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Transcript of Subprime Mortgage Distress Effect on CDOs Kevin Kendra Managing Director Derivative Fitch U.S....
Subprime Mortgage Distress Effect on CDOs
Kevin KendraManaging DirectorDerivative FitchU.S. Structured Credit
Glenn CostelloManaging DirectorFitch RatingsCo-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
www.derivativefitch.com 3
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 4
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-by-Sector 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-by-Sector Analysis,” by Global Structured Finance
www.derivativefitch.com 5
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
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?
www.derivativefitch.com 7
Subprime RMBS Structure
Interest
ScheduledPrincipal
&Prepayments
‘AAA’L + % or Net WAC
Accounts
‘AA’L + % or Net WAC
‘A’L + % or Net WAC
‘BBB’L + % or Net WAC
‘BBB-’L + % or Net WAC
ResidualExcess Interest
Servicer
REMICTrust
Monthly MortgagePayments
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
M41 M42 M43 M44 M45 M46 M47 M48 M49 M50
M51 M52 M53 M54 M55 M56 M57 M58 M59 M60
M61 M62 M63 M64 M65 M66 M67 M68 M69 M70
M71 M72 M73 M74 M75 M76 M77 M78 . . .M
2000
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 . . .
M1000
$
$
$ P
$ I
InterestPayments
PrincipalPayments
‘AAA’
‘AA’
‘A’
‘BBB’
‘BBB-’
Residual
$ I
$ P
ScheduledPrincipal
&Prepayments
www.derivativefitch.com 8
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 9
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 10
Structured Finance CDO Structure
‘AAA’CDO
‘AA’CDO
‘A’CDO
‘BBB’CDO
Preferred Sharesor Equity
CDOBonds
SpecialPurposeVehicle(CDOTrust)
CDOTrust
CDO Portfolio
CDOBond 1
CDOBond 3
CDOBond 4
CDOBond 5
CDOBond 2
RMBSBond 1
RMBSBond 3
RMBSBond 4
RMBSBond 5
RMBSBond 2
RMBSBond 6
RMBSBond 8
RMBSBond 9
RMBSBond 10
RMBSBond 7
RMBSBond 11
RMBSBond 13
RMBSBond 14
RMBSBond 15
RMBSBond 12
RMBSBond 16
RMBSBond 18
RMBSBond 19
RMBSBond 20
RMBSBond 17
RMBSBond 21
RMBSBond 23
RMBSBond 24
RMBSBond 25
RMBSBond 22
RMBSBond 26
RMBSBond 28
RMBSBond 29
RMBSBond 30
RMBSBond 27
RMBSBond 31
RMBSBond 33
RMBSBond 34
RMBSBond 35
RMBSBond 32
RMBSBond 36
RMBSBond 38
RMBSBond 80
RMBSBond 37 . . .
CDOBond 6
CDOBond 8
CDOBond 9
CDOBond 10
CDOBond 7
Note Coupon(L + bps)
Proceeds($)
Bond Coupons(L + bps)
Proceeds($)
www.derivativefitch.com 11
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
> CDO notes typically issued when asset manager has accumulated
approximately 60-80% of the target portfolio
> Initial portfolio is typically fully ramped within 6 months of CDO note
issuance
www.derivativefitch.com 12
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 13
U.S. Mortgage and Capital Market DiagramMortgage Origination Market
RMBS Market
CDO Market
Borrower
RMBS Investor/CDO Manager
RMBS Investor/CDO Manager
FinancialInstitution, REIT,Specialty Finance
Company
MortgageOriginator
FinancialInstitution
“Held for Sale”Assets
CompanyBalanceSheet
InvestmentAssets
FinancialInstitution, REIT,Specialty Finance
Company
MortgageOriginator
FinancialInstitution
“Held for Sale”Assets
REMICTrust
RMBS
MortgagePayments
Proceeds($)
FinancialInstitution
CDO WarehouseRMBS Conduit
AAA
BBBResidual
CDOTrust
CDO
AAA
BBBResidual
FinancialInstitution
CDO Warehouse CDO Arranger
InstitutionalInvestors
CDO Investor
www.derivativefitch.com 14
ABX.HE Structure
‘AAA’RMBS
‘AA’RMBS
‘A’RMBS
‘BBB’RMBS
‘BBB-’RMBS
Residual
RMBS1
‘AAA’RMBS
‘AA’RMBS
‘A’RMBS
‘BBB’RMBS
‘BBB-’RMBS
Residual
RMBS2
‘AAA’RMBS
‘AA’RMBS
‘A’RMBS
‘BBB’RMBS
‘BBB-’RMBS
Residual
RMBS3
‘AAA’RMBS
‘AA’RMBS
‘A’RMBS
‘BBB’RMBS
‘BBB-’RMBS
Residual
RMBS4
‘AAA’RMBS
‘AA’RMBS
‘A’RMBS
‘BBB’RMBS
‘BBB-’RMBS
Residual
RMBS5
‘AAA’RMBS
‘AA’RMBS
‘A’RMBS
‘BBB’RMBS
‘BBB-’RMBS
Residual
RMBS6
‘AAA’RMBS
‘AA’RMBS
‘A’RMBS
‘BBB’RMBS
‘BBB-’RMBS
Residual
RMBS7
‘AAA’RMBS
‘AA’RMBS
‘A’RMBS
‘BBB’RMBS
‘BBB-’RMBS
Residual
RMBS8
ABX.HE.AAA‘AAA’RMBS
‘AA’RMBS
‘A’RMBS
‘BBB’RMBS
‘BBB-’RMBS
Residual
RMBS9
‘AAA’RMBS
‘AA’RMBS
‘A’RMBS
‘BBB’RMBS
‘BBB-’RMBS
