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Subprime Mortgage Distress Effect on CDOs

Subprime Mortgage Distress Effect on CDOs. Kevin Kendra Managing Director Derivative Fitch U.S. Structured Credit. Glenn Costello Managing Director Fitch Ratings Co-Head, U.S. RMBS. Introduction and Agenda.

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Subprime Mortgage Distress Effect on CDOs

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  1. Subprime Mortgage Distress Effect on CDOs Kevin Kendra Managing Director Derivative Fitch U.S. Structured Credit Glenn Costello Managing Director Fitch Ratings Co-Head, U.S. RMBS

  2. Introduction and Agenda Recent headlines and quotes related to CDOs and the U.S. subprime mortgage markets Selected Fitch Research related to Subprime RMBS and CDOs Webcast Agenda

  3. U.S. subprime mortgage market media coverage has moved mainstream . . . • Mortgage market news is now regularly on the front page of the Wall Street Journal and New York Times • Over 80 articles on subprime mortgages were filed with various news agencies last week. • A web site, “The Mortgage Lender Implode-O-Meter” tracks U.S. mortgage lenders that have either shut down or are no longer operating independently along with, “Mortgage Banking Bust News and Commentary.” • 853,106 visitors to the site from January 1 to March 12, 2007 • Claims 36 lenders “imploded” by either bankruptcy filing, halting major operations or last-ditch acquisition • Claims another 10 lenders are “ailing” www.derivativefitch.com

  4. Selected Fitch Subprime RMBS and CDO Research 15-Apr-05 “U.S. Subprime RMBS in CDOs,” co-authored by U.S. Structured Credit and RMBS groups 07-Sep-05 “Operational Risks Inherent in New RMBS Products,” by U.S. RMBS group 17-Jan-06 “2006 Global Structured Finance Outlook: Economic & Sector-by-Sector Analysis,” by Global Structured Finance 24-Jul-06 “U.S. Structured Finance CDO Performance: 2006 Update,” by U.S. Structured Credit group 21-Aug-06 “U.S. Subprime RMBS in CDOs (Update),” co-authored by U.S. Structured Credit and RMBS groups 04-Oct-06 “40, 45 and 50 Year Mortgages: Option ARMs, Hybrid ARMs and FRMs,” by U.S. RMBS group 13-Dec-06 “2007 Global Structured Finance Outlook: Economic & Sector-by-Sector Analysis,” by Global Structured Finance www.derivativefitch.com

  5. Agenda • Stress in the U.S. Mortgage and Capital Markets • How does a mortgage loan get into a CDO? • What is causing stress in the U.S. Mortgage Markets? • Subprime RMBS Performance and Outlook • What are the drivers of subprime RMBS performance? • How does this impact originators, issuers and servicers? • What are Fitch’s expectation for mortgage losses and RMBS impact? • What is Fitch’s outlook for RMBS? • Fitch-rated CDO Exposure to Subprime Mortgage Markets • What CDOs may be affected by stress in the subprime mortgage markets? • What is the potential impact on structured finance CDOs? • CDO Surveillance – Process, People and Tools www.derivativefitch.com

  6. Stress in the U.S. Mortgage and Capital Markets How does a mortgage loan get into a CDO? What is causing stress in the U.S. Mortgage Markets?

  7. Subprime RMBS Structure $ P $ I Principal Payments Monthly Mortgage Payments REMIC Trust Accounts Interest Payments Scheduled Principal & Prepayments Servicer Interest ‘AAA’ L + % or Net WAC M1 M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12 M13 M14 M15 M16 M17 M18 M19 M20 M21 M22 M23 M24 M25 M26 M27 M28 M29 M30 ‘AAA’ $ M31 M32 M33 M34 M35 M36 M37 M38 M39 M40 M41 M42 M43 M44 M45 M46 M47 M48 M49 M50 $ I M51 M52 M53 M54 M55 M56 M57 M58 M59 M60 M61 M62 M63 M64 M65 M66 M67 M68 M69 M70 ‘AA’ L + % or Net WAC ‘AA’ M71 M72 M73 M74 M75 M76 M77 M78 . . . M 2000 ‘A’ L + % or Net WAC ‘A’ M1 M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12 M13 M14 M15 M16 M17 M18 M19 M20 $ ‘BBB’ L + % or Net WAC ‘BBB’ M21 M22 M23 M24 M25 M26 M27 M28 M29 M30 $ P ‘BBB-’ L + % or Net WAC ‘BBB-’ Scheduled Principal & Prepayments M31 M32 M33 M34 M35 M36 M37 M38 . . . Residual Excess Interest Residual M 1000 www.derivativefitch.com

