Primer 2005

2005 EDITION
Home Equity Handbook
Editors: Charles Schorin Monica Mehra
2005 EDITION
Editors: Charles Schorin Monica Mehra

This material has been prepared in accordance with our conflict management policy. The policy describes our organizational and administrative arrangements for the avoidance, management and disclosure of conflicts of interest. The policy is available at: www.morganstanley.com/ institutional/research. Please see additional important disclosures at the end of this material. Morgan Stanley & Co. Incorporated February 17, 2005
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SECTION I. INTRODUCTION TO THE HOME EQUITY MARKET 1 MARKET O VERVIEW
Market Size Collateral Types Transaction Structure Underwriting Guidelines
1 5
SECTION II. THE COLLATERAL 2 COLLATERAL T YPES

Traditional Subprime Mortgages Home Equity Lines of Credit (HELOCs) Home Improvement Loans (HILs) High Combined Loan-to-Value Loans (High CLTVs)
FICO BORROWER C REDIT S CORES
9 27
29 4 5
4 5 6
Parameters Migration Patterns Distribution Analysis Cumulative Loss Projections

PERFORMANCE B Y C HARACTERISTIC 47 6 1
Factors Affecting Default Default Prediction Regression

TRANSITION R OLL R ATE M ATRIX 63 6 5 67 7 3
Delinquency Migration Patterns

SERVICER R ATINGS
Rating Criteria Types of Servicing Product Distinction
SECTION III. METRICS 7 PREPAYMENTS

Historical Performance Impact on Available Funds Cap Prepayment Rate Stability
DELINQUENCIES
77 9 4
95 1 03
9 10
Performance by Status Default Timing Excess Spread Surveillance

LOSS S EVERITY 105 1 09
111 1 15
Loan Size Impact

CREDIT E NHANCEMENT
Stressing Subordination Levels
SECTION IV. THE STRUCTURE 11 MEZZANINE & S UBORDINATE C LASSES

Loss, Prepayment and LIBOR Stresses Analyzing Performance
119 1 36
12
NIM S
137 1 59
13
Sources of Cash Flow Primary Mortgage Insurance Sizing Analyzing Performance

CLEAN-U P CALLS U 161 1 81
14
Mechanics Benefits of Calling Call Timing

TRIGGERS 183 1 95
15 16
Types Mechanics Impact of Prepayments Delinquency Trigger Thresholds

AVAILABLE F UNDS C AP 197 2 05 207 2 22
Complex Corridors
MORTGAGE I NSURANCE
17
Types Key Factors Loss Severity Distribution Insurer Performance Data

BOND I NSURANCE 223 2 27
Wrapped Market Major Insurers
SECTION V. REGULATORY ENVIRONMENT 1 18 EITF 0 3-1 BASEL II 19 SECTION VI. HOME PRICES 20 HOME PRICES
Housing Fundamentals Real vs. Nominal Price Growth Prices in Areas of Economic Decline
231 2 33 235 2 45
249 2 73
SECTION VII. ANALYZING SECURITIZATION PERFORMANCE 21 RATINGS T RANSITION M ATRIX 22 CREDIT COORDINATES
Issuer Performance in Loss/Delinquency Space
277 2 81 283 2 86 287 2 94 295 3 01 303 3 41
23 24 25
INDUSTRY P ERFORMANCE C OMPARISON SEPARATING T HE G OOD F ROM T HE B AD
Forecasting Ultimate Loss Rates

TRANSACTION M ONITORING
APPENDIX
GLOSSARY O F T ERMS 345 3 51
Overview
HANDBOOK F ORMAT
This handbook is organized into seven sections: the first section provides an introduction to todays home equity loan market, including market size, collateral types, securitized transaction capital structure, and loan underwriting parameters. The second section provides an in-depth analysis of the collateral, FICO scores, performance characteristics, delinquency transitions and servicer ratings. The third section focuses on metrics for analyzing collateral, including prepayments, delinquencies, loss severity and credit enhancement. The fourth section analyzes the structure of a home equity transaction by looking at subordinate and mezzanine classes, NIMs, clean-up calls, performance triggers, available funds cap and mortgage and bond insurance. The fifth section looks at regulatory issues related to home equity transactions, including EITF 03-1 and Basel II. The sixth section looks at home prices in different interest rate environments. Finally, the seventh section focuses on analyzing the performance of home equity transactions. The handbook concludes with an appendix that contains a glossary of terms used in the home equity loan and securitization arenas. This handbook is a compilation of articles originally written by Charles Schorin, Amol Prasad, Laura Heins, Sarah Barton, Jae Choi, Monica Mehra and Laurent Gauthier. We hope that our readers will find the Home Equity Handbook helpful in understanding this important sector of the ABS market. As always, we welcome your comments and thoughts for improvement, both on this handbook and for our research generally.
Section I Home Equity Handbook
Introduction to the Home Equity Market
Please refer to important disclosures at the end of this material.
Market Overview
SIZE O F T HE M ARKET
chapter 1
The HEL ABS market grew tremendously in the late 1990s, followed by a period of consolidation as some of the thinly capitalized finance company lenders encountered difficulty. In the past three years, the sector has rebounded dramatically, with HELs accounting for more than 40% of the U.S. ABS market issuance, representing the largest single securitized asset class. The share of HEL ABS issuance that is floating rate shifted dramatically over the years. Whereas in 1997, floating rate securities accounted for only 62% of HEL ABS, now the floating rate share is over 90% (Exhibit 1).
exhibit 1
HEL ABS ISSUANCE AND HEL SHARE OF ABS MARKET
Source: Morgan Stanley, Intex, Asset-Backed Alert
The year 2004 saw almost $450 billion of HEL ABS brought to market. The largest issuers in 2004 are displayed in Exhibit 2.
exhibit 2
LARGEST ISSUERS OF HEL ABS IN 2004
Source: Morgan Stanley, SDC
Home Equity Handbook chapter 1
Market Overview
INTRODUCTION T O H EL S
Todays home equity ABS market is comprised of both first and second lien mortgages. Several years ago, second lien mortgages, originated for the purpose of financing expenditures, made up most of the home equity loan market. As the securitization market evolved through the mid-to-late 1990s, there was a move towards first lien debt consolidation loans to subprime borrowers. These loans have longer maturities and larger loan balances than the original second lien HELs. In the past two years, HELs have increasingly been used on purchase loans for first time home buyers borrowers who perhaps have no credit history rather than a subprime credit history. Within the ABS market, the four most common types of collateral are home equity loans (HELs), home equity lines of credit (HELOC), home improvement loans (HILs), and high combined loan-to-value loans (high CLTVs).
Home Equity Loan (HEL)
The term home equity loan primarily refers to first lien mortgages for subprime borrowers. A borrower is designated as subprime due to a weak or unsubstantiated credit history. Weak credit history is caused by having some delinquencies in the recent past or having a considerable amount of outstanding debt. These, as well as other factors, would result in lower values of FICO scores, suggesting a weaker quality borrower or, put alternatively, one who is more likely to default.1 As stated above, borrowers without substantiated credit histories have increasingly turned to HELs as purchase loans.
Home Equity Line of Credit (HELOC)
The term home equity line of credit refers to second lien open-end, revolving loans. HELOCs may be partially or completely drawn down or paid back over time. These loans tend to carry floating rates with high lifetime caps and no interim caps. While HELOCs are used in the securitization, they are considerably outnumbered by the volume of first lien HELs.
Home Improvement Loan (HIL)
Home improvement loans are loans for the specific purpose of financing an addition or modification to a home. Some, but not all, HILs are originated under a government program that insures the loans.
High Combined Loan to Value (High CLTV)
High combined loan-to-value loans are generally made to borrowers with solid credit histories, but who have accumulated considerable non-mortgage debt. The high CLTV loan allows the borrower to take advantage of a lower interest rate by consolidating debt into a new mortgage, which usually is in a second lien position. The CLTV ratio could be as high as 110%125%.
FICO scores are a measure of a borrowers credit quality and are discussed more in Chapter 3.
CAPITAL S TRUCTURE O F S ECURITIZED H ELS
The typical capital structure of a securitized HEL transaction collateralized by 2/28 hybrid ARMs is shown in Exhibit 3. Discussions of the interaction of the various classes of the capital structure with collateral performance are in several chapters in Sections III and IV of this handbook.
exhibit 3
REPRESENTATIVE HEL CAPITAL STRUCTURE
Source: Morgan Stanley
Market Overview
HOME E QUITY L OAN U NDERWRITING
Exhibit 4 shows a summary of representative underwriting guidelines that subprime lenders use when evaluating their borrowing applicants. The difference in credit grades can result in substantially different mortgage rates offered to borrowers. Exhibit 5 shows the combination of credit grades and interest rates for the hybrid ARMs initial fixed rate period for a representative subprime pool. It is clear that borrowers who improve their credit standing can dramatically lower their mortgage rate.
exhibit 4
REPRESENTATIVE SUBPRIME UNDERWRITING MATRIX SUMMARY
Source: Various transaction prospectuses
exhibit 5
Credit Grade
A+ A AB C+ C
Note Rate (%)

5.75 5.85 5.90 6.25 6.90 9.50
HIGHER SUBPRIME CREDIT GRADES
Note: This credit grade/mortgage rate grid shows finer credit gradations than the summary in Exhibit 4. Source: Originator rate sheets.
Section II Home Equity Handbook
The Collateral
Collateral Types
This chapter discusses the various collateral types within the home equity loan arena. Without a doubt, the most prevalent type of loan is the traditional subprime mortgage. Exhibit 1 shows the breakdown between collateral types for 2004 securitizations.
chapter 2
exhibit 1
HEL COLLATERAL DISTRIBUTION FOR 2004 TRANSACTIONS
Source: Morgan Stanley, Asset-Backed Alert
TRADITIONAL S UBPRIME M ORTGAGES
The following characteristics are typical of traditional subprime mortgages.

General Loan/Borrower Characteristics
Closed-end amortizing loans where the funds are fully disbursed at the closing of the loan and amortize over a specified period. Adjustable rate mortgages (ARM) or fixed rate mortgages. Since 1997, most ARMs are hybrid mortgages. Typically, hybrid loans in subprime securitizations are 2/28 and 3/27 loans. The 2/28 loan is fixed for two years and then resets semiannually to six-month LIBOR for the remaining 28 years and the 3/27 loan is fixed for three years and then resets semiannually to six-month LIBOR for the remaining 27 years. The loan term is usually between 5 and 30 years. May have a balloon payment. Average loan size is $150,000. First or second lien. Currently, the large majority are first liens. The loan purpose is usually debt consolidation or cash-out refinance. Borrowers typically use the cash to pay down or consolidate their higher interest rate credit card debt, allowing the borrower to pay a lower interest rate and take advantage of the tax deductibility of mortgage interest payments. More recently, we have seen subprime mortgages increasingly being used for home purchases by borrowers with unsubstantiated credit histories. Average FICO is between 575 and 625, although this range has moved higher in the past two years.
Collateral Types
exhibit 2
COLLATERAL CHARACTERISTICS OF REPRESENTATIVE SUBPRIME MORTGAGE TRANSACTIONS

