanine bonds were more risky than the original seniors, since if
subordination levels were inaccurate, additional losses could be concentrated in a small
sector. To address this concern, a credit wrap by the Financial Security Assurance
Holdings Co. Ltd. (FSA) was sometimes placed around the AAA-rated regular seniors or
AA-rated mezzanines in super-senior structures. Although the FSA wrap acted much like
a pool policy, the guarantee was on a specified bond or bonds rather than the entire pool
of mortgages.
Besides addressing investor concerns regarding subordination levels, the super-senior
structure also became popular as a defensive mechanism to protect senior-rated bonds
against the downgrading of a third-party credit enhancer. The added value of this
approach became apparent in 1992 when Primary Mortgage Insurance Co. was tempo-
rarily downgraded after Hurricane Andrew hit Florida.
Super-senior tranches may also prove their worth in the coming months as prepayments
continue at a slow rate. With a shifting interest structure, the faster the prepayment rate,
the quicker the ratio of the subordinate tranche to the total remaining collateral
increases relative to that of the senior tranche, thus improving the credit enhancement
Figure 2. Super-Senior Structure
of the senior tranche. For example, in 1993 Moodys upgraded 63 MBS.
1
The upgrades
stemmed from increased protection levels resulting from fast prepayments that were
allocated almost exclusively to the senior tranches. As prepayments slow, downgrading
may occur (see figure 3). A period of fast prepayments followed by slow prepayments also
tends to reduce the credit quality of the remaining collateral, as homeowners in better
financial situations tend to prepay before others.
2
Super-seniors are designed not only to
have increased protection against losses but also to provide protection against downgrad-
ing. Downgrading can be very expensive even if losses do not occur. For example, a AA-
rated security generally trades 15 to 30 basis points wider than a comparable AAA-rated one.
Figure 3. Impact of Prepayments on Subordination Level
Note: PSA = Public Securities Association Standard Prepayment Model.
Regular Senior Super-Senior
FSA Wrap
AAA Senior
Subordinate Subordinate
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1
Moodys also downgraded 62 structures, primarily because of declining collateral credit quality.
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Higher incomes lead to lower loan-to-value ratios.
Dominance of the Senior-Subordinate Structure
The market witnessed a relatively large increase in the cost of pool insurance in early
1992, primarily because of general loss experience in California and several other states.
Also in 1992, new Securities and Exchange Commission regulations allowing subordi-
nates rated BBB and above to be included as publicly traded securities contributed to
increased liquidity of the subordinates. As a result, the market began to further credit-
tranche the subordinates, and the percentage of senior-subordinate deals rose to 83 (see
table 2). The total subordinate tranche was typically divided into a small unrated bond,
followed by B-rated, BB-rated, BBB-rated, A-rated, and AA-rated securities.
These changes, along with reduced loss expectations in the higher rated subordinates and
better analyses, helped attract new buyers. This new acceptance of and confidence in the
evaluation of credit risk was most evident in the BBB-rated sector and above. Investor
participation in the nonagency mortgage sector was further spurred as the bull market
caused many investors to consider alternative investments to increase yield and provide
prepayment protection. Mortgage funds, hedge funds, and foreign investors began to join
insurance companies in buying the credit risk embedded in the subordinates. Confidence
was further increased in 1993 when Standard & Poors dramatically reduced the amount
of subordination necessary to achieve a AAA rating. Given the new investors, increased
volume, more extensive historical data, and lower interest rates, total execution on
subordinate tranches increased substantially (by about 10 percentage points for new-
origination current-coupon securities) from the levels achieved three years earlier.
Superior Convexity Characteristics of Subordinates
In a market plagued by rapid prepayments, the extra call protection offered by subordi-
nates in a shifting interest structure was also a key factor in their growth and their lower
overall transaction costs. As a result, AA-rated mezzanine tranches often traded tighter
than AAA-rated plain-vanilla tranches of equal average life, because the shifting interest
structure reduced their prepayment risk. Shifting interest structures work by directing
all collateral prepayments to the senior bonds without paying down a pro rata amount of
the subordinates for a time (typically 5 years for fixed-rate mortgages, 10 years for
adjustable-rate mortgages). This causes higher levels of subordination to build up over
time as senior bonds are paid off by prepayments while the subordinate tranches are not
(see figure 3).
