Subprime Mortgage
Distress Effect on CDOs
Kevin Kendra
Managing Director
Derivative Fitch
U.S. Structured Credit
Glenn Costello
Managing Director
Fitch Ratings
Co-Head, U.S. RMBS
Introduction and Agenda
> Recent headlines and quotes related to CDOs and the
U.S. subprime mortgage markets
> Selected Fitch Research related to Subprime RMBS
and CDOs
> Webcast Agenda
U.S. subprime mortgage market media coverage
has moved mainstream . . .
>
Mortgage market news is now regularly on the front page of the Wall Street
Journal and New York Times
>
Over 80 articles on subprime mortgages were filed with various news agencies
last week.
>
A web site, “The Mortgage Lender Implode-O-Meter” tracks U.S. mortgage
lenders that have either shut down or are no longer operating independently
along with, “Mortgage Banking Bust News and Commentary.”
–
853,106 visitors to the site from January 1 to March 12, 2007
– Claims 36 lenders “imploded” by either bankruptcy filing, halting major
operations or last-ditch acquisition
– Claims another 10 lenders are “ailing”
www.derivativefitch.com
2
Selected Fitch Subprime RMBS and CDO Research
15-Apr-05
“U.S. Subprime RMBS in CDOs,” co-authored by U.S. Structured
Credit and RMBS groups
07-Sep-05 “Operational Risks Inherent in New RMBS Products,” by U.S. RMBS
group
17-Jan-06
“2006 Global Structured Finance Outlook: Economic & Sector-bySector Analysis,” by Global Structured Finance
24-Jul-06
“U.S. Structured Finance CDO Performance: 2006 Update,” by U.S.
Structured Credit group
21-Aug-06 “U.S. Subprime RMBS in CDOs (Update),” co-authored by U.S.
Structured Credit and RMBS groups
04-Oct-06
“40, 45 and 50 Year Mortgages: Option ARMs, Hybrid ARMs and
FRMs,” by U.S. RMBS group
13-Dec-06 “2007 Global Structured Finance Outlook: Economic & Sector-bySector Analysis,” by Global Structured Finance
www.derivativefitch.com
3
Agenda
>
Stress in the U.S. Mortgage and Capital Markets
– How does a mortgage loan get into a CDO?
– What is causing stress in the U.S. Mortgage Markets?
>
Subprime RMBS Performance and Outlook
– What are the drivers of subprime RMBS performance?
– How does this impact originators, issuers and servicers?
– What are Fitch’s expectation for mortgage losses and RMBS impact?
– What is Fitch’s outlook for RMBS?
>
Fitch-rated CDO Exposure to Subprime Mortgage Markets
– What CDOs may be affected by stress in the subprime mortgage markets?
– What is the potential impact on structured finance CDOs?
– CDO Surveillance – Process, People and Tools
www.derivativefitch.com
4
Stress in the U.S. Mortgage and
Capital Markets
> How does a mortgage loan get into a CDO?
> What is causing stress in the U.S. Mortgage Markets?
Subprime RMBS Structure
$P
$I
Monthly Mortgage
Payments
REMIC
Trust
Accounts
Interest
Payments
Principal
Payments
Scheduled
Principal
&
Prepayments
M1 M2 M3 M4 M5 M6 M7 M8 M9 M10
M11 M12 M13 M14 M15 M16 M17 M18 M19 M20
M21 M22 M23 M24 M25 M26 M27 M28 M29 M30
M31 M32 M33 M34 M35 M36 M37 M38 M39 M40
$
‘AAA’
L + % or Net WAC
‘AAA’
M41 M42 M43 M44 M45 M46 M47 M48 M49 M50
$I
M51 M52 M53 M54 M55 M56 M57 M58 M59 M60
Interest
Servicer
M61 M62 M63 M64 M65 M66 M67 M68 M69 M70
M
2000
‘AA’
L + % or Net WAC
‘AA’
M1 M2 M3 M4 M5 M6 M7 M8 M9 M10
‘A’
L + % or Net WAC
‘A’
‘BBB’
L + % or Net WAC
‘BBB’
‘BBB-’
L + % or Net WAC
‘BBB-’
Residual
Excess Interest
Residual
M71 M72 M73 M74 M75 M76 M77 M78 . . .
