Rising interest rates in the first three quarters of 1994 led to reduced production of new nonConforming jumbo loans, decreasing the quantity of mortgage loans available for securitization.
The resultant situation has left issuers and originators competing aggressively for each loan, sometimes compromising credit quality to generate enough critical mass to create a mortgage-backed security (MBS). Consequently, asset quality has deteriorated and risk has greatly increased.
Heightened competition significantly impacts the asset quality and risk of a loan pool. For example, current conditions are such that it may be tempting for an underwriter to validate a borderline loan that formerly would have been rejected.
A review of current pool characteristics reflects this decline in asset quality. During the first quarter of 1994, when production was still quite robust, the weighted-average LTVs of 30-year fixed-rate mortgage pools were about 71% to 72%. In contrast, current pools have moved toward weighted-average LTVs of 77% to 79%, and some pools are as high as 82% to 84% weighted-average LTV. This change is adverse because the higher the LTV, the more likely a loan is to default and the higher the potential loss on the loan.
Another characteristic that has changed is the quality of borrower occupancy attributes. PreViously, pools rarely included any investor-occupied properties. However, the percentage of investor properties, which are generally riskier than other property types, has increased to about 3% and sometimes as high as 10% of the pool.
Pool property-type characteristics have changed as well. Pools that once consisted predominantly of single-family home loans are now made up of a mix of single-family homes, condominium properties, and planned unit developments (PUDs). These property types are risky because they may take longer to liquidate and, consequently, may realize added costs.
Additionally, some pool sizes have shrunk to the point where the possible variance from statistically based expectations has increased significantly.
The news about pool characteristics is not all bad. Although pool sizes are smaller, the diversity of property locations is constant and, in many cases, has increased. While there are fewer loans available for production, most large issuers have a national origination network and loans continue to be originated from all over the country. Also, since interest rates began to rise, the level of refinancings, particularly equity or cash-out refinancings, has deeply declined. Therefore, pools now include a greater portion of purchase money mortgages, which have less credit risk than refinancings.
Nevertheless, the change in po61 characteristics could impact the credit quality of MBS and indicates a need to increase credit support levels to maintain rating levels. Duff & Phelps Credit Rating Co. evaluates each pool on the basis of individual loan characteristics and determines credit support levels based on defined and published factors and multiples. As the credit quality of pool deteriorates, credit support levels for each rating level will increase.
Ironically, despite the declines in mortgage pool characteristics, some transactions not rated by Duff & Phelps are being issued with lower credit enhancement or higher ratings. Duff & Phelps warns investors not to conclude that. lower levels of credit enhancement on those transactions indicate better credit quality. On the contrary, Duff & Phelps believes credit enhancement levels should be higher on those transactions to reflect a reduced level of asset quality.
