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The downgrade environment.

Drexel Burnham Lambert failed in 1989. A record number of thrifts and banks failed in 1990. Major U.S. and foreign banks have had their credit rating downgraded in the past year. How will these stresses to the financial system affect the credit quality of private mortgage-backed securities (MBS)?

Moody's Investors Service believes that although the strains on the financial system may have an adverse impact on selected mortgage pass-throughs, most highly rated private MBS are adquately protected against credit downgrades of affiliated financial institutions.

Private MBS: third-party risk

Private, residential, whole-loan pass-throughs are complex securities that frequently depend on a variety of external sources of credit support to obtain a high rating from Moody's. External or "third-party" credit support differs fundamentally from internal credit support, because the credit quality of the support may change as the rating of the entity providing support changes. Internal credit support, either in the form of cash or subordinated collateral, has the same value throughout the life of the security.

External support is primarily provided through pool insurance policies, letters of credit, corporate guarantees or surety bonds, all of which are used to protect against credit losses. In addition, external support is often used to cover risks from fraud, special hazard or borrower bankruptcy. A third party is also often involved in a mortgage pass-through transaction as an advancer and/or servicer, or in the role of trustee.

No "weak-link" approach

When rating a private MBS, Moody's takes into account all the ratings of involved parties, as well as the total amount of credit support available. Moody's goal is that two securities with the same rating have the same expected change in internal rate of return as a result of credit losses. (For more details of this approach, see "Credit Analysis of Structured Securities," Moody's Investors Service, 1991.)

The credit performance of a private MBS depends not only on the performance of the underlying mortgages but also on the conditions and extent to which third parties fulfill their obligations. In determining a rating, Moody's analyzes a wide range of possible economic and legal conditions that would define the amount of cast flow into the structure and assigns a probability to each scenario. The average of these probability-weighted cash flows are then examined to compute an expected loss, and the number derived is compared with expectations for other structured and corporate bond ratings.

Moody's does not use a weak-link approach in rating private mortgage-backed securities. In other words, the rating of a security is not necessarily the lowest rating of the entities supplying credit support. Instead, Moody's looks at both the combined value of all the forms of support and the value of the unsupported collateral. The intrinsic value of the collateral supplements the credit quality of third-party support.

A default of a third party providing some form of credit support does not necessarily mean that a mortgage-backed security will suffer a cash shortfall. Moreover, even if it does, the severity of loss may be small, because investors receive funds from the unsupported collateral. Thus, depending on the quality of the assets and on the correlation of that quality with the fortunes of the third party, the credit quality of a transaction is usually higher than the credit quality of the third party itself.

Example: Citicorp (Baa2);

Citicorp pass-throughs (A2)

A prime example of the analysis discussed in the previous section is Moody's rating action, which affected Citicorp mortgage pass-throughs, in response to the downgrade of Citicorp's senior debt rating to Baa2 from A3 on January 25, 1991. On the same day, Moody's downgraded 48 mortgage-backed securities (totaling $3 billion) issued before March 1990, whose sole form of credit support was a Citicorp corporate gurantee. The guarantee amount typically ranged from 6 percent of 10 percent of the original balance.

Although Citicorp's rating was dropped 2 raiting notches, the rating for most of the pass-throughs was lowered only one notch, to A2 from A1. The rating of the mortgage pass-throughs was three rating notches above the rating of the entity suppllying credit support. (Four pass-through ratings were lowered to A3).

In analyzing the rating of the pass-throughs, Moody's examined the cash flows to the security under both Citicorp defaul and no-defaul scenarios and assigned probabilities to each. The correlation betwen the mortgages underlying between the mortgages underlying the pass-through and the performance of Citicorp was also examined. The conclusion was that the underlying strenght of the unsupported mortgage collateral raiseed the rating well above the rights of the third-party guarauntee.

Example:L FBS pass-throughs maintain

Aaa ratings

On August 13, 1990 Moody's downgraded the long-term rating of Dai-Ichi Kangyo Bank (DKB) of Tokyo from Aaa to Aal because of profitability and asset quality concerns. DKB provided a letter of credit (LOC) as support for two transactiions issued in 1986 by FBS Mortgage Corporation, St. Paul, Minnesota.

The FBS pass-throughs consisted of 15-year mortgage collateral, with total delinquencies of less than 1 percent and no losses. More than one-third of each pool had paid off in the four years following the date of issuance, with no reduction of the initial level of credit support. Based on the strength of the mortgages in the pools, along with the Aa1 rating of the letter-of-credit provider, Moody's confirmed the ratings of the two FBS pass-throughs at Aaa.

Strengthening programs

One characteristic of the private MBS market that differs from the traditional corporate bond markets is that an issuer of an MBS will oftem attempt to strengthen a security or a program in order to maintain a certain rating or to attain a better rating for future transactions. This action is usually taken in response to a downgrade a third party, which threatens the original rating of an existing pass-through.

As an example of protecting a program, in April 1990, Citicorp Mortgage Securities began to issue mortage secutities with credit support in the form of a combination of subordinated class, a buildup of a spread account from excess interest and 1 percent guarentee form Citicorp, which was in a first-loss position. In some later structures, cash was substituted for the 1 percent guarantee. This structure was formulated in response to both a changing regulatory environment and a downgrade of Citicorp in early 1990. Moody's determined that the new structure was consistent with the Aa3 and Aaa ratings sought by Citicorp Mortgage Securities.

Indeed, after the secdon downgrade of Citicorp a year later, the ratings of all pass-throughs using the new structure (20 transactions) were confirmed at the original rating levels. Citicorp had successfully transformed its program into one that was less vulnerable to third-party downgrade risk.