  8. Characteristics of Subprime Mortgages • Typical Subprime Loan Types • Hybrid Adjustable-Rate Mortgages (ARMs) • 2/28 Mortgage is fixed for the first two years and then switches to adjustable rate for the remaining 28 years • Other common Hybrid ARMs 3/27 and 5/25 terms • Hybrid Interest Only (IO) ARMs • 40-Year Hybrid ARMs • Piggyback Second Liens • Limited Documentation Loan Programs www.derivativefitch.com

  9. Characteristics of Subprime RMBS • Standard Structural Features of Subprime RMBS • Subordination serves as credit enhancement to account for credit risk • Interest rate instruments to hedge interest rate risk • Performance test at three year mark • If test fails then the priority of payments remains unchanged with the senior notes receiving all principal proceeds • If test passes then principal proceeds repays subordinated notes until targeted subordination is met. • Defaulted loans worked out by servicers • Each Subprime RMBS will have somewhat unique performance profiles www.derivativefitch.com

  10. Structured Finance CDO Structure CDO Portfolio CDO Trust CDO Bonds Special Purpose Vehicle (CDO Trust) ‘AAA’ CDO RMBS Bond 1 RMBS Bond 2 RMBS Bond 3 RMBS Bond 4 RMBS Bond 5 RMBS Bond 6 RMBS Bond 7 RMBS Bond 8 RMBS Bond 9 RMBS Bond 10 Note Coupon (L + bps) RMBS Bond 11 RMBS Bond 12 RMBS Bond 13 RMBS Bond 14 RMBS Bond 15 RMBS Bond 16 RMBS Bond 17 RMBS Bond 18 RMBS Bond 19 RMBS Bond 20 Bond Coupons (L + bps) Proceeds ($) RMBS Bond 21 RMBS Bond 22 RMBS Bond 23 RMBS Bond 24 RMBS Bond 25 RMBS Bond 26 RMBS Bond 27 RMBS Bond 28 RMBS Bond 29 RMBS Bond 30 Proceeds ($) ‘AA’ CDO RMBS Bond 31 RMBS Bond 32 RMBS Bond 33 RMBS Bond 34 RMBS Bond 35 ‘A’ CDO RMBS Bond 36 RMBS Bond 37 RMBS Bond 38 RMBS Bond 80 . . . ‘BBB’ CDO CDO Bond 1 CDO Bond 2 CDO Bond 3 CDO Bond 4 CDO Bond 5 Preferred Shares or Equity CDO Bond 6 CDO Bond 7 CDO Bond 8 CDO Bond 9 CDO Bond 10 www.derivativefitch.com

  11. Characteristics of Structured Finance CDOs • Cash SF CDO Asset Portfolio Highlights • Portfolios contain between 60 and 140 bonds • Assets may be diversified by market sector, however recent vintage SF CDOs have been concentrated in subprime RMBS • Assets may be diversified by risk profile (intial ratings) • Assets may be diversified by vintage • Asset acquisition and selection • Asset manager warehouses bonds prior to issuing CDO notes • CDO notes typically issued when asset manager has accumulated approximately 60-80% of the target portfolio • Initial portfolio is typically fully ramped within 6 months of CDO note issuance www.derivativefitch.com

  12. Characteristics of Structured Finance CDOs • Cash SF CDO Note Highlights • Credit enhancement comes from subordination and excess spread • Interest is paid sequentially to note holders • Overcollateralization (OC) and Interest Coverage (IC) performance tests are checked prior to distributions to subordinate notes • Excess interest may be used to: • If tests are passing then distributed to Preferred Shares or Equity • A portion may be used to repay mezzanine notes • If tests are failing then distributions may be used to cure the tests • Purchase new assets • Pay down senior notes www.derivativefitch.com