Residual
RMBS10
‘AAA’RMBS
‘AA’RMBS
‘A’RMBS
‘BBB’RMBS
‘BBB-’RMBS
Residual
RMBS20
‘AAA’RMBS
‘AA’RMBS
‘A’RMBS
‘BBB’RMBS
‘BBB-’RMBS
Residual
RMBS11
. . .
. . .
. . .
. . .
. . .
. . .
. . .
ABX.HE.AA
ABX.HE.A
ABX.HE.BBB
ABX.HE.BBB-
www.derivativefitch.com 15
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 16
ABX.HE Prices
0.60
0.65
0.70
0.75
0.80
0.85
0.90
0.95
1.00
11/1/
06
11/8/
06
11/15
/06
11/22
/06
11/29
/06
12/6/
06
12/13
/06
12/20
/06
12/27
/061/3
/07
1/10/0
7
1/17/0
7
1/24/0
7
1/31/0
72/7
/07
2/14/0
7
2/21/0
7
2/28/0
7
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
ABX.HE Prices(As of Mar 1, 2007)
Source: Markit Group Limited.
www.derivativefitch.com 17
Stress in the Subprime Mortgage Markets
Home Price Appreciation (HPA) begins to dramatically slow nationally
2Q 2006 3Q 2006 4Q 2006 1Q 2007
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
Small originators come under financial pressure as repurchase levels soar.
Reports of small originators closing doors.
Ownit Mortgage files for bankruptcy (Dec) citing withdrawn financing from Merrill Lynch.
Fremont under pressure from EPDs
ABX.HE indices start to show stress
Fremont announces it will stop originating second lien loans.
First-time home buyers blamed for EPDs
MLN ceases originations in Jan and files for bankruptcy in Feb.
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
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?
www.derivativefitch.com 19
Subprime RMBS Collateral Performance Summary
www.derivativefitch.com 20
Subprime and Alt-A Delinquencies RisingFitch-Rated Transactions
60+ Delinquency (Including Foreclsoure, REO and Bankruptcy)By Credit Sector
0%
2%
4%
6%
8%
10%
12%
14%
Subprime Alt-A Prime
Source: FitchRatings, LoanPerformance
www.derivativefitch.com 21
2006 Vintage Delinquency Similar to 2000Fitch-Rated Transactions
Subprime 60+ Delinquency By Age (First 24 Months)
0%
5%
10%
15%
20%
25%
30%
2000 2001 2002 2003 2004 2005 2006
Source: FitchRatings, LoanPerformance
www.derivativefitch.com 22
Early 2006 Vintage Loss Also Trending HighFitch-Rated Transactions
Subprime Cumulative Loss By Age
0%
1%
2%
3%
4%
5%
6%
1 7 13 19 25 31 37 43 49 55 61 67 73
2000 2001 2002 2003 2004 2005 2006
Source: FitchRatings, LoanPerformance
www.derivativefitch.com 23
2006 Vintage Alt-A Also Showing StressFitch-Rated Transactions
Alt-A 60+ Delinquency By Age (First 24 Months)
0%
2%
4%
6%
8%
10%
2000 2001 2002 2003 2004 2005 2006
Source: FitchRatings, LoanPerformance
www.derivativefitch.com 24
Fitch-Rated Alt-A Not Representative of Broader Performance
Alt-A 60+ Delinquency By Age
0%
1%
2%
3%
2005 Fitch 2005 Industry 2006 Fitch 2006 Industry
Source: FitchRatings, LoanPerformance
www.derivativefitch.com 25
Subprime RMBS Collateral Performance Drivers
www.derivativefitch.com 26
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
Source: FitchRatings, LoanPerformance
www.derivativefitch.com 27
ABX-HE Indices: 2006 Reference Pools Underperform 2005
60+ Delinquency By Age
0%
2%
4%
6%
8%
10%
12%
ABX 06-1 ABX 06-2 ABX 07-1
Source: FitchRatings, LoanPerformance
www.derivativefitch.com 28
ABX-HE Indices: Loans with 2nd Liens Underperforming
No 2nd Lien 60+ Delinquency
0%
2%
4%
6%
8%
10%
12%
14%
16%
ABX 06-1 ABX 06-2 ABX 07-1
Has 2nd Lien 60+ Delinquency
0%
2%
4%
6%
8%
10%
12%
14%
16%
ABX 06-1 ABX 06-2 ABX 07-1
Source: FitchRatings, LoanPerformance
www.derivativefitch.com 29
ABX-HE Indices: Limited-Documentation Underperforming
Full-Doc 60+ Delinquency
0%
2%
4%
6%
8%
10%
12%
ABX 06-1 ABX 06-2 ABX 07-1
Limited-Doc 60+ Delinquency
0%
2%
4%
6%
8%
10%
12%
ABX 06-1 ABX 06-2 ABX 07-1
Source: FitchRatings, LoanPerformance
www.derivativefitch.com 30
Piggybacks 2nds and Lim Docs: ResiLogic Model Sensitive To Risk-Layering
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%
2005 Vintage First-Lien 60+ Delinquency – Loans 12 Months Seasoned
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%
ResiLogic Single-Loan Results (2/28 ARM Single-Family, Purchase, Owner-Occ.)
www.derivativefitch.com 31