The effect of the shifting interest structure on the subordinates principal cash flows is
shown in figure 4. Because prepayments are locked out and shifted away from the
subordinates for the first five years, the amount of principal paid out is fixed for the first
five years across a wide range of prepayment scenarios. Although the principal balance
outstanding after the lockout would be affected by changes in prepayment speed, the
lockout would greatly dampen the overall average life variability of the bond.
In marked contrast, the impact of changing prepayments on the seven-year senior class
with the same average life is shown in figure 5. Here, principal paydowns change at both
the beginning and the end of the principal payment window. In fact, average life
instability is magnified because of the transfer of all prepayment risk for a time.
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Figure 4. Principal Paydowns of a Seven-Year Subordinate Tranche
The side effect of this credit enhancement technique, which is common to all subordinate
pieces, is to reduce significantly their negative convexity (the risk of the duration of a
bond changing when it is least desired) and average life variability. The average lives of
the two seven-year securities (the senior and the subordinate) are compared in table 3.
The average life of the subordinate tranche at a pricing speed of, for example, 275 percent
of the Public Securities Association Standard Prepayment Model (PSA) would be 7.84
years, about one month shorter than that of the senior tranche. However, in this example,
the average life of the subordinate tranche shortens by only about 0.5 year, as compared
with a shortening of 1.8 years for the senior tranche, if prepayments rose to 400 percent
PSA. Similar stability would hold at slower speeds. The subordinate tranche extends by
only about 0.5 year, as compared with an extension of 2 years for the senior tranche, if
prepayments slow to 200 percent PSA.
Another security resulting from a credit enhancement technique that incorporates both
insurance and a senior-subordinate structure is the credit certificate. A standard
noncredit tranched subordinate obtains an insurance policy from GEMICO similar to an
FSA wrap whereby the subordinate would collect for any credit losses (see figure 6). If
GEMICO or an alternative insurer is downgraded, only the subordinate is affected. The
senior bonds respond exactly like a senior tranche in a regular senior-subordinate
structure; that is, they have no additional protection.
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Pricing Speed
Figure 5. Principal Paydowns of a Seven-Year Senior Tranche
The investor should note when evaluating these bonds that the relatively small subordi-
nate (5 to 8 percent of the deal in a single-family, fixed-rate structure) collects for losses
on the entire pool. Because the subordinate collects shortfalls from the insurer, losses act
as prepayments, even during the lockout period. Thus, a 1 percent annual loss on
collateral with a 6.5 percent subordinate is equivalent to a 14.4 percent constant-
percentage prepayment to the subordinate. Making a speed adjustment for defaults is
very important when evaluating these bonds, even when they are in their lockout period.
Lower Credit Quality Mortgages
The success of selling higher risk collateral gave rise to selling nonconforming,
nonperforming, or delinquent collateral called A, B, C, and D paper. The A paper consists
of mortgages without delinquencies that would generally conform to agency standards
except that their loan balances are too large. B and C mortgages are made to borrowers
with some incriminating mark on their credit history, such as one or a few 30- to 60-day
delinquencies. C paper may have a few to several 30-day delinquencies or one 90-day
delinquency. Loans to borrowers who are habitually delinquent or have a default on their
record are classified as D paper.
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Figure 6. Structure of a Credit Certificate Security
GEMICO
Collateral
Credit
Certificates
Regular Senior
Default Collects
from Wrap
Insurance

Lower quality paper has the advantage of having more stable prepayment characteris-
tics. Irrespective of rates, these borrowers have a much harder time refinancing. Multiple
refinancings spurred by the no-point, no-fee phenomenon seen in 1993 for higher quality
mortgages do not occur. Lower quality borrowers are charged much higher upfront costs
in the form of higher points, so a greater change in interest rates is necessary before
refinancing becomes economical. In addition, these loans often carry prohibitive prepay-
ment penalties.
