Académique Documents
Professionnel Documents
Culture Documents
Rating Methodology
Introduction Summary Part I: Business Practices Part II: Loan-by-Loan Analysis Evaluating the Frequency of Default Evaluating the Severity of Default Part III: Geographic Influences and Macroeconomics Part IV: Use and Evaluation of Historical Performance Part V: Various Loan Types and Transactions Structures Part VI: Various forms of Liquidity and Credit Enhancement Part VII: Currency Risk Part VIII: Piercing the Sovereign Ceiling Part IX: Credit Support Calculation - Cash Flow Model Part X: Legal Risks
CONTACT: Linda Stesney Managing Director Structured Finance Latin America (212) 553-3691
Linda.Stesney@moodys.com
INTRODUCTION
Moody's analysis of Latin American residential mortgage securitizations incorporates some of the same elements as those in analysis of a U.S. transaction: loanto-value (LTV) ratio, borrower credit quality, underwriting standards, debt-toincome (DTI), servicing practices, and historical information on the performance of similar loan types. In addition, Moody's considers country-specific factors that may influence credit performance, including the legal environment, currency exchange risks and the judicial system. All factors can vary greatly from jurisdiction to jurisdiction and will be the subject of future supplements to this report.
Investor Liaison
Vernessa Poole All Asset Backed and Residential Mortgage Backed Securities (212) 553-4796
Vernessa.Poole@moodys.com
SUMMARY
The rating process begins with a review of both the originator's and the servicer's operations and proceeds with an analysis of the characteristics of the loans in the pool. The analyst responsible for the transaction will work with a rating committee to determine the credit enhancement levels consistent with the requested rating. Several iterations are often needed, as the issuer adjusts support levels and tranche sizes to achieve the structure believed to be the most efficient overall. Changes in the timing or the priority of promised cash flows are considered as well. Legal documents describing the rights of investors, in addition to cash flows and servicing obligations, are examined to ensure that the structure of the transaction is consistent with the ratings to be assigned.
WEBSITE:
www.moodys.com
Following the assignment of a rating, Moody's monitors the performance of the underlying loan pool, as reflected in the monthly servicing reports. Moody's may adjust the rating of any security if subsequent events, such as a sharp increase in collateral losses, macro or microeconomic factors or sovereign events, dictate a change.
Servicing quality is influenced by a number of factors, including the use of software and technology, personnel training and retention, scalability of the servicing platform and the employee base to allow for portfolio growth, and financial condition of the servicer. The Latin American mortgage market is not as developed as that of the United States; therefore, the range of mortgage products originated and serviced, as well as the number of experienced servicers are limited. In this environment the need to replace a servicer on a deal is of the utmost importance, because if the original servicer fails, delinquencies and losses on the investor notes or certificates could rise significantly if the losses on the mortgage loans are not effectively resolved. In identifying a replacement servicer, compatibility of computer systems and software is critical also to reduce problems associated with transferring loans from one system to another and notifying borrowers of the change. Transfers can result in temporary performance problems so the goal is to avoid disruptions of any great duration. If the replacement servicer's systems are not compatible with those of the current servicer, servicing can not only be interrupted, it can also be affected negatively. The negative effect on delinquencies and loan losses will be more pronounced in lower-credit-quality pools than in prime-quality pools. In a market where the number of qualified servicers is limited, it is preferable to have a "hot" backup servicer. In other words, a backup who receives daily data tapes, who has excess capacity, and who is on the same servicing system as the primary servicer. Usually, a "hot" back up servicer is used when the pool of potential servicers is limited and/or the financial viability of the primary servicer is in question. In other situations a "warm" or "cold" backup servicer may be sufficient. Moody's will review the servicing arrangements to determine if they provide the incentive to service effectively. In evaluating the effectiveness of the backup servicer's arrangements, Moody's assesses the likelihood that these arrangements will be activated, the effect that the introduction of a backup servicer would have on the asset performance, and the potential for portfolio deterioration following a servicing disruption. Depending on our findings, a servicer reserve fund may be needed to cover any (1) advances, if applicable, during the servicing transfer, (2) increase in servicing fees and 3) other costs arising from the transfer. In some rare instances, the servicer reserve also covers increases in defaults due to servicing transfer. If not, then the increase in defaults must be covered by additional credit enhancement. Also, the need for a backup servicer depends on the rating the issuer is seeking, on the stability of the asset type, and on the financial stability and importance of the servicer or institution in that region. When transaction documents designate the trustee as backup servicer, Moody's verifies the capacity of the trustee to carry on the servicing duties. If the trustee does not have the servicing expertise, Moody's will then evaluate the trustee's ability to find a successor servicer. Quality Control Moody's analyzes the originator's quality control practices, such as how they review the performance of underwriters, collectors, and other employees involved in the sourcing, origination, and servicing of mortgage loans. Moody's also reviews reports tracking employee and loan performance. The originator's review of outside parties, such as appraisers, sellers, and servicers, is also examined, as is the company's review of loan files.
