Study Finds Low MBS Losses, But Rising Rates Add Concern

Rating agency Standard & Poor's has found that only 172 of the more than 15,000 classes of residential mortgage-backed securities it has rated since 1978 have gone into default.

That's the good news. The bad news is that 50 of those defaults occurred last year. Another 22 of the total defaulted in 2001 and 20 defaulted in 2002.

S&P credit analyst Robert Pollsen said the recent spurt in defaults related largely to one issuer, however.

Of the 2003 defaults, 33 of the transaction classes had been issued by Conseco Finance Corp./Green Tree. In terms of defaults by original rating, only three of the 172 in total RMBS defaults carried an original rating of "AAA." Those three defaults, which occurred in 1997 and 1998, all related to Guardian Savings and Loan, Huntington Beach, Calif.

No RMBS deal rated "A+" or higher by S&P has defaulted since 2001.

Mr. Pollsen said the good news is that the Conseco-related defaults are largely in the past.

"Based on the results of this default study, where the average seasoning of defaulted classes was approximately five years, we can say that, generally speaking, the chances for default after a five-year period of decent or strong performance is fairly unlikely," Mr. Pollsen said.

He noted that in many cases the Conseco downgrades were related to the parent company, since the deals were backed by a limited guaranty as a primary credit support rather than subordination. This creates a "weakest link" problem for the deals when the parent company gets downgraded.

Mr. Pollsen told NMN that while rising interest rates and slowing home price appreciation may create some credit challenges for the RMBS sector, rising employment levels should be a counterbalance to this pressure.

In addition, many RMBS ratings have benefited from refinancing activity, which allowed prepayments to pay down senior bonds in deals, resulting in more credit support for the subordinate pieces. That leads to upgrades.

But with refinancing on the wane, that effect will taper off.

In addition, home price gains have also helped reduce defaults and lower loss rates when defaults occur.

"If a mortgagor does get into trouble, rising property values have usually bailed them out," Mr. Pollsen said.

Rising interest rates and slowing home price gains mean the duration of RMBS transactions is likely to extend and defaults may rise, S&P analysts said during their recent conference in Orlando, Fla.

However, S&P said that the potential rise in defaults and losses should be covered by the availability of more excess interest.

Credit analyst and S&P director Terry Osterweil, who spoke at the rating agency's recent conference in Orlando, Fla., said that the RMBS industry faces several new challenges in a rising rate environment.

S&P developed a "housing volatility index" in 1998 to predict the volatility of house prices across the country.

"Current data are showing a shift toward more volatility in house price changes. This has resulted in an increase in market value declines, and therefore increased severities and loss coverage requirements," Mr. Osterweil said.

S&P chief economist David Wyss said in a summary of the rating agency's recent conference that generally, housing is more affordable than it has been since the early 1970s because of low interest rates.

But he believes that while mortgage losses are low today, interest rates will likely gradually rise, and that means housing price appreciation and construction starts will slow.

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