Rate 2/28 (%) 3/37 (%) Total ARM (%) Fixed (%) Average Loan Balance ($) Loans with PrePayment Penalty (%) FICO 1st Lien (%) 1st Quartile 2nd Quartile 3rd Quartile
Issuer
Deal Name
Ameriquest Countrywide CSFB GMAC Household Lehman Brothers/SASC Long Beach Morgan Stanley Option One
2003-1 2003-BC1 2003-1 2003-KS1 2002-4 2003-1 2003-1 2003-NCI 2003-1
NA 50.9 0.0 NA 0.0 0.0 NA 70.3 NA
NA 12.5 0.0 NA 0.0 0.0 NA 2.7 NA
73.9 63.4 0.0 100.0 0.0 0.0 69.2 76.2 72.1
26.1 36.6 100.0 0.0 100.0 100.0 30.8 23.8 27.9
145,485 142,740 300,571 125,634 102,561 399,599 166,463 156,117 167,180
77.3 87.6 9.8 86.5 89.5 25.5 67.0 77.3 79.4
100.0 100.0 100.0 100.0 89.1 100.0 93.5 100.0 99.3
551-575 581-600 NA 560-579 541-580 NA 561-580 526-550 NA
601-625 621-640 NA 600-619 581-620 NA 621-640 576-600 NA
651-675 641-660 NA 620-639 621-660 NA 661-680 626-650 NA
To consider subprime mortgage characteristics further, we look at Exhibit 2. This table reports loan characteristics for recent transactions from large issuers. While there are some differences between collateral characteristics, it is clear that most of the subprime mortgage securitizations employ first lien adjustable rate mortgages, with prepayment penalties and average loan balances on the order of $150,000. It is interesting that two deals that contain only fixed rate mortgages have average loan balances in the $300,000-400,000 range and the other fixed rate deal has an average loan balance of only $100,000 (this is a high LTV transaction). Average FICO scores in Exhibit 2 are in the 600-625 range, although there is a fairly wide range of FICOs within the quartiles. We discuss FICOs and FICO dispersion in considerable detail in Chapter 3.
Credit Performance
Subprime mortgages are characterized by fairly high delinquencies relative to prime mortgages. Likewise, subprime mortgage pools typically have foreclosures and, ultimately, losses that are higher than those experienced by prime mortgages. It is for this reason that their subordination level is a multiple of that on prime mortgage securitizations (discussed in the section below). Exhibit 3 shows serious delinquencies by issue year cohort for fixed and adjustable rate HEL transactions, while Exhibit 4 reports cumulative losses for the same cohorts. What is apparent from Exhibit 4 is that if all 1997-98 vintage HEL transactions had performed as per the average loss curve for the respective cohort, there would not have been the credit problems that those vintage HEL transactions had experienced. In fact, the problem was not the average loss curve, but rather the outlier of losses, such as those experienced by Southern Pacific, ContiMortgage and The Money Store in their 1998 cohorts, to name a few of the poorest performing issuers cohorts. Cumulative losses for these issuers have reached 7-8%, or in rare instances, as high as 12%. These compare with expected losses on the order of 4-5% for most subprime pools.
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FICO 4th Quartile Avg. LTV (%) Cash Out (%)
Loan Purpose Rate Term Refi. (%) Average Gross Margin on ARMs (%) Average Mortgage Rate (%) Average Team Original (Months) Remaining Months Owner Occupied (%) Single Family (%)
Avg.
Purchase (%)
Other (%)
Full Doc. (%)
>625 601-620 NA >759 >605 NA >600 >600 NA
615 624 NA 609 620 NA 626 596 609
80.4 79.6 72.5 62.0 100.7 57.6 80.7 76.6 76.5
55.1 69.1 26.7 55.6 NA 29.6 46.4 65.0 65.6
37.5 11.3 37.6 4.9 NA 55.5 11.6 17.7 6.2
7.4 19.6 35.5 36.3 NA 15.6 41.6 17.3 26.0
0.0 0.0 0.0 0.0 NA 0.0 0.0 0.0 0.0
6.2 6.9 NA 7.6 NA NA 5.3 6.5 5.2
6.3 7.6 7.0 6.2 10.6 6.1 7.9 6.1 7.9
NA 350 356 360 32.3 165 349 354 356
350 346 352 356 307 160 347 351 355
95.3 96.9 90.9 92.6 96.3 90.3 94.0 94.6 92.5
71.9 NA 49.1 61.5 NA 65.6 56.0 56.5 56.7
62.0 61.3 70.1 63.2 NA 77.5 76.9 76.4 73.2
exhibit 3 SERIOUS DELINQUENCIES ON FIXED AND
ADJUSTABLE RATE HELS
Note: Loans considered seriously delinquent are 60+ days late, as well as loans to borrowers who have filed for bankruptcy and loans that are in foreclosure or REO status. Source: Morgan Stanley, Intex
exhibit 4 CUMULATIVE LOSSES ON FIXED AND
ADJUSTABLE RATE HELS
Source: Morgan Stanley, Intex
11
Collateral Types
Prepayments
Home equity loan prepayment patterns differ significantly from those of conventional mortgages. For example, fixed rate HELs display considerably less interest rate sensitivity prepaying at faster, but less variable, rates than agency pass-throughs. (Exhibit 5)
exhibit 5
FIXED RATE HELS ARE LESS SENSITIVE TO INTEREST RATES THAN AGENCY MORTGAGES
HYBRID ARMS ARE MORE CALENDAR, THAN RATE, SENSITIVE
12
The reasons for HELs faster, but less variable, prepayment rates are: Borrowers moving from a lower to a higher credit grade (i.e., credit cures) can receive lower mortgage rates, even in the absence of a secular lowering of Treasury yields, making the HEL prepayments faster in their base case. Rates available to subprime borrowers tend to move less in lock-step with Treasuries than do mortgage rates on conventional loans, making HEL prepayments less variable. Adjustable rate HEL prepayments, on the other hand, are more seasoning, than interest rate, sensitive. The collateral has a fixed rate period for two or three years, usually with a prepayment penalty, followed by an adjustable rate period for the remaining 28 or 27 years. Because the loans are a combination of fixed and adjustable rate periods, they are referred to as hybrid ARMs or 2/28 ARMs (or 3/27 ARMs). Borrowers often employ these loans to take advantage of the relatively low fixed rate period, and when the prepayment penalty and fixed rate period expire, refinance into another hybrid ARM. This causes prepayment rates to spike around the interest rate transition date. Exhibit 6 shows prepayments on hybrid ARM pools. The prepayment pattern described above relatively low in the initial fixed rate, prepayment penalty period, spiking around the reset date and then declining is evident in the graph. The reason that the graph shows a longer period of fast prepayments is due to a combination of dispersion in reset date (i.e., 2/28 loans that were originated a few months apart will reset at different calendar dates) and inclusion of 3/27, as well as 2/28, ARMs in the pools.
13
Collateral Types
HOME E QUITY L INES O F C REDIT ( HELOC)
The following are characteristics typical of home equity lines of credit.

Revolving loans allow the borrower to draw cash up to a predetermined limit, as the borrower needs it. This contrasts with a closed-end loan where the funds are fully distributed at the loans closing. Utilization rate is the amount the borrower has drawn down divided by the maximum amount the borrower can draw. Average utilization rates, including those for loans not included in securitizations, have historically ranged from 73-85%. The size of the securitized HELOC market remains relatively small compared to the traditional subprime home equity market because many banks historically have held these loans on their balance sheet. However, we expect increased HELOC securitizations going forward, as the American Jobs Creation Act of 2004 gave HELOCs REMIC status, facilitating their securitization. Mostly second liens. Average FICO for HELOC securitizations range from 700 to 740. Can be fully amortizing or have an interest-only period. May have a balloon payment. Average credit limit between $50,000-130,000. Both the bonds and the collateral are typically floating rate. The borrowers interest rate is typically indexed to the prime rate. HELOC bonds are typically indexed to 1-month LIBOR.
exhibit 6
COLLATERAL CHARACTERISTICS OF REPRESENTATIVE HELOC TRANSACTIONS