Some of the following factors could affect both the frequency and the severity of default. Evaluating the Frequency of Default A. Borrower Credit Quality A borrower's capacity to pay plays a central role in our rating approach. A borrower's credit quality is often determined by his/her track record in paying past consumer and mortgage debt. In the United States, creditreporting bureaus collect debt payment information about borrowers and provide prospective lenders with summary reports. Example of greater risk of default: Question: Which borrower has a lower risk of default? a) "D" borrower with a 70% LTV b) "A" borrower with a 85% LTV Answer: b) The "A" borrower has a lower risk - albeit the evidence suggests that a properly maintained property with a 70% LTV will have some equity even in an economic downturn. Those credit bureaus also use statistical models that produce a credit score for each borrower (e.g., the FICO or Fair Issacs Company CreditScore used in the US), which is meant to predict the borrower's future credit performance over the same time horizon. In Latin America, however, the borrower's credit history is not generally easy to determine because of a lack of centralized repositories, such as credit bureaus, for credit information.
In the United States, some lenders place their borrowers into broad categories, designated by letter grades, which are meant to rank borrowers according to their credit profiles. That practice, however, is not common in Latin America, so Moody's will "bucket" a group of borrowers together by certain risk factors Credit History Moody's considers the borrower's length of employment, bank statements, savings, disposable income before and after the mortgage, and income history. The post-mortgage debt-to-income ratio (DTI) also provides insight into the borrower's capacity to repay the loan. The DTI is the ratio of the mortgage and other debt obligations to income. It is important that Moody's understand how the DTI ratio is calculated and whether it includes other debt (back-ended DTI) or debt solely related to the mortgage loan in question (front-ended DTI)1. Past judgments, defaults, foreclosures and bankruptcies are also relevant in identifying the riskier borrowers. Verifying Payment History Although Latin America generally lacks a centralized reporting of credit information, which renders a credit history review more difficult than in the United States, the compensating factor is that Latin American borrowers usually have pre-existing, long-term relationships with the lenders. That enables the lendersnormally banks to make an accurate assessment of borrower quality by examining their payment history. In addition, although, access to credit information in Latin America is limited, compared to that in the U.S., financial institutions in Latin America nonetheless screen potential borrower's credit histories by exchanging information with other credit providers and banks. Where credit bureaus do exist, they are of limited use because the bureaus expunge negative information (i.e., a borrower delinquencies) once an overdue debt has been paid. In addition, as a relatively small percentage of the population incurs debt2, the bureau will not provide information on individuals with transactions made only in cash. Documentation Obtaining the proper documentation from the borrower relating to his/her employment status, income, and assets can help a lender determine a borrower's credit quality. If a lender does not obtain all or some of the information ("non-documentation "or "low documentation") or obtains the information from less reliable sources, the lender may not assess the borrower's payment capacity correctly.
1 For a detailed discussion on terminology use, please refer to Moody's Special Reports titled, "Contradictions in Terms: Variations in Terminology in the Mortgage Market," published June 9, 2000 and "Beauty is in the Eye of the Beholder: Recognizing Variations in Subprime Mortgage Underwriting Standards," published on March 27, 1998. It is estimated that in some Latin American countries only 25% of the population have credit cards.
In Latin America, most lenders' underwriting guidelines require borrowers to provide full documentation when applying for a loan. Full documentation is generally more extensive than that in the United States. Usually Latin American borrowers must establish that they have been continuously employed or self-employed for at least 12 months prior to the loan. All salaried borrowers must provide a recent pay stub, a letter from the employer stating the length of employment, and written verification of employment. The latter is normally verified in most Latin American countries with the Labor Department, which maintains a registry of employees. Self-employed borrowers must provide income tax returns for the past three years on average and bank statements for the past six to twelve months. The borrower's DTI is the most commonly used measure of their capacity to pay their debt obligations. DTI is a coverage ratio defined as the borrower's monthly debt service divided by their gross monthly income. The method of calculating the DTI varies somewhat from lender to lender, but it is typically "back-ended," that is, it includes all monthly debt payment obligations, such as mortgage payments (including insurance and taxes), credit card payments, car loan payments, student loan payments, and all recurring monthly income, such as salary. The lower the DTI, the greater the cushion the borrower has against unforeseen fluctuations in borrower income or debt. The coverage can change over time because it does not predict borrowers' income levels or debt burden, but rather, provides a snapshot view at a single point in time.
.
Country A Country B
Assumptions: Income Tax Country A : 50% Income Tax Country B : 20% Gross Income ST/LT Debt $100 $20 $100 $20
It is very important to understand how DTI is computed because as can be seen in the example above, in reality, an individual in country A has a much higher DTI than an individual in country B.
It is important to note that the above example assumes that mortgage debt is not tax-deductible, as mortgage interest is in the United States, where the DTI is calculated based on gross income not after-tax income. Of course, the U.S. tax obligations are relatively uniform throughout the country so there is no need for a different analysis of after-tax income for people in different parts of the country. The issue of residual income is an interesting one, because some U.S. lenders do look at residual income, in addition to DTI. It is generally thought that those borrowers with higher incomes can bear a higher DTI because they will also have greater residual income, notwithstanding their somewhat higher tax bracket. Many variations exist in the computation and reporting of DTI ratios, such as the decision to include short-term debt or revolving debt. A part of our analysis is to gain an understanding of the originator's computation practices and to adjust reported ratios where appropriate. For example, in a few countriessuch as Brazilsalaried employees, by law, are entitled to a so-called 13th wage, which is a bonus amounting to a month's wages, which is given at the end of the year. The amount is not normally computed in the DTI calculation since the DTI calculation is based on monthly income, but it can be considered as disposable income. In general, Latin American borrowers tend to have lower DTIs than those of their U.S. counterparts. The amount of their aggregate debt is usually lower than that of a U.S. borrower because of the lack of available financing and the limited use of credit cards and other forms of revolving and installment debt. Only a small percentage of people, mainly those in the middle to upper classes, use credit cards or have other debt outstanding, which would usually be limited to a car loan. Most of the people that have credit cards typically have no more than two, with a credit limit that is a small percentage of their monthly income. Also very important is that the concept of "rolling balances," that is, carrying a balance on the credit card, is not very common due to the high interest rates and high penalty fees.
