End of Refinancing Boom May Lead to Deterioration of Loan Quality

Over the last two years, rapidly rising home values and heavy refinancing dramatically improved the credit quality of home loans packaged into securities, according to Standard & Poor's.

High-quality borrowers locked into interest rates almost never before seen in their lifetime to refinance loans, resulting in an across-the-board increase in FICO scores and a decrease in loan-to-value ratios during the refinancing boom.

But that may be about to change, the rating agency warns. And S&P says that external factors may affect credit enhancement levels that will be applied to mortgage-backed securities.

Thomas Warrack, a managing director in S&P's residential mortgage group and author of a recent report on changes in the residential market, told Mortgage Servicing News that as the refinance boom comes to a close, the jumbo home loan business will return to more of a home purchase environment.

S&P expects collateral characteristics and credit scores to "return to a more normal range" when that happens. That would mean FICO scores should return to an average in the 710 to 720 range and loan-to-value ratios in the low to mid-70s.

Mr. Warrack said that S&P's loan-level analysis will be able to pick up even slight changes in the collateral mix that increase the risk profile of a loan pool. By contrast, the average LTV on prime transactions exceeded 730 in the second and third quarters of 2003.

"Our credit enhancement requirement will begin to go up accordingly with that change in collateral mix," Mr. Warrack said.

In addition, subprime lenders may have more trouble finding lower-risk clients.

"During the refinance boom, as prime lenders have focused their attention on the highest-quality borrowers, subprime lenders have been able to capitalize by moving up the credit spectrum, lending to higher credit quality borrowers," S&P analysts said in a report.

As a result, average FICO scores increased from the 590 to 600 range to the 620 to 630 range for subprime transactions during the last two years.

"This has caused a convergence between the subprime and alt-A markets," S&P said in its report.

But in the coming months, S&P anticipates that credit quality may shift downward as lending volume tapers off. Essentially, FICO scores may fall in subprime pools as prime lenders return to a more historically normal lending environment.

S&P said its loan models are "poised to capture any drift in credit quality and impose higher credit enhancement requirements on its rated deals," the rating agency said in a report on how the residential mortgage market affects credit enhancement requirements.

Although S&P analysts do not believe there is a real estate bubble, their home value index suggests that going forward, home price increases will be muted and the possibility that minor price declines will occur in some markets has increased.

As such, depending upon the geographic dispersion of a pool of loans, loss severity rates will rise in the months ahead, S&P said.

Mr. Warrack also expressed concern about the "imprudent" use of automated valuation models to assess collateral in some cases. While S&P supports the use of AVMs as long as the particular model being used is appropriate for the home price point and geographic area.

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