Cut-Off Date Principal Balance ($MM) FICO 1st Quartile 2nd Quartile 3rd Quartile 4th Quartile Avg. Range of Loan Rates Low (%) High (%)
Issuer
Deal Time
Average Combined LTV (%)
Average Loan Balance
2nd Lien (%)
Countrywide GMAC Morgan Stanley Wachovia
2002-C 2002-HE3 2002-1 2002-HE2
849.8 407.2 472.5 1,200.0
81.3 78.0 72.3 77.7
29,065 26,100 63,733 49,523
92.7 93.8 68.3 55.6
621-679 680-699 676-700 676-700
680-719 720-739 7001-725 726-750
>720 760-779 751-775 751-775
>720 820-8539 826-850 826-833
714 721 715 725
3.0 4.0 3.0 3.8
11.5 13.0 17.5 9.9
14
Exhibit 6 compares collateral for some recent HELOC securitizations for the larger issuers in 2002. The loans are largely, but not exclusively, second liens, with LTVs on the order of 75-80%. FICO scores of these HELOCs are about 100 points higher than those on traditional subprime mortgages. The loans are generally for homes that are owner occupied and, for these transactions, the loans do not contain prepayment penalties. There is a wide distribution of losses among the various cohorts, largely because of the relatively small data set (Exhibit 7). For 1999 and 2000 originations, performance is largely influenced by a few underperforming deals from Advanta.
exhibit 7
HELOC CUMULATIVE LOSSES
Average Loan Rate (%)
Average Remaining Term (Months)
Loan Type Fixed (%) ARM (%) Revolving Period Ends
Owner Occupied (%)
Full Doc. (%)
Single Family (%)
Loans with Prepayment Penalty
Average Credit Limit
Average Utilization Rate (%)
Average Debt-toIncome Ratio (%)
4.2 6.5 5.0 4.8
298 218 120 231
0.0 0.0 5.1 0.0
100.0 100.0 94.9 100.0
NA Feb-04 NA Dec-03
>97.5 97.4 89.5 90.1
NA 81.1 NA 50.1
76.2 83.6 80.4 92.0
NA 0.0 0.0 0.0
40,517 42,952 133,655 89,747
71.7 78.2 47.6 55.2
<45.0 36.3 45.0 <50.0
15
Collateral Types
HOME I MPROVEMENT L OANS ( HIL) General Loan/Borrower Characteristics
The proceeds from the loan are typically used to improve the property. Closed-end amortizing loans where the funds are fully disbursed at the closing of the loan and amortize over a specified period. The borrower typically pays a fixed interest rate. Small balance. Loans can be either conventional or FHA Title 1 HILs.
Conventional HILs
Conventional HILs are not part of the FHA Title 1 program and, therefore, lenders do not benefit from FHA Title 1 insurance. As a result, the loans are subject to more rigorous underwriting standards. However, the conventional HIL does not have any limitations on LTV or loan size, and assets may not secure it.
FHA Title 1
The U.S. Department of Housing and Urban Development (HUD), through the National Housing Act (NHA) of 1934, created the Federal Housing Authority (FHA). Title 1 of the NHA is intended to encourage lending to middle-class families for the construction and improvement of homes through insurance coverage for approved borrowers. Title 1 provides for the insurance of HILs. HUD has only a few underwriting requirements: the debt-to-income ratio of the borrower not exceed 45%, LTV lower than 100% and that loans for amounts greater than $7,500 are secured. Because FHA underwriting occurs only if a claim is made, the lender (approved specifically by HUD for the Title 1 program) uses its own discretion in assessing the borrowers credit. The FHA requires the home improvement to be a light or moderate rehabilitation. For single family homes, the loan amount is capped at $25,000, and for multi-family structures, the maximum loan amount is $12,000 per family and $60,000 for the entire structure. The loans do not carry prepayment penalties, but do have a maximum term. The maximum loan term for a single family house is 20 years and for a multi-family structure it is 15 years. The funds must be used for permanent improvements to the property, and a work order may be required to ensure that the money was not used for debt consolidation or extravagant upgrades. For example, a swimming pool or spa would not qualify.
16
FHA insurance is designed to protect the lender from extensive losses, but only to a certain level. Once the lender originates the HIL, the FHA credits 10% of the loan amount to the lenders reserve account. An annual premium, 50 bp usually charged separately to the borrower, is required to maintain this reserve account. If a borrower defaults, the FHA then checks to make sure the origination process was proper, the loan balance was used for an approved improvement, and loan servicing was sufficient. If the claim is approved, the FHA pays 90% of the remaining loan balance and associated default fees to the lender. The effective loss severity is then 10%. However, because the reserve balance is at most 10% of the lenders total FHA portfolio, it is possible that the reserve account runs out and loss severity returns to 100%. The 10% limit on insurance becomes an incentive for the lender to underwrite effectively.
17
Collateral Types
HIGH C OMBINED L OAN-T O-V ALUE L OANS T V
High combined loan-to-value loans (high CLTV) are risky by nature because the loans have CLTVs above 100%, i.e., the value of the loan exceeds the value of the home. These loans emerged as an alternative for homeowners with higher interest rate credit card debt. The loans allow borrowers to consolidate their credit card debt at lower interest rates while also benefiting from partial tax deductibility of interest payments. Interest on the amount that exceeds the home value is not tax deductible. The term combined loan-to-value refers to the sum of the outstanding first and second liens (and subsequent liens, if any) divided by the value of the home. High CLTV loans can be viewed as a hybrid between regular home equity loans and unsecured credit card loans. Arguably, high CLTV loans are more like credit cards because both are extended on the basis of borrower credit quality, and have limited or no collateral securing the loan. Although credit cards and high CLTV loans are similar, it is difficult to compare high CLTV deals to credit card deals. Credit cards are revolving lines of credit, while high CLTV loans are typically closed-end, non-revolving obligations. Credit card deals also have a master trust structure, while high CLTV deals are issued from discrete trusts. In a master trust structure, new receivables may be added to the collateral pool during the revolving period or when a new deal is being issued from the trust. It is easier to compare the performance of high CLTV deals to subprime deals (non-high CLTV) because both have static pools. Although high CLTV collateral is riskier than subprime home equity loans, the loss coverage levels (as calculated by Standard & Poors) are greater than those of subprime deals. The big question we are trying to answer is are the loss coverage levels adequate for high CLTV transactions?
Main Issuers
Some of the issuers in the subprime market also issue in the high CLTV market. Since 1999, the main issuer of high CLTV deals has been GMAC/RFC, an issuer that is also active in the subprime world. Within the past few years, GMAC/RFC has been the only consistent issuer of high CLTV loans, but Irwin Financial, CSFB, Bayview, Countrywide and Bear Stearns have also issued deals. In 1997 and 1998, Empire Funding and FirstPlus were the predominant issuers in the market. Cityscape, City National, GMAC, Master Financial and Life Savings Bank were also participants during those years. The high CLTV market, however, has experienced changes similar to the subprime markets since 1997, with many issuers either filing for bankruptcy or consolidating through mergers or acquisitions. Empire Funding, FirstPlus and Cityscape all filed for bankruptcy. In addition, BB&T Corp purchased Life Savings Bank.
18
CLTVs between 100-125% Second liens Fixed-rate, closed-end loans Small loan balances of approximately $45,000 Credit scores range from 650-690 Primarily originated to consolidate debt Loan maturities range from 5-25 years Examples of high-CLTV loan characteristics can be seen in Exhibit 8.
Delinquencies, Cumulative Losses and Loss Severity
Surprisingly, high CLTV 60+ day delinquencies are lower than those of subprime (non-high CLTV) loans. In contrast, high CLTV cumulative losses are much higher than those of subprime mortgages. This phenomenon is due to two interrelated reasons: 100% loss severity for high CLTV loans Speed at which high CLTV loans are written off Losses are realized quickly, keeping delinquencies low compared to subprime home equities. The 100% loss severity combined with the quick realization of losses makes cumulative losses for high CLTV climb more rapidly than subprime.
Loss Severity
Defaulted loans with greater than 100% CLTVs and second lien position generally result in 100% loss severity. In contrast, defaulted subprime loans typically have a loss severity of 30-40%. As a result, most second lien high CLTV servicers do not advance interest and principal on loans because the probability of recovering any money is very low. The inability to recover any money is due to two things: 1) the high CLTV and 2) the second lien position. Generally, the CLTVs range between 100-125%, leaving no equity cushion to absorb any potential negative home price variation compared to the appraisal value, advancing and legal expenses of foreclosure. In addition, the majority of loans are second liens. A second lien mortgage lender is unable to foreclose on the property securing the loan unless it forecloses subject to the first lien. In that case, all recoveries must be paid to the first mortgage and any other higher priority liens prior to paying the second mortgage, resulting generally in 100% loss severity.
Speed of Loss Realization
Typically, high CLTV loans are written off after 180 days since the expected recovery is zero. In contrast, a defaulted subprime (non-high CLTV) loan can take as long as one to two years to work through the foreclosure process and for a loss to be realized. High CLTV servicers move delinquencies to losses more quickly than non-high CLTV subprime loans, keeping delinquency levels lower and cumulative losses rising more quickly on high CLTV deals.
19
Collateral Types
exhibit 8
EXAMPLE OF HIGH CLTV LOAN CHARACTERISTICS AT ISSUANCE
Bloomberg Ticker
Avg. CLTV
2nd Lien (% of)
Avg. Credit Scores
Gross WAC
Avg. Remaining Term
Avg. Loan Balance
DLJAB 2000-6 GMACM 2000-CL1 GMACM 2000-HLTV GMACM 2000-HLT2 GRP1 GMACM 2000-HLT2 GRP2 GMACM 2001-HLT1 GRP1 GMACM 2001-HLT1 GRP2 GMACM 2002-HLT1 GRP1 GMACM 2002-HLT1 GRP2 RAMP 2000-HL1 GRP1 RAMP 2000-HL1 GRP2 RAMP 2000-RZ2 RFMS2 2000-HI1 GRP1 RFMS2 2000-HI1 GRP2 RFMS2 2000-HI2 GRP1 RFMS2 2000-HI2 GRP2 RFMS2 2000-HI3 GRP1 RFMS2 2000-HI3 GRP2 RFMS2 2000-HI4 GRP1 RFMS2 2000-HI4 GRP2 RFMS2 2001-HI2 GRP1 RFMS2 2001-HI2 GRP2
1
117.0 104.0 113.2 112.9 112.7 115.3 113.1 116.8 114.7 117.9 116.1 102.5 114.7 113.4 115.2 112.3 115.1 112.1 116.1 113.5 117.1 114.2
100 100 100 100 100 100 100 100 100 100 100 0 100 100 100 100 100 100 100 100 99.8 100
691 615 685 687 691 685 689 686 691 660-6791 660-6791 724 680-6991 680-6991 680-6991 680-6991 680-6991 680-6991 680-6991 680-6991 697 705
13.09 15.97 14.64 14.95 14.82 15.12 15.03 14.66 14.56 13.55 13.13 10.28 13.75 13.34 13.83 13.30 13.94 13.32 13.97 13.48 13.87 13.46
224 251 269 250 261 240 266 240 269 227 247 357 228 256 231 247 230 241 233 248 237 252
43,165 26,513 47,764 40,781 78,507 38,793 73,586 39,042 76,326 40,322 69,570 147,306 34,632 53,914 35,129 54,700 36,117 54,805 37,266 57,526 38,226 58,483
The credit scores represent a conservative approximation of the weighted average from the data ranges provided in the prospectus. A true weighted average for this deal cannot be calculated. The percentages represent loans that solely used debt consolidation. Source: Deal prospectuses
Cumulative Losses
Cumulative losses on high CLTV loans are higher than those of subprime home equity loans (Exhibits 9 and 11).1 Whereas cumulative losses on fixed subprime loans in 1996 transactions were 4.0% after 56 months of seasoning, cumulative losses on the 1996 vintage high CLTV loans were almost 15%, after seasoning for the same length of time. At any given point on the seasoning curve, for any origination year cohort, cumulative losses are higher for high CLTV loans than for subprime loans. One encouraging trend in the high CLTV sector is lower cumulative loss levels for newer origination year cohorts. After two years of seasoning, for example, cumulative losses for the 1996 cohort were 6.0%, while losses for the 1997
For further discussion of subprime HEL delinquencies and losses, see A New Universe, Morgan Stanley Securitized Perspectives, July 20, 2001.
20
Owner Occupied (%)
Full Doc (%)
Single Family (%)
Avg. Debt-toIncome
Prepay Penalties (%)
Reason for Loan Cash Out Debt Consolidation
100 100 100 100 100 100 100 100 100 100 100 95 100 100 100 100 100 100 100 100 100 100
93 100 100 100 100 100 100 100 100 100 100 67 100 100 100 100 100 100 100 100 100 100
93.2 87.4 88.9 91.5 91.2 92.2 92.1 89.3 82.8 96.9 98.5 68.8 91.1 79.9 90.6 79.3 90.0 77.6 90.4 84.1 91.3 88.2
NA 38.9 41.5 39.7 42.7 40.1 43.8 40.0 43.3 39.4 40.7 39.2 39.5 40.9 39.7 41.5 40.0 42.2 40.0 42.4 40.4 42.3
No 58.4 64.4 62.8 67.5 57.5 66.1 NA NA 62.4 70.8 35.0 57.0 59.5 55.4 57.1 53.9 56.0 52.1 54.8 52.0 53.4
NA 45.6 13.9 13.1 15.8 12.0 15.8 24.9 23.3 1.1 0.0 0.0 7.8 8.1 9.1 10.1 10.9 15.4 10.2 12.1 8.3 7.8
NA 53.2 57.9 58.2 49.2 50.42 37.3 66.22 65.92 97.5 97.4 0.0 87.4 84.0 86.3 84.0 84.9 72.1 85.1 80.4 88.0 81.82
cohort were lower, at 5.7%. The 1998 cohort had losses of 4.6%, and the 1999 cohort had the lowest level of losses, 4.1%.
Delinquencies
Delinquencies on high CLTV loans are lower than, or comparable to, delinquencies for subprime mortgages (Exhibits 10 and 12). At the end of 2003, 60+ day delinquencies on most high CLTV cohort years were 1,100 bp to 1,700 bp lower than delinquencies for comparable fixed subprime mortgage cohorts.
21
Collateral Types
exhibit 9
CUMULATIVE LOSSES FOR HIGH CLTV LOANS
exhibit 10
60+ DAY DELINQUENCIES FOR HIGH CLTV LOANS
Forms of Credit Enhancement
We estimate that roughly half of our high CLTV universe utilizes a senior/subordinate structure in conjunction with other forms of credit support such as excess spread and overcollateralization. The remaining portion utilizes surety bonds with some combination of excess spread, overcollateralization and/or reserve accounts. Over time, the use of surety bonds as a form of credit enhancement for high CLTV deals has varied. During 1996, surety bonds were the prevalent form with almost all deals using this type of credit enhancement. During 1997-1998, senior/sub deals were the dominant form of credit enhancement (in excess of 70% of deals), giving way again to surety bonds in 1999 and 2000 (in excess of 75% of deals). Since 1999, Ambac has provided the most surety bonds for the high CLTV sector.
22
exhibit 11
CUMULATIVE LOSSES FOR FIXED SUBPRIME HEL
exhibit 12
60+ DAY DELINQUENCIES FOR FIXED SUBPRIME HEL
23
Collateral Types
S&P Loss Coverage Ratios
The high CLTV deals that S&P rated during the second quarter of 2004 had the following average characteristics: CLTV of 117% Credit score of 690 Loss coverage of 40% for AAA Loss coverage of 20% for BBB Loss coverage of 11% for B The second quarter 2001 deals had lower loss coverage levels, benefiting from loan seasoning beyond the initial ramp up period for losses and lower LTVs that also resulted from the seasoning.
exhibit 13
Percent
AAA BBB B
S&P HIGH CLTV LOSS COVERAGE LEVELS
50 40 30 20 10 0
98 1Q 99 2Q 99 3Q 99 4Q 99 1Q 00 2Q 00 3Q 00 4Q 00 1Q 01 2Q 01 3Q 01 4Q 01 1Q 02 2Q 02 3Q 02
Note: The deals rated by S&P in the 2nd quarter 2001 had lower loss coverage levels due to seasoning beyond the initial loss ramp-up period. Source: Standard & Poors
Prepayments
The interest rate sensitivity of high combined loan-to-value2 (high CLTV) loan prepayments lies between the extremes of subprime home equity loan (HEL) prepayments and agency MBS prepayments. High CLTV loan prepayments have recently demonstrated more interest rate sensitivity than subprime HEL prepayments, but remain less sensitive than conventional mortgage prepayments.
Less Sensitive Than Conventional Prepayments...
While refinancing opportunities are readily available for A-quality borrowers in the conventional mortgage market, it is more difficult for borrowers in the high CLTV market to find refinancing opportunities. Although high CLTV loans are generally extended to A or Alt-A quality borrowers, the loans are typically in a second lien position and result in 100% loss severity. As a result, lenders are
For more information on high CLTV loans, see High Wire Act?, Morgan Stanley Securitized Perspectives, August 10, 2001.
24
more reluctant to extend refinancing opportunities for these types of loans. In addition, the lender base for high CLTV loans is fairly limited, which also curbs refinancing activity. Our universe of subprime HEL ABS consists of 92 issuers, while our high CLTV ABS universe consists of 18 issuers. Lenders may be more willing to provide refinancing opportunities, however, if there has been home price appreciation. Home price appreciation would increase the equity in homes, thereby reducing the riskiness of new loans. In addition, as loans season, the CLTV is reduced through monthly payments. This also creates opportunities for high CLTV borrowers to refinance.
But More Sensitive than Subprime Prepayments
Recently, high CLTV prepayments have tended to be more interest rate sensitive than subprime mortgage prepayments (Exhibit 14). This trend may be partially attributable to a reduced incidence of prepayment penalties. Between 52% and 71% of the high CLTV loans in 2000 and 2001 securitizations have prepayment penalties. In contrast, 80-85% of recently securitized subprime HELs have prepayment penalties. More prepayment penalties, coupled with impaired borrower credit, result in fewer refinancing opportunities (slower speeds) for subprime loans.
exhibit 14
THREE-MONTH CPRS FOR 1997 ORIGINATION YEAR COHORT
Prepayment Speeds
High CLTV prepayments prior to 2001 exhibited stable behavior. After the initial ramp-up period of 1.5-2.0 years, prepayment speeds for the 1996 and 1997 origination year cohorts hovered in the mid-20% range until 2001.
25
Collateral Types
exhibit 15
THREE-MONTH CPRs OF HIGH CLTV LOANS
exhibit 16
THREE-MONTH CPRs OF FIXED RATE HEL
26
exhibit 17
FNMA CONVENTIONAL PREPAYMENTS
We believe that three factors played a role in the sudden increase in high CLTV prepayment speeds: A decline in interest rates An increase in home prices Fewer prepayment penalties The Fed Funds Rate was cut by 275 bp in the first half of 2001, which resulted in faster prepayments even among subprime borrowers. The first quarter of 2001 also had a 9% year-over-year increase in home prices, which had been the largest year-over-year increase in the OFHEO house price index. As seen in Exhibit 15, prepayments were fairly flat prior to 2001. By 2001, however, prepayment penalty periods expired on many of the older cohort loans, and many borrowers were free to refinance their high CLTV loans.
27
28
FICO Borrower Credit Scores