Another curious point is the cultural difference between the use of credit cards in the U.S. and in Latin America. Most countries in Latin America use the credit cards to split the amount due on a product or purchase in several installments to fit the borrower's "pocket." That is similar to the way some people in the States purchase furniture or appliances by paying the cost as installment debt. B. Loan Type Most mortgage loans in Latin America securitizations are Example: either adjustable-rate mortgages (ARMs) or fixed-rate mortLoans can be classified as: gages (FRMs). Generally ARMs are riskier than FRMs. That is because of the potential "payment shock" that the ARM bor- Adjustable Rate Mortgage (ARMs) rowers face should interest rates increase, thereby increasing Fixed Rate Mortgages (FRMs) their monthly payments. The interest rate exposure to could Baloon Payment Loans lead to a higher default frequency for ARM borrowers. Balloon mortgages are loans in which all or a large portion of principal is due at maturity. Balloon payment loans typically offer low payments during the term of the loan, because they are shorter-term loans and have little or no principal paid during the term. A large payment is required at maturity, when all or a large amount of the principal is due. The risk of a borrower being unable to make a large payment or to refinance at maturity is significant. The problem is compounded if interest rates go up, if the value of the property declines, or if the borrower has had recent delinquency or credit problems. Any of those events could severely limit the borrower's ability to refinance the balloon mortgage at maturity. This type of loan in Latin America, however, is rare. ARM loans in Latin America are usually indexed to an interest or inflation index, although salaries may also be adjusted for inflation, there may be a mismatch between the rate at which the borrower's mortgage payments increase and the frequency with which his or her salary adjusts. There were instances in Latin American countries where indexes skyrocketed to 2000% per year while salaries never caught up. C. Loan Purpose How the borrower uses the proceeds from the loan affects the probability of default. Residential mortgage loans can be made to purchase a property, to refinance an existing mortgage, to improve the home, or for many other purposes, such as paying tuition. In the United States, because of differing historical performance patterns, Moody's differentiates loans based on their purpose. Generally loans to purchase a home or to refinance an existing loan at a lower rate have the lowest default frequencies.
Conversely, when equity is released through a cash-out refinance or a home equity loan, the default frequency is greater. In those cases, the determination of property value is made by an appraiser. Rate-term refinancing also depends on an appraisal for property valuation. Borrowing against the equity in a home may indicate that the borrower's actual income stream is insufficient to support his/her lifestyle or that other debt burdens are placing a greater strain on overall finances than anticipated at the time the home was purchased. D. Occupancy Status In Latin America, mortgage financing is generally available only for primary residences to be occupied by primary residents. Properties purchased as the owner's primary residence have lower frequencies of default than second homes or investment properties since the borrower's incentive to maintain a primary residence is greater than for a second home or an investment property. Examples: Types of ownership include: Owner-occupied Vacation properties Investor properties Rental properties
Examples: Some of the types include the following: First lien mortgages High LTV Mortgage Loans Home improvement loans (HILs) Home equity loans (HELs) Home Equity Lines of Credit (HELOC/"cash out refinancings") Others
The probability of default frequency on a nonowner-occupied home, such as a vacation, rental or investment property, is much greater than on an owner-occupied residence. Investment properties usually depend on income from the property itself, such as rents, instead of or in addition to the borrower's salary.