M11 M12 M13 M14 M15 M16 M17 M18 M19 M20
M21 M22 M23 M24 M25 M26 M27 M28 M29 M30
M31 M32 M33 M34 M35 M36 M37 M38 . . .
M
1000
www.derivativefitch.com
$
$P
Scheduled
Principal
&
Prepayments
6
Characteristics of Subprime Mortgages
>
Typical Subprime Loan Types
– Hybrid Adjustable-Rate Mortgages (ARMs)
>
2/28 Mortgage is fixed for the first two years and then switches to
adjustable rate for the remaining 28 years
>
Other common Hybrid ARMs 3/27 and 5/25 terms
– Hybrid Interest Only (IO) ARMs
– 40-Year Hybrid ARMs
– Piggyback Second Liens
– Limited Documentation Loan Programs
www.derivativefitch.com
7
Characteristics of Subprime RMBS
>
Standard Structural Features of Subprime RMBS
– Subordination serves as credit enhancement to account for credit risk
– Interest rate instruments to hedge interest rate risk
– Performance test at three year mark
>
If test fails then the priority of payments remains unchanged with the
senior notes receiving all principal proceeds
>
If test passes then principal proceeds repays subordinated notes until
targeted subordination is met.
– Defaulted loans worked out by servicers
>
Each Subprime RMBS will have somewhat unique performance profiles
www.derivativefitch.com
8
Structured Finance CDO Structure
CDO
Trust
CDO Portfolio
RMBS RMBS RMBS RMBS
Bond 1 Bond 2 Bond 3 Bond 4
RMBS
Bond 5
RMBS RMBS RMBS RMBS RMBS
Bond 6 Bond 7 Bond 8 Bond 9 Bond 10
Note Coupon
(L + bps)
RMBS RMBS RMBS RMBS RMBS
Bond 11 Bond 12 Bond 13 Bond 14 Bond 15
RMBS RMBS RMBS RMBS RMBS
Bond 16 Bond 17 Bond 18 Bond 19 Bond 20
Bond Coupons
(L + bps)
RMBS RMBS RMBS RMBS RMBS
Bond 21 Bond 22 Bond 23 Bond 24 Bond 25
RMBS RMBS RMBS RMBS RMBS
Bond 26 Bond 27 Bond 28 Bond 29 Bond 30
RMBS RMBS RMBS RMBS RMBS
Bond 31 Bond 32 Bond 33 Bond 34 Bond 35
RMBS RMBS RMBS
Bond 36 Bond 37 Bond 38
...
CDO
CDO
CDO
CDO
Bond 1 Bond 2 Bond 3 Bond 4
RMBS
Bond 80
CDO
Bond 5
CDO
CDO
CDO
CDO
CDO
Bond 6 Bond 7 Bond 8 Bond 9 Bond 10
www.derivativefitch.com
CDO
Bonds
Proceeds
($)
Special
Purpose
Vehicle
(CDO
Trust)
‘AAA’
CDO
Proceeds
($)
‘AA’
CDO
‘A’
CDO
‘BBB’
CDO
Preferred Shares
or Equity
9
Characteristics of Structured Finance CDOs
>
Cash SF CDO Asset Portfolio Highlights
– Portfolios contain between 60 and 140 bonds
– Assets may be diversified by market sector, however recent vintage SF
CDOs have been concentrated in subprime RMBS
– Assets may be diversified by risk profile (intial ratings)
– Assets may be diversified by vintage
– Asset acquisition and selection
>
>
Asset manager warehouses bonds prior to issuing CDO notes
>
Initial portfolio is typically fully ramped within 6 months of CDO note
