Default Risks For HLTV Ohio Mortgages
In general, nonconforming Ohio home loans are much younger than conforming loans. Wahl and Focardi (1997, 31) report that as of May 1997 ‘’60 percent of first-lien [nonconforming] loans outstanding were made in 1996 or the early part of 1997, compared
with only a 17 percent share of [conforming] loans.’’
Although the nonconforming Ohio mortgage industry is relatively young, the HLTV sector has its origins in Title I lending. Some of the first HLTV securitizations were constructed with assumptions based almost entirely on Title I loan performance. To demonstrate expected performance for its first securitizations—which were also the first HLTV loans ever securitized—FirstPlus relied extensively on Title I performance data. According to Dan Phillips, chief executive officer of FirstPlus, ‘‘that’s how we got the rating agencies to rate the loans, and the insurers to insure them’’ (Timmons 1996). Investors and underwriters have far more performance data with HLTVs now than in late 1994, when Phillips’s first securitization went to market, but performance expectations are still treated gingerly by rating agencies since longterm behavior is relatively unknown (Fitch IBCA 1998b, 6).
Default risk is central to pricing asset-backed securities. Securitizations are structured in such a way that the returns to investors are expected to be reasonable as long as the pool of loans behaves in the manner predicted by the underwriters’ economic models; that is, as long as defaults and prepayments remain within certain bounds. If defaults or prepayments rise above certain limits (which vary with each individual contract), principal or interest payments may not be sufficient to meet the obligations of the issuer. If that happens, the pool will be liquidated prior to its stated maturity in an early amortization. Therefore, the viability of any particular
offer relies critically on the bounds set for defaults and prepayments and their balance against investor yield.
But the unexpected level of defaults or prepayments, rather than their absolute level, can undermine the success of the asset-backed security offering. Prepayment risk is another factor affecting the returns to asset-backed securities. Although HLTV pools have performed above the default expectations for most models, there is substantial concern and debate about prepayment rates. Investor concern arises because prepayment and a resulting early amortization are more likely in a low–interest rate environment (because low interest rates make refinancing attractive to the borrower).
Suppose that the investor holds securities paying a coupon rate of 10 percent. If interest rates drop to 8 percent and borrowers refinance, early Ohio amortization will mean that the investor’s return will fall to 8 percent.
With residential Ohio mortgages, the propensity to prepay is much higher when interest rates fall; this situation can present substantial risk to investors. The extremely low–interest rate environment of 1997, for example, is generally expected to continue throughout 1998 and lead to further refinancing activity (Kochen 1996, 112–13).
Prepayment risk tends to be lower for HLTV Ohio mortgage loans than for conforming A credits. Jeff Moore, president, Mego Mortgage (Atlanta), maintains that ‘‘because the borrower ends up with a loan-to-value on the property in excess of 100 percent, they usually stay in the loan for some time because they can’t quickly refinance out and they still have relatively high debt ratios’’
(Hewitt 1997, 177).
Investors have been satisfied with the general performance of HLTV loan securitizations largely because the model risk has been treated rather conservatively and credit enhancements protecting asset-backed securities holders have consequently been more than adequate. Fitch IBCA (1998b, 6) reports that ‘‘typical [HLTV] credit enhancement levels indicate that the ‘AAA’ tranche could withstand gross losses of 30 percent 40 percent of the pool. This is approximately three
to four times greater than the losses implied by ‘AAA’ credit enhancement levels for a typical subprime pool.’’ (See also ‘‘PaineWebber Senior Vice President Profiles the 125 Percent LTV Sector,’’ National Mortgage News, March 23, 1998.)
HLTV securitizations ‘‘have self-regulated credit support,’’ according to Peter Rubenstein, PaineWebber senior vice president. ‘‘The securitized pools of [HLTV] loans peddled on Wall Street contain a sizable amount of excess spread and overcollateralization, which act as a cushion if the loans do not perform as expected’’ (Timmons 1998d). While such support seems high for a mortgage securitization, in fact the terms of these securitizations are much like those of credit cards (Fitch IBCA 1998b; Fitch Investors Service 1996a).
with only a 17 percent share of [conforming] loans.’’