The additional credit risk inherent in these loans can be offset by the higher interest rate,
lower loan-to-value ratio (LTV), and more predictable prepayment profile. However, the
investor must focus on the strength of the servicer and an accurate assessment of
liquidation value rather than the borrowers ability to pay. Appraisals must come from
independent sources with quality controls to ensure reliability. An experienced liquida-
tor is of major importance to the amount and timing of liquidation. Typical B and C loans
have LTVs around 65 percent, versus 75 percent for A loans. With accurate valuation,
this additional 10 percentage points, coupled with the higher interest rate, should
compensate for the higher credit risk. Another factor to consider is the time to foreclosure.
The sooner the defaulted property is liquidated, the more valuable it is. California, where
the majority of this paper originated, averages 4 months to foreclosure, versus the
national average of 12 months.
More complicated credit enhancement structures and familiarity with the reserve funds
have helped create a lower credit quality securitization market. To illustrate, consider a
deal issued by Bear, Stearns & Co. in 1993 that included a large percentage of delinquent
loans. To facilitate the sale of the subordinate, a reserve fund was added in the first-loss
position. The reserve fund was then tranched into four different credit levels, and a
buyback schedule was added that ensured some release of cash under the conditions of
the schedule. As a result, there was substantial investor participation in a good portion
of the reserve fund. Other examples of lower credit quality securitized transactions
include deals that are typically backed by subperforming, nonperforming, and real estate
owned (REO) properties. Subperforming mortgages are loans that are 3 to 12 payments
delinquent with less than 10 percent equity. REO property includes properties acquired
before deal issuance. The net sale proceeds of these properties are passed through to the
bondholders.
Monitoring Low-Quality Collateral
Deals that are backed by poor-quality mortgages or real property must be evaluated and
monitored differently. An investor should be familiar with the unpaid principal balance
of the mortgage (UPB), anticipated net proceeds (ANP), quick-sale brokers price opinions
(BPO), and bond value (BV). UPB is the outstanding debt owed on the mortgages. ANP
for nonperforming and REO property is assumed to be 85 percent of BPO. The 15 percent
discount should be sufficient to cover any advances to the servicers and expenses
associated with the sale. ANP for subperforming mortgages is the lesser of UPB and the
sum of 10 years of schedule principal and interest. BPO is a drive-by valuation by an
independent real estate broker in the community. It is the expected proceeds of a sale,
which includes assumptions about the interior of the house and the time involved in
marketing. The initial BV is determined by the rating agencies and is assumed to be the
maximum amount in bonds the collateral can support given a worst-case scenario. The
rating agencies determine a very conservative ANP amount in bonds the collateral can
support and a very conservative length of time to receipt of cash flows given a worst-case
scenario. This method attempts to ensure that total cash receipts over the life of the deal
will be greater than the value of bonds issued. Since the number produced by rating
agencies is more conservative than the expected value, there is built-in over-
collateralization. If ANP increases, the amount of overcollateralization increases.
An example of a performance update showing the amount of collateral supporting the
bonds outstanding is shown in table 4, using the assumptions in table 5.
UPB in the first month decreases by the UPB of the liquidated mortgages. BV decreases
by the sum of all proceeds less any fees and bond interest. Note that no fees are assessed
in this example. ANP decreases by the sum of the ANP of liquidated mortgages and other
proceeds received. The results are shown in table 4.
