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A peak year for private pass-throughs.

The private pass-through market hit some shaky ground in 1991 produced by deteriorating credit quality and fallout from a trembling economy. Even so, the RTC, a refi wave and risk-based capital rules sent non-agency MBS issuance soaring to new heights.

During the past year, the private (non-agency) mortgage securities market was strongly affected by the fluctuations and shocks felt in the U.S. economy. The crisis in the thrift industry, the lingering economic recession, the sharp drop in home prices in certain areas and the decline in interest rates were all factors that contributed to the changes in the mortgage markets.

Early in 1992, the economic future is decidedly uncertain and is further clouded by the unpredictable outcome of the presidential election.

As regional economies weakened in the Northeast and California - the source of the bulk of originations in the non-agency mortgage market - credit risk began to replace interest-rate risk as the major concern in the minds of many investors. The credit concerns of investors led to the record issuance in 1991 of nearly $30 billion of non-agency mortgage pass-throughs rated Aaa, the highest rating of Moody's Investors Service. In comparison, about $10 billion of Aaa-rated pass-throughs were issued in 1990 and a total of less than $3 billion from 1987 to 1989.

New and complex structures also raised questions about the relative credit risks of various classes of securities. Concern was also expressed by institutional investors about the nature of the collateral from failed thrift institutions that was being securitized. At the same time, the creditworthiness of some seasoned pools was improving, which Moody's recognized by upgrading $2.5 billion of seasoned pass-through securities early in the year.

As the securitization of non-agency mortgages continues to evolve into a larger and more complex market, the supply of information about individual transactions becomes ever more important. Beginning this year, Moody's Investors Service will supply monthly information on the credit performance and prepayments on each mortgage pass-through it has rated. As of the end of the first quarter of 1992, about 800 transactions had been rated by Moody's. Moody's goal in providing this information, along with its credit ratings, is to make the market more efficient, from the perspective of both issuers and investors.

Following a review of new issuance and credit performance of the private mortgage market offerings in the past year, this article examines the credit risks of a new type of structure, dubbed "super-senior," which was used in almost one-fourth of the dollar volume of all non-agency pass-throughs issued in 1991.

Volume soars from refinancing

Last year was a period of record issuance in the private-label mortgage pass-through market, with almost $50 billion in new securities issued (See Chart 1). The private-label mortgage market consists of non-conforming mortgages that are securitized and sold into the secondary market with a rating that is most often Aaa or Aa2. The bulk of the mortgage collateral consists of loans whose dollar size exceeds the Fannie Mae/Freddie Mac purchase limit, which this year was set at $202,300 for single-family homes. Total private pass-through volume last year was almost double that of 1990 and more than five times that of 1987. Preliminary data for the first quarter of 1992, along with

Moody's issuance projections for the remainder of the year, indicate that last year's extraordinary volume actually may be surpassed in 1992.

The explosion in issuance during the past two years can be in large part explained by the "three Rs": refinancing, RTC and risk-based capital requirements. First, sharp drops in both fixed and adjustable mortgage rates have spurred a wave of refinancing that started in 1991 (See Chart 2). These drops have continued unabated in the first quarter of 1992. Although there are signs of an economic turnaround, which would boost interest rates from current lows, refinancings should continue to play a major role in mortgage originations during the first half of the year. As the economy strengthens and as interest rates rise in the second half, refinancing activity should be reduced.

At the end of 1991, prepayments on private-label mortgage pools, seasoned at least one year, were running at an annual rate of more than 30 percent. If interest rates rise in the second half of the year, prepayments on non-agency ARM securities could fall below 20 percent at an annual rate, with private-label, fixed-mortgage prepayments falling even further, to 10 percent or less.

In 1991, 54 percent of the total issuance had fixed-rate collateral, 41 percent had ARM collateral, with balloon mortgages and graduated payment mortgages accounting for the remainder. Most refinancing activity appears to be into fixed-rate mortgages, although the steepness of the yield curve makes the initial rate on ARMs attractive to homeowners expecting to move within a few years.