Credit scores quantitatively assess the risk associated with a particular borrower. Consumer credit lenders utilize credit scores to help determine a borrowers ability to repay a loan. There are many different types of credit scores and some companies even employ their own proprietary systems. Nevertheless, the industry standard is Fair, Isaac & Co.s FICO score. Introduced in 1985, FICO scores are now utilized in 75% of U.S. mortgage originations, and 75% of domestic credit card providers are clients of Fair, Isaac & Co. A FICO score is a numeric value incorporating numerous factors including a borrowers payment history and current financial stability (Exhibit 1).
exhibit 1
chapter 3
OPENING THE BLACK BOX: FICOS MAGIC FORMULA
Source: Morgan Stanley, Wall Street Journal
Points are assigned for each category and totaled to compile a composite FICO score. Exhibit 2 offers sample point values for some of the different elements which factor into a FICO score.
29

exhibit 2
ADDING UP POINTS: SAMPLE PORTION OF SCORECARD

Column Points 75 10 15 25 55 30 55 65 50 40 25 15 12 35 60 75 70 60 45 25 20 15 25 50 60 50 No Public Record 0-5 6-11 12-23 24+
Number of Months Since the Most Recent Derogatory Public Record (Bill Payment History)
Average Balance on Revolving Trades (Debt Ratio)
No Revolving Trades 0 1-99 100-499 500-749 750-999 1,000 or more
Number of Months in File (Length of Credit)
Below 12 12-23 24-47 48 or more
Number of Inquiries in Last 6 Months (Propensity to Look for New Credit)
0 1 2 3 4+
Number of Bank Card Trade Lines (Credit Mix)
0 1 2 3 4+
Source: Morgan Stanley, Fair, Isaac & Co.
All of the following analysis preceeds Fair Isaac so-called next generation FICO score. We believe the upcoming implementation of this new and improved score should be taken as evidence that FICO scores are a useful tool likely to be used going forward.
SAMPLE P ORTFOLIO A NALYSIS
For our examination, we reviewed Fair Isaac data detailing two years of performance for nearly one million accounts across a variety of different industries. The odds of repayment may differ from industry to industry, so later in this chapter we include data that is specific to home equity loans.
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Contrary to what may be popular belief, FICO scores do not have a normal distribution centered at the mean (Exhibit 3). FICO scores range from 300-850 and, aside from the tails, each successive category contains more consumers than the previous one. To restate, more people have a FICO score between 790 to 800 than 780 to 790.
exhibit 3
THE FICO DISTRIBUTION IS NOT NORMAL
In addition to influencing the approval decision, FICO scores can be used for risk-based pricing. Lenders offer more attractive rates to borrowers with better credit quality (Exhibit 4).
exhibit 4
HIGHER FICO SCORES EARN LOWER INTEREST RATES
(% as of 11/1/02) 18 16 14 12 10 8 6 4 2 0 530 570 610 650 690
30-Yr Fixed Mortgage Home Equity Loan 60-Month Auto Loan
730
770
31

FICO T HE F ORTUNE T ELLER
Measuring performance by FICO stratification reinforces the validity of riskbased pricing strategies. Borrowers with lower FICO scores exhibit poorer credit performance, or increased likelihood of negative performance. In our study, negative performance is defined as the occurrence of a delinquency or chargeoff any time during the two-year period we examined. For all three metrics displayed, we see an inverse correlation between negative performance and FICO scores (Exhibit 5).
exhibit 5
FICO AND PERFORMANCE ARE HIGHLY CORRELATED
(% Exhibiting Negative Performance) 100 90 80 70 60 50 40 30 20 10 0

30 060+ 90+ Charge-off
In addition to addressing the likelihood of negative performance, FICO scores help predict the final outcome of delinquent borrowers. Based on a subset of only 60+ day delinquencies, borrowers with a lower FICO score show increased likelihood of becoming more seriously delinquent than higher FICO borrowers (Exhibit 6). Nearly all of the low FICO borrowers 60+ days delinquent became 90+ days delinquent whereas only about half of the high FICO borrowers became more seriously delinquent.
exhibit 6
FICO SCORES HELP PREDICT SERIOUSNESS OF DELINQUENCY
(% Exhibiting More Serious Negative Performance) 100 80 60 40 20 0

53 053 9 57 057 9 61 061 9 65 065 9 69 069 9 73 073 9 77 077 9 80 085 0 30 05 00
90+/60+ Charge-off/60+
32
50 0 53 053 9 57 057 9 61 061 9 65 065 9 69 069 9 73 073 9 77 077 9 80 085 0
SCORES M IGRATE O VER T IME
FICO scores are snapshots in time, and therefore prone to change as time passes. Fair Isaac recommends that companies periodically refresh FICO data for proper monitoring. A transition study, completed by Fair, Isaac & Co., finds that most scores stay relatively constant, but some scores migrate significantly over time (Exhibit 7).
exhibit 7
OVER 40% MIGRATE AT LEAST 20 POINTS IN 9 MONTHS
The appearance or disappearance of a serious delinquency is just one factor that could materially change a FICO score. By stratifying this data according to FICO score, we see that high scores are the most likely to remain stable and low scores are more likely to rise than fall (Exhibit 8). Scores between 600 and 700, a typical range for ABS collateral, are more likely to rise 20-40 points than fall 20-40 points; however, there is a greater chance of falling 40+ points than rising 40+ points.
exhibit 8
Migration Amount
HIGH SCORES ARE MORE STABLE

550 to 599 600 to 649 650 to 699 700 to 749 750 & Higher All
Less Than 550
Low to 40 40 to 21 20 to +20 +21 to +40 +41 to High
2.9% 7.9% 54.4% 16.3% 18.2%
8.9% 8.8% 50.1% 15.9% 16.1%
10.4% 6.9% 59.4% 14.6% 8.4%
6.7% 7.3% 68.2% 11.9% 5.6%
4.7% 7.7% 71.9% 11.5% 3.9%
3.3% 7.9% 83.4% 4.8% 0.3%
5.2% 7.7% 72.8% 9.7% 4.3%
33

exhibit 9
3-Month Migration Leading Up to Observation Score
PERFORMANCE ODDS ARE OFTEN INDEPENDENT OF PRIOR SCORES

Less Than 550 550 to 599 600 to 649 650 to 699 700 to 749 750 & Higher All Scores
Low to 40 40 to 21 20 to +20 +21 to +40 +41 to High All Migrations
1.0 1.3 1.7 1.9 1.1 1.3
2.5 2.1 3.0 2.9 2.5 2.7
5.9 5.3 6.2 5.4 6.0 5.9
16.2 13.3 14.3 14.1 13.3 14.2
62.5 59.1 50.1 46.2 31.7 49.6
355.1 354.4 309.0 207.6 93.5 275.6
6.1 14.8 29.7 23.5 17.7 23.3
Fair Isaac also examined whether incorporating a borrowers previous FICO score marginally improves the predictive ability. Exhibit 9 calculates the odds of a borrower becoming 90+ days delinquent. For example, there will be six times as many good performers as negative performers for borrowers with 600-649 FICO that migrated downwards at least 41 points during the prior three months. If there is no clear pattern in the data, then knowing the most recent score migration provides no additional value. For scores less than 700, there is no discernible pattern. For higher scores, we find that there is a correlation. Borrowers moving upward to higher FICO scores were more likely to default than borrowers moving downward from even higher FICO scores.
MIGRATIONS DONT SNOWBALL
Second Score Migration First Score Migration Low to 41 40 to 21 20 to +20 +21 to +40 +41 to High
exhibit 10
Low to 41 40 to 21 20 to +20 +21 to +40 +41 to High
6.6% 4.6% 4.2% 6.7% 13.4%
7.1% 6.0% 6.7% 12.8% 12.3%
49.8% 61.9% 77.8% 70.5% 64.4%
17.6% 18.6% 8.2% 7.2% 7.6%
18.6% 8.3% 2.9% 2.6% 2.1%
To confirm that no additional information is garnered from historical FICO scores, Fair Isaac studied consecutive 3-month score migrations. They found that regardless of the first migration, scores were most likely to be relatively unchanged during the second migration (Exhibit 10). One clear pattern from this migration study is a reversion to the mean. Scores that moved over 40 points during the first period were overwhelmingly likely to move in the opposite direction than in the same direction during the second migration. This is contrary to popular belief that customers with substantial downward migration in one period will continue to snowball downwards.
34
NOT A LWAYS T HE M OST P OPULAR M EASURE A ROUND
Despite their widespread use, credit scores have been historically controversial. Lawrence Lindsey, then a member of the Federal Reserve Board, made headlines in 1995 when he was denied a Toys R Us credit card, despite his $123,000 annual salary and unblemished payment record. Multiple credit applications while refinancing his mortgage caused computer models to automatically reject his application. Current models are more sophisticated and ignore multiple credit applications during a small time span, but computerized credit models already suffered the publicity nightmare. Despite hesitancy from issuers, we believe FICO scores are an important measure of the expected future performance. Many issuers have questioned the governments designation of borrowers with FICO scores below 660 as subprime. Our data shows that 82.5% of charged off customers had FICO scores below 660 (Exhibit 11). If the cutoff was lowered to 600, we would only capture 58.3% of the charged off customers. This is not to say that consumers with lower FICO scores are not creditworthy or profitable, but simply that a large portion of charge-offs occur within this area of the curve and companies should monitor accordingly.
exhibit 11
660 LOOKS GOOD TO US
GRADING F ICO D ISTRIBUTIONS
Many HEL issuers exhibit superior disclosure, separating FICO scores into 20-25 point buckets. In addition, they typically provide the mean score, which investors may find easier to interpret than the larger, more complex table. We strongly encourage investors to avoid focusing solely on the mean, but rather analyze the distribution to prevent misleading interpretations.
35