Table 4. Example of a Performance Update
UPB ($) ANP ($) BV ($) BV/ANP (%)
Initial 200,000,000 149,337,000 130,395,000 87.32
Month 1 197,000,000 146,337,000 127,545,000 87.16
Month 2 194,000,000 143,337,000 125,395,000 87.48
Month 3 191,000,000 139,837,000 122,295,000 87.46
Month 4 188,000,000 136,837,000 118,845,000 86.85
Table 5. Assumptions
Other Proceeds
UPB ($) Proceeds ($) ANP ($) Principal ($) Interest ($)
Month 1 3,000,000 2,700,000 2,100,000 150,000 750,000
Month 2 3,000,000 2,000,000 2,100,000 150,000 750,000
Month 3 3,000,000 2,700,000 2,100,000 400,000 1,000,000
Month 4 3,000,000 3,300,000 2,100,000 150,000 750,000
Subordinates Pooled Together and Reissued with Various Ratings
Given the increasing sophistication of the market and the successful attempts to
securitize lower credit quality collateral, it was only a matter of time before Wall Street
began to re-REMIC subordinated piecesthat is, repackage securities previously pack-
aged under a Real Estate Mortgage Investment Conduit (see figure 7). Subordinates from
other deals are accumulated in portfolio until there are enough to offer seasoning,
liquidity, and diversity. These deals are then divided into a number of differently rated
tranches in an attempt to maximize execution.
Figure 7. Reissued Pooled Subordinate Structure
While these structures have the added attraction of diversity, the risk is that defaults and
loans can sometimes affect securities in unexpected ways, depending on how the deal is
structured. One of the most important structural aspects affecting the value of the
various subordinate tranches, and one that was initially underestimated by the market,
is when and to what extent the more senior tranches are compensated if defaults occur.
When liquidation proceeds are less than the defaulted loan amount, resulting in a loss,
different structures typically provide for two ways to compensate the senior securities:
(1) compensate only the senior tranches for the lesser of the senior prepay percentage
of the recovered principal
3
and the senior tranches pro rata share of the defaulted loan
or (2) pay the senior tranches pro rata share of the defaulted loan, even though it
may be larger than the amount ultimately recovered. In the first case, when the payoff
amount is limited to the lesser of the recovery or the defaulted loan amount, the senior
tranche receives only the available cash flows, so the subordinated classs cash flow is
undisturbed.
3
The senior prepay percentage equals the senior tranches percentage share of principal payments plus all
prepayments of the subordinates that are allocated to the senior bonds.
Deal 1
Unrated
Subordinates
Unrated
Subordinates
Unrated
Subordinates
Unrated
Subordinates
Senior Senior Senior Senior
. . . Deal N Deal 3 Deal 2
Credit Tranche
for Resale
Unrated subordinates
pooled together
for seasoning, diversity,
and liquidity
A BBB BB B Unrated

In the second case, however, where the entire loan amount must be paid off up front and
the recovery amount is less than the entire defaulted loan amount, the shortfall in cash
is diverted from the subordinated classs interest and principal, delaying the cash flows
due to the subordinates. If the deal is structured so that the priority of payments is
interest-principal-interest-principal,
4
then the principal of the first-loss subordinate will
be the first to be deferred. If this amount of principal is insufficient, then the interest of
the first-loss subordinate will be deferred. If this is still insufficient, then the principal
of the next lowest tranche will be hit, and then its interest, and so on up the credit levels
of the structure until the entire cash shortfall is made up to the most senior tranches (see
figure 8). If interest as well as principal must be diverted, the interest shortfall to the
subordinated classes will be tracked as deferred interest, payable in subsequent
periods before applying cash flow to reduce the principal balances of these classes.
Unfortunately, unlike deferred principal balances, deferred interest on many of these
deals did not accrue interest.
5
In late 1993, a deal handled by Prudential Home Securities
was acutely affected. Because it was originated in California in 1989 and 1990, the deal
was experiencing greater than average losses. In fact, defaults have caused principal and
interest to be deferred on subordinates rated as high as A. It is important to note that a
cash shortfall is not the same as an actual loss. For example, the A-rated class has
experienced interruptions in cash flow, but losses still have not exceeded those of lower
rated classes. If this is the case, there will be sufficient cash to repay deferred interest
by the end of the deal. Thus even these high-rated tranches could experience a loss in
yield even though their subordination levels may be sufficient over time to protect them
Figure 8. I-P-I-P Structure Default Recovery Pattern
A
BBB
BB
B
Unrated
I
I
I
I
I
P
P
P
P
P
Rating Cash Flows

4
Also known as I-P-I-P, this means that the interest and then the principal of the highest quality tranche are
paid first, followed by the interest and then the principal of the second highest quality tranche, and so on. For
a default or loss, this order is reversed: The principal of the lowest quality tranche is deferred or lost, and then
its interest; next, the principal of the next lowest quality tranche is affected, and then its interest, and so on.
