S&P Warns on Subprime-Backed Issues

The ratings agency places $12 billion in residential mortgage-backed securities on CreditWatch negative, due to poor-performing underlying loans

From Standard & Poor's RatingsDirect

On July 10, Standard & Poor's Ratings Services placed its credit ratings on 612 classes of residential mortgage-backed securities (RMBS) backed by U.S. subprime collateral on CreditWatch with negative implications. The affected classes total approximately $12.078 billion in rated securities, which represents 2.13% of the $565.3 billion in U.S. RMBS rated by Standard & Poor's between the fourth quarter of 2005 and the fourth quarter of 2006. A list of the issuers of the RMBS securities in question appears at the end of this article.

Beginning in the next few days, we expect that the majority of the ratings on the classes that have been placed on CreditWatch negative will be downgraded. We will lower our rating:

• To CCC on any class that does not pass our stress test scenario (a class is expected to experience a principal write-down or, with respect to the senior classes, a principal shortfall) within 12 months, regardless of its current rating;

• To B on any class that does not pass our stress test scenario within 13 to 24 months;

• To BB on any class that does not pass our stress test scenario within 25 to 30 months; and

• To BBB on any class that does not pass our stress test scenario within 31 to 36 months.

The CreditWatch actions are being taken at this time because of poor collateral performance, our expectation of increasing losses on the underlying collateral pools, the consequent reduction of credit support, and changes that will be implemented with respect to the methodology for rating new transactions. Many of the classes issued in late 2005 and much of 2006 now have sufficient seasoning to evidence delinquency, default, and loss trend lines that are indicative of weak, future credit performance. The levels of loss continue to exceed historical precedents and our initial expectations.

No Signs of Abating

We are also conducting a review of collateralized-debt obligations (CDO) ratings where the underlying portfolio contains any of the affected securities subject to these rating actions.

We have been watching these transactions on a regular basis and have been monitoring market trends. At this time, we do not foresee the poor performance abating. Loss rates, which are being fueled by shifting patterns in loss behavior and further evidence of lower underwriting standards and misrepresentations in the mortgage market, remain in excess of historical precedents and our initial assumptions.

New data reveal that delinquencies and foreclosures continue to accumulate at an increasing rate for the 2006 vintage. We see poor performance of loans, early payment defaults, and increasing levels of delinquencies and losses.

Total aggregate losses on all subprime transactions issued since the fourth quarter of 2005 is 29 basis points, compared to seven basis points for similar transactions issued in 2000. Transactions from the 2000 vintage are used as a comparison because they were, until now, the worst performing vintage of this decade. When recent transactions with the same seasoning are compared on a quarterly basis with similar transactions issued in 2000, we find that both mean losses and standard deviations are running in excess of the 2000 book for the fourth quarter of 2005 through the fourth quarter of 2006.

Weakness in Property Market

Seriously delinquent loans (90 days-plus, foreclosure, and real estate-owned) on average also exceed the 2000 book of business for each quarterly comparison except for the fourth quarter of 2005.

On a macroeconomic level, we expect that the U.S. housing market, especially the subprime sector, will continue to decline before it improves, and home prices will continue to come under stress. Weakness in the property markets continues to exacerbate losses, with little prospect for improvement in the near term. Furthermore, we expect losses will continue to increase, as borrowers experience rising loan payments due to the resetting terms of their adjustable-rate loans and principal amortization that occurs after the interest-only period ends for both adjustable-rate and fixed-rate loans.