RTC issuance soars

The second major factor in the surge in issuance has been the Resolution Trust Corporation (RTC). Since the third quarter of last year, the RTC has been issuing an average of about $1 billion to $2 billion per month in rated pass-through securities and is expected to continue at this pace for the next two years. The collateral used in RTC transactions has differed markedly from the mortgages in typical rated pass-throughs. The weighted-average characteristics of pass-throughs rated by Moody's in 1991 are shown in the first column of Table 1. The figure also gives a collateral summary for two specific RTC transactions.
Average Pool Characteristics, 1991 vs.
Selected RTC Pools (data as % of pool,
except as noted)
 "Average" RTC RTC
 Pool 91-2 91-6
Credit support 7.3 23.0 21.0
Weighted Average LTV 72 73 74
Over 80% LTV 14 7 50
Nonowner 6 15 24
Condominium 8 11 12
PUD 4 12 7
Equity refinance 25 26 21
Seasoning (months) 19 28 125
Limited documentation 49 35 100
California 59 99 28
New York area 12 0 1
Texas area 3 0 28
Moody's rating Aa2-Aaa Aaa Aaa

The "average" rated mortgage pool in 1991 had a weighted-average loan to-value (LTV) ratio of approximately 72 percent, with 14 percent of the loans exceeding 80 percent LTV. Investor or second homes in the average rated pool constituted 6 percent of securitized loans, and about 12 percent were loans on condominiums o planned-unit developments (PUDs). About one-fourth of loans typically were "cash-out," or equity take-out, refinancings. Despite the fact that man lenders announced cutbacks or even discontinuation of limited documentation mortgage programs, almost half the loans in private pools in 1991 had limited documentation in some form. However, in 1991 many lenders had tightened standards for limited documentation loans.

As in previous years, loans on properties in California made up more than half the total. Only about one in ten loans securitized were from the New York-New Jersey-Connecticut area, down from as high as 25 percent in prior years. Loans from such oil-producing states as Texas, Oklahoma and Louisiana represented only about 3 percent of all loans. The average seasoning of pools in 1991 was about 19 months; however, most pools were either new originations or were seasoned more than three years.

The predominate rating of the senior classes of mortgage pass-throughs in 1991 was Aaa, with Aa2 being the second most common rating. The average level of credit support available to senior classes was just in excess of 7 percent of the balance of the securities.

Pools sold by the RTC had greater risk characteristics than those of the typical pool. Credit support for Aaa-rated senior classes tended to be about 15 percent to 25 percent or more. The reasons for the high level of credit support are evident from the two representative pools shown in Table 1. For example, RTC 91-6 had a large number of loans with LTV ratios exceeding 80 percent and a higher weighted-average LTV than the average rated pool in 1991. In addition, the pool had high percentages of non-owner-occupied properties, condominiums and PUDs. The pool of loans backing RTC 91-6 also had a high concentration of properties in the oil-producing states, which had witnessed sharp drops in property values during the past decade.

Issuers other than RTC also posted record offering volumes in 1991 and are expected to match or exceed those records in 1992. The top issuers of mortgage pass-throughs rated by Moody's Investors Service in 1991 were as follows:
Volume (billions of dollars)
Prudential Home Mortgage 5.4
Resolution Trust Corporation 5.3
Residential Funding Corporation 4.3
Ryland Mortgage Securities 3.2
Citicorp Mortgage Securities 2.9
Chase Mortgage Finance 2.3
Structured Mortgage Asset (Lehman Brothers) 1.9
Sears Mortgage Securities 1.8
GE Capital 1.0

Senior/subordinated structure makes a comeback

Regulatory and capital requirements are the third force behind the surge in pass-through issuance. The pressure on banks and thrift institutions to meet more stringent risk-based capital requirements not only has been a force powering securitization in the mortgage markets, but also for other types of assets such card receivables and auto loans.

Despite the fact that for some issuers a large amount of capital must be held against retained subordinated classes of mortgage securities, the senior/subordinated structure saw a resurgence in 1991. The senior/subordinated structure was by far the most popular form of structure (66 percent of all issues rated by Moody's), followed by the reserve fund used by RTC (15 percent of the total). Pool insurance policies or letters of credit were used in less than 20 percent of all transactions and corporate guarantees shrank to only 1 percent of the market.