5
The prevailing climate suggests a move toward the payment of interest on deferred interest.
from any principal losses. If interest does accrue on interest deferrals each month, then
there will be minimal yield loss, only a lag to distribution and a lengthening in the
average life of the securities.
6
Summary and Conclusion
While different nonagency securities may bear the same credit ratings, the structuring
techniques used to achieve those ratings play a critical role in the ultimate performance
of the securities under certain scenarios. In general, the lower the credit quality of the
collateral, the greater the impact that structure will have on security performance.
Mortgage securities that achieve their ratings through structure rather than collateral
credit quality need to be monitored more frequently. The market is evolving toward
greater sophistication and complexity, and the complex interaction between structuring
techniques and performance must be better understood by all players. While the major
credit-rating agencies all make a determination as to their expectation for the frequency
and timing of defaults as well as the severity of losses, each agency tends to value risk
differently, as described in the appendix. To protect the investor, the issuer is forced to
take the highest level of credit enhancement required by two agencies.
Appendix
Default Criteria: The Different Approaches of the Rating Agencies
The amount of credit enhancement necessary to obtain a given rating is determined by
the rating agencies. Nearly all deals are rated by two of four agencies: Fitch, Standard
& Poors, Moodys, or Duff & Phelps. Each rating agency tends to value risk differently.
To protect the investor, the issuer is forced to take the highest level of credit enhancement
required by two agencies.
However, similarities among the four agencies do exist. All make a determination as to
their expectation for the frequency and timing of defaults as well as the severity of losses.
These determinations are usually based on empirical evidence that analyzes regional
demographics and expected economic performance, loan characteristics, servicing, and
underwriting evaluations. Penalties are assigned for high LTVs, high loan balances,
mortgages used for investment purposes or for second or vacation homes, limited
documentation, cash-out refinancings, and other threatening characteristics. The
differences among the agencies lie in the trigger points,
7
the amount of the penalties, and
the severity of the worst-case default scenario. Each distinct rating, from AAA to CCC,
has an expected default scenario that is then modified by collateral characteristics. AAA-
rated securities must stay intact to a higher default scenario than CCC-rated ones. The
6
Whether the subordinate not in the first-loss position ultimately recovers this cash also depends on the
amount of credit support remaining.
7
The trigger point is a level in a credit risk category that an agency believes signifies a new level of risk. For
example, Standard & Poors may assign a new level of penalty for mortgages greater than the trigger point of
$400,000, whereas Fitch may assign a different penalty for mortgages greater than the trigger point of
$350,000. Each agency has its own schedule of trigger points and penalties for the various credit risk
characteristics.
integrity of the bonds cash flows must be sustained by the lower level subordinates or
other credit enhancements in whatever default scenario is specified by the relevant
rating agency. Therefore, a AAA-rated security might have 10 times the subordinate level
of a CCC-rated security.
Similarities among certain structural characteristics also exist. A deal in which credit
enhancement does not grow over timesuch as a senior-subordinate structure in which
the subordinate pays pro rata, a released spread account,
8
or a reserve fund with a one-
time, upfront depositrequires more upfront enhancement than structures in which
credit enhancement increases, such as a buildup reserve fund, a spread account, or a
senior-subordinate with shifting of prepayments.
Rating agencies believe that the most tenuous time for the investor occurs between years
2 and 7. Historical data show that 50 to 60 percent of defaults occur within the first five
years for a fixed-rate mortgage. This is because amortization and price appreciation have
not had sufficient time to reduce the LTV of the homeowner (i.e., for the homeowner to
build up equity) and because the payment history has yet to be established. Credit
enhancement levels begin to step down after 7 to 10 years, depending on the structure and
the increase in homeowner equity.