issuance
CDO notes typically issued when asset manager has accumulated
approximately 60-80% of the target portfolio
www.derivativefitch.com
10
Characteristics of Structured Finance CDOs
>
Cash SF CDO Note Highlights
– Credit enhancement comes from subordination and excess spread
– Interest is paid sequentially to note holders
– Overcollateralization (OC) and Interest Coverage (IC) performance tests
are checked prior to distributions to subordinate notes
– Excess interest may be used to:
>
>
>
If tests are passing then distributed to Preferred Shares or Equity
A portion may be used to repay mezzanine notes
If tests are failing then distributions may be used to cure the tests
– Purchase new assets
– Pay down senior notes
www.derivativefitch.com
11
U.S. Mortgage and Capital Market Diagram
Mortgage Origination Market
Mortgage
Payments
Borrower
Proceeds
($)
Financial
Institution, REIT,
Specialty Finance
Company
Company
Balance
Sheet
Financial
Institution
Mortgage
Originator
Investment
Assets
“Held for Sale”
Assets
RMBS Market
Financial
Institution, REIT,
Specialty Finance
Company
Financial
Institution
Mortgage
Originator
“Held for Sale”
Assets
REMIC
Trust
AAA
RMBS Investor/
CDO Manager
RMBS
RMBS Conduit
Financial
Institution
BBB
Residual
CDO Warehouse
CDO Market
Financial
Institution
RMBS Investor/
CDO Manager
CDO Warehouse
www.derivativefitch.com
AAA
CDO
Trust
CDO Arranger
BBB
Residual
CDO
Institutional
Investors
CDO Investor
12
ABX.HE Structure
RMBS RMBS RMBS RMBS RMBS RMBS RMBS RMBS RMBS RMBS RMBS
10
8
9
4
6
7
11
2
3
5
1
...
RMBS
20
‘AAA’
RMBS
‘AAA’
RMBS
‘AAA’
RMBS
‘AAA’
RMBS
‘AAA’
RMBS
‘AAA’
RMBS
‘AAA’
RMBS
‘AAA’
RMBS
‘AAA’
RMBS
‘AAA’
RMBS
‘AAA’
RMBS
...
‘AAA’
RMBS
ABX.HE.AAA
‘AA’
RMBS
‘AA’
RMBS
‘AA’
RMBS
‘AA’
RMBS
‘AA’
RMBS
‘AA’
RMBS
‘AA’
RMBS
‘AA’
RMBS
‘AA’
RMBS
‘AA’
RMBS
‘AA’
RMBS
...
‘AA’
RMBS
ABX.HE.AA
‘A’
RMBS
‘A’
RMBS
‘A’
RMBS
‘A’
RMBS
‘A’
RMBS
‘A’
RMBS
‘A’
RMBS
‘A’
RMBS
‘A’
RMBS
‘A’
RMBS
‘A’
RMBS
...
‘A’
RMBS
ABX.HE.A
‘BBB’
RMBS
‘BBB’
RMBS
‘BBB’
RMBS
‘BBB’
RMBS
‘BBB’
RMBS
‘BBB’
RMBS
‘BBB’
RMBS
‘BBB’
RMBS
‘BBB’
RMBS
‘BBB’
RMBS
‘BBB’
RMBS
...
‘BBB’
RMBS
ABX.HE.BBB
‘BBB-’
RMBS
‘BBB-’
RMBS
‘BBB-’
RMBS
‘BBB-’
RMBS
‘BBB-’
RMBS
‘BBB-’
RMBS
‘BBB-’
RMBS
‘BBB-’
RMBS
‘BBB-’
RMBS
‘BBB-’
RMBS
‘BBB-’
RMBS
...
‘BBB-’
RMBS
ABX.HE.BBB-
...
Residual
Residual Residual Residual Residual Residual Residual Residual Residual Residual Residual Residual
www.derivativefitch.com
13
Characteristics of the ABX.HE Indices
>
The ABX.HE indices are equally weighted indices of the 20 largest volume
subprime RMBS issuers.