6 Moodys Investors Service
Moodys Approach To Rating Latin American Residential Mortgage Backed Securities
In an economic decline renters may be harder to find or may themselves default on their rental payments. The probability of default frequency on a vacation property is also much greater than on an owner-occupied residence. Under adverse financial or economic conditions, the borrower's loyalty to a vacation home or investment property is not as strong as it would be on their primary residence. Evaluating the Severity of Default A. Loan-to-value ratio Borrower equity, measured by the loan-to-value (LTV) ratio, is an important buffer against loss when a default occurs. The amount of the borrower's equity in the home will affect his/her willingness to continue to pay on the loan or to sell it quickly to avoid a lengthy foreclosure. In a problematic situation, such as death, divorce, illness, or unemployment, a homeowner with a large equity stake will probably sell the home to pay off the mortgage loan instead of going through a foreclosure proceeding and consequently facing a loss. The LTV ratio, which measures how much equity a borrower has in a property, is an important gauge to determine remaining equity and also helps to estimate the frequency and severity of default. The LTV ratio reflects the borrower's equity in a property, but equity can grow through time as a result of scheduled amortization, partial prepayments of principal, and any appreciation in home values. In fact, the LTV can be measured at any point in time, even years after a loan has closed. Moreover, an equity cushion helps protect lenders from housing market declines and extensive carrying costs3 during foreclosure proceedings4. Lowermiddle-income to middle-income individuals tend to have a lower LTV because of the higher downpayments (20% to 30%) required in Latin America. As a result, loans carry less risk for the borrower has a more vested interest in the property at the onset. For low-income borrowers, downpayments are lower at approximately 10% or even less due to government subsidies. The low downpayment loans in Latin America are generally the product of social policies that encourage housing rather than to the potential risk profile of the borrower. Property Appraisals LTV is a key determinant of loss frequency and severity of a defaulted mortgage loan. The value of the property is established through an appraisal process. In the States, appraisals can take many different forms and provide varying degrees of comfort concerning the value of the property. Appraisals can be drive-by appraisals (involving a cursory examination of the exterior of the property, but no interior inspection), tax-assessment record-based values; and comparable sales data and valuation database, known as automated appraisals. Moody's derives more comfort from "full appraisals," which are based on interior and exterior examinations. Accurate assessment of future liquidations and recoveries as indicated by an appraisal will help Moody's determine expected losses for a securitized mortgage pool. Full appraisals such as that of Fannie Mae in the U.S., offer the comprehensive information available on the value of the underlying property. Therefore, Moody's analysis in Latin America gives more credit for full appraisals, which compare with those of the FNMA than appraisals based on a drive-by, desk review, tax assessment, automated valuation methodology or comparable sales data. Moody's looks also more favorably on appraisals made by approved, independent, engineers or fee appraisers and reviewed by underwriters and quality control staff of the originator. Even when a full appraisal is used, the appraisal process is an inherently subjective process. For example, the value ascribed to various home improvements may vary from appraiser to appraiser.
3 4
Among the components of such costs are past due principal and interest, legal fees, taxes, and selling costs. For more information on this subject please refer to Moody's Special Report titled, "Clearing the Mists: Inside the Elusive Concept of Loan Loss Severity," published on August 27, 1999.
The properties selected as comparables may also vary, resulting in differing opinions on the value of the property in question. In the U.S., for example, appraisals in jumbo quality loans can vary. Moody's will try to determine if there are systemic biases in a lenders appraisal system by comparing the original appraised value with the sales price on defaulted properties, adjusting for general market declines and subsequent changes in the properties condition. For seasoned loans, the original appraised amount may be stale and a more current valuation may be needed. If the lender does not provide an updated appraisal as an approximation, the original appraised value may be adjusted to reflect changes in the real estate price trends in the region. That adjustment, however, will not capture, changes to the property condition for a neighborhood (such as a new highway or high-tension wires in close proximity to the house). More refined methods are not yet available in Latin America, including Broker Price Opinion5, real estate indexes, and automated valuation databases. Most of the appraisers in Latin American countries, when reviewing the property, include a review of the market in general. Appraisals are normally performed by qualified engineers who are regulated by an engineering association and are therefore obliged to adhere to specific and rigorous technical norms. The appraiser will provide a written report for each appraisal. The appraisals include interior and exterior photographs of the property, a description of its most important characteristics and of the quality of the materials used, the location, and the infrastructure of the neighborhood (for example, the presence of schools, supermarkets, and transportation, among others). Latin American lenders rely only on the expertise of the appraiser, as little reliable data are available on sales prices. The lack of sales price data also made the job of appraisal more difficult because borrowers can not readily test their opinions against the market. In most Latin American countries real estate sales must be registered with the notary public, but because home buyers often pay in cash to avoid capital gain taxes they tend to understate the value of the homes valuing this affirmation of limited value to a mortgage lender. Loan Seasoning The scheduled amortization of principal on a loan is determined by its interest rate, principal payment terms, and term (level-payment fully amortizing). The interest component of a level-payment fully amortizing loan is extremely high in the early years of the loan's life, which means that in the first years of amortization the amount of payments applied to principal are very low. It is important to note that the shorter the loan maturity or the lower the coupon rate, the faster the rate of amortization. See the table below for an illustration:
Loan Terms
30-year loan at 7% 15-year loan at 7% 30-year loan at 10% 15-year loan at 10% 30-year loan at 7% 15-year loan at 7% 30-year loan at 10%
Time Elapsed
12 months 12 months 12 months 12 months 36 months 36 months 36 months
Generally, all things being equal, the faster accumulation of equity means that the incentive to avoid default is increasedtranslating into a lower expected frequency of defaultand any recovery upon foreclosure would be highertranslating into a lower expected severity upon default. In the absence of home value depreciation, seasoned loans will have lower effective LTVs because of scheduled amortization.
Appraisal that consists of an exterior inspection of the property and an exterior inspection of all comparable sales used to support an opinion of value.
