RMBS defaults still a worry for structured finance investors

Despite talk of economic recovery, structured finance investors in the US and Europe remain concerned about defaults and losses on RMBS deals, according to S&P research.

US and European investors’ forecasts for the performance of the collateral underlying global residential mortgage-backed securities (RMBS) are converging, according to Standard & Poor’s Valuation and Risk Strategies’ latest quarterly survey, completed at the end of March. In particular, the increasing consensus reveals expectations of a significant deterioration in the performance of certain European and US mortgage collateral types.

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In general, investors predict increases in loss severity and constant default rates (CDRs) across all vintages of UK prime and non-conforming loan RMBS collateral; while forecasts for loss severity on US prime mortgage collateral generally remain elevated and CDR forecasts on lower quality US mortgage loans have increased since the previous quarterly survey.

The ongoing quarterly valuation survey asks RMBS investors to provide details of their specific input assumptions when valuing all classes of UK, European and US RMBS on an asset, vintage and individual transaction level. Respondents are primarily risk managers, credit analysts and portfolio managers; split evenly between the buy-side and the sell-side. Contrasting the latest results with previous surveys provides insights into current trends in structured finance valuation methodologies and investor forecasts for the performance of RMBS collateral over the next 12 months and beyond.

The key assumptions surveyed are loss severity (the severity of any losses occurring on the collateral in default), CDRs (the percentage of debtors not keeping up repayments, leading to repossession or delinquency), recovery lag (the time it takes for investors to recover any monies due) and constant prepayment rates (CPRs; the percentage of debtors making early repayment of principal).

Loss severity

Perhaps as a sign investors expect some kind of correction following the recent rally in house prices, the latest survey shows that loss severity expectations have risen across all RMBS asset classes in Europe, most significantly in the UK and Spain, since the end of 2009. For example, investors’ average 12-month forecasts have increased for the loans backing UK non-conforming loan RMBS, UK prime RMBS and Spanish RMBS by 14%, 9% and 8%, respectively. In fact, average 12-month loss severity forecasts for 2006 and 2007 vintages of UK non-conforming loan collateral have returned to the elevated expectations polled in the Q3 2009 survey, at 38% and 40%, respectively.

Indeed, the most recent survey suggests loss severity assumptions across all vintages of UK non-conforming mortgages are now at their highest level (38%) since investors first took part in this survey in Q1 2009. By contrast, 12-month loss severity forecasts for Italian RMBS collateral have risen by only 0.7% since the Q4 2009 survey and by only 0.3% for Dutch RMBS collateral.

Meanwhile, 12-month loss severity forecasts in the latest US survey have come down slightly across the higher quality prime collateral. However, vectored forecasts for loss severities on prime mortgages remain elevated, at only 20% less than the levels expected of subprime collateral. Loss severity forecasts for Alt-A and subprime mortgages remain at, or marginally above, the levels polled in the Q4 2009 survey. The Q1 2010 12-month loss severity forecasts for all classes of US mortgages appear to be more pessimistic than any of the forecasts given in each of the surveys before the end of last year.

Constant default rates

Twelve-month CDR expectations have increased across all vintages of UK non-conforming mortgages since the previous survey but fell on prime mortgage collateral. For example, from average CDR expectations of 3.81% in the Q4 2009 survey, investors now predict that 2004 vintage non-conforming mortgages may experience CDRs of 4.31%. CDR forecasts on 2005 vintage non-conforming mortgage loans have increased to 4.65% from 4.32% since the last survey; 2006 vintage CDR forecasts have moved up to 5.5% from 4.94%; and average forecasts for 2007 vintage loans have increased to 5.79% from 5.35%.

By contrast, reported 12-month collateral CDR estimates for UK prime RMBS vintages have dropped slightly on average from the Q4 2009 survey, from 1.1% to 1.0%. That said, when asked for their vectored CDR assumptions, investors typically expected default rates for all prime RMBS mortgages to rise over the next 24 months.