Each rating agency has a unique approach to quantifying the credit risk of these factors.
The following sections attempt to describe some approaches taken by each rating agency
but are not all-encompassing by any means. The investor should always ultimately look
to the source.
Fitch. Fitch Investor Services typically uses the mid-1980s Texas default scenario. Texas
experienced the most severe decline in real estate values in the postwar period. Fitch
believes that the experience of Texas during the mid-1980s is the most relevant for the
current mortgage market. Because the experience of Texas is a more recent event than
the Great Depression, Fitch believes it better represents the character of the typical
borrower todaynamely, that the borrower has a similar debt burden or debt-service
ratio. Also, loan characteristics, such as LTV and weighted average maturity, are more
in line with todays mortgage profiles. Fitch studied 2 million loans between 1981 and
1986 throughout the country while focusing on Texas and found a striking correlation
between LTVs and defaults.
Default frequency is based on the LTV and specific loan characteristics. Adjustments for
limited or alternative documentation range from 1.0 to 1.5 times the original assessment.
Cash-out refinancings (which make a loan highly dependent on appraisals) range from
1.1 to 1.25. Second or vacation homes range from 1.1 to 1.25, while adjustable-rate
mortgages or buydowns range from 1.05 to 1.55. Once default frequency is established,
loss severity is determined on the basis of price declines that, in turn, depend on the
economic and geographic considerations for a region. Fitch analyzed trends in industry
diversification, economic interdependence, employment growth, building, and the economy
in six regions of the country to determine severity. Fitch has a table for assessing loss
coverage, required for different credit quality grades of nonagency securities.
8
That is, a spread account that does not accumulate over time but rather for which, after an initial deposit,
servicing is released, or paid out.
For example, the loss coverage for a BBB security from California with a 70 to 80 percent
LTV would be 1.2 percent (0.17 0.07). This benchmark would then be adjusted for loan
characteristics and performance of the servicer and underwriter. The servicer is impor-
tant for maintaining the credit quality of the pool. How quickly a foreclosure is processed
and how often a successful workout is achieved are very important. The underwriter is
responsible for quality control and accurate appraisals.
For A-rated and non-investment-grade paper (lower than BBB), Fitch uses a default
model based on 43 regions across the United States, recognizing that mortgage perfor-
mance is more sensitive to the local economy. Additionally, Fitch (1994) takes into
consideration economic indicators that affect losses: unemployment rate, employment
growth, personal income growth, population growth, home prices, home sales, and
housing starts. Each variable is stressed while taking into consideration the regional
diversity of the pool.
Standard & Poors. Standard & Poors (S&P) uses the Great Depression era of the 1930s
as a worst-case benchmark for foreclosures and loss severity. The Great Depression
coupled high unemployment with sharply declining real estate values. S&P understands
the differences in U.S. social and economic culture as well as the differences in loan type
(balloon mortgages were popular at the beginning of this century), LTV, and legislation.
However, the default experience of Texas in the mid-1980s confirmed S&Ps AA loss
assumptions. S&P uses these to provide risk assessments for underlying pools and
derives credit levels based on these assessments. Since most early securitizations (1970
to the early 1980s) were sold as private placements, obtaining performance data is
difficult.
S&P also surveyed outstanding losses on residential mortgages and uses them as a
measure of a transactions performance. The analysis resulted in a default curve, similar
to the standard default assumption, with maximum defaults of 13 percent occurring in
years 3 to 5. By applying this curve to a specific pool, total losses can be forecast. The
default curve approach has some shortcomings but generally performs well on average,
even though an individual pool may vary significantly. This analysis provides useful
information about the credit protection of subordinated tranches.