>
Three ABX.HE indices have been issued to date:
– ABX.HE.06-1 represents 20 subprime RMBS issued in 2H 2005
– ABX.HE.06-2 represents 20 subprime RMBS issued in 1H 2006
– ABX.HE.07-2 represents 20 subprime RMBS issued in 2H 2006
>
Each index has 5 series representing different levels of risk
– AAA, AA, A, BBB and BBB-
>
The ABX.HE has proven to be effective in providing market transparency in an
otherwise opaque market
– Allows market participant to express market views
– Provides hedging mechanism for mortgage warehouse facilities
www.derivativefitch.com
14
ABX.HE Prices
ABX.HE Prices
(As of Mar 1, 2007)
ABX-HE-BBB 06-1
ABX-HE-BBB- 06-1
ABX-HE-BBB 06-2
ABX-HE-BBB- 06-2
ABX-HE-BBB 07-1
ABX-HE-BBB- 07-1
1.00
0.95
0.90
0.85
28
/07
2/
21
/07
2/
14
/07
2/
7
7/0
2/
31
/07
1/
24
/07
1/
17
/07
1/
7
10
/07
1/
3/0
1/
7/0
6
12
/2
0/0
6
12
/2
3/0
6
12
/1
/06
12
/6
9/0
6
11
/2
2/0
6
11
/2
5/0
6
11
/1
11
/8
11
/1
/06
0.75
/06
0.80
0.70
0.65
0.60
Source: Markit Group Limited.
www.derivativefitch.com
15
Stress in the Subprime Mortgage Markets
2Q 2006
Home Price Appreciation
(HPA) begins to
dramatically slow
nationally
3Q 2006
HPA continues to slow
Early payment defaults
(EPDs) begin to rise
dramatically.
RMBS Conduits become
more aggressive in putting
loans back to originators
for repurchase.
Lenders start to publicize
improved underwriting
guidelines
4Q 2006
Small originators come
under financial pressure
as repurchase levels soar.
1Q 2007
Fremont announces it will stop originating
second lien loans.
First-time home buyers blamed for EPDs
Reports of small
originators closing doors.
MLN ceases originations in Jan and files
for bankruptcy in Feb.
Ownit Mortgage files for
bankruptcy (Dec) citing
withdrawn financing from
Merrill Lynch.
Fremont under pressure
from EPDs
ABX.HE indices start to
show stress
New Century reveals accounting errors in
Feb and in Mar announces it will not file
quarterly financials and under criminal
probe into stock trading and accounting
irregularities.
NovaStar says they will have no taxable
income for several years in Feb.
ABX.HE bottoms out with slight rebound
Cash HEL spreads widen
www.derivativefitch.com
16
Subprime RMBS Performance and
Outlook
> What are the drivers of subprime RMBS performance?
> How does this impact originators, issuers and
servicers?
> What is Fitch’s outlook for RMBS?
Subprime RMBS Collateral Performance Summary
www.derivativefitch.com
18
Subprime and Alt-A Delinquencies Rising
Fitch-Rated Transactions
60+ Delinquency (Including Foreclsoure, REO and Bankruptcy)
By Credit Sector
14%
12%
10%
8%
6%
4%
2%
Subprime
www.derivativefitch.com
Alt-A
20
06
07
20
06
01
20
05
07
20
05
01
20
04
07
20
04
01
20
03
07
20
03
01
20
02
07
20
02
01
0%
Prime
Source: FitchRatings, LoanPerformance
19
2006 Vintage Delinquency Similar to 2000
Fitch-Rated Transactions
Subprime 60+ Delinquency By Age
(First 24 Months)
30%
25%
20%
15%
10%
5%
www.derivativefitch.com
13
7
1
2000
2001
19
0%
2002
2003
2004
Source: FitchRatings, LoanPerformance
2005
2006
20
Early 2006 Vintage Loss Also Trending High
Fitch-Rated Transactions
Subprime Cumulative Loss By Age
6%
5%
4%
3%
2%
1%
2000
2001
www.derivativefitch.com
2002
2003
2004
Source: FitchRatings, LoanPerformance
2005
73
67
61
55
49
43
37
31
25
19
13
7
1
0%
2006
21
2006 Vintage Alt-A Also Showing Stress
Fitch-Rated Transactions
Alt-A 60+ Delinquency By Age
(First 24 Months)
10%
8%
6%
4%
2%
2000
www.derivativefitch.com
2001
19
13
7
1
0%
2002
2003
2004
Source: FitchRatings, LoanPerformance
2005
2006
22
Fitch-Rated Alt-A Not Representative of Broader Performance
Alt-A 60+ Delinquency By Age
3%
2%
1%
2005 Fitch
www.derivativefitch.com
19
13
7
1
0%
2005 Industry
2006 Fitch
Source: FitchRatings, LoanPerformance
2006 Industry
23
Subprime RMBS Collateral Performance Drivers
www.derivativefitch.com
24
Piggyback 2nds and Low Doc Associated With Early
Default
Collateral Attributes By Vintage
Vintage
Avg.