The growing popularity of the senior/subordinated structure can be attributed to three factors: (1) a growing concern for the potential downgrade risk of third-party credit enhancers, (2) the expense of obtaining insurance for risks not covered by pool policies; and (3) the growing market for subordinated classes. The first factor was covered extensively in the May 1991 issue of Mortgage Banking. (See "The Downgrade Environment" by Howard Esaki, May 1991, pp. 41-43.) One of the major costs of pool policy transactions is the provision of special-hazard and bankruptcy insurance, neither of which are covered by the pool policy. The perceived increase in risks from bankruptcy in 1991 raised the cost of pool policy transactions. However, due to a recent Supreme Court ruling, Dewsnup v. Timm, these risks have diminished somewhat in 1992. In addition, a more active market for subordinated classes appears to be developing as investors become more familiar with the risks of these classes.

Deterioration of mortgage credit quality

The lingering national economic recession has taken its toll on the credit quality of mortgages in the non-agency security market. The latest available data, for a selected group of 38 pools, show that at the end of 1991, delinquencies were at or near the highest levels since Moody's began compiling the data in 1989. Delinquency rates for all pools rated by Moody's (nearly $70 billion) at the end of the third quarter of 1991 are shown in Table 2. [TABULAR DATA OMITTED]

At the end of the third quarter, total mortgage delinquencies (of more than 30 days) on private pass-throughs seasoned more than a year had increased for six consecutive quarters to 4.9 percent. Total delinquencies on private pass-throughs were slightly above 4 percent at the end of 1991. Loans in foreclosure also rose to 1.4 percent of seasoned loans, up from about 0.7 percent at the end of 1990. The rise in loans in foreclosure was the seventh consecutive quarterly increase.

The largest jump in delinquencies for loans backing rated, non-agency securities came in the category of adjustable-rate mortgages. The delinquency rate for ARMs with negative amortization and without negative amortization rose to 5.1 percent and 8.8 percent, respectively. Loans permitting negative amortization tended to have lower delinquency rates because they are mainly on properties in California, and mortgages from that state have posted lower delinquency rates than the national average.

The delinquency rate for 30-year, fixed-rate loans rose from 2.8 percent at the end of 1990 to 3.2 percent at the end of the third quarter of 1991 (See Table 2). In the same period, the delinquency rate on 15-year loans rose from 1.5 percent to 2.8 percent. The delinquency rate for GPMs and GEMs, a relatively small sector of the market, was at 5.4 percent, compared with 4.3 percent at the end of 1990.

Seasoned pass-throughs (those initially rated by Moody's more than a year ago) have a remaining balance of about $35 billion. All pass-throughs rated by Moody's have a current balance of roughly $68 billion, with a total delinquency rate of 4.0 percent, as of the end of last year's third quarter. Seasoned pass-throughs have a higher delinquency rate because they are past the period of low delinquencies characteristic of the early months of a pool.

Cumulative realized losses on mortgages increased in the third quarter to 5 basis points (.05 percent) of aggregate original balances for all seasoned pools, compared with 2 basis points at the end of 1990. For all pools, total remaining credit enhancement is just in excess of 10 percent of outstanding pool balances. ARM pools, considered the riskiest, have credit support of more than 13 percent of remaining balances.

Credit quality also deteriorated in certain regional mortgage markets that produce significant amounts of loans that go into private pass-through securities (See Chart 3). At the end of 1991, total delinquencies on a group of high-balance mortgages on a sample of California properties had risen to just below 3 percent. That was the highest level since Moody's began tracking the sample in 1989. In the New York-New Jersey-Connecticut area, delinquencies rose to about 6 percent, slightly below the high for the year, which was recorded in September.

The rise in the level of mortgage delinquencies reflects the continued sluggish economy and the weakness in home prices, especially in the higher price ranges. The pools of mortgages tracked each month do not change except for prepayments or defaulted loans. In the recent period of falling interest rates, the better loans in the pool may be refinanced at lower rates, leaving poorer loan quality remaining in the sample.

