by Calculated Risk on 6/04/2007 03:45:00 PM

04 Jun 2007 12:46 PM (EDT)

Fitch Ratings-New York-04 June 2007: Increased use of loan modifications as a loss mitigation tool may cause larger numbers of poorly performing subprime loans to be reported as performing well. This could allow for early overcollateralization (OC) release in securitizations, according to Fitch Ratings, which has amended its rating criteria for U.S. subprime RMBS/HEL ABS to better reflect this trend in its rating opinions. The changes will be effective for transactions closing in August 2007.

As U.S. home price growth has slowed and begun to fall, mortgage delinquency rates, particularly subprime mortgage delinquencies, have risen. The concomitant rise in mortgage foreclosures has resulted in a focus by policy makers, regulators, community groups and mortgage/securitization industry participants on ways to assist homeowners in avoiding foreclosure. One approach that is gaining increasing favor is loan modification, which means changing the terms of the mortgage in order to make the payments more affordable to the borrower. Successful loan modifications can preserve homeownership and reduce loss to securitizations. However, when loan terms are changed, common servicing industry practice is to report borrowers payment performance under the new terms, so that the high risk of such loans is not apparent. This has implications for securitization structures that are addressed in Fitch's revised criteria.

Fitch's new rating criteria will reflect the risk of early OC release followed by high levels of borrower re-default, where such risk is deemed to be substantial. Analysis of various loss timing and cash flow scenarios will be incorporated into Fitch's rating opinions. Fitch's criteria will also consider any structural features within a securitization that may reduce the risk of OC release as a function of modification practices.

Fitch has long been of the opinion that loan modifications are an important part of a mortgage servicer's loss mitigation strategy for limiting loss on defaulted mortgages. Successful loan modification programs can benefit investors in RMBS through maximizing cash flow and reducing loss. Fitch has discussed the challenges facing servicers in its report 'U.S. RMBS Servicer Workshop' May 18, 2007. Today Fitch has also released a new report analyzing loan modifications and other loss mitigation tools ('U.S. RMBS Loss Mitigation Strategies').

While Fitch recognizes the value of loan modification programs, the extensive levels of modifications that some servicers are contemplating, and that others have already initiated, presents new challenges in analyzing the credit risk of securitizations. Varying practices with respect to capturing and reporting data on loan modifications can make it difficult to track the quantity and characteristics of modified loans. Moreover, the performance of mortgages post-modification may vary widely and the timing and amount of re-default and loss is uncertain.

Loan modifications and subsequent loan performance is also of concern when considering the effectiveness of trigger events designed to prevent OC step-down. These trigger events are based on performance tests which compare delinquency rates to available credit enhancement. In a trigger event, the securitization fails the performance test and enhancement is not released as it would be if the test was passed. While there has been much discussion of the effectiveness of the standard trigger language in use today, extensive use of modifications, coupled with the reporting of modified loans as contractually current, presents a new situation. It is quite conceivable that securitizations with high levels of mortgage defaults will not fail delinquency trigger tests, thus allowing OC to step down. Fitch believes that recognition of this risk requires a change in rating criteria for subprime RMBS/HEL ABS.

Fitch announces the following change to its criteria: When analyzing new securitizations, if a trigger event's performance test definition effectively counts modified loans as part of the '60+ day' delinquency calculation, Fitch will continue to assume for modeling purposes that trigger events will be in effect in its rating stress scenarios. Effective inclusion of modified loans in performance tests could be achieved through reporting mortgage delinquency status on an original contractual basis, or adding new terms to trigger definitions. For example, recent transactions from one issuer have featured the following amendment to the definition of 60+ day delinquency: 'each Mortgage Loan modified within 12 months of the related Distribution Date'. Fitch sees this amended definition as having two benefits: First, it addresses the risk described above by including modified loans in the trigger definition. Second, by limiting the inclusion to a 12-month period, transactions containing performing modified loans are not unduly penalized under the performance test.

When analyzing proposed securitizations that allow for extensive modification without reporting original contractual delinquency status, Fitch will consider the likelihood of OC stepping down, potentially followed by subsequent high defaults. In some instances Fitch's credit ratings may be lower on securitization classes which Fitch views as having heightened risk of substantial loss relative to post step-down credit enhancement. Analysis of various loss timing and cash flow scenarios will be incorporated into Fitch's rating opinions. Fitch's approach will be further elaborated in an update to the U.S. RMBS cash flow modeling criteria, currently described in the report 'U.S. RMBS Cash Flow Modeling Criteria: Updated' February 6, 2007. Fitch's updated criteria will be effective for deals closing in August 2007. The August effective date allows for sufficient time for Fitch to describe its revised methodology in detail and consider any market commentary.

Fitch's rating opinions on new securitizations will reflect the potential impact of the extensive use of loan modifications. However, Fitch recognizes that many existing securitizations may release OC despite high levels of mortgage default, if large numbers of modified loans are reported as current. This may in turn result in downgrades, depending on analysis of available credit enhancement and forecasted levels of re-default. However it must be stressed that more severe rating actions could result if modifications were not made. Outstanding transactions that allow for original contractual delinquency reporting may exhibit greater rating stability reflecting trigger events and higher subordination levels, particularly if data on the amount of cash flow being generated by modified loans is provided. Additionally, while changes to the documents of existing deals is difficult, servicers may find that they have some discretion under the documents as to when and if to report a modified borrower as current, thus achieving similar results as that for new deals outlined above. Fitch will be in on-going discussions with servicers to determine what reporting practices are being put in place alongside modification programs.

Emphasis Added.