According to our data, about 12% of customers with 635 FICO scores will default (See Exhibit 5). Conversely, if we incorporate the entire distribution of a sample HEL portfolio in estimating expected cumulative defaults, we would arrive at cumulative defaults of 16%, even though the mean remains 635 (Exhibit 12).
Expected Cumulative Defaults
Distribution Average FICO FICO Distribution for Sample HEL Transaction
16% 12%
exhibit 12
DISTRIBUTIONS PAINT A LARGER PICTURE
10% 8% 6% 4% 2% 0%
Avg. FICO: 635
It is not coincidental that the mean FICO score underestimates cumulative defaults, by 33% in our example. The mean will always underestimate cumulative defaults because of the convex shape of the FICO default curve. The only exception would be if all borrowers had the exact same FICO score. As we have established, investors should focus on more than simple averages when analyzing FICO scores for a loan portfolio. The scores can be distributed many different ways, and some distributions are far superior to others. As a rule of thumb, investors should look for portfolios concentrated near the mean, avoiding barbell distributions.
36
30 051 50 1- 0 53 520 155 540 157 560 159 58 1- 0 61 60 1- 0 63 620 165 640 167 660 169 68 1- 0 71 700 173 720 17 75 40 177 760 179 780 18 80 00 085 0
Expected Cumulative Defaults
Normal Better Worse
15% 13% 19%
exhibit 13
AVOID BARBELLS, LOOK FOR TIGHT DISTRIBUTIONS
We found that a barbell distribution sent cumulative default rates upwards of 19%, far above the 12% cumulative defaults originally forecasted by the simple average. As expected, we see that tighter distributions approach the lower cumulative default expectation forecasted by the mean FICO score (Exhibit 13).
exhibit 14
Agency
EACH AGENCY HAS ITS OWN FICO

Version of FICO
Equifax Experian (formerly TRW) TransUnion Source: Morgan Stanley
BEACON Experian/Fair, Isaac Risk Score EMPIRICA
A S MALL C LARIFICATION
Consumers actually have multiple FICO or credit scores. The FICO designation refers more to the processes employed than any single number. Most consumers have at least three distinct FICO scores, one for each major credit reporting agency (Exhibit 14).
37

HEL S PECIFIC D ATA
The HEL industry exhibits far superior disclosure with regard to FICO scores than most other ABS sectors; nevertheless, investors are not privy to updated scores. Fear exists that this information may become stale, but we find that performance remains highly linked to the FICO score at origination.
FICO SCORES MAINTAIN PREDICTIVE VALUE
exhibit 15
1998 LOAN ORIGINATIONS
Source: Morgan Stanley, Loan Performance
38
Using loan level information for numerous issuers across the industry, we monitored performance over time for 30-year subprime adjustable-rate mortgages stratified by loan origination year and FICO score. We find that even years after the loan was originated and the FICO score was recorded, higher FICO scores exhibit lower delinquency rates (Exhibit 15).
39

While the connection between FICO and performance looks solid, we do not intend to imply that FICO scores are the final word. We reorganized the same data from Exhibit 15, this time grouping performance by FICO stratification.
exhibit 16
OUTSIDE FACTORS STILL INFLUENCE PERFORMANCE
<=500
501-550
551-600
40
For virtually every FICO stratification, we find that the 1999 vintage exhibits lower delinquencies (Exhibit 16). We offer this as evidence that other factors prevalent in the market influence the performance of subprime home equity loans.
601-650
651-700
>700
41

Shifting our focus to losses we see that higher FICO scores exhibit superior performance. (Exhibit 17). Exhibit 17 is limited to loan originations from 1999, but other vintages also produce similar results.
exhibit 17
FICO PREDICTS LOSSES WELL CUMULATIVE LOSSES FOR 1999 ARM LOAN ORIGINATIONS
Note: Although loans were originated throughout the year, we measure performance starting in January of the following year. In order to reflect performance as a time series starting from loan origination, the data was shifted backwards six months to reflect the average seasoning of the loan, which would range from 0 to 12 months. Source: Morgan Stanley, Loan Performance
In considering the four vintages from 1998-2001, we found that the 1998 cumulative loss curve is consistently among the highest for a given FICO bucket, while the 1999 curve is nearly always the lowest. Based on this information, we propose 1998 as an upper bound for cumulative losses and 1999 as the lower bound. Exhibit 18 offers a sample band width of potential performance based on three years of seasoning.
exhibit 18
VINTAGE PERFORMANCE ESTABLISH UPPER/LOWER BOUNDARIES CUMULATIVE LOSSES AFTER 36 MONTHS OF SEASONING
42
PROJECTING L OSSES
While we believe our data series to be a good forecaster of losses, we are constrained by its length of approximately four years. In order to create estimates covering the entire life of the deal, we need to project the curves outward via a loss timing curve. We first compared the observed timing across all FICO buckets, to ensure that each stratification would not demand a separate curve. While Exhibit 18 demonstrates the disparity in the absolute level of losses, Exhibit 19 shows the timing of losses is quite similar. Exhibit 19 calculates the cumulative losses experienced for each monthly period as a percentage of the final cumulative losses (or in this case, the last observed cumulative loss in month 45). We cannot know with certainty that this trend will continue throughout the life of the loans; however, we believe it reasonable to assume that the timing of losses for home equity loans is mainly independent of FICO score.
exhibit 19
TIMING IS INDEPENDENT OF FICO 1999 ARM LOAN ORIGINATIONS
43

We found that each FICO bucket does not require a separate curve, but we still need an appropriate loss timing curve to lengthen our time series. In addition to our proprietary model developed from historical data series, we found curves developed by all three rating agencies.1
exhibit 20
A VARIETY OF TIMING CURVE OPTIONS
Source: Morgan Stanley, Intex, Moodys, S&P Fitch ,
Although the curves appear very similar, we realize that even small variations make large impacts when extrapolated. In order to test the predictive capabilities of each timing curve, we calculate expected cumulative losses for each monthly observation (Exhibit 21). We accomplish this by grossing up cumulative losses based on the timing curves from Exhibit 20. We made projections only after 24 months of performance, as less seasoned observations are more prone to inaccuracies.
exhibit 21
PREDICTIVE CAPABILITIES APPEAR ACCURATE CUMULATIVE LOSS PREDICTIONS FOR 1999 ARM LOAN ORIGINATIONS
All of these timing curves are constructed to predict losses starting with issuance of the ABS. Our loan level data starts with the origination of the loan. As a result, the timing curves were shifted four months to account for loan seasoning prior to issuance.
44
A perfectly flat horizontal line would show that the loss prediction is not fluctuating over time. Therefore, the timing curve is appropriate and we can reasonably expect cumulative losses to equal the current prediction. An upward slanted curve would imply that the timing curve is too fast, and that losses are more back-loaded, while a downward slanted curve would imply the opposite. None of these curves are perfect, but we consider all four curves to be a decent method for projecting losses. The loss projections for the entire mixture of FICO scores range from around 4-5%, consistent with market beliefs. More importantly, we have established a quantitative methodology to compare pools with different FICO distributions (Exhibit 22).
exhibit 22
CUMULATIVE LOSS PROJECTIONS BY FICO

Projected Cumulative Losses Based on 1998 Cohort Cum Loss Timing Curve
FICO
Average
Morgan Stanley
Moodys ARM
S&P
Fitch
<=500 501-525 526-550 551-575 576-600 601-625 626-650 651-675 676-700 >700 (All FICOs)
10.99% 8.48% 7.77% 5.27% 4.32% 3.81% 3.63% 3.12% 3.07% 2.64% 4.96%
11.12% 8.58% 7.86% 5.34% 4.37% 3.85% 3.67% 3.15% 3.10% 2.67% 5.02%
9.96% 7.68% 7.04% 4.78% 3.92% 3.45% 3.29% 2.82% 2.78% 2.39% 4.50%
11.71% 9.04% 8.28% 5.62% 4.61% 4.06% 3.87% 3.32% 3.27% 2.81% 5.29%
11.16% 8.61% 7.89% 5.36% 4.39% 3.87% 3.68% 3.17% 3.12% 2.68% 5.04%
Projected Cumulative Losses Based on 1999 Cohort Cum Loss Timing Curve FICO Average Morgan Stanley Moodys ARM S&P Fitch
<=500 501-525 526-550 551-575 576-600 601-625 626-650 651-675 676-700 >700 (All FICOs)
9.81% 7.39% 6.06% 4.59% 3.94% 3.13% 2.65% 2.18% 1.84% 1.35% 4.06%
9.42% 7.10% 5.83% 4.41% 3.79% 3.00% 2.54% 2.10% 1.76% 1.30% 3.90%
8.84% 6.67% 5.47% 4.14% 3.55% 2.82% 2.39% 1.97% 1.65% 1.22% 3.66%
10.44% 7.87% 6.45% 4.88% 4.20% 3.33% 2.82% 2.32% 1.95% 1.44% 4.32%
10.53% 7.94% 6.51% 4.93% 4.23% 3.36% 2.84% 2.34% 1.97% 1.45% 4.36%
45
46
Performance by Characteristic
The credit performance impact of most HEL traits is typically apparent in terms of direction, but not necessarily in terms of magnitude. For example, we can easily surmise that owner occupied homes are a better credit risk than investment properties, and that full documentation is superior to limited documentation, but can we quantify the relative importance of each factor? We published our original Default Traits analysis last year, at which time we related the tendency of home equity loan ABS defaults to eight basic characteristics of the loans.1 The characteristics we examined were: Occupancy Status Loan Purpose FICO Lien Position Property Type Documentation Level LTV Interest-rate Type
chapter 4
The purpose of that analysis was to quantify the magnitude of each characteristics contribution to the default rate. It is pretty clear a priori the direction in which each characteristic will impact defaults, but until our analysis, the magnitude of those impacts had not been quantified. Likewise, everyone expects that loans without full documentation would be permitted only if compensating factors such as higher FICO scores were present, but we quantified how much higher FICOs should be for one to be indifferent between the presence of each of these negative characteristics and higher FICO scores. Our conclusions last year were: FICO is the strongest default predictor. Owner occupancy is worth 75 FICO points. Full documentation is worth 50 FICO points. Purchase and refi loans have similar default rates. ARMs have higher default rates than fixed rate loans, but lower loss severities. Default rates improve with extreme LTV ratios.
For the original report, see the Morgan Stanley ABS Perspectives, Default Traits, December 22, 2003, or Chapter 5 of the Home Equity Handbook, 2004 edition.
47
In this chapter, we update that analysis, taking advantage of a considerable quantity of additional data, both in terms of additional loans that were not included in the data set on which the previous research was performed, as well as additional seasoning of the loans that were included in the prior analysis. In this analysis, we add a variable for loan size that was not part of our prior work, and for the refi/purchase loan purpose, we break out cash out and noncash out refis. Furthermore, we show how the results of this analysis can be employed to estimate default rates on a pool of loans with various percentages of the given characteristics.
SUMMARY
FICO is the strongest predictor of credit performance. Owner occupancy is worth 75-80 FICO points. Documentation level is worth 40-50 FICO points LTV is worth 10 FICO points for each 5% of LTV. Interest rate type (ARM vs. fixed rate) is worth 20 FICO points. Purchase loans default more frequently than refinance loans. Non-cash out refinance loans default more frequently than cash out refinance loans. Although data are extremely limited, IOs default less frequently than fully amortizing loans. Loan size is only weakly related to defaults. One interesting result we found was that purchase loans default more frequently than refinance loans. We had only an inkling of this relationship previously, but now have more data to support it. Even more interesting is that non-cash out refinancings default more frequently than cash out refinancings, which most market participants would find counter-intuitive. We also found that even though data thus far are limited, subprime interest-only (IO) loans default less frequently than fully amortizing loans. As IOs have become an increasingly important component of the subprime market, we will continue to monitor this relationship. We thought that loan size may have some relationship to defaults, but we found only a tenuous relationship between larger loan sizes and a slightly less likelihood of default than smaller loan sizes; the more important impact of loan size is on severity, rather than default frequency. Finally, we found that the tails of the LTV distribution no longer unambiguously outperform the center. Moreover, we also noted some changes in the relative default frequency of some of the LTV buckets for certain vintages, with some of the higher LTV buckets now defaulting at a greater rate relative to the average than before, and some lower LTV buckets defaulting at a lower rate relative to the average than before.
48
THE D ATA
Exhibit 1 summarizes the data employed in the present analysis. We incorporate 2.5 times as many loans and 3 times the original dollar volume of loans than in our report published last year.2 Each subsequent section of this report follows the order of our previous research in addressing individually each of the loan characteristics and their impact on default.
exhibit 1
THE DATA
Origination Year 1998 1999 2000 2001 2002 2003 2004 Total
Loan Count 203,717 294,507 282,276 351,903 516,572 701,597 260,167 2,610,739
Original Loan Balance ($BN) 17.5 27.3 27.2 40.2 69.4 105.4 39.0 326.1
Rather than graphically depict the absolute default rates of each characteristic, we instead show the relationship of the characteristics relative to the average. We do this because the more recent vintages will have experienced lower absolute default rates than the more seasoned vintages, but it is noteworthy that the relative contribution of various characteristics to overall default rates is remarkably stable across vintages. It also is important to note that the graphical depictions of these relationships do not control for correlations across characteristics. That is, loans with lower levels of documentation, for example, tend also to have higher FICO scores and lower loan-to-value ratios, as lenders attempt to offset the negative aspect of the limited docs with more positive attributes. While these correlated attributes are not controlled for in the graphs, we do estimate these relationships statistically which does control for the correlated attributes and report these in the latter part of this report.
OCCUPANCY S TATUS
Investment properties, not surprisingly, default at higher rates than owneroccupied premises, as shown in Exhibit 2. It is noteworthy that the magnitude of this difference has declined over the past several years: for the 1998 issue year, investor properties defaulted at a 40% greater rate than average, while for the 2003 issue year, they defaulted at only a 15% greater rate. Even so, loss severities for investor properties are 15-20% greater than for owner-occupied homes.
That said, some of the data, particularly from 2004, is not seasoned enough to provide meaningful information. It will be clear from each exhibit which years and, therefore, how much data are included in each segment of the analysis.
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exhibit 2
INVESTOR PROPERTIES DEFAULT 15% TO 40% GREATER THAN AVERAGE
PROPERTY T YPE
The vast majority of our data comprises single-family residences, although over the past several years, that percentage has declined, with an increasing share of observations attributable to condominiums and co-operatives, multi-unit properties and planned unit developments. (Exhibit 3)
exhibit 3
SINGLE-FAMILY RESIDENCES COMPRISE THE VAST MAJORITY OF OUR DATA