  13. Borrower RMBS Conduit CDO Arranger RMBS Investor/ CDO Manager RMBS Investor/ CDO Manager U.S. Mortgage and Capital Market Diagram Mortgage Origination Market Mortgage Payments Financial Institution Company Balance Sheet Financial Institution, REIT, Specialty Finance Company Proceeds ($) “Held for Sale” Assets Investment Assets Mortgage Originator RMBS Market AAA Financial Institution REMIC Trust Financial Institution Financial Institution, REIT, Specialty Finance Company BBB Residual CDO Warehouse RMBS “Held for Sale” Assets Mortgage Originator CDO Market AAA Financial Institution Institutional Investors CDO Trust BBB Residual CDO Warehouse CDO Investor CDO www.derivativefitch.com

  14. ABX.HE Structure RMBS 10 RMBS 8 RMBS 9 . . . RMBS 4 RMBS 6 RMBS 7 RMBS 11 RMBS 20 RMBS 2 RMBS 3 RMBS 5 RMBS 1 ‘AAA’ RMBS ‘AAA’ RMBS ‘AAA’ RMBS ‘AAA’ RMBS ‘AAA’ RMBS ‘AAA’ RMBS ‘AAA’ RMBS ‘AAA’ RMBS ‘AAA’ RMBS ‘AAA’ RMBS ‘AAA’ RMBS ‘AAA’ RMBS . . . ABX.HE.AAA ABX.HE.AA ‘AA’ RMBS . . . ‘AA’ RMBS ‘AA’ RMBS ‘AA’ RMBS ‘AA’ RMBS ‘AA’ RMBS ‘AA’ RMBS ‘AA’ RMBS ‘AA’ RMBS ‘AA’ RMBS ‘AA’ RMBS ‘AA’ RMBS ABX.HE.A . . . ‘A’ RMBS ‘A’ RMBS ‘A’ RMBS ‘A’ RMBS ‘A’ RMBS ‘A’ RMBS ‘A’ RMBS ‘A’ RMBS ‘A’ RMBS ‘A’ RMBS ‘A’ RMBS ‘A’ RMBS ABX.HE.BBB . . . ‘BBB’ RMBS ‘BBB’ RMBS ‘BBB’ RMBS ‘BBB’ RMBS ‘BBB’ RMBS ‘BBB’ RMBS ‘BBB’ RMBS ‘BBB’ RMBS ‘BBB’ RMBS ‘BBB’ RMBS ‘BBB’ RMBS ‘BBB’ RMBS ABX.HE.BBB- ‘BBB-’ RMBS ‘BBB-’ RMBS ‘BBB-’ RMBS ‘BBB-’ RMBS ‘BBB-’ RMBS ‘BBB-’ RMBS ‘BBB-’ RMBS ‘BBB-’ RMBS ‘BBB-’ RMBS ‘BBB-’ RMBS ‘BBB-’ RMBS ‘BBB-’ RMBS . . . . . . Residual Residual Residual Residual Residual Residual Residual Residual Residual Residual Residual Residual www.derivativefitch.com

  15. Characteristics of the ABX.HE Indices • The ABX.HE indices are equally weighted indices of the 20 largest volume subprime RMBS issuers. • Three ABX.HE indices have been issued to date: • ABX.HE.06-1 represents 20 subprime RMBS issued in 2H 2005 • ABX.HE.06-2 represents 20 subprime RMBS issued in 1H 2006 • ABX.HE.07-2 represents 20 subprime RMBS issued in 2H 2006 • Each index has 5 series representing different levels of risk • AAA, AA, A, BBB and BBB- • The ABX.HE has proven to be effective in providing market transparency in an otherwise opaque market • Allows market participant to express market views • Provides hedging mechanism for mortgage warehouse facilities www.derivativefitch.com