B. Time To Foreclose and Coupon Affects Loan Loss Severity Accrued and unpaid interest on a defaulted loan is a major component of loan loss severity. If a servicer advanced payments on a loan, including taxes, insurance, and principal and interest, the servicer will be paid from liquidation proceeds, thus increasing loss severity. The costs are known as carrying costs. The longer it takes to foreclose on and sell a defaulted property, the higher the associated payments will be and, thus the loss severity. Therefore, local foreclosure laws and the lender's actual foreclosure experience in a specific country becomes a significant driver of loss severity. The time to foreclose on a property varies substantially among countries or states because of economic conditions, statutory notice requirements, limitations regarding the sale of foreclosed property, court system delays, availability of non-judicial remedies and procedures, and rights of redemption6. The longer it takes to foreclose on a defaulted loan, the greater the carrying cost of the loan, in addition to the risk of property value depreciation. Latin America's mortgage interest rates can be as high as 20% or even higher, which is mainly related to the index rate. Higher interest rates result in higher loss severities on the loans, because accrued and unpaid interest on defaulted loansa principal component of loss severitywill increase. That will be particularly pronounced when foreclosure timelines are long. In addition, higher interest rates reduce the rate of principal amortization, resulting in higher LTVs than would occur if interest rates were lower. It is also important to verify whether foreclosure laws are in place to expedite the eviction and foreclosure process (please refer to Legal Section). On the positive side, in Latin America, borrowers cannot use the bankruptcy system to delay the foreclosure process. That is evident, but to a lesser extent, in Latin America because of 1) cultural differences, such as the stigma of going through foreclosure and the concern of suffering additional penalties as a result of the damage incurred and 2) properties are harder to damage due to type of construction, which is mainly bricks and concrete. In the event of damage, the cost for the lender to refurbish the home is generally much lower in Latin America due to the following: Labor costs and building materials are less expensive in Latin America than those in the U.S. Less probability of damage because materials used in Latin American construction are harder to damage. Also, in Latin America, homes, either for rent or for purchase, are not equipped with appliances, light fixtures, light switches, kitchen cupboards, built-in closets, and other amenities. As a result, the lender does not have to make replacements for the future borrower. C. Property Type Property types range from single-family, detached homes to co-ops and condominiums. Compared with standalone structures, attached housing in the States and units in multi-family properties (co-ops and condos) tend to have greater loss severity in the event of default. The greater severity is the result of these property types being less liquid than stand-alone homes and they might have to remain on the market for a longer time. It is also due to greater price volatility in markets where there is a high concentration of co-ops and condos, such as in New York City. In a distress situation, such illiquidity could lead to higher carrying costs, which might not be the case depending on the country in Latin America, the state or the MSA, (Metropolitan Statistical Area) and the socioeconomic level of the borrower. The liquidity of a property is not as dependent on the property type, per se, as is the property type compared with those in the same area. A co-op or a condo in a location where the primary form of home owned is a coop or condo, such as in New York City, will have a higher degree of liquidity than a co-op or a condo in a real estate market, primarily with detached single-family homes. Similarly, a home that has a high price compared to those around it, will be less liquid than the same home for the same price in a wealthier neighborhood.
For more details on this subject please refer to Moody's report titled, "Moody's Approach to Rating Residential Mortgage Servicers," published on January 19, 2001.
Unlike the U.S., median home price data are not readily available in Latin America. Consequently, it is not feasible to determine the price of a home in relation to the area's median price. Nevertheless, Moody's analysts conduct a very thorough study of the different areas with the local appraisal experts, which allows them to understand the demand and valuation of properties in a certain area. In that way, Moody's identifies properties that are less liquid and that may experience greater price volatility and higher loss severity.
In particular, performance data that covers periods during which there were negative economic events and environments, such as recessions, are particularly informative, as they show the effect of economic downturns on the performance of loans in that country. Actually, this is an advantage that countries in Latin America have, as a result of several major and minor economic "hiccups" in those countries. The precision of any projection, in part, depends on the amount and accuracy of information available. The greater the variability associated with the projected loss, the higher the amount of credit support needed to support a particular rating. When projecting future losses, a severe economic downturn in a Latin American country could be considered as a benchmark for that country in the sense that it can be used as a "worse case scenario" when projecting future losses. When data are not available, there is more uncertainty about how the portfolio will perform in the future. In such a situation, Moody's analyzes different assets in the country, if available, and draws an analogy, if possible, taking into consideration the different recovery rates and other aspects of the different asset type. The most useful form of performance data is static pool data rather than portfolio data. A static pool refers to a group of loans originated at approximately the same time using the same underwriting guidelinesthe performance of which is tracked as a group. Once loans in the static pool are identified, no new loans are added. By isolating the group, as the loans age or season, their delinquencies, foreclosure rates, percentage of REOs, and losses can be measured and a loss curve developed. That method avoids distortions that can arise in rapidly growing portfolios as new, performing loans are added to already seasoned pools. Historical Performance In rating a residential mortgage pool, Moody's analyzes loan delinquencies, losses, foreclosures, times to foreclosure, recoveries, carrying costs, restructured contracts (modifications), short sales and other nonforeclosure resolutions, cure rates, etc. Moody's discusses performance measures with the originator and servicer to understand which factors have contributed to the performance. For example, high losses in a pool of relatively low LTV loans may call into question appraisal practices. Moody's may compare the loan characteristics and performance to other pools as a way of benchmarking originators/servicers' practices. Even when loan performance is tracked on a static pool basis, mortgage originators and servicers do not report performance data in a consistent manner, both in the US and in Latin America. For example, a loan that is 30days past due may mean: the loan is 1 day past due the grace period has terminated the loan is 30 days past due the loan is 31 days past due Another example is the so-called rolling 30-day delinquency (i.e., where a borrower is always one month behind on his mortgage payments). Some servicers report that borrower as having been 30 days late just one time. Thus Moody's must understand exactly how an originator /servicer is counting delinquencies so that the data can be properly interpreted and fairly compared with that of other originators.