Mtge Bal
FICO
LTV
CLTV
Low/No
Doc
Purchase
DTI
Calif.
WAC
Mortgages That Defaulted By Month 12 (90+ Days Delinquent)
2006
221,148
615
82%
89%
54%
56%
43%
31%
8.40
2005
180,730
604
82%
88%
48%
50%
42%
22%
7.78
2004
157,827
593
82%
85%
43%
40%
41%
19%
7.82
2003
146,219
589
82%
83%
41%
33%
41%
20%
8.44
Mortgages That Performed Through Month 12 (Never 90+ Days Delinquent)
2006
205,773
625
80%
85%
43%
42%
42%
27%
7.94
2005
194,163
627
81%
85%
40%
39%
41%
31%
7.13
2004
174,634
624
81%
83%
38%
34%
40%
34%
7.07
2003
155,236
620
80%
81%
34%
27%
40%
32%
7.59
www.derivativefitch.com
Source: FitchRatings, LoanPerformance
25
ABX-HE Indices: 2006 Reference Pools Underperform 2005
60+ Delinquency By Age
12%
10%
8%
6%
4%
2%
ABX 06-1
www.derivativefitch.com
ABX 06-2
16
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
0%
ABX 07-1
Source: FitchRatings, LoanPerformance
26
ABX-HE Indices: Loans with 2nd Liens Underperforming
ABX 06-1
www.derivativefitch.com
ABX 06-2
ABX 07-1
ABX 06-1
Source: FitchRatings, LoanPerformance
ABX 06-2
16
15
14
13
12
11
10
9
8
7
6
5
3
2
0%
1
0%
16
2%
15
2%
14
4%
13
4%
12
6%
11
6%
10
8%
9
8%
8
10%
7
10%
6
12%
5
12%
4
14%
3
14%
2
16%
1
16%
4
Has 2nd Lien 60+ Delinquency
No 2nd Lien 60+ Delinquency
ABX 07-1
27
ABX-HE Indices: Limited-Documentation Underperforming
Full-Doc 60+ Delinquency
ABX 06-1
www.derivativefitch.com
ABX 06-2
ABX 07-1
ABX 06-1
Source: FitchRatings, LoanPerformance
ABX 06-2
16
15
14
13
12
11
10
9
8
7
6
5
4
3
1
16
15
14
0%
13
0%
12
2%
11
2%
10
4%
9
4%
8
6%
7
6%
6
8%
5
8%
4
10%
3
10%
2
12%
1
12%
2
Limited-Doc 60+ Delinquency
ABX 07-1
28
Piggybacks 2nds and Lim Docs: ResiLogic Model
Sensitive To Risk-Layering
2005 Vintage First-Lien 60+ Delinquency – Loans 12 Months Seasoned
Piggyback 2nd
Full Doc
FICO
LTV
60+ DQ
Relative DQ
No
Yes
610
82
5.8%
100%
No
No
630
80
7.6%
131%
Yes
Yes
639
80
7.3%
125%
Yes
No
671
80
9.3%
160%
ResiLogic Single-Loan Results (2/28 ARM Single-Family, Purchase, Owner-Occ.)
Second Lien
Doc
FICO
LTV/CLTV
Expect. Loss
Relative Loss
No
Full
620
80
3.7%
100%
No
Limited
620
80
4.5%
120%
No
None
620
80
5.2%
140%
Yes
Full
660
80/100
4.3%
116%
Yes
Limited
660
80/100
5.2%
140%
Yes
None
660
80/100
6.15%
165%
www.derivativefitch.com
29
Home Price Stress Driving Defaults Higher
Cumulative California HPA By Origination Qtr.