  16. ABX.HE Prices www.derivativefitch.com

  17. Stress in the Subprime Mortgage Markets 2Q 2006 3Q 2006 4Q 2006 1Q 2007 Home Price Appreciation (HPA) begins to dramatically slow nationally Fremont announces it will stop originating second lien loans. First-time home buyers blamed for EPDs MLN ceases originations in Jan and files for bankruptcy in Feb. New Century reveals accounting errors in Feb and in Mar announces it will not file quarterly financials and under criminal probe into stock trading and accounting irregularities. NovaStar says they will have no taxable income for several years in Feb. ABX.HE bottoms out with slight rebound Cash HEL spreads widen Small originators come under financial pressure as repurchase levels soar. Reports of small originators closing doors. Ownit Mortgage files for bankruptcy (Dec) citing withdrawn financing from Merrill Lynch. Fremont under pressure from EPDs ABX.HE indices start to show stress HPA continues to slow Early payment defaults (EPDs) begin to rise dramatically. RMBS Conduits become more aggressive in putting loans back to originators for repurchase. Lenders start to publicize improved underwriting guidelines www.derivativefitch.com

  18. Subprime RMBS Performance and Outlook What are the drivers of subprime RMBS performance? How does this impact originators, issuers and servicers? What is Fitch’s outlook for RMBS?

  19. Subprime RMBS Collateral Performance Summary www.derivativefitch.com

  20. Subprime and Alt-A Delinquencies RisingFitch-Rated Transactions www.derivativefitch.com Source: FitchRatings, LoanPerformance

  21. 2006 Vintage Delinquency Similar to 2000Fitch-Rated Transactions www.derivativefitch.com Source: FitchRatings, LoanPerformance

  22. Early 2006 Vintage Loss Also Trending HighFitch-Rated Transactions www.derivativefitch.com Source: FitchRatings, LoanPerformance

  23. 2006 Vintage Alt-A Also Showing StressFitch-Rated Transactions www.derivativefitch.com Source: FitchRatings, LoanPerformance

  24. Fitch-Rated Alt-A Not Representative of Broader Performance www.derivativefitch.com Source: FitchRatings, LoanPerformance

  25. Subprime RMBS Collateral Performance Drivers www.derivativefitch.com

  26. Piggyback 2nds and Low Doc Associated With Early Default www.derivativefitch.com Source: FitchRatings, LoanPerformance

  27. ABX-HE Indices: 2006 Reference Pools Underperform 2005 www.derivativefitch.com Source: FitchRatings, LoanPerformance

  28. ABX-HE Indices: Loans with 2nd Liens Underperforming www.derivativefitch.com Source: FitchRatings, LoanPerformance

  29. ABX-HE Indices: Limited-Documentation Underperforming www.derivativefitch.com Source: FitchRatings, LoanPerformance

  30. Piggybacks 2nds and Lim Docs: ResiLogic Model Sensitive To Risk-Layering 2005 Vintage First-Lien 60+ Delinquency – Loans 12 Months Seasoned ResiLogic Single-Loan Results (2/28 ARM Single-Family, Purchase, Owner-Occ.) www.derivativefitch.com

  31. Home Price Stress Driving Defaults Higher www.derivativefitch.com Source: FitchRatings, OFHEO

  32. Impact On Subprime Originators, Issuers and Servicers www.derivativefitch.com

  33. Originator Crisis Caused By Repurchase Wave • The sudden performance deterioration caused a spike in first payment defaults (FPDs) and early payment defaults (EPDs) • Loan buyers exercised their rights to put first payment defaults back to originators • Large outlays for repurchase put substantial strain on smaller, poorly capitalized companies • Early payment defaults in warehouse lines caused lenders to tighten • The need to change product mix further constrained lenders as they saw volume/profitability fall • High repurchase obligations and lack of financing drives marginal players into bankruptcy (Ownit, ResMae, MLN, People’s Choice) • Larger players also under severe stress (Fremont, New Century, Accredited) • Discount loan pricing continues to weigh on originators • Well-capitalized entities can weather the storm, and opportunistic buyers are active www.derivativefitch.com

  34. www.derivativefitch.com Source: Fremont Investment & Loan

  35. www.derivativefitch.com Source: Fremont Investment & Loan

  36. www.derivativefitch.com Source: Fremont Investment & Loan

  37. Issuers Continue To Struggle For Liquidity • No demand for high concentrations of high risk products • Pipeline leaves large volume of loans without a home • Difficult to find clearing levels for subordinate bonds • New deals beginning to appear with different collateral characteristics • Investors on the sidelines waiting to see more evidence of better collateral www.derivativefitch.com

