Evolution Of Loan And Borrower Characteristics

In the two preceding sections I discussed the main characteristics that distinguish different sectors of the nonagency market. The data in Exhibit 5-2 highlights the main differences between the sectors for the vintage year 2004. Not surprisingly, some of these characteristics have changed over time. In order to capture some of that movement, Exhibit 5-7 shows how several of these key characteristics have evolved over the past nine years.

In this exhibit, first note the sharp increase in the ARM's share in the jumbo and alt-A sectors. In 2001, jumbos and alt-As had 27.4% and 20.1% ARMs, respectively. In 2004, their ARM shares were 76.0% and 63.0%. Subprime, which traditionally had a large ARM component, had 74.5% ARMs in 2004, its highest ARM percentage on record. This trend toward more ARMs is unusual because the ARM percentage typically declines when fixed rates are very low, as they were in 2003 and 2004. It appears that the high cost of homes has encouraged many homeowners to take out an ARM because the initial monthly payment rates are considerably less than for a fixed-rate loan. It also reflects the growing popularity of hybrid

Evolution of Nonagency Loan Characteristics

Type

Orig Year

# Loans

Orig_Amt

ARM % 2nd Lien % Orig WAC

Fl CO

LTV

Loan Size

Investor %

Full Doc %

Prime

1996

74,039

20,922

11.3

0.0

7.84

712

76.4

283

0.4

74.3

1997

139,298

41,191

12.4

0.0

7.66

719

75.0

296

0.7

72.7

1998

298,781

98,597

9.0

0.0

7.23

725

72.3

330

0.6

72.3

1999

200,547

70,398

19.4

0.0

7.19

721

72.4

351

0.9

65.2

2000

124,244

45,715

33.1

0.0

7.92

725

74.5

368

1.1

64.0

2001

273,718

119,565

27.4

0.0

7.02

730

69.2

437

0.5

72.5

2002

355,807

166,750

43.1

0.0

6.10

735

65.9

469

0.5

66.7

2003

440,909

204,666

49.2

0.0

5.14

736

66.0

464

1.1

52.4

2004

351,448

150,494

76.0

0.0

4.67

733

71.5

428

2.5

46.9

ALT-A

1996

39,018

5,215

1.4

0.0

8.90

705

74.2

134

22.6

37.3

1997

89,180

11,180

0.2

0.5

8.50

711

75.1

125

21.7

36.6

1998

153,699

23,752

0.4

0.0

7.89

711

74.4

155

18.5

39.5

1999

92,113

13,831

3.9

0.0

8.25

698

77.0

150

20.2

37.9

2000

70,082

13,086

8.8

0.0

9.20

697

79.5

187

14.8

35.3

2001

109,667

29,298

20.1

0.0

7.85

700

76.2

267

8.8

31.3

2002

185,440

46,939

28.4

0.0

7.05

706

74.9

253

13.4

31.9

2003

371,351

86,072

32.3

0.0

6.02

711

73.9

232

19.5

30.3

2004

516,806

121,334

63.0

0.2

5.67

710

79.8

235

18.5

33.4

SubPrime

1996

111,613

7,873

30.9

7.6

9.80

623

75.3

71

5.0

63.7

1997

229,734

17,335

45.7

6.8

10.03

609

76.7

75

5.4

68.2

1998

370,118

31,730

49.5

4.1

9.80

606

77.7

86

5.9

72.1

1999

513,518

46,551

50.9

3.1

9.90

606

78.2

91

4.9

68.6

2000

437,407

43,053

66.5

2.6

10.56

596

79.0

98

5.0

74.7

2001

499,170

59,509

69.2

1.8

9.58

603

79.8

119

4.8

72.9

2002

676,520

93,259

73.7

1.5

8.51

611

80.2

138

5.1

67.3

2003

1,041,450

165,270

67.8

1.2

7.49

622

81.6

159

5.4

64.3

2004

1,161,174

194,048

74.5

1.9

7.10

624

83.2

167

5.5

62.4

loans (adjustable-rate loans with an initial fixed period), which are included in the ARM category.