10%
8%
6%
6 months
12 months
18 months
4%
2%
0%
200503
200504
200601
200602
200603
-2%
www.derivativefitch.com
Source: FitchRatings, OFHEO
30
Impact On Subprime Originators, Issuers and
Servicers
www.derivativefitch.com
31
Originator Crisis Caused By Repurchase Wave
>
The sudden performance deterioration caused a spike in first payment defaults
(FPDs) and early payment defaults (EPDs)
>
>
Loan buyers exercised their rights to put first payment defaults back to originators
>
>
Early payment defaults in warehouse lines caused lenders to tighten
>
High repurchase obligations and lack of financing drives marginal players into
bankruptcy (Ownit, ResMae, MLN, People’s Choice)
>
>
>
Larger players also under severe stress (Fremont, New Century, Accredited)
Large outlays for repurchase put substantial strain on smaller, poorly capitalized
companies
The need to change product mix further constrained lenders as they saw
volume/profitability fall
Discount loan pricing continues to weigh on originators
Well-capitalized entities can weather the storm, and opportunistic buyers are active
www.derivativefitch.com
32
www.derivativefitch.com
Source: Fremont Investment & Loan
33
www.derivativefitch.com
Source: Fremont Investment & Loan
34
www.derivativefitch.com
Source: Fremont Investment & Loan
35
Issuers Continue To Struggle For Liquidity
>
>
>
>
>
No demand for high concentrations of high risk products
Pipeline leaves large volume of loans without a home
Difficult to find clearing levels for subordinate bonds
New deals beginning to appear with different collateral characteristics
Investors on the sidelines waiting to see more evidence of better collateral
www.derivativefitch.com
36
Distressed Companies Were Unrated or Low Rated
Servicers
Originator
Servicer?
Current Servicer Rating
Prior Servicer Rating
Ameriquest
Yes
RPS2+ RW Evolving
RPS2+
Ownit (Bankrupt)
No
N/A
N/A
ResMae (Bankrupt)
No
N/A
N/A
MLN (Bankrupt)
Yes
Unrated
Unrated
Fremont
Yes
RPS4 RW Negative
RPS3+
New Century
Yes
RPS4 RW Negative
RPS3+
Accredited
Yes
RPS3-
RPS3+
People’s Choice (Bankrupt)
No
N/A
N/A
www.derivativefitch.com
37
Challenges To Servicers
> High risk products require intensive servicing
> Falling origination volumes will change ratio between
performing loans which are profitable to service and nonperforming loans which are less profitable
> Low home price inflation combined with ARM resets will require
loss mitigation proficiency
> Regulatory and legislative scrutiny may hamper effective
timeline management
www.derivativefitch.com
38
Strengths Of Servicers
>
>
Servicing is concentrated among capable, well-capitalized entities
Industry has the capacity to absorb loans from distressed portfolios
Distribution Among Servicer Ratings By Current Balance
(Fitch-Rated)
NR/NA, 7%
RPS4, 7%
RPS3, 0%
RPS1, 49%
RPS2, 37%
www.derivativefitch.com
Source: FitchRatings, LoanPerformance
39
Subprime RMBS Outlook
www.derivativefitch.com
40
Subprime ARM Resets Yet To Come…
First Reset Date as % Of Subprime Outstandings
35%
30%
25%
20%
15%
10%
5%
0%
2004 &
Earlier
www.derivativefitch.com
2005
2006
2007
Source: FitchRatings, LoanPerformance
2008
2009
41
2005-2006 Vintage Subprime Hybrid ARMs Face
Upward Rate Adjustment Even if Rates Remain Flat
2-28 Hybrid ARM Initial Rate Adjustments by Year Originated
Vintage
Initial Coupon
Rate After Initial Reset*
2000
10.2
10.2
2001
9.4
9.4
2002
8.4
8.4
2003
7.5
9.8
2004
7.1
10.1
2005
7.3
10.3**
2006
8.4
11.4**
* Lifetime Rate Floors typically prevent rates from adjusting down at the reset date and
initial adjustment caps typically limit the amount of the first adjustment to 300 bps.