ARM or FRM loans denominated in local currency and the securities denominated in dollars (please refer to Part VII: Currency Risk for more details) The following table focuses on a few assorted structures: Diverse Structures: Different transaction structures 1a) Senior/Subordinated* (with interest subordination)
Purpose Senior investors receive interest and principal monthly. Subordinated investors receive interest after senior investors have received interest and principal. Principal is only distributed to the subordinated investors once the senior investors are paid in full.
Comments It shortens the average life of the senior class due to the "turbo" structure, in which principal (principal balance, prepayments, liquidation proceeds, and repurchases) are applied to pay down the senior class first. Also, the credit enhancement, in the form of subordinated bonds grows as a percentage of the outstanding bonds, since it does not receive principal until the senior classes are paid off.
Pro rata**
Class B interest is subordinated only to Class A interest. In US MBS deals, cash is usually allocated to pay senior bond interest, then sub bond interest, then senior bond principal, and finally subordinated bond principal. Also, regularly scheduled principal gets paid to the sub classes after the senior classes have gotten their monthly interest allocation. Principal prepayments, are allocated to the seniors for some period of time, and then are distributed among all the classes (in order of priority). Cash remaining after payments to investors ("excess spread") is retained in a reserve fund. This money could be used as credit protection to any class. This structure has more than one senior/subordinated class, and it pays sequentially among the senior classes. Investors receive interest and principal monthly, or any other payment frequency. Credit enhancement is normally provided by a third party guaranty. This structure increases the average Principal is allocated among life of the senior securities and senior and subordinated reduces the average life of the subortranches on a pro-rata basis. dinated securities. In this structure the dollar amount of credit enhancement reduces over time. Even though, as a percentage of the outstanding balance, all the classes remain the same.
*This type of structure might have several variations such as lock out periods. **This type of structure normally has lockout periods (i.e., subordinated class has to represent X% of the remaining balance) or delinquency and loss triggers.
Prefunding At the closing date of an MBS transaction, there may be a mismatch between the principal amount of the MBS bonds being issued and the principal balance of the mortgage loans. The originator anticipates being able to originate a sufficient principal balance of the mortgage loans, as well as a sufficient principal amount of mortgage loans during a stated period, typically three to six months after closing (the prefunding period). The MBS proceeds in excess of the mortgage principal balance are segregated in a prefunding account until new loans meeting specific eligibility criteria (generally, the same underwriting standards and loan characteristics similar to those loans already in the pool) are originated and sold to the trust. Amounts in the prefunding account can be invested only in eligible investments7 which generally have a lower interest rate than that of the coupon on the MBS bonds, resulting in a negative carry. The latter must be covered by some form of credit enhancement (e.g., excess spread for a liquidity reserve for a capitalized interest account). If at the expiration of the prefunding period not all the mortgages have been sold to the trust, then funds in the prefunding account will be used to pay down senior MBS bonds. Negative Carry The presence of prefunding accounts leads Moody's to direct its analysis toward another potential problem: negative carry. Negative carry is defined as the difference between the return on the investments that the funds in the prefunding account earn to and the coupon promised to investors. Moody's analyzes the structure of the transaction to determine the potential extent of the shortfall and to ensure that there is enough credit enhancement, excess spread, or liquidity reserves to protect security holders' timely distributions of debt service. However, if it is determined that not enough cash is available in the deal, a capitalized interest account might be needed. If a reserve fund is needed, and depending on the transaction structure, it will have to be sized according to a stressed LIBOR or any other applicable index. Prepayment lockouts A prepayment lockout will allow the senior classes to receive all principal prepayment either until they are paid off or, for a specific period of time, until certain tests are met. By distributing principal prepayments to the senior classes, the subordinate bonds grow as a percentage of the outstanding mortgage balance. Although principal prepayment reduces the exposure of the senior classes to losses because credit enhancement from the subordination of the subordinate classes is preserved by locking out the sub classes from principal prepayments, it returns principal to senior investors sooner than it would in a pro rata structure and, therefore, accentuates prepayment risk. Conversely the subordinated certificates have greater exposure to extension risk. In Latin America, the type of structure used depends on investor demand in the particular country where issuance takes place. But if a structure, such as a principal prepayment lockout were to be used, the principal prepayment effect would not be as strong as in the U.S., due to the lower prepayment speed rates throughout Latin America. Delinquency and Loss Triggers Many MBS transactions incorporate performance triggers intended to prevent credit enhancement from leaking out of a deal (e.g., from a stepdown) if it is performing worse from expected. A performance trigger will reallocate cash flow to senior bonds or, conversely, prevent cash from being paid to subordinate bondholders, to prevent erosion of credit enhancement in the form of subordinated bonds. For a trigger to be effective, the originators' performance data, including method of calculating delinquencies and losses, must be thoroughly understood. Delinquency information might be tricky to understand, because it is usually calculated differently from originator to originator, as discussed previously. That lack of standardization in the calculation of delinquency ratios makes the performance comparisons between originators particularly challenging.