S&Ps most important determinant of loss is based on economic factors, such as change
in housing price, change in salary, and change in employment. The next consideration is
underwriting. Mortgage payments should be less than 30 percent of monthly salary. Any
loans for which payments begin below the fixed-rate equivalent (e.g., growing-equity
mortgages, graduated-payment mortgages, adjustable-rate mortgages, balloons) are
subject to greater risk. Income, employment, and down payment should be verified. Solid
underwriting helps mitigate errors in economic projections. The last important element
in determining loss is credit history. S&P found that LTV mitigates losses but must be
below 50 percent to cover losses in a depressionlike scenario. The lower LTV loans with
limited documentation of the late 1980s did not deter losses.
In February 1994, S&P concluded that mortgage market fundamentals, such as low
interest rates, coupled with the improvement in mortgage market information systems,
will result in improved credit performance. Two new data sources enabled S&P to
reanalyze various default relationships. Accordingly, S&P has revised its loss criteria,
particularly for 15-year mortgages, jumbo loan balances, seasoned pools, and small pools.
As a benefit to all new loan originations, the lower mortgage rates and the high number
of refinancings reduce the debt burden of the individual and reduce the lenders carrying
costs for foreclosed properties. This situation has resulted in lower credit requirements,
particularly for 15-year paper. Fifteen-year mortgages build equity much faster than
comparable 30-year mortgages, since more of the payment is applied to principal. Also,
because payments are higher for an equal loan balance, 15-year borrowers must have
higher income. To a lesser degree, these benefits are applicable to 20-year mortgages as
well. Since these findings are supported by historical data, S&P revised loss severity on
shorter term mortgages.
Using the new market data, S&P correlated loan balance and default rates, resulting in
new foreclosure frequency adjustment factors. These adjustment factors increase the
amount of subordination required. Only loans with balances greater than $400,000 will
now be classified as jumbos, and only these loans will have factors greater than 1.0,
regardless of LTV. Loans between $400,001 and $600,000 will have a factor of 1.2 and
typically default twice as frequently as loans less than $400,000, loans with balances
between $600,001 and $1 million have a 1.6 factor, and loans over $1 million have a
multiple of 3.0 and default nearly five times as often as loans with balances less than
$400,000. S&Ps current adjustments for high LTVs proved adequate.
Seasoned pools have several advantages. A borrowers ability to pay generally increases
over time. The loan balance amortizes faster, thereby increasing the borrowers equity,
which deters foreclosures. And home prices tend to appreciate over long periods. To date,
S&P has reduced loss coverage by 25 percent for loans seasoned 5 to 10 years and by 50
percent for loans seasoned more than 10 years.
Pools with fewer than 300 loans were penalized for possible sampling error, assuming
that the pool would not be diversified enough to resemble average performance. These
numbers were updated for a 99 percent confidence level, normalizing to 300 loans. The
updated data reduced the credit enhancement requirements on small pools.
Moodys. Ratings by Moodys not only incorporate probability of defaults but also include
a forward-looking approach that reflects the loss in yield due to ultimate losses and
nonpayments by the credit enhancement provider.
Moodys derives a benchmark of subordination levels based on probabilities of default in
the data-rich single-family, 30-year, fixed-rate, owner-occupied mortgage sector. Mil-
lions of loans were statistically analyzed to determine the correlation between LTV and
default. Severity is derived as an expected annual appreciation in home values less a
severe loss assumption derived from empirical evidence. Given the frequency of fore-
closure and defaults, Moodys runs a Monte Carlo simulation that assesses the effect of
a large number of outcomes to determine an expected loss scenario. The change in yield
or annual internal rate of return of a security due to losses is analyzed and rated. From
the benchmark, adjustments are made for mortgage characteristics, property character-
istics, overall pool characteristics, and servicer quality. Mortgage characteristics include
LTV, type, amortization schedule, coupon, documentation, loan purpose, seasoning,
mortgage insurance, and originator quality. Property characteristics include type,
geographic location, and whether the property is owner occupied. Geographic location
determines home value, economic diversity, time to foreclosure, and special hazard. Pool
characteristics include number of loans, concentration, and structure.