Meanwhile, the reported average 12-month CDR forecasts for Spanish RMBS collateral have marginally increased since the last survey for 2006 and 2007 vintages, but have fallen for 2004 and 2005 vintages. The average collateral default rate forecast across all vintages has improved to 2.77% from 2.86% since the end of last year. The latest survey results seem to suggest there is also improved sentiment surrounding CDRs on all vintages of Dutch RMBS collateral, in particular for the 2005 vintage where 12-month CDR assumptions have declined to below 1% from above 4%.

However, 12-month default rate expectations for lower quality US RMBS collateral are higher in this survey versus the fourth quarter in 2009, and this is expected to keep increasing. For example, when asked for their monthly vectored default rate input assumptions over the next 24 months, investors predicted CDRs on 2006 Alt-A fixed rate, Alt-A adjustable rate and Alt-A pay option ARM collateral to peak at 20%, 30% and almost 50%, respectively.

Meanwhile, the average 12-month CDR forecasts for both US prime fixed rate and adjustable rate RMBS loans are in line with Q4 2009 estimations, ranging between 2% for the early vintages up to 10% on the later vintages.

The latest survey results indicate that 12-month recovery lag estimates have decreased on every class of UK and European RMBS. Recovery lag forecasts across the average of UK non-conforming RMBS vintages, for example, have come in to just under 14 months from the 15 months forecast in Q4 2009. More notably, the average Italian RMBS recovery lag prediction has moved in to 49 months from 57 months, while the average Dutch RMBS recovery lag prediction has come in to 32 months from 34 months.

However, the opposite is generally the case for the recovery lag on the loans backing all classes of US RMBS. For example, reported average recovery lag forecasts for US Alt-A fixed rate RMBS have increased to nine months from six months, and for all vintages of US prime fixed rate RMBS they have risen further – to just above 10 months in the latest survey from six months in the previous survey.

Constant prepayment rate

The reported average 12-month CPR forecast across all vintages of UK prime RMBS collateral remains consistent with Q4 2009 forecasts, at just over 13%. However, the survey results show that CPR forecasts on UK non-conforming mortgages have increased significantly to 9.3% from 6.9%. Indeed, reported 12-month CPR assumptions for all vintages of UK non-conforming mortgages have risen since the last survey: the average for 2004 vintage assumptions is up to 9.14% from 8.38%; the average 2005 assumption is up to 8.67% from 7.37%; for 2006 it is up to 8.03% from 6.13%; and for 2007 it is up to 7.10% from 5.84%. Similarly, 12-month CPR assumptions for Spanish RMBS collateral have generally increased across all vintages since the end of 2009.

Meanwhile, the latest results suggest that 12-month CPR forecasts for US RMBS collateral remain in line with investors’ expectations polled in Q4 2009. But when asked for their vectored forecasts, investors typically expected CPRs on US RMBS collateral to decrease slightly over the next 24 months.

While the results suggest there remain signs of nervousness around the ongoing performance of some RMBS collateral – most notably in the UK – the results of the Q1 2010 survey also indicate a convergence of opinion, on both the buy- and sell-sides of the market. Indeed, input assumptions polled in this, the fifth, valuation consensus survey have more in common with the preceding set of forecasts than has been the case before.

Furthermore, the disparity among assumptions for individual transactions has pulled back. Transaction-specific assumptions for US, UK and European RMBS collateral are generally more tightly bound in this survey while the number and degree of outliers has lessened, especially for loss severity assumptions and to a certain degree for default rate assumptions.

The survey results suggest confidence in pricing and valuation remains a concern in the US and European structured finance markets, but increased transparency in the valuation process and improved consensus among market participants will contribute towards bringing confidence back to pre-crisis levels.

James West and Jim Elder are directors of S&P Valuation and Risk Strategies, which is independent from S&P’s credit ratings business