Feb 07 - Fitch Ratings says that prime residential mortgage portfolios with low expected loss levels need an additional level of scrutiny to ensure that idiosyncratic risks are adequately mitigated. This applies to portfolios securing either residential mortgage-backed securities (RMBS) or mortgage covered bonds (MCB). Fitch will conduct an additional level of review for portfolios where expected losses, when applying a ‘AAA’-level stress, are below 4%.
While such instances are relatively infrequent, they can arise where portfolios consist of mortgage loans with exceptionally strong credit characteristics. Although a handful of such portfolios have been seen to date, given tighter post-crisis underwriting limits across the globe, which in some instances have continued to tighten, it is likely portfolios with stronger credit profiles will feature more frequently. This means the 4% loss expectation could be tested more often. Depending upon the outcome of this additional analysis, it could result in an increase to expected credit protection supporting ratings on bonds, so that there is an enhanced cushion to protect ratings against idiosyncratic risks.
The agency’s credit analysis of RMBS transactions and MCB programmes incorporates a loan-level analysis with country-specific stress assumptions. Expected loss levels for a portfolio are generally derived from the weighted average probability of default (PD) (or foreclosure frequency) and the weighted average loss severity (LS) of the portfolio. Where this analysis implies an exceptionally low portfolio level expected loss (EL), Fitch will conduct further analysis to assess whether potential idiosyncratic risks are sufficiently mitigated by such low levels of protection.
Loan-level PD assumptions are derived from a range of assumptions, based upon variables such as loan-to-value (LTV) ratios, debt-to-income ratios, loan product characteristics or credit scores. Loan level loss severity assumptions are similarly derived from factors, including LTV ratios, stressed house price decline assumptions and foreclosure cost assumptions. A portfolio of loans that demonstrates strong credit characteristics on one or more of these variables will generally attract a lower overall PD and/or LS expectation. However, such a portfolio could experience higher losses than expected overall, due to the potential for individual loans unexpectedly defaulting and potentially realising a higher LS than expected, despite apparently strong credit characteristics.
The specific drivers of these idiosyncratic loss outcomes are difficult to determine in advance. For example, the loss may result from unforeseeable factors affecting a property’s value. Servicers could also choose to prioritise higher LTV loans for workout, meaning low LTV loans could see a longer workout period and incur greater carry costs prior to security being enforced. It is important that the potential for this risk is assessed and portfolios contain supplementary credit protection against it where necessary.
For RMBS and MCB portfolios where the relevant rating criteria delivers a ‘AAA’ level portfolio expected loss of less than 4%, Fitch will perform supplementary analysis to assess whether sufficient credit protection would result to protect ratings against these risks. The agency may also perform additional analysis on portfolios with ‘AAA’ level loss expectations in excess of 4%, where the expected loss is low compared with peer transactions in the same country or for a sector outside of prime.
Fitch would expect to receive supplementary historical performance data and foreclosure history specific to loans with strong credit characteristics over a period of economic stress, specifically with regard to loans that defaulted - as well as those that experienced unexpectedly high LS, despite these characteristics. Fitch will examine this data to assess the nature of these loans and what insight can be drawn regarding drivers for unexpected losses within these cohorts. Following this analysis, Fitch may choose to apply specific deterministic stresses or sensitivities to model-derived loss rates. This could include, for example, applying loan-level floors to default and/or loss severity assumptions, imposing a minimum number of defaulting loans or loans with high loss severities or the application of a simple floor applied to credit protection to support ratings. Depending upon the outcome of this additional analysis, it could result in an increase to credit protection, so that there is an enhanced cushion to protect ratings against such idiosyncratic risks.
This supplementary analysis will be performed, where applicable, when a new rating is assigned. However, the risks involved and the extent of credit protection will also be considered at the surveillance review for existing transactions and programmes. If the analysis for an existing rating suggests credit protection may be insufficient due to increased idiosyncratic risk, Fitch may downgrade the affected bonds, depending upon other aspects of asset performance and expectations for the evolution of future credit protection.
Portfolios that show ‘AAA’ expected loss levels below 4%exclusively as a result of supplementary credit protection, such as mortgage insurance (for example, Lenders Mortgage Insurance, the Dutch Nationale Hypotheek Garantie or the Canada Mortgage and Housing Corporation guarantee), would not be subject to additional analysis.
Fitch expects to incorporate more detail with respect to this analysis into its residential mortgage loan loss criteria reports as they are reviewed in the coming 12 months.