Home Price Stress Driving Defaults Higher
Cumulative California HPA By Origination Qtr.
-2%
0%
2%
4%
6%
8%
10%
200503 200504 200601 200602 200603
6 months
12 months
18 months
Source: FitchRatings, OFHEO
www.derivativefitch.com 32
Impact On Subprime Originators, Issuers and Servicers
www.derivativefitch.com 33
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
> Large outlays for repurchase put substantial strain on smaller, poorly capitalized
companies
> Early payment defaults in warehouse lines caused lenders to tighten
> The need to change product mix further constrained lenders as they saw
volume/profitability fall
> 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)
> Discount loan pricing continues to weigh on originators
> Well-capitalized entities can weather the storm, and opportunistic buyers are active
www.derivativefitch.com 34Source: Fremont Investment & Loan
www.derivativefitch.com 35Source: Fremont Investment & Loan
www.derivativefitch.com 36Source: Fremont Investment & Loan
www.derivativefitch.com 37
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 38
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 39
Challenges To Servicers
> High risk products require intensive servicing
> Falling origination volumes will change ratio between
performing loans which are profitable to service and non-
performing 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 40
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)
RPS1, 49%
RPS2, 37%
RPS3, 0%
RPS4, 7%
NR/NA, 7%
Source: FitchRatings, LoanPerformance
www.derivativefitch.com 41
Subprime RMBS Outlook
www.derivativefitch.com 42
Subprime ARM Resets Yet To Come…
First Reset Date as % Of Subprime Outstandings
0%5%
10%15%20%25%30%35%
2004 &Earlier
2005 2006 2007 2008 2009
Source: FitchRatings, LoanPerformance
www.derivativefitch.com 43
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
Source: FitchRatings, LoanPerformance
www.derivativefitch.com 44
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 45
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.
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?
www.derivativefitch.com 47
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’)
www.derivativefitch.com 48
Average Structured Finance CDO Portfolio Composition by CDO Vintage
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
2000 2001 2002 2003 2004 2005 2006
RMBS ABS CMBS CDO Other
www.derivativefitch.com 49
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.
www.derivativefitch.com 50
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.
www.derivativefitch.com 51
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.
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?
www.derivativefitch.com 53
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
www.derivativefitch.com 54
CDO Surveillance – Process, People and Tools
People
Process
Tools
• Proprietary surveillance database
• Data scrubbing and processing
• Automated e-mail notification
• Automated credit models
CDO
Surveillance
• Dedicated Staff
• Understanding of underlying assets
• Formal Analyst training program
• Surveillance process blends use of tools and technology, quantitative techniques and fundamental credit analysis to perform ongoing monitoring and rating action recommendations
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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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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
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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
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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
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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
New York
One State Street Plaza
New York, NY 10004
Tel. +1 212 908 0500
London
101 Finsbury Pavement
London EC2A 1RS
Tel. +44 (0) 20 7862 4000
Hong Kong
Suite 3902, Tower Two, Lippo Centre
89 Queensway, Hong Kong
Tel. +852 2263 9963