Feb 07 - Fitch Ratings says that prime residential mortgage
portfolios with low expected loss levels need an additional level of scrutiny to
ensure that idiosyncratic risks are adequately mitigated. This applies to
portfolios securing either residential mortgage-backed securities (RMBS) or
mortgage covered bonds (MCB). Fitch will conduct an additional level of review
for portfolios where expected losses, when applying a 'AAA'-level stress, are
While such instances are relatively infrequent, they can arise where portfolios
consist of mortgage loans with exceptionally strong credit characteristics.
Although a handful of such portfolios have been seen to date, given tighter
post-crisis underwriting limits across the globe, which in some instances have
continued to tighten, it is likely portfolios with stronger credit profiles will
feature more frequently. This means the 4% loss expectation could be tested more
often. Depending upon the outcome of this additional analysis, it could result
in an increase to expected credit protection supporting ratings on bonds, so
that there is an enhanced cushion to protect ratings against idiosyncratic
The agency's credit analysis of RMBS transactions and MCB programmes
incorporates a loan-level analysis with country-specific stress assumptions.
Expected loss levels for a portfolio are generally derived from the weighted
average probability of default (PD) (or foreclosure frequency) and the weighted
average loss severity (LS) of the portfolio. Where this analysis implies an
exceptionally low portfolio level expected loss (EL), Fitch will conduct further
analysis to assess whether potential idiosyncratic risks are sufficiently
mitigated by such low levels of protection.
Loan-level PD assumptions are derived from a range of assumptions, based upon
variables such as loan-to-value (LTV) ratios, debt-to-income ratios, loan
product characteristics or credit scores. Loan level loss severity assumptions
are similarly derived from factors, including LTV ratios, stressed house price
decline assumptions and foreclosure cost assumptions. A portfolio of loans that
demonstrates strong credit characteristics on one or more of these variables
will generally attract a lower overall PD and/or LS expectation. However, such a
portfolio could experience higher losses than expected overall, due to the
potential for individual loans unexpectedly defaulting and potentially realising
a higher LS than expected, despite apparently strong credit characteristics.
The specific drivers of these idiosyncratic loss outcomes are difficult to
determine in advance. For example, the loss may result from unforeseeable
factors affecting a property's value. Servicers could also choose to prioritise
higher LTV loans for workout, meaning low LTV loans could see a longer workout
period and incur greater carry costs prior to security being enforced. It is
important that the potential for this risk is assessed and portfolios contain
supplementary credit protection against it where necessary.
For RMBS and MCB portfolios where the relevant rating criteria delivers a 'AAA'
level portfolio expected loss of less than 4%, Fitch will perform supplementary
analysis to assess whether sufficient credit protection would result to protect
ratings against these risks. The agency may also perform additional analysis on
portfolios with 'AAA' level loss expectations in excess of 4%, where the
expected loss is low compared with peer transactions in the same country or for
a sector outside of prime.
Fitch would expect to receive supplementary historical performance data and
foreclosure history specific to loans with strong credit characteristics over a
period of economic stress, specifically with regard to loans that defaulted - as
well as those that experienced unexpectedly high LS, despite these
characteristics. Fitch will examine this data to assess the nature of these
loans and what insight can be drawn regarding drivers for unexpected losses
within these cohorts. Following this analysis, Fitch may choose to apply
specific deterministic stresses or sensitivities to model-derived loss rates.
This could include, for example, applying loan-level floors to default and/or
loss severity assumptions, imposing a minimum number of defaulting loans or
loans with high loss severities or the application of a simple floor applied to
credit protection to support ratings. Depending upon the outcome of this
additional analysis, it could result in an increase to credit protection, so
that there is an enhanced cushion to protect ratings against such idiosyncratic
This supplementary analysis will be performed, where applicable, when a new
rating is assigned. However, the risks involved and the extent of credit
protection will also be considered at the surveillance review for existing
transactions and programmes. If the analysis for an existing rating suggests
credit protection may be insufficient due to increased idiosyncratic risk, Fitch
may downgrade the affected bonds, depending upon other aspects of asset
performance and expectations for the evolution of future credit protection.
Portfolios that show 'AAA' expected loss levels below 4%exclusively as a result
of supplementary credit protection, such as mortgage insurance (for example,
Lenders Mortgage Insurance, the Dutch Nationale Hypotheek Garantie or the Canada
Mortgage and Housing Corporation guarantee), would not be subject to additional
Fitch expects to incorporate more detail with respect to this analysis into its
residential mortgage loan loss criteria reports as they are reviewed in the
coming 12 months.