1998 84.3 5.4 5.4 2.9 1.0 0.9 1999 83.8 6.1 5.2 3.3 1.2 0.3 2000 80.6 7.1 6.8 3.4 1.8 0.2 2001 81.5 6.5 6.7 3.7 1.3 0.3 2002 79.3 7.3 7.9 4.5 0.8 0.2 2003 2004 77.3 77.2 7.9 7.0 9.0 10.5 5.1 4.5 0.6 0.8 0.1 0.0
% of Total Issuance Single-Family Residence Multi-Unit Planned Unit Dev. Condo/Co-op Manufactured Housing Other
Exhibit 4 shows the relative default frequency of the various property types. We will not dwell on this very much, because away from the single-family residences, the other property types occur infrequently, limiting the reliability of these results. That said, we do see that condo/co-ops have defaulted as much as 40% below average; planned unit developments have defaulted from 10-30% below to 15-30% above average; and multi-unit properties have consistently defaulted above the average. Manufactured housing has had such limited representation in HEL ABS pools that we can for all intents and purposes ignore it.
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exhibit 4
VARIOUS PROPERTY TYPES PERFORM DIFFERENTLY
LOAN P URPOSE
One of the interesting results of our previous Default Traits analysis was that refinance loans defaulted no more frequently than purchase loans; indeed, for vintages since 2001, we now find that purchase loans actually defaulted with greater frequency than refi loans (Exhibit 5). This is counter-intuitive, as most investors would prefer purchase loans over refi loans because the market transaction upon which the purchase loan is based should result in a more accurate property appraisal.3 For the 1998-2000 vintages, purchase loans had almost 10% lower loss severities than refi loans, although this relationship seems not to hold for the more recent vintages.
exhibit 5
PURCHASE LOANS DEFAULT MORE FREQUENTLY THAN REFI LOANS...
That said, one may argue that the accuracy of the appraisal should have greater importance for the severity in the event of default than for the default frequency.
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In the present analysis, we take this one step further and break down the refi loan category into cash out and non-cash out refinancings (Exhibit 6). Interestingly, cash out refinancings, which most market participants would view a priori as more risky than non-cash out refinancings, actually consistently default with less frequency than non-cash out refinancings.
exhibit 6
AND NONCASH OUT REFIS DEFAULT MORE FREQUENTLY THAN CASH OUT REFIS
DOCUMENTATION L EVEL
We have reported a few times that low or no documentation (limited doc) loans historically have defaulted at higher rates than full documentation (full doc) loans.4 We previously have estimated that investors should be indifferent between loans with full docs and those with low docs, but with 50 more FICO points. That said, the low doc loans typically have had only 20-25 points higher FICO scores and so default at considerably greater rates than full doc loans. The low doc loans, however, have lower LTVs than full doc loans and so experience lower loss severity and loss levels than full doc loans (Exhibit 7).
exhibit 7
LIMITED DOC LOANS DEFAULT WITH GREATER FREQUENCY THAN FULL DOC LOANS
See the Default Traits research report referred to in Footnote 1, as well as the Morgan Stanley ABS Perspectives, Whats Up Doc? Comparative Credit Quality of Limited and Full Doc HEL ABS, November 8, 2004.
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FICO
We frequently have commented on the relationship between FICO scores and credit performance. Not surprisingly, there is a clear relationship between FICO scores and default rates. Exhibit 8 shows that the lowest FICO scores default about twice as often as the average FICO and the highest FICOs default about half as often as the average FICO. It is noteworthy that even though the absolute level of defaults is much lower for the 2002 and 2003 vintages than for the more seasoned issue years, the pattern of default by FICO range for these vintages is remarkably similar to that from the more seasoned vintages.
exhibit 8 (Default Rate %, Avg. = 100) <= 500 501 525 526 550 551 575 576 600 601 625 626 650 651 675 676 700 > 700
FICO SCORES ARE STRONGLY RELATED TO PERFORMANCE
1998 201 169 146 123 100 88 78 68 54 43
1999 205 170 147 119 104 89 77 64 54 38
2000 195 156 131 110 98 89 80 65 57 42
2001 204 165 133 114 106 95 86 72 61 42
2002 199 171 148 121 106 96 88 70 62 47
2003 NM 215 168 136 101 91 83 70 68 53
LIEN P OSITION
One result of the present analysis that differs from our previous work concerns the relative default risk of the different lien positions. In our previous work, for which the lien position analysis included only 1998-2001 vintages, we found that second (and higher) liens actually defaulted at a much lower rate than first liens. We were surprised by this result, but attributed it to the higher FICO scores required for second liens. In the present analysis, which extends through 2003 vintage data, we got a different result. (Exhibit 9) We find that while second and higher liens from 2001 and prior vintages defaulted at a much lower rate than first liens, the junior lien positions defaulted at a much greater rate than first liens for 2002 and 2003. We are not sure how much to make of this due to the relatively low volume of second and higher liens, as well as the relatively small amount of defaults for the more recent vintages, but this relationship is one that should continue to be monitored.
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exhibit 9
DO SECOND LIENS DEFAULT MORE OR LESS THAN FIRST LIENS? RELATIVE DEFAULTS BY LIEN POSITION DO NOT DISPLAY A CLEAR PATTERN
LOAN-T O-V ALUE R ATIO T V
We found the relationship between LTV and defaults is not linear. The average performance of an LTV range is generally 76-80%, although for some vintages the average is lower (Exhibit 10). In some cases, lower LTV buckets actually default at a higher than average rate, presumably because the lower LTV loans were originated with lower FICO scores. Likewise, for some vintages, the higher LTV categories defaulted at below average rates, presumably because the higher LTV loans were originated with higher FICO scores. This is similar to the result we found in last years study. What is interesting about the current analysis is that we see changes in the default ratios of some of the LTV buckets, such that the LTV tails no longer unambiguously outperform the center. For example, last year, we found that the default ratio of the 2000 vintage 96-100% LTV bucket defaulted at 83% of the average, whereas we now report that this bucket has defaulted at 104% of the average. Some of the lower LTV buckets for the same 2000 vintage are now reporting lower defaults relative to the average: the 56-60% and 61-65% LTV categories show their defaults relative to the average are 12-13% lower than we reported a year ago. It also is noteworthy that for 1998-2000 vintages, the tails of the LTV distribution pretty much outperform the center, whereas for 2001 and 2002, higher LTVs generally default at greater rates than lower LTVs. The relationship for the 2003 vintage is somewhat mixed up due to the low absolute levels of default seen thus far.
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exhibit 10
LTV-DEFAULT RELATIONSHIP IS NOT LINEAR
(Default Rate %, Avg. = 100) <= 55 56 60 61 65 66 70 71 75 76 80 81 85 86 90 91 95 96 100 > 100
1998 46 83 107 108 114 100 111 96 80 100 88
1999 56 84 96 101 112 100 112 99 81 89 104
2000 60 92 103 100 109 100 110 99 91 104 57
2001 55 66 84 90 97 105 109 105 105 105 105
2002 61 77 88 94 99 104 111 99 102 126 NM
2003 65 87 109 99 113 108 108 91 87 100 NM
INTEREST R ATE T YPE
In addition to the usual question regarding the relative default rates of fixed and adjustable rate mortgages, the market has more recently focused on the credit quality of interest-only (IO) mortgages, particularly as they have grown in the subprime arena. We see that IOs and this combines both fixed and ARM IOs, as there were insufficient data in either category alone have thus far defaulted at below average rates. We again note, however, that thus far there have been low absolute levels of default for the 2002 and 2003 vintages, and IOs account for less than 5% of our mortgage data in these years. Exhibit 11 shows that, similar to our previous analysis, ARMs and balloons default at much greater rates than fixed rate mortgages, and moreover, that gap has widened for the more recent vintages.
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exhibit 11
ARMS AND BALLOONS DEFAULT AT HIGHER RATES THAN FIXED RATE MORTGAGES; IOS THUS FAR DEFAULT AT LOWER RATES
LOAN S IZE
We expect that larger loans would lead to lower loss severities, but the relationship between loan size and default likelihood is less clear. We found in our more macro analysis in a companion article in this report that loan size does not have a statistically significant explanatory power for default rates.5 Here we find that the loan size/default relationship is somewhat tenuous (Exhibit 12). For some vintages there appears to be some relationship over some subset of loan sizes by which larger loan sizes are correlated with lower default rates, although overall this relationship is not consistent. This may well be because in the regression in the present analysis, we consider loan size but do not decouple it from other variables with which it may be correlated.
exhibit 12
LOAN SIZE IS TENUOUSLY RELATED TO DEFAULT RATES
See the chapter titled House Prices in this handbook.
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MULTI-V ARIABLE R EGRESSION V
We want now to put this all together and control for the overlapping characteristics of these variables to estimate the independent influence of each trait on defaults. We set up the estimation in Exhibit 13.
exhibit 13 Trait Non-Scalar Variables Property Type Occupancy Status Interest Rate Type Loan Purpose Documentation Level Lien Position Scalar Variables LTV FICO Loan Size
MULTI-VARIABLE REGRESSION OPTIONS