  38. Distressed Companies Were Unrated or Low Rated Servicers www.derivativefitch.com

  39. Challenges To Servicers • High risk products require intensive servicing • Falling origination volumes will change ratio between performing loans which are profitable to service and non-performing loans which are less profitable • Low home price inflation combined with ARM resets will require loss mitigation proficiency • Regulatory and legislative scrutiny may hamper effective timeline management www.derivativefitch.com

  40. Strengths Of Servicers • Servicing is concentrated among capable, well-capitalized entities • Industry has the capacity to absorb loans from distressed portfolios www.derivativefitch.com Source: FitchRatings, LoanPerformance

  41. Subprime RMBS Outlook www.derivativefitch.com

  42. Subprime ARM Resets Yet To Come… www.derivativefitch.com Source: FitchRatings, LoanPerformance

  43. 2005-2006 Vintage Subprime Hybrid ARMs Face Upward Rate Adjustment Even if Rates Remain Flat www.derivativefitch.com Source: FitchRatings, LoanPerformance

  44. Subprime Rating Activity Trends www.derivativefitch.com

  45. Fitch Subprime RMBS Outlook • 2006 will prove to be a poor vintage. Early defaults combined with on-going low HPA and ARM reset risk will drive losses higher than recent vintages, and in many instances higher than initial expectations. • While the general trend is poor, much work is needed to refine forecasts of long-term performance, and to differentiate among deals. Rating actions will be taken promptly as the data warrants. Fitch does not foresee significant investment grade defaults given current trends. • There already is, and will continue to be, substantial performance differences among originators, issuers, servicers, products and geographic areas. • Origination volume will drop. Low HPA will reduce refinancing incentives. Product changes will limit the “affordability purchase” borrowers. The final form of regulatory guidance could greatly curtail subprime product offerings. • Loan attributes are changing. Whether this results in true improvements in credit quality remains to be seen. www.derivativefitch.com

  46. Subprime Mortgage Markets and Fitch-rated CDOs What CDOs may be affected by stress in the subprime mortgage markets? What is the potential impact on structured finance CDOs?

  47. Subprime RMBS Exposure in Structured Finance CDO • Fitch rates over 200 structure finance CDOs with exposure to approximately 6,500 subprime RMBS bonds with a current notional balance in excess of $50 billion. • Subprime RMBS exposures are diversified by: • Vintage (originations between 2000 and 2006) • Rating (current ratings between ‘CCC’ and ‘AAA’) www.derivativefitch.com

  48. Average Structured Finance CDO Portfolio Composition by CDO Vintage www.derivativefitch.com

  49. CDOpinions Article dated January 23rd, 2007 • In the ‘Collateral Talk’ section of our bi-weekly newsletter we address likely scenarios facing structured finance CDOs in 2007 • Current delinquencies and defaults in 2006 subprime RMBS may be severe enough that some mezzanine bonds will face negative rating migration pressure in 2007 • 2003 vintage subprime RMBS is more likely to be downgraded as the majority of these deals have passed their performance triggers and the structures will release credit enhancement making them more vulnerable to future stress. www.derivativefitch.com

  50. Structured Finance CDO Exposure to Subprime RMBS • Structured Credit Special Report exploring the effects of Subprime RMBS Performance on CDOs soon to be published - Co-authored between RMBS and Structured Credit • Preliminary Analysis: • RMBS downgrades in the second and third quarters of 2007 will likely be concentrated in the 2003 and 2004 vintages and in the ‘A’ and lower-rated portions of the subprime RMBS structures. • Issuance from the second half of 2005 and 2006 are expected to under perform older vintages over time, with second lien securitizations coming under stress first. • If a substantial number of 2005 and 2006 subprime RMBS is downgraded in 2007, then it is likely to trigger downgrades of subordinate classes in mezzanine SF CDOs in 4Q 2007 or 2008. • The ratings of the most senior classes are likely to be unaffected. www.derivativefitch.com

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