Another noteworthy trend is the decline in second liens in the subprime market. In earlier days, subprime contained an average of 6% to 8% second liens. In recent years, second liens have accounted for less than 2% of subprime deals.

Exhibit 5-7 also shows that FICO scores have drifted higher in jumbos, rising from around 720 in the late 1990s to around 735 in 2004. In contrast, the alt-A and subprime sectors saw their FICOs decline in the years 1999-2001. This was a period of rising interest rates, and as origination volumes fell, issuers scrambled to maintain market share by lowering underwriting standards. When interest rates fell in 2002-2003, volumes picked up, and underwriting standards tightened once again. This helped raise FICO scores in alt-A back to where they were before the 1999-2001 decline, whereas FICOs in subprime at 624 in 2004 are at a record high level. In part, the increase in subprime FICOs reflects the rapid move by subprime issuers into the lower end of the alt-A market, sometimes referred to as the alt-B or the "gap" part of the nonagency market.

While FICO scores have increased, LTV ratios have risen in alt-A and especially in subprime. Also, loan size has increased in all three sectors, with the largest increase registered in subprime. Again, this reflects the push by subprime issuers into the alt-A sector, as well as the general rise in home prices and mortgage loan amounts.

CREDIT AND PREPAYMENT PERFORMANCE Determinants of Credit Performance

I have just covered some of the key characteristics determining credit performance in the nonagency market. Exhibit 5-8 summarizes these factors. I split them into two categories—those affecting default rates and those influencing loss severity.

Under the default-rate section in the exhibit, I first list FICO scores because this particular credit measure has a very large impact on default rates. LTV ratio is also important because, as mentioned earlier, a high LTV ratio sometimes reflects a stressed financial situation. The remaining factors are placed in order of their relative importance to credit performance. However, it should be added that many of these variables are closely related; hence it is often difficult to make a precise ordinal ranking of their influence on either credit or prepayments. Thus this list, especially with respect to a few of the last factors, should be viewed more as indicative than as a precise ranking of credit determinants.

Referring to Exhibit 5-8, under the severity category, lien is the most important. Since most second liens have loss severities approaching 100%, this factor is clearly important. Mortgage insurance is in a similar category. If a default occurs and mortgage insurance is present, loss severity usually will be reduced. LTV ratio is obviously important in loss severity, and loan size comes into play because of the fixed costs involved in foreclosing and liquidating real estate-owned (REO) property.

EXHIBIT 5-8

Major Factors Driving Credit Performance

Credit Performance

Defaults

Severity

FICO

Lien

Mortgage Insurance LTV

Loan Size Investor

Investor Loan Purpose Loan Size

Determinants of Prepayments

Exhibit 5-9 lists four of the key factors influencing prepayments. I have mentioned, but not stressed, the prepayment effects of loan characteristics in this chapter. However, as I pointed out earlier, FICO scores are very important with respect to speed considerations in that they determine the amount of credit-curing refinancings a sector experiences and how easy it is to refinance into another loan. And these two elements are the ones that create stability in subprime prepayments. LTV ratio is also important in that a very high LTV ratio makes it more difficult for a homeowner to refinance. And, of course, loan size is a key prepayment factor in many sectors because the larger the loan balance, the more of an economic incentive there is to refinance.

Exhibit 5-10 summarizes where the major nonagency sectors fall in terms of credit and prepayment stability. For the agency MBS market, that point on the figure represents credit in terms of FICO score, excluding the agency aspect of credit rating.

EXHIBIT 5-9

Major Factors Driving Prepayments

Credit versus Prepayment Stability

Prepayment Stability

Prepayment Penalty

FICO

Loan Size

EXHIBIT 5-10

Credit versus Prepayment Stability

Prepayment Subprimes§ Stability

oAgency

Alt-A o

(Lower)

Credit

(Higher)

Hence the jumbo sector is shown as having a credit (FICO) similar to agency collateral. However, because of their larger size, jumbos are less stable from a prepayment view than agencies. Alt-A has a lower credit than agency and jumbo, and because its size falls between the two, so does its ranking in terms of prepayment stability. The subprime sector has by far the lowest credit rating, but it also is by far the most stable in terms of prepayments.

