Risk Management

S&P: Mortgage Securities Are Safer than Collateral

The rating agency mounts a defense of the securitization of residential mortgage-backed securities.
David KatzNovember 14, 2008

Under fire from critics who say the rating agencies contributed to the financial crisis by slapping sterling grades on questionable securities, Standard & Poor’s Ratings Services has issued a new report contending that Grade AAA securitization paper might be more immune to losses than previous market projections suggest.

In the market for residential mortgage-backed securities, also known as RMBS, there’s a big difference “between a loss on the collateral underlying a transaction and a principal write-down on a rated certificate,” according to the report, issued earlier this week. “When it comes to subprime RMBS, the difference might even surprise you.”

To be sure, the rating agency predicts losses on the underlying mortgages of U.S. subprime RMBS certificates issued from the second half of 2005 through the first half of 2007 to hit $180 billion. At the same time, S&P forecasts that write-downs of RMBS principal will amount to $85 billion.

“So while we expect losses to RMBS investors to be significant, we expect them to be much less than the losses generated by the RMBS collateral,” says the report. The difference between the write-downs on the certificates and the losses on the collateral stems from credit enhancements that support the rated securities.

A write-down of the principal on the RMBS certificates happens when collateral losses exceed available credit support. As of August 2008, collateral losses for S&P’s rated U.S. subprime RMBS contracts issued from the second half of 2005 through the first half of 2007 totaled about $32 billion. Despite those collateral losses, actual principal write-downs were under $3 billion.

The aim of the credit enhancements that RMBS transactions contain is to protect investors in the rated certificates from losses on the certificates’ principal. The credit enhancements absorb collateral losses before they hit the certificates’ principal write-downs, according to the report.

Besides such credit support, many RMBS transactions generate excess spread, which can also cover collateral losses, the rating agency says. Excess spread is the difference between the interest generated by the mortgage loans and the interest due on the RMBS securities.

Even though subprime RMBS losses may not match those of the underlying collateral, ongoing home price declines will continue to cause write-downs on the securities, according to the rating agency. “In our opinion, declining home prices, limited credit, and a poor economy will continue to pressure subprime borrowers who are already struggling to make their monthly mortgage payments,” says S&P.

The authors of the report also predict that because of the economic downturn, delinquencies on subprime mortgages will continue to rise until market conditions brighten, and they forecast that home prices will keep dropping until the end of 2009. From their peak in July 2006, residential real estate prices have fallen by about 29.5 percent, according to S&P.