For more details on Eligible Investments please refer to Moody's report title, "Temporary Use of Cash in Structured Transactions: Eligible Investment Guidelines," published on April 12, 1996.
Prepayments The prepayment profile for mortgage loans is very different in the U.S. than it is in Latin American countries. As so many sources of mortgage financing are available in the States, a borrower can refinance a mortgage loan, assuming that the borrower's credit profile has not deteriorated, with relative ease when prevailing interest rates drop. Prepayment speeds on MBS deals in the U.S. can be very erratic, and will be strongly influenced by interest rate environment. Prepayments can result in an adverse selection of loans in the pool; in other words, the better-performing borrowers will command lower interest rates and will be more likely to refinance than lower credit quality borrowers. Faster prepayment speeds can reduce the excess spread available as a source of credit enhancement and will be factored into our analysis of credit enhancement levels. In Latin America, however, there are fewer refinancing options and pool prepayment speeds tend to be more stable and the level of spread deterioration is lower due to prepayments. Advancing Most U.S. MBS deals are structured so that the servicers advance interest, and sometimes principal, on delinquent mortgage loans in the pool to the extent that they l are deemed to be recoverable (i.e., when the loan either cures or is liquidated). The advancing mechanism is intended to provide liquidity for the transaction, thus allowing timely payments to be made on the bonds. Without advancing, a mortgage pool would generate smaller monthly payments to security holders when homeowners are delinquent, followed by larger income streams when homeowners cure their delinquencies or when their property is liquidated. As a result, advancing makes the cash flows less volatile and investors can anticipate receiving their interest in more even payments. Ultimately, however, the impact of advancing on investors depends on how cash flows are allocated among tranches. For instance, in a typical senior subordinated structure, the benefits of advancing actually benefit the subordinate classes more, because principal and interest distributions are made first to the senior tranches. The senior class will suffer only if there are no advances and if delinquencies exceed the subordinate class. However, the subordinate pieces would still experience a far greater number of shortfalls when the loan is actually liquidated and the advances reimbursed.
It is important to distribute the losses in a front loaded curve in order to verify the availability of excess spread, since the greatest dollar amount of excess spread is concentrated in the early years when the level of losses are low and there is a higher amount of loans outstanding. Another factor, basis risk, which we include in our modeling, can affect the excess spread, Basis risk is created when the mortgage loans and the bonds are indexed to a different index. For example, if the mortgage loans have a fixed-interest rate, but the bonds are adjustable rate, as interest rates rise, excess spread will decline. Surety Bond Surety bonds are guarantees from a third party. Moody's reviews the insurance policy to make sure the legal obligation of the insurance company is consistent with our rating. The legal obligations we focus on include the insurer's obligation to make timely payments of interest and principal and and any the carve-outs of the policy. Moreover, Moody's analyzes the credit quality of the insurer, and a public rating is assigned to the providers. The rating of the transaction is linked to the credit quality of the insurer. Cross-Collateralization For transactions that contain two or more loan groups, such as separate groups of FRMs and ARMs, cross-collateralization created by using excess spread from one group to support the other group, as needed. Moody's considers the excess spread when analyzing the transaction; however, we have to model excess spread to determine how much loss protection is available from it throughout the life of the deal. Partial Credit Guarantees When analyzing partial credit guarantees Moody's examines the terms of the insurance policy or guarantee to evaluate how much credit support is being provided. That includes determining whether there are any carveouts under the policy or guaranty and when the insurer or guarantor is obligated to make a payment after a loss occurs. Another very important aspect of the partial guaranty is the reimbursement of the insurer in the waterfall8. The insurer should not be reimbursed before the senior security holders are paid in full because a partial credit guarantee is not considered liquidity. A partial credit guarantor should only be reimbursed before senior security holders for amounts related to mortgage loans they bought out of the pool and for which they would be receiving recoveries. That is to say, if a guarantor purchased a defaulted loan, any amounts relating to recoveries on the defaulted loan should be reimbursed to the guarantor directly. Finally, the rating on the bonds may be limited by the rating of the insurer or guarantor. Lender Mortgage Insurance Mortgage insurance in an MBS deal is typically paid by the borrower if the loan has an LTV greater than 80. The lender can also purchase insurance on a certain portion of the pool. Mortgage insurance protects the property owner from negligence and errors. The presence of mortgage insurance does not change our assessment of the frequency of default, but it does change the severity of default9. Moody's must also know the number and the quality of the loans covered by mortgage insurance. It is also important to assess the credit quality of the mortgage insurance provider, in order to know if the provider is capable of making payments under the claims and if they are willing to make the payments. Mortgage insurance does not change our assessment of frequency of default but does change the severity of default.