Main Option (0) Single-Family Residence Owner ARM Purchase Full First Alternative Option (1) NA Investor Fixed Refinancing Limited/Low/No Second (or higher)
11 buckets by 5 points 10 buckets by 25 points 7 buckets by $50,000
We classified the explanatory variables in Exhibit 13 as either scalar or non-scalar (or qualitative) variables. We were able to put each of the non-scalar variables into either of two categories, a main option for which we assigned a value of zero and an alternative for which we assigned a value of 1. For example, the main option for documentation level was full docs, so observations of loans with full docs received a value of 0 in the estimation, while those with limited docs received a value of 1. Since single-family residences account for the vast majority of our sample, we did not attempt to estimate default differences for the various property types. For the loan purpose variable, we did not break out refinance loans into cash out and non-cash out refinancings, as we kept the analysis to two options for each qualitative variable. We initially had estimated the equations including loan size, but the magnitude of its contribution to explaining default rates was trivial and its inclusion sharply lowered the explanatory power of the equations.
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Exhibit 14 reports the coefficients of our regression analysis for each vintage individually, as well as that for combining all vintages together. For the combined regression, we used dummy variables for the issue years, as seasoning alone would be expected to account for some absolute differences in levels of default rate. Exhibit 15 reports the statistical significance of each variable.
exhibit 14
DEFAULT RATE COEFFICIENTS

1998 19.8 7.4 -1.9 1.0 3.7 -1.4 -2.2 0.8 1999 20.0 6.6 -1.7 -0.0 3.2 -2.7 -2.2 0.8 2000 19.2 6.8 -1.7 0.3 3.1 -3.1 -2.1 0.8 2001 13.3 6.0 -0.6 -1.9 3.1 -1.3 -1.5 0.8 2002 7.9 2.4 -1.2 -1.6 1.9 1.5 -0.7 0.3 All Vintages 9.4 4.9 -1.1 -1.0 2.8 -1.6 -1.5 0.6 9.0 8.3 8.7 4.7
Intercept Occupancy Status Interest Rate Type Loan Purpose Documentation Level Lien Position FICO LTV 1998 Dummy Variable 1999 Dummy Variable 2000 Dummy Variable 2001 Dummy Variable
exhibit 15
T-STATISTICS INDICATE STRONG STATISTICAL SIGNIFICANCE

1998 57.4 37.6 12.8 -8.1 3.7 13.5 -2.4 -44.3 14.2 1999 65.5 47.9 13.6 -8.9 -0.1 14.0 -3.9 -55.3 15.8 2000 59.2 42.3 13.5 -7.7 1.3 12.5 -4.8 -47.3 15.4 2001 57.8 37.2 15.2 -3.9 -11.1 17.6 -2.3 -42.0 18.9 2002 56.7 38.6 11.1 -11.8 -15.6 20.2 3.2 -36.5 11.2 All Vintages 68.4 49.3 25.2 -12.5 -11.5 31.6 -5.5 -84.8 29.2 66.1 71.7 76.2 47.4
R-Squared (%) T-Statistic Intercept Occupancy Status Interest Rate Type Loan Purpose Documentation Level Lien Position FICO LTV 1998 Dummy Variable 1999 Dummy Variable 2000 Dummy Variable 2001 Dummy Variable
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Most variables were statistically significant and strongly so, although for some vintages, loan purpose turned out not to be significant. Similar to our prior analysis, FICO score had the strongest statistical significance. The magnitudes of contribution to default of the explanatory variables were roughly similar to our analysis of a year ago, although some variables deviated marginally in magnitude from the results of our previous estimation.
APPLYING T HE A NALYSIS
In this section, we apply the results of our analysis to estimate default probabilities on a sample loan and a sample loan pool. We then use our coefficients to normalize the contribution to default likelihood in terms of FICO score for each of the loan characteristics.
Sample Loan
We can take our regression coefficients from Exhibit 14 and apply them to a sample loan, with the characteristics shown in Exhibit 16. We use the coefficients estimated over the entire data set, with dummy variables for issue year, but we alternatively could have employed the vintage-specific coefficients. Based upon our estimates, we would expect a loan with these traits or a pool of identical loans with these traits to have a default rate of 11.7%. If the borrowers FICO score were in the 626-650 range, then the default probability would decline by 1.5%, to 10.2%.
exhibit 16 Category Intercept Occupancy Status Interest Rate Type Loan Purpose Documentation Level Lien Position FICO LTV 1998 1999 2000 2001 Dummy Dummy Dummy Dummy Variable Variable Variable Variable
DEFAULT RATE FOR SAMPLE LOAN

Type Owner ARM Refinancing Limited First 601-625 86-90 Type Value 0 0 1 1 0 6 8 0 0 0 1 Coefficient 9.4 4.9 -1.1 -1.0 2.8 -1.6 -1.5 0.6 9.0 8.3 8.7 4.7 Value x Coefficient 9.4 0 0 -1.0 2.8 0 -9.0 4.8 0 0 0 4.7
2001 Vintage
Expected Default Rate 11.7%

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Sample Loan Pool
In this example, we consider a sample loan pool with the characteristics as indicated under the Type column in Exhibit 17. We replace the 0/1 choice for the non-scalar variables Type Value with the fraction of the type indicated in the Type column. For the scalar variables FICO and LTV, we take weighted averages of their bucket categories to get an average bucket value; in the case of FICO, the weighted average bucket is 5.5. Similarly, we use the dummy variables according to the share of vintage year represented by the pool. With the characteristics laid out as we have described, we compute an expected cumulative default rate on this pool of 13.4%. If the pool instead had all of its loans in the 601-625 FICO score bucket, our expected cumulative default rate would drop to 12.6%.
exhibit 17 Category Intercept Occupancy Status Interest Rate Type Loan Purpose Documentation Level Lien Position FICO
DEFAULT RATE FOR SAMPLE POOL

Type 85% Owner, 15% Investor 75% ARM, 25% Fixed 70% Refinancing, 30% Purchase 35% Limited, 65% Full 100% First 10% 551 575 40% 576 600 40% 601 625 10% 626 650 20% 81 85 60% 86 90 20% 91 95 Type Value 0.15 0.25 0.70 0.35 0 5.5 Coefficient 9.4 4.9 -1.1 -1.0 2.8 -1.6 -1.5 Value x Coefficient 9.4 0.7 -0.3 -0.7 1.0 0
-8.3 8 0.6 4.8 0 0 0.5 0.5 9.0 8.3 8.7 4.7 0 0 4.4 2.4
LTV
1998 Dummy Variable 1999 Dummy Variable 2000 Dummy Variable 2001 Dummy Variable
50% 2000 Vintage 50% 2001 Vintage
Expected Default Rate 13.4%

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Whats It Worth in FICO?
We now want to normalize in terms of FICO score the contribution to default of each of these characteristics. Put differently, how much compensation in terms of FICO scores would make an investor indifferent between a loan or loan pool having more of an unfavorable characteristic with higher FICO versus less of that unfavorable characteristic? The tradeoffs are shown in Exhibit 18.
exhibit 18
FICO VALUE OF LOAN CHARACTERISTICS

1998 -82.8 21.7 -11.1 -41.4 15.9 25.0 -9.4 1999 -75.3 19.3 0.2 -36.2 30.5 25.0 -8.8 2000 -80.9 19.7 -3.2 -36.5 37.3 25.0 -9.8 2001 -102.1 11.0 32.2 -52.7 22.9 25.0 -12.8 2002 -81.1 41.2 52.7 -64.5 -51.0 25.0 -8.4 All Vintages -83.8 18.2 17.0 -47.4 27.6 25.0 -10.0 -153.4 -140.8 -148.3 -79.6
Equivalent FICO Points Occupancy Status Interest Rate Type Loan Purpose Documentation Level Lien Position FICO LTV 1998 Dummy Variable 1999 Dummy Variable 2000 Dummy Variable 2001 Dummy Variable
From Exhibit 14, the coefficient for doc level is about 1.5 to 2 times that of FICO score. Since each FICO bucket is worth 25 points, we could say that the impact of limited docs on default likelihood is essentially the same as that of a full doc borrower with about 40-50 points lower FICO. This is another way of saying that one should in principle be indifferent between lending to a full doc borrower or lending to one with limited docs, but with 40-50 points higher FICO. We have seen that, in fact, limited doc borrowers historically have had FICO scores that are only about 20-25 points higher than full doc borrowers, which is why limited doc borrowers still default at higher rates than full doc borrowers: the limited doc borrowers do have higher FICO scores, but not sufficiently high to completely offset the risk characteristic of limited docs.6
CONCLUSION
We updated our previous default traits analysis, incorporating a considerable quantity of additional data, as well as additional seasoning of the previously employed data. The results of this analysis are broadly similar to those of our prior work, although some relationships and the magnitudes of some of our derived values changed a bit. A few of the more interesting results we found are greater evidence that purchase loans default more frequently than refinance loans, that non-cash out refinancings default more frequently than cash out refis and that, albeit with limited data just yet, IO loans default less frequently than fully amortizing loans. We also found that loan size was only weakly related to default frequency.
See the Morgan Stanley ABS Perspectives, Whats Up, Doc? Comparative Credit Quality of Limited and Full Doc HEL ABS, November 8, 2004.
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Transition Roll Rate Matrix

Using loan level data, we offer a transition matrix detailing the pattern of movement from one delinquency bucket to another for subprime home equity loans. Our universe covers 30-year subprime fixed and adjustable rate home equity loans originated by a variety of issuers across the industry. We ran data separately for each vintage, in order to monitor static pools. For each remittance month, we grouped loans by OTS performance category, and then monitored the status into the following month. Comparisons between fixed and adjustable rate mortgages, as well as across different vintages, produced similar results. In addition, we found the effects of seasoning to be limited.1 Consequently, we display the average migration percentage for each performance bucket using loans originated in 1998 (Exhibit 1). For most categories, we see that the majority of loans do not migrate to another bucket. This is intuitive: current loans stay current, while REO loans will remain REO for some time.
chapter 5
exhibit 1
TRANSITION MATRIX: MOST LOANS MAINTAIN STATUS

30 Day Del % 60 Day Del % Second Month 90+ Day ForeDel closure % % Bankruptcy % Prepay/ Write-off %
First Month
Current %
REO %
Current 30 Day Del 60 Day Del 90+ Day Del Foreclosure REO Bankruptcy
94.1 38.5 15.3 2.8 3.5 0.0 1.5
2.4 25.3 12.0 1.3 0.5 0.0 0.2
0.1 24.4 20.5 2.5 0.4 0.0 0.2
0.0 0.4 32.6 73.9 2.0 0.3 1.3
0.1 7.5 15.8 14.7 82.3 0.4 5.2
0.0 0.0 0.0 0.6 4.9 85.4 0.2
0.1 0.6 1.0 1.5 3.5 0.2 90.5
3.2 3.2 2.8 2.8 3.0 13.8 0.9
Other categories, such as 30 or 60 days delinquent, represent a transition period. The majority of loans are either cured, or advance in delinquency. Some borrowers, however, resume payments but are unable to catch up on previously missed payments. As a result, the status of these borrowers remains unchanged in the following month. From Exhibit 1, we see that approximately 20-25% of 30-60 days delinquent borrowers fit this profile. We note that the different reaging policies employed by servicers could impact these figures. We are intrigued that nearly 64% of 30 days delinquent loans do not advance to a more severe stage of delinquency. This is consistent with the industry expression of serious delinquencies, which refers to loans more than 60 days delinquent.
Although we did not find any clear seasoning patterns, we did notice increased volatility during earlier months. We attribute this to the small balances for certain categories. For example, there are very few REO loans early in the life of the transaction, consequently, migration levels can fluctuate. As a result, Exhibit 1 reflects performance from January 2000 to July 2003 for loans originated in 1998.
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Transition Roll Rate Matrix

There are some fields that remain difficult to explain. For example, we would expect REO loans to either be written-off or remain REO not revert to current or 90+ days delinquent status. We threw out a few obviously flawed data points, but the sheer magnitude of the data set makes some imperfect data unavoidable. We attribute the relatively small unexplainable percentages to faulty data. In Exhibit 2, we only consider the loans which do not remain in the same category. The percentages from Exhibit 1 are recalculated, excluding loans that do not migrate. For current loans, we find that over half of the loans not reported as current in the following month either prepaid or defaulted (as we consider write-offs unlikely for current loans). The majority of other previously current loans become 30 days delinquent. It was difficult to ascertain the pattern for seriously delinquent loans from Exhibit 1, with most loans remaining in the same category for multiple months. From Exhibit 2, however, we see that serious delinquencies only tend to get worse. For these loans we consider write-offs much more likely than prepayments.
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exhibit 2
IF IT MOVES, WHERE DOES IT GO?