Although the nonconforming Ohio mortgage industry is relatively young, the HLTV sector has its origins in Title I lending. Some of the first HLTV securitizations were constructed with assumptions based almost entirely on Title I loan performance. To demonstrate expected performance for its first securitizations—which were also the first HLTV loans ever securitized—FirstPlus relied extensively on Title I performance data. According to Dan Phillips, chief executive officer of FirstPlus, ‘‘that’s how we got the rating agencies to rate the loans, and the insurers to insure them’’ (Timmons 1996). Investors and underwriters have far more performance data with HLTVs now than in late 1994, when Phillips’s first securitization went to market, but performance expectations are still treated gingerly by rating agencies since longterm behavior is relatively unknown (Fitch IBCA 1998b, 6).
Default risk is central to pricing asset-backed securities. Securitizations are structured in such a way that the returns to investors are expected to be reasonable as long as the pool of loans behaves in the manner predicted by the underwriters’ economic models; that is, as long as defaults and prepayments remain within certain bounds. If defaults or prepayments rise above certain limits (which vary with each individual contract), principal or interest payments may not be sufficient to meet the obligations of the issuer. If that happens, the pool will be liquidated prior to its stated maturity in an early amortization. Therefore, the viability of any particular
offer relies critically on the bounds set for defaults and prepayments and their balance against investor yield.
But the unexpected level of defaults or prepayments, rather than their absolute level, can undermine the success of the asset-backed security offering. Prepayment risk is another factor affecting the returns to asset-backed securities. Although HLTV pools have performed above the default expectations for most models, there is substantial concern and debate about prepayment rates. Investor concern arises because prepayment and a resulting early amortization are more likely in a low–interest rate environment (because low interest rates make refinancing attractive to the borrower).
Suppose that the investor holds securities paying a coupon rate of 10 percent. If interest rates drop to 8 percent and borrowers refinance, early Ohio amortization will mean that the investor’s return will fall to 8 percent.
With residential Ohio mortgages, the propensity to prepay is much higher when interest rates fall; this situation can present substantial risk to investors. The extremely low–interest rate environment of 1997, for example, is generally expected to continue throughout 1998 and lead to further refinancing activity (Kochen 1996, 112–13).
Prepayment risk tends to be lower for HLTV Ohio mortgage loans than for conforming A credits. Jeff Moore, president, Mego Mortgage (Atlanta), maintains that ‘‘because the borrower ends up with a loan-to-value on the property in excess of 100 percent, they usually stay in the loan for some time because they can’t quickly refinance out and they still have relatively high debt ratios’’
(Hewitt 1997, 177).
Investors have been satisfied with the general performance of HLTV loan securitizations largely because the model risk has been treated rather conservatively and credit enhancements protecting asset-backed securities holders have consequently been more than adequate. Fitch IBCA (1998b, 6) reports that ‘‘typical [HLTV] credit enhancement levels indicate that the ‘AAA’ tranche could withstand gross losses of 30 percent 40 percent of the pool. This is approximately three
to four times greater than the losses implied by ‘AAA’ credit enhancement levels for a typical subprime pool.’’ (See also ‘‘PaineWebber Senior Vice President Profiles the 125 Percent LTV Sector,’’ National Mortgage News, March 23, 1998.)
HLTV securitizations ‘‘have self-regulated credit support,’’ according to Peter Rubenstein, PaineWebber senior vice president. ‘‘The securitized pools of [HLTV] loans peddled on Wall Street contain a sizable amount of excess spread and overcollateralization, which act as a cushion if the loans do not perform as expected’’ (Timmons 1998d). While such support seems high for a mortgage securitization, in fact the terms of these securitizations are much like those of credit cards (Fitch IBCA 1998b; Fitch Investors Service 1996a).
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