If the mortgages are dollar denominated, then the borrower is taking the currency risk and the credit quality of the mortgage is affected by any currency fluctuations. An assessment must be made as to the likelihood of the borrowers' continued ability to pay the mortgages in dollars. If the mortgages are local currency denominated, then the currency risk depends on whether the bonds are also or whether they are dollar (or some other currency) denominated. These two issues are described as "direct volatility risk" and "indirect volatility risk," respectively. Direct Volatility Risk The risk is present when the MBSs are, for instance, denominated in dollars and the collateral is denominated in local currency. The direct risk will not affect the frequency of default by the borrowers as the borrower is only obligated to make local currency payments; thus, if there is an appreciation of the local currency vis--vis the dollar, the borrower is obligated to meet the payment in local currency. Investors, on the other hand, are taking the risk that the mortgage collections in local currency will not be sufficient to pay the bonds in dollars. The following issues are examined in Moody's analysis of the currency risk: Exchange rate history of the specific country in Latin America vis--vis the dollar. Exchange rate outlook of the specific country in Latin America vis--vis the dollar. Frequency of transferring the mortgage payments offshore because funds are exposed to a country's sovereign risk, while onshore. Timing of a devaluation. Magnitude of a devaluation. After considering the factors described above, Moody's will evaluate how the issuer has addressed the currency risk to make it consistent with the ratings on the bonds. Several measures can be taken to reduce that risk, including. Long-term currency swap agreement benefiting the deal. Hedge agreement benefiting the deal. Subordination, which has to be sufficient to cover currency risk as well as credit risk. Indirect Volatility Risk Another risk considered in analyzing an MBS deal in Latin America is one in which the loans are denominated in U.S. dollars, while the borrower receives income in the local currency. If the local currency were devalued, the borrower's payment obligations would increasepossibly significantly putting added financial pressure on the borrower and increasing the likelihood of default. Therefore, we also look at the same points described in the direct risk situation, but analyze what will be the likely impact of each of those points in the borrower's ability to pay the mortgage, in contrast to the deal's ability to pay the MBS, independent of losses on the loans. The risk can also be addressed at each rating level through an appropriate additional amount of subordination. Please refer to Part IX: Credit Support Calculation, which describes how Moody's models the risk.
A foreign currency obligation may be rated above the sovereign rating ceiling only if the transaction incorporates features that reduce either the probability of government interference or the severity of losses to investors should the government interfere. Various mechanisms are available to enable the rating of a security to exceed the relevant sovereign ceiling of the country in which the issuer or originator is domiciled and to support debt service payment in the event of a debt moratorium or other form of convertibility and transferability restrictions. Some of the most commonly used mechanisms include: Political risk insurance (PRI) An offshore reserve account A letter of credit with an offshore Prime-1-rated bank A/B loan structure, where a multilateral creditor remains lender of record, but sells participation in the under lying loans. Moody's believes that the amount of required support to protect investors against sovereign risk depends on the potential duration of the convertibility or transferability event. Whichever of the mechanisms is used (excluding the A/B loan structure), the amount available offshore must be equal to at least a certain number of months10 depending on each Latin American country's scheduled interest and principal payments if the rating on the security is to be greater than the sovereign ceiling11.
Moody's then incorporates the systemic risk and macroeconomic shocks into the model. We discuss these thoroughly with our sovereign analysts, incorporating transaction and country features either for cross-border deals or for national deals, to determine which shocks are pertinent. In each case we address such questions as the following: How many macroeconomic shocks are likely to occur during the life of the transaction? What is the probability of each shock occurring? How much time is likely to elapse between one shock and the next? What is the magnitude of each shock? How long is each shock likely to last? How do those shocks affect the frequency of default? Moody's then simulates the macroeconomic shocks and applies varying magnitudes and duration to each one, to increase the base default rate. At the same time, Moody's analyzes the historical performance data of the pool to be securitized. Ideally, we would receive static performance data for the securitized pool, the performance of all the assets originated by the same originator, and, finally, the performance of the assets on an industrywide basis. Monte Carlo simulations can help us to estimate how the frequency and the severity of pool defaults will affect the performance of the rated securities. The model indicates the impact of the factors on the expected loss a major factor in determining the appropriate rating. Simulations incorporating macroeconomic shock effects, deal-specific defaults and recoveries, and the local currency guideline driven defaults with no recoveries are run through a model of the bond structure to estimate the expected loss on each class of securities. By dividing the dollar amount of expected total losses by the size of the senior class, for example, we can estimate expected loss in percent terms. We compare the percentage to the weighted-average life of the security with Moody's expected loss table to determine the rating and to verify if the credit support is sufficient to support the desired rating. By knowing the desired rating, Moody's can change the credit support needed to achieve it.
Security Interest Opinion: An opinion that the trustee will have a first-priority perfected security interest in all the assets included in the trust estate (including any prefunding account), which are pledged or transferred to the trustee for the benefit of the investors. It can either be a stand-alone opinion if there is no true sale, or, if there is a true sale, it would be a back-up security interest opinion. Fraudulent Conveyance/Transfer: Another means by which a creditor can attempt to pull assets back into the debtor's estate is by establishing that a fraudulent transfer occurred. The need for comfort on this issue increases as the parent/transferor's credit approaches investment grade or lower. A legal opinion should address issues such as: 1. The intent of the parties. 2. The solvency of the transferor. 3. The fair value of the consideration received for the property transferred. Enforceability Opinion: The opinion usually states that all documents (including surety bonds) relating to the transaction have met the following requirements: 1. Legal, valid, binding, and enforceable in accordance with their terms. 2. Duly authorized, executed, and delivered by all parties. 3. Do not conflict or violate all parties' organizational documents, bylaws, or any agreements, or orders by which all parties are bound, or any applicable laws or regulations.