30 Day Del % 60 Day Del % Second Month 90+ Day ForeDel closure % % Bankruptcy % Prepay/ Write-off %
First Month
Current %
REO %
Current 30 Day Del 60 Day Del 90+ Day Del Foreclosure REO Bankruptcy 51.5 19.3 10.9 20.2 0.1 16.0
40.2 15.3 5.1 2.5 0.0 1.9
1.5 32.7 10.1 2.0 0.0 1.5
0.3 0.5 41.1 10.6 1.7 13.4
1.8 10.1 19.5 54.8 2.7 55.2
0.0 0.0 0.0 1.9 27.9 2.0
1.9 0.8 1.3 5.1 19.6 1.1
54.3 4.3 3.5 12.1 17.2 94.4 10.0
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Servicer Ratings
Servicer performance first became a focus of the rating agencies and home equity ABS investors when the actions of ContiMortgage seemingly exacerbated the decline in performance. In a case study, Fitch cited an inappropriate decision-making process to mitigate loan losses, which helped contribute to the high loss severities on its loans. Ironically enough, it was the servicer that stepped in for ContiMortgage, Fairbanks, that made the next big splash. Although servicing cannot eliminate bad performance of poorly underwritten collateral, it can reduce the loss severity by adhering to standard industry servicing timelines and implementing loss-mitigation techniques such as cash for keys, short-pay or short-sales to shorten foreclosure timelines and reduce loss severities. Servicer ratings are gaining importance with investors, and we believe that greater rating agency scrutiny is generating greater discipline for the industry. We discuss the different types of servicing and the different criteria for each type. Standard & Poors has been evaluating servicers since 19891, but it was the ContiMortgage experience that prompted Fitch and subsequently Moodys to start rating servicers. It also has created more demand for Standard & Poors to make its evaluation process more transparent. By publicly rating the servicers, the rating agencies created a more stringent criteria and review process for the servicers, resulting in more discipline for the industry. The rating agencies now rate the different types of servicing master, primary and special. In addition, they differentiate prime, alt-A and subprime mortgages from niche product types such as HELOC, HLTV and MH loans. The rating scale for each of the servicers has five tiers (see Exhibit 1).
chapter 6
exhibit 1
SERVICER RATING SCALES

Fitch S&P Moodys
Highest Rating
1 (Overall Superior Performance) 2 (Noted Strengths) 3 (Full Approval) 4 (Qualified Approval)
Strong Above Average Average Below Average Weak
SQ1 SQ2 SQ3 SQ4 SQ5
Lowest Rating
5 (Conditional Approval)
Source: Fitch, Moodys and Standard & Poors
Standard & Poors has a Select Servicer List of approved servicers. An approved servicer has at least an Average rating and a stable or better outlook. Approved servicers have the option to reveal their actual rating.
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Servicer Ratings
CRITERIA F OR R ATING S ERVICERS
Generally, the rating agencies place emphasis on three main areas of the servicing business: loan/asset administration; management/organization; and financial position. The following are important details that rating agencies delve into in order to assess the servicer: Company and management experience Commitment to the business Ability to meet financial requirements Staffing and training Stability of operations and procedural controls Loan administration from boarding loans to escrow accounts Compliance to industry standards Capacity to handle current and projected volume (staffing and technology) Current and prior performance Loan resolutions
DIFFERENT T YPES O F S ERVICING
The main types of servicing that the rating agencies review are master, primary and special servicing. Below we describe what the main responsibilities are for each type of servicing and the important areas of focus for the rating agencies for each servicing type. Master Servicer The master servicers primary responsibility is to oversee the sub-servicer(s). This typically includes: Tracking the movement of funds between the primary and master servicer accounts. Ensuring orderly receipt of the servicers monthly remittance and servicing reports. Monitoring the collection comments, foreclosure actions and REO activities. Aggregating reports and distribution of funds to trustees/investors. As a result of these primary responsibilities, the rating agencies focus on the master servicers ability to oversee and monitor the sub-servicer(s). In addition, it is important that the master servicer be able to assume responsibility from the primary servicer(s) and/or be able to find another sub-servicer. Furthermore, the rating agencies place weight on the master servicers financial standing because it may or may not need to advance principal and interest. A primary and special servicer can be a sub-servicer. Also, some deals do not have master servicers.
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Primary Servicer A primary servicer typically handles all aspects of loan administration, and the rating agencies focus is on its ability to manage all these various responsibilities. A primary servicer handles cash management functions such as the collection of monthly payments, remittance of funds to the trust account or master servicer, and ongoing maintenance of escrow accounts. In addition, it manages delinquent borrowers by following up with them, implementing loss-mitigation techniques, initiating foreclosure proceedings when necessary, and disposing of the real estate owned (REO) property. A primary servicer also delivers appropriate information for investor reports to the trustee. Furthermore, the rating agencies will put weight on the servicers ability to advance principal and interest. Special Servicer A special servicer manages delinquent loans after a specified stage of delinquency. It is responsible for performing default management, loss mitigation for loans and REO management. The rating agencies focus on the special servicers ability to manage defaulted loans and implement loss-mitigation techniques, with particular emphasis on key performance statistics. The key performance statistics include roll rates, resolution rates and timeline management.
DISTINCTIONS I N S ERVICING D IFFERENT P RODUCTS
The rating agencies distinguish between different mortgage products because there is a distinction in the way different assets need to be serviced due to unique characteristics. For example, when comparing prime mortgage servicing to subprime mortgage servicing, there is a greater emphasis placed on the subprime servicers financial status due to the greater advancing requirements for subprime servicers. In contrast, second-lien servicers generally are not required to advance principal and interest because there is usually 100% loss severity; therefore, there is no ability for the servicer to recover advances. As a result, the financial status is less important for second-lien servicers. Home equity lines of credit (HELOCs) and manufactured housing (MH) also have special servicing requirements, with HELOCs requiring the ability to track draws and MH requiring the servicer to potentially physically repossess the unit. In Exhibit 2, we have provided a list of servicer ratings that are updated as of April 10, 2003. We have, however, updated the ratings for Fairbanks. Fairbanks surprised the market in April 2003 when S&P dropped the servicer rating to BELOW AVERAGE from STRONG. Other rating agencies also followed, citing a loss of confidence in management controls. We believe the rating agency focus is particularly positive for the subprime industry. In contrast to the prime market, the subprime borrowers tend to have a greater number of loans falling in and out of delinquency; as a result, it is important to have a servicer that manages the delinquent loans, focuses on timeline management and implements loss-mitigation techniques to reduce loss severity.
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Servicer Ratings
exhibit 2 RESIDENTIAL LOAN SERVICER RATINGS
Master Name ABN AMRO Mortgage Group Accredited Home Lenders Altegra Credit Corp. American Business Financial Services American General Financial Ameriquest Mortgage Aurora Loan Services Bank of America Mortgage Celink Cendant Mortgage Centex Home Equity Champion Mortgage Company Chase Manhattan Mortgage Chevy Chase Bank CitiMortgage Clayton National Compu-Link Countrywide EMC Mortgage Corp. Equity One Fairbanks Capital Corp. First Horizon Home Loan Corp. First Nationwide Mortgage First Republic Bank First Union National Bank/Wachovia Fleet Mortgage GMAC Mortgage Corp GRP Financial Services GreenPoint Mortgage Corp. Home Loan and Investment Bank Homecomings Financial (GMAC-RFC) HomeEq Servicing Corp. Homeloan Management Limited HomeSide Lending Inc. Household Financial Services
1
Prime Residential Loan Moodys S&P1 Above Avg./Stable Fitch RPS2+ Moodys
Residential S&P1 Fitch
S&P1
Fitch
RPS3+ Yes Yes Yes Strong/Stable Yes RMS2+ Yes Strong/Stable RPS1 Yes RPS2
Strong/Stable
RPS1Above Avg./Positive Yes RPS2
Yes
RMS1-
Strong/Stable Yes Above Avg./Positive
RPS1
Above Avg./Stable
RPS1-
RPS1
RMS2
Strong/Stable Yes
RPS1
Strong/Stable Yes Above Avg./Stable Below Avg./Stable
RPS1 RPS1
RPS3-
Above Avg./Stable Yes RMS2+ Strong/Stable Yes
RPS2
Strong/Stable
RMS1
SQ1
Strong/Stable
RPS1
Above Avg./Stable
RPS1
Yes Yes RMS1 Strong/Stable RPS1 SQ1 Strong/Stable Strong/Stable RPS2 Strong/Negative Yes RPS1 RPS1 RPS2
Yes in the S&P column means that the servicer is on S&Ps Select Servicer List but has chosen not to reveal their rating. Select Servicers have a minimum rating of Average and an outlook of Stable. S&P defines term Alternative in the context of being an alternative loan compared to a closed-end first lien. This category includes closed-end second liens, HELOCs, FHA Title 1 Home Improvement loans and high loan-tovalue mortgages (125% LTV). Source: Fitch, Moodys and Standard & Poors
2
70
Subprime Moodys Fitch
Alt-A Moodys S&P

1
Special Fitch Moodys
Home Equity High LTV Fitch Moodys
(HELOC & 2nds) Fitch Moodys
Alternative2 S&P1
Yes RPS3+ RSS3
Yes RPS2+ RPS1-
RSS2-
Above Avg./Stable RPS2+ Above Avg./Stable
RPS1-
Yes
RSS1-
RPS1-
Yes
Yes Above Avg./Stable Above Avg./Stable RPS1 SQ1 Strong/Stable Yes RSS1RSS1 SQ2 Strong/Stable
SQ4
RPS3
Below Avg./Stable
RSS3
SQ4
RPS3-
Yes Above Avg./Stable Above Avg./Stable RPS2RPS2Yes RSS2 RPS1 RPS1 Strong/Stable
SQ1
RPS1 RPS1
Above Avg./Stable Strong/Stable
RSS1 RSS1
SQ2
RPS1
SQ1
RPS1
SQ1
Strong/Stable Strong/Stable
Yes
71
Servicer Ratings
exhibit 2 RESIDENTIAL LOAN SERVICER RATINGS
(CONTINUED)
S&P1
Master Name HSBC Mortgage Corp. Impac IndyMac Bank F.S.B. Interbay Funding, LLC Irwin Home Equity Liberty Lending Services Litton Loan Servicing Master Financial Matrix Financial Services New Century Mortgage New South Federal Savings Bank NovaStar Mortgage Novus Financial Ocwen Federal Bank FSB Old Kent Mortgage Services Option One Mortgage PSB Lending PNC Consumer Services PNC Mortgage Corp. of America Provident Funding Associates (CA) PCFS Financial Services (GA) Principal Residential Mortgage, Inc. PCFS Mortgage Resources (OH) RBMG, Inc. Republic Bank Saxon Mortgage Services (Formerly Meritech) SN Servicing Corp SouthTrust Bank Superior Bank, FSB The CIT Group Union Planters PMAC U.S. Mortgage Washington Mutual Savings Bank Wells Fargo Home Mortgage Wendover Financial Services Corp. Wilshire Credit Corp. World Savings FSB
1
Prime Residential Loan Moodys S&P1 Yes Fitch Moodys
Residential S&P1 Fitch
Fitch
Yes Yes RMS2+ Yes RPS2Yes RPS2-
Yes Yes Avg./Stable Avg./Stable Yes SQ1 Yes RPS1
Yes Above Avg./Stable Yes Yes Yes Yes Strong/Stable RPS1 Strong/Stable RPS2 RPS3
RPS3 Above Avg./Stable Yes Avg./Stable RPS3 RPS3 RPS2-
Above Avg. Yes
Above Avg.
Avg./Developing Yes Yes Yes Yes