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Scratch & Dent Market Growing

An investor base for "scratch and dent" mortgage loans is growing, which may be good news for servicers and investors in re-performing and subperforming mortgage loans.

But it also has required rating agencies to develop new methodologies for evaluating the default frequency and severity on these unusual loan types, focusing closely on the borrower's repayment patterns and the loan servicer's ability to manage these loans, according to Moody's Investors Service.

Typically, scratch-and-dent loans fall outside the guidelines an issuer of MBS has established for inclusion in its loan pools for jumbo A, alternative-A or subprime securities program. The four major reasons for noncompliance, according to Moody's, are misassigned credit grades, poor appraisal quality, consumer law compliance issues and missing loan documentation.

"We expect steady continued issuance as issuers continue to access the capital markets, with competition being expected to increase as the new market entrants compete with established market players," said Moody's analyst Christine Lachnicht, author of a Moody's report on scratch-and-dent securitizations.

Moody's said the scratch-and-dent loans are typically performing, and the credit enhancement is adjusted to reflect their increased risk. Leaders in the securitization of scratch-and-dent loans include GMAC-RFC, Countrywide, Option One and Ameriquest.

Pools of re-performing loans, those that have suffered a serious 90-day delinquency in the past, but have demonstrated a recovery in payment ability, also are finding a niche in the securities marketplace. Truman Capital and Credit Suisse First Boston have recently joined the market of issuers of re-performing loan securities, according to Moody's. And Morgan Stanley has recently announced its intention to enter the market.

In its report on the scratch-and-dent market, Moody's said that "borrower quality and servicer ability" are the key determinants of default frequency for re-performing loans.

To gauge repayment ability, Moody's assess a borrower's "payment velocity," comparing the total amount paid by a borrower over the total amount owed by the borrower during a specific time period. Payment velocity is more indiciative than an updated FICO score in determining a re-performing borrower's ability to make payments, Moody's said.

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