Moodys (1993) has recently analyzed housing prices through 1993 and showed that loans
greater than $203,150 ( jumbo loans) have greater price volatility and therefore greater
loss potential from depreciation. In 1993, homes in the Los Angeles area with values
greater than $222,000 depreciated by 22 percent, while homes between $157,000 and
$222,000 depreciated by 14.5 percent. Moodys (1994) believes price volatility will
continue and become the dominant force in determining losses and sees this as a rising
credit risk in MBS.
Duff & Phelps.
9
Like Fitch, Duff & Phelps (D&P) focuses on default and loss performance
of 3 million loans throughout the country beginning in 1981 and focuses on Houston in
the mid-1980s as a model for severe economic conditions. The determination of credit
enhancement level begins with an analysis of expected loss based on LTV, mortgage type,
and property type, further adjusted for pool characteristics, servicer, and underwriter.
Using this data, D&P determines how these features affect losses and determines a
housing price index by metropolitan statistic area, the smallest reliable geographic unit.
For each rating, D&P establishes an economic scenario that incorporates change in
income, change in employment, and change in housing prices. In addition to a nationwide
study, D&P analyzed adverse economic conditions in several discrete geographic areas
that, if they occurred nationwide, would resemble a moderate recession or depression.
This analysis enabled D&P to determine what conditions a security at a given rating level
should be able to sustain. A security rated AAA would sustain a depressionlike condition,
like that in Texas, and one rated BBB would sustain a recession in a highly industrial
concentrated area, like that in New York in the early 1990s. The following are three
examples of case studies that D&P used in determining its rating requirements:
1. AAA. Texas by the end of 1986 had 2 percent of all homes in foreclosure, with
Houston suffering the most at a 4 percent foreclosure rate. Since Texas has a very
short time to foreclosure (about one month), D&P believes this situation is equiva-
lent to more than a 12 percent nationwide foreclosure rate. Housing prices between
September 1985 and the end of 1988 fell by more than 30 percent. During this time,
Houston experienced a 50 percent decline in oil payroll coupled with an exodus after
housing availability grew in anticipation of population growth. For a bond to be
rated AAA, it must sustain this level of severity and a 13 percent cumulative default
rate.
2. A. According to some data, Boston by May 1992 had 4 percent of loans in foreclosure,
with a 14 percent decrease in median house prices. It appears that construction
expanded faster than the local economy could sustain. D&P expects an A rating to
withstand these foreclosure and severity levels without losses. D&P determined a
benchmark number of 6.5 percent in cumulative defaults for an A rating.
3. BBB. New York by mid-1992 had 1.3 to 2.7 percent of loans in foreclosure, with New
Jersey reaching 3.1 to 5.1 percent. New York is a special case because the financial
sector in 1987 represented 20 percent of income but only 13 percent of employment.
It is believed that house prices changed along with the income in this sector. By
9
This section is based on Duff & Phelps (1993).
1991, employment in the financial markets had fallen by 10.5 percent. House prices
decreased by 13.4 percent between 1988 and 1990, with condominiums and co-ops
falling by 33 percent. This situation made performance highly dependent on one
sector. D&P equates this kind of economy to a BBB rating.
References
Duff & Phelps Credit Rating Co. 1993. Rating of Residential MBS.
Fitch Investor Services. 1994. Fitch Mortgage Default Model Regional Summary, January 3.
Moodys Investor Services. 1993. Jumbo Mortgages: Higher Priced Housing Experiences Greater
Price Volatility. Structured Finance Special Report, December.
Moodys Investor Services. 1994. Moodys Sees Rising Credit Risk in MBS. Structured Finance
Special Report, January.

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Understanding Nonagency Mortgage Security Credit 197 Journal of Housing Research Volume 6, Issue 2 197

Fannie Mae 1995. All Rights Reserved.

Source: Bear, Stearns & Co., Inc.

210 Nancy DeLiban and Brian P. Lancaster

Rating Cash Flows

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