Exhibit 5-10 essentially shows how collateral within various sectors behaves and the tradeoff between credit and prepayment stability. It is not possible just using collateral to migrate to the desirable, upper-right section of the exhibit. However, it is possible to move in that direction via financial engineering. For example, an agency planned amortization class (PAC) bond would be on the same credit line as agencies, but would exhibit more prepayment stability.

Prepayment experience

The relative prepayment volatility for the three nonagency sectors is illustrated in Exhibit 5-11. This exhibit shows prepayment speeds for fixed, seasoned loans with 0 to 150 basis points of refinancing incentive for the three nonagency sectors and 1999 FNMA 7s for comparison. Jumbos show the most response to interest-rate changes, followed by alt-As and then subprime. This relative response to rate moves is the reason that investors are concerned primarily with prepayment speed in jumbo and credit in subprime and both in alt-A.

Expected Losses and Credit Enhancement

For the reasons outlined earlier (higher FICOs, lower LTV ratios, etc.), the jumbo sector has fewer losses than alt-A, and alt-A fewer losses than subprime. Exhibit 5-12 compares the typical losses on the three sectors. It disaggregates the losses into two

EXHIBIT 5-11

EXHIBIT 5-11

parts, cumulative defaults and loss severity. Both default and loss severity are the lowest for jumbo, next lowest for alt-A, and greatest for subprime. Total cumulative losses amount to 5 to 10 basis points for jumbo deals, 50 to 60 for alt-As, and 400 to 450 for subprime.

Of course, the rating agencies require more credit enhancement for the riskier subprime loans and more for alt-A than for jumbo loans. Exhibit 5-13 shows the typical amount of enhancement required for the various rating classes (AAA, AA, etc.) and then compares those enhancement levels with expected losses. This yields a set of loss coverage ratios for the various rating classes for each nonagency sector. AAA bonds for jumbos have 25 to 30 times coverage, alt-As 10 to 12.5 times coverage, and subprime 4 to 5 times coverage. At the BBB level, Jumbos have 4.5 to 5.5 times coverage, alt-As 2.5 to 3.3 times coverage, and subprime 2.0 to 2.5 times coverage. These coverage ratios suggest that credit losses can increase by many multiples before most nonagency MBS would encounter a loss of principal.

EXHIBIT 5-12

Loss Comparison: Jumbo, Alt-A, and Subprime

EXHIBIT 5-12

Loss Comparison: Jumbo, Alt-A, and Subprime

Cum. Loss

Cum. Default Rate

Loss Severity

Jumbo

10 bp =

1.00%

10%

Alt-A

60 bp =

3.00%

20%

Subprime

400 bp =

11.50%

35%

Rating Level Loss Coverage

Jumbo

Alt-A

Rating

Enhancement

Loss Coverage

Rating

Enhancement

Loss Coverage

AAA

2.60-3.00

25-30x

AAA

6.00-7.50

10.0-12.5x

AA

1.20-1.50

AA

3.00-3.75

A

0.65-0.90

A

2.00-2.50

BBB

0.45-0.55

4.5-5.5X

BBB

1.50-2.00

2.5-3.3X

BB

0.30-0.35

BB

0.75-0.90

B

0.15-0.20

1.5-2.Ox

B

0.35-0.50

0.5-1,0x

Current loss =

10 bps

Current loss

= 60 bps

Subprime

Rating

Enhancement

Loss Coverage

AAA

18.00-22.00

4.0-5.Ox

AA

14.00-16.00

A

11.00-13.00

BBB

8.00-10.00

2.0-2.5X

BB

B

Current loss =

400-450 bps

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