Derivative Fitch: Second-Lien RMBS Exposure in CDOs Marginal But May Increase.

NEW YORK -- Though subprime closed-end second-lien (CES) RMBS transactions represent a small sub-sector of the overall subprime RMBS universe, these transactions are proving to be some of the worst performers through the first four months of 2007, prompting Derivative Fitch to take a closer look at the potential impact of subprime CES RMBS on Fitch-rated CDOs.

Fitch rates a total of 116 U.S CDOs with exposure to subprime CES RMBS transactions, though only 35 U.S. CDOs have exposure to the 2006 vintage subprime CES RMBS transactions that are experiencing the greatest stress. These U.S. CDOs include 16 mezzanine SF CDOs, 11 high-grade SF CDOs, four synthetic SF CDOs, three commercial real estate (CRE) CDOs and one market value SF CDO. CES exposure in European CDOs is isolated to eight transactions with relatively mild exposure. Seven of the CDOs are synthetic transactions and one is a cash-flow transaction. The highest total exposure in the European CDOs is approximately 2.2% of the reference portfolio. Fitch has reviewed these CDOs and the underlying exposures to gauge the potential impact on the rated CDO notes. At this time the cumulative exposure to subprime CES RMBS transactions in these CDOs is not sufficient to cause Fitch to place any tranche on Rating Watch Negative. However, as Derivative Fitch expects this negative performance trend to continue, the potential for negative actions on both high-grade and mezzanine SF CDOs increases dramatically where there are significant exposures to 2006 subprime CES RMBS and limited asset manager flexibility to sell assets.

The rating performance for subprime CES RMBS differs from other subprime RMBS transactions in the timing and severity of rating actions, as well as the depth of the impact further up the RMBS capital structure. For example, recent rating actions on a one-year seasoned rated subprime CES RMBS from the other major rating agencies resulted in the senior notes (originally rated 'AAA' and 'Aaa') experiencing a two-notch downgrade and the mezzanine bonds experiencing over a ten-notch downgrade and will likely realize losses in the next payment period. The performance drivers of the subprime CES RMBS sub-sector and projected CDO impact will also be the topic of a forthcoming special report.

The poor performance of recent vintage ABS backed by pools of CES mortgages results from the interaction of a number of factors. The most significant factor is that the overwhelming majority of the loans in these pools were originated with a combined loan-to-value (CLTV) ratio of 100%. That is, the borrower mortgaged the full value of the home, typically through taking a first lien of 80% LTV, combined with a second lien on the remaining 20%. This means that in an environment with little home price growth, or outright home price declines, there is no equity cushion. When a borrower cannot make their mortgage payments, the lack of home equity eliminates refinancing as an option and therefore increases the likelihood the borrower will default. Home prices are flat to falling in areas where these mortgages are concentrated, such as California, driving higher levels of default. Given that the borrowers have subprime credit, the probability that the borrower will have difficulty with the payments is relatively high, and adding on additional layered risk factors such as stated income programs, further increased default risk.

Subprime CES deals differ from subprime first-lien deals in the timing of collateral loss. Defaulted first liens go through a foreclosure and liquidation process that can take many months, often over a year, thus delaying loss realization. Defaulted CES are typically 100% charged-off 180 days after default, due to the poor prospects for recovery on a junior lien. Therefore loss given default on CES is recognized much earlier in the life of a deal than is the case for first-lien subprime mortgage. Thus, to the degree that collateral is underperforming, rating actions may also occur earlier in the life of the RMBS transaction in which it was securitized.

Additionally, some CES securitizations also have structural features that have resulted in increased downgrade risk. Unlike most first-lien transactions, which establish required overcollateralization (OC) at deal closing, many CES deals were structured to build OC over time using excess spread. High voluntary prepayment rates reduced the amount of excess spread available, exacerbated by increasing losses. As a result, some deals never reached the required OC amount and thus were more vulnerable to rising losses. Fitch discussed this problem in depth in a report last year, updated as of Feb. 6, 2007, 'U.S. RMBS Cash Flow Modeling Criteria For Second-Lien Mortgage Products: Updated'.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.