**Projected assuming 6mL remains unchanged from today
www.derivativefitch.com
Source: FitchRatings, LoanPerformance
42
Subprime Rating Activity Trends
Year Action Taken
Downgrades
Upgrades
2003
124
47
2004
156
88
2005
148
142
2006
331
259
Through 3/21/2007
80
94
www.derivativefitch.com
43
Fitch Subprime RMBS Outlook
>
2006 will prove to be a poor vintage. Early defaults combined with on-going low
HPA and ARM reset risk will drive losses higher than recent vintages, and in
many instances higher than initial expectations.
>
While the general trend is poor, much work is needed to refine forecasts of
long-term performance, and to differentiate among deals. Rating actions will be
taken promptly as the data warrants. Fitch does not foresee significant
investment grade defaults given current trends.
>
There already is, and will continue to be, substantial performance differences
among originators, issuers, servicers, products and geographic areas.
>
Origination volume will drop. Low HPA will reduce refinancing incentives.
Product changes will limit the “affordability purchase” borrowers. The final form
of regulatory guidance could greatly curtail subprime product offerings.
>
Loan attributes are changing. Whether this results in true improvements in
credit quality remains to be seen.
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44
Subprime Mortgage Markets and
Fitch-rated CDOs
> What CDOs may be affected by stress in the subprime
mortgage markets?
> What is the potential impact on structured finance
CDOs?
Subprime RMBS Exposure in Structured Finance
CDO
>
Fitch rates over 200 structure finance CDOs with exposure to approximately
6,500 subprime RMBS bonds with a current notional balance in excess of $50
billion.
>
Subprime RMBS exposures are diversified by:
– Vintage (originations between 2000 and 2006)
– Rating (current ratings between ‘CCC’ and ‘AAA’)
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Average Structured Finance CDO Portfolio
Composition by CDO Vintage
RMBS
ABS
CMBS
CDO
Other
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
2000
www.derivativefitch.com
2001
2002
2003
2004
2005
2006
47
CDOpinions Article dated January 23rd, 2007
>
In the ‘Collateral Talk’ section of our bi-weekly newsletter we address likely
scenarios facing structured finance CDOs in 2007
– Current delinquencies and defaults in 2006 subprime RMBS may be
severe enough that some mezzanine bonds will face negative rating
migration pressure in 2007
– 2003 vintage subprime RMBS is more likely to be downgraded as the
majority of these deals have passed their performance triggers and the
structures will release credit enhancement making them more vulnerable
to future stress.
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Structured Finance CDO Exposure to Subprime
RMBS
>
Structured Credit Special Report exploring the effects of Subprime RMBS
Performance on CDOs soon to be published - Co-authored between RMBS
and Structured Credit
>
Preliminary Analysis:
– RMBS downgrades in the second and third quarters of 2007 will likely be
concentrated in the 2003 and 2004 vintages and in the ‘A’ and lower-rated
portions of the subprime RMBS structures.
– Issuance from the second half of 2005 and 2006 are expected to under
perform older vintages over time, with second lien securitizations coming
under stress first.
– If a substantial number of 2005 and 2006 subprime RMBS is downgraded
in 2007, then it is likely to trigger downgrades of subordinate classes in
mezzanine SF CDOs in 4Q 2007 or 2008.
– The ratings of the most senior classes are likely to be unaffected.
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49
Corporate CDOs Exposure to U.S. Subprime
Mortgage Originators?
>
Small corporate debt exposure to subprime mortgage originators
– Fitch rates 18 TruPS CDOs with exposure to residential mortgage REITs or
other residential mortgage lenders
>
>
11 REIT TruPS CDOs
7 Hybrid TruPS CDOs
– Total REIT exposure typically capped between 5-15%
>
Structured Credit Special Report called, “Residential Mortgage Exposure in
CDOs of Trust Preferred Securities” to be published in March 2007
– Co-authored between REIT, Financial Institutions and Structured Credit
– Conclude that Fitch’s sensitivity analysis shows the TruPS CDO structures
allow the CDO to withstand 1-2 collateral defaults without negatively
impacting the CDO note ratings.