Seasoned issues upgraded to Aaa

Despite the surge in delinquencies on mortgages backing non-agency pass-throughs, there are a number of pools that have very low delinquency rates and negligible, if any, reductions in credit support. In the first quarter of this year, Moody's Investors Service upgraded to Aaa the ratings of 40 mortgage pass-throughs with then-current balances of $2.5 billion.

The securities, which were issued from 1987 to 1989, were initially rated Aa2 or Al. The upgrades reflect the large amount of credit support available to support the Aaa securities and the low level of delinquencies and foreclosures compared with the level of credit support.

Most of the affected pass-throughs use a senior-subordinated structure and almost all are backed by adjustable-rate mortgages. Most of the pools are made up of loans originated in California. Although on a national basis, ARMs have experienced higher delinquency rates than fixed-rate mortgages, seasoned California pools have much lower delinquency rates than average. Many of the loans in the upgraded pools have benefited from the substantial rise in California home prices that occurred from 1987 through 1990.

During the past year, ARMs have prepaid at extremely rapid rates. The mortgage pools supporting each of the securities have paid down to less than 50 percent of their original amounts.

Super-senior structures

During the last year, almost one-fourth of all non-agency mortgage transactions began using a new structure that differentiates the level of credit risk among classes that are all senior to a Aaa-level of credit support. In essence, a single class that would be rated Aaa as one entity was divided into at least two parts: a "super-senior" class and a class or classes subordinate to the super-senior, but senior to credit support. (The class between the super-senior and credit support is sometimes called to as a "mezzanine" class, and is referred to in the rest of this article as a junior class.) These so-called "super-senior" structures are of limited value to the super-senior class, but may significantly increase the risk to the junior class.

Moody's estimates that the improvement in expected yield for the most senior classes is about 1 basis point (.01 percent) per year, while the junior class has an increased level of risk that may decrease its initial rating from Aaa to Aa1 or lower. As a rule of thumb, the smaller the size of the junior piece, the more likely it will not meet Moody's Aaa-rating standard. In addition, the junior class may be more vulnerable to a downgrade if the collateral backing the security deteriorates significantly.

The new structures typically have external credit support in the form of a pool insurance policy or letter of credit in an amount that would raise the security to Aaa if it were a single class or if losses were shared among all classes. The multiple senior-class structure creates some classes that are "overenhanced"; that is, they have more credit support than is necessary to obtain a rating of Aaa. The small amount of risk that would have been borne by the senior classes is shifted to the junior classes. For example, if the senior classes are 90 percent of the total security and the junior classes are 10 percent, and if losses exceed credit support by 1 percent, the senior classes would lose nothing and the junior classes would lose 10 percent of their value. On the other hand, without the "super-senior" structure in place, the Aaa-class would have lost only 1 percent of its value. The shifting of first-loss priority to the junior class may thus reduce the credit quality of that class considerably.

Moody's believes that the senior classes of these new "super senior" structures benefit only marginally in comparison with normally enhanced classes, while the concentration of losses into junior classes may restrict the ability of those classes to achieve the same rating as the senior classes. Although the frequency of loss is unchanged for the junior class, the severity of a loss may increase by a large multiple.


The non-agency mortgage securities market continues to grow and evolve. The burst of issuance that began in 1991 should extend into 1992, fueled by refinancing activity, ongoing RTC issuance and risk-based capital requirements. The trend toward more complex structures will also continue as investors demand securities to meet specific investment objectives and as issuers tailor securities to meet those needs.

Moody's Investors Service plays a part in the non-agency mortgage market by providing accurate credit evaluations of mortgage-backed securities on a timely basis. Toward that end, in 1992, Moody's will begin the electronic dissemination of credit and prepayment information on all rated pass-throughs on a monthly basis for its subscribers. It is Moody's goal that such information will help to make the marketplace more efficient and will allow investors to make more informed decisions.

Howard Esaki, Ph.D., is an associate director in the structured finance department at Moody's Investors Service.
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Title Annotation:private mortgage securities
Author:Esaki, Howard
Publication:Mortgage Banking
Date:Apr 1, 1992
Previous Article:Controlling the fluid pipeline.
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