Another example of the ability of issuers to compensate for the downgrade of a third-party credit support provider was the response by several issuers of pass-throughs and collateralized mortgage obligations (CMOs) following the downgrade of Cypress, California-based Security Pacific National Bank in December 1990. Security Pacific provided backup advancing, that is, it advanced payments on delinquent loans if the primary advancer defaulted, in several transactions with a low-rated or unrated servicer. In some cases, a provisions was added that stated if the short-term rating of Security Pacific was lowered bellow Prime-1 (Moody's highest short-term rating), the issuer would within 30 days place an amount of cash in an account to be used for advancing. The amount of cast was determined by examininh the delinquency history of the transaction.

Five transactions issued by Western Federal Savings and Loan, Marina Del Ray, California, in 1990 also maintained Aa2 ratings following the Security Pacific downgrade by adding a provision stating that GEMICO, a Aaa-rated entity, would provide backup advancing. The Western Federal; pass-throughs used GEMICO pool policies as credit support.

One option available to an issuer to maintain a rating is to replace a credit-support provider that has been downgraded with a higher-rated entity. This occurred last year when Residential Funding Corporation (RFC) of Minneapolis, Minnesota, responded to a downgrade of Tokyo-based Fuji Bank, Ltd., from Aaa to Aa1, which provided a letter of credit on a transation issued earlier in the year. RFC substituted a letter of credit from the Aaa-rated Industrial Bank of Japan, Ltd., of Tokyo in order to maintain the Aaa rating on its pass-through.

Finally, two pass-throughs issued by Glendale Federal Bank, Glendale, California, in 1990 are examples of transactions initially structured to avoid third-party downgrade risk. The Glendale Federal securities use a Security Pacific National Bank letter of credit as credit support. In order to protect against the "event risk" of a Security Pacific downgrade, a provision was added to the original documents stating that if Security Pacific were to be downgraded below Aa3, the letter of credit would be drawn upon and placed in an eligible investment account. When Security Pacific was, in fact, downgraded] in December, the LOC was drawn down, and the pass-throughs remained rated at Aa2 without any changes made to the transaction.

Private MBS credit ratings:

how volatile?

While it is true that many pass-through transactions are protected from certain kinds of third-party risk, private-label mortgage-backed securities are by no means "downgrade proof." In 1990, Moody's downgraded the ratings on 56 mortgage pass=throughs, which represented about 10 percent of outstanding private mortgage pass-through ratings. As of the end of March, 48 pass-through ratings had been downgraded in 1991. Two questions arise. First, how does this compare with changes in Moody's more traditional ratings of corporate bonds? Second, are private MBS ratings more, or less, volatile than other ratings?

The answers can be found in the results of a new study completed by Moody's Investors Service in February 1991, titled "Changes in Corporate Credit Quality 1970-1990." The study examines historical changes in the credit ratings of more than 4,000 rated U.S. and international debt issuers (industrial and utility companies, financial institutions, sovereign issuers and structred finance issuers) from 1970 through 1990. The study also analyzed trends in the direction ad stability of the credit quality or fated issuers in the past 21 years.

One of the findings was that on average during the 1980s, approximately 12 percent of rated issuers ended the calendar year in a different long-term letter-rating category than at the beginning of the year. In 1990, the number of issuers with a rating change was also 12 percent. Table 1 summarizes the rating changes, by refined rating category, from 1983 through 1990.

For the double-A and triple-A rating categories, the ratings for more mortgage pass-throughs, an average of between 8 percent and 16 percent of ratings, were downgraded each year. A much smaller number, between 2 percent and 5 percent, were upgraded on average each year. the downgrade number for private mortgage pass-throughs in the past year, about 10 percent, is generally in line with the figures for all Moody's ratings.

The number of upgrades in the pass-through sector has thus far been below the average found for all Moody's ratings for 1990. One private MBS was upgraded in 1990, and four transactions were upgraded in 1989. Although the number of upgrades of private mortgage securities has been below the average for all Moody's ratings, the private MBS market is relatively new, with large volumes of transactions brought to market only in the last five years. A more statistically significant comparison of upgrades and downgrades of private mortgage-backed securities with other Mooody's ratings can be made in the future as the number of transactions grows and as a longer rating history becomes known.

Most MBS well protected

Moody's continually monitors the private mortgage-backed securities it has rated for possible upgrades or downgrades. With a few exceptions, credit support for private mortgage securities is a large multiple of expected losses on the underlying mortgage collateral. In aggregate, as of year-end 1990, pass-throughs rated by Moody's had lost about 1 basis point (.01 percent) of original balances. The aggregate remaining credit support for these pools was more than 10 percent of the remaining balances.

Since most pass-throughs appear adeqately protected against a deterioration in mortgage quality, the major remaining concern in over a decline in the credit quality of the institutions providing various forms of credit support. Currently, very few pass-throughs appear to be threatened by the turmoil in the financial services industry. In many cases, the response of issuers to downgrades of institutions providing credit support has been either to replace the downgraded institution or to strengthen the structure of the transaction to maintain credit quality. In addition, the fundamental credit quality of the underlying residential mortage collateral has acted as a cushion to protect private mortgage-backed securities from the shock waves emanating from the financial markets.
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Title Annotation:secondary marketing of mortgage-backed securities
Author:Esaki, Howard
Publication:Mortgage Banking
Date:May 1, 1991
Previous Article:Building business.
Next Article:An inside job.

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