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CDO Surveillance – Process,
People and Tools
> How does Derivative Fitch monitor CDOs?
> What is Fitch doing to provide better clarity and
understanding to this topic?
Defining CDO Surveillance
>
Our goal is to:
– Provide accurate and timely ratings on all Fitch-rated CDOs
– Maintain ratings across all parts of the CDO capital structure
– Work with Asset Managers in understanding portfolio strategy and risks
– Promote transparency by providing in-depth commentary on Fitch’s
analysis and market trends
>
Our perspective is from:
– Investors looking to buy the bond on the secondary market
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52
CDO Surveillance – Process, People and Tools
• Proprietary surveillance database
• Dedicated Staff
• Data scrubbing and processing
• Understanding of underlying assets
• Automated e-mail notification
• Formal Analyst training program
• Automated credit models
Tools
People
CDO
Surveillance
Process
• Surveillance process blends use of tools and technology, quantitative techniques and
fundamental credit analysis to perform ongoing monitoring and rating action recommendations
www.derivativefitch.com
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CDO Surveillance Framework
Three Pillars of CDO Performance
> Performance of Underlying Assets
–
Primary CDO performance driver is the performance of the underlying assets
–
Successful CDO surveillance must be able to measure and monitor performance
changes
> CDO Structural Features
–
CDO structural features vary deal-by-deal
–
Features may impact rating actions on specific CDO tranches
–
Features may impact severity of rating actions on CDO tranches
> Asset Manager’s Decisions
–
Asset Manager incentive or focus may change throughout the life of a CDO
–
Successful CDO Surveillance must work with Asset Managers to:
> Understand manager’s view on asset selection
> Understand manager’s view of asset performance and trading strategy
> Assess manager’s ability to adjust to current market conditions
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54
CDO Surveillance – Process
>
Identifying Deals for Review
– Event-driven reviews
– CDO CreditWatch notifications
– One year since last review
– Support research or performance reports
>
CDO Asset and Liability Modeling
– VECTOR Model simulates asset defaults
– Cash Flow Model stresses CDO liability structure
>
>
Credit Committee
Communicating Rating Action to the Public
www.derivativefitch.com
55
CDO Surveillance – People
>
Dedicated Surveillance Group
– 23 Global CDO Credit Analysts: 16 U.S. and 7 EU
– 7 Global Data and Operations Analysts: 7 U.S. and 2 EU
>
Interaction with Other Fitch Ratings Groups
– CMBS, RMBS, ABS, Financial Institutions, Corporates, Insurance, REITs,
Homebuilders, Project Finance, Public Finance, etc.
>
Interact with Quantitative Finance Research Analysts
– Fitch’s Default Vector Model
– Fitch’s Master Data Warehouse
– Market Implied Ratings
– CRS Model
www.derivativefitch.com
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CDO Surveillance – Tools
>
CDO CreditWatch E-mail Notifications
– Portfolio credit migration
– Change in OC/IC compliance status
– Change in portfolio compliance status
– CDO tranche amortization
– Counterparty rating breaches
>
CDO Daily Report
– Consolidated report with CDO CreditWatch notifications for “My Portfolio”
– Includes links to press releases for new:
>
>
>
New Issue Ratings
Rating Actions
Presale, Criteria and Special Reports
www.derivativefitch.com
57
CDO Surveillance and Research Initiatives
>
Forthcoming Research on Subprime RMBS and CDOs
– Impact of Subprime RMBS in Structured Finance CDOs
– Residential Mortgage Exposure in CDOs of Trust Preferred Securities
– Rating Considerations for the Tranche ABX.HE (TABX.HE) Indices
>
Other Initiatives
– Conferences and investor meetings
– RMBS and CDO group collaboration
>
>
>
Joint credit committee representation
RMBS cash flow repository
Bi-weekly senior management meeting
www.derivativefitch.com
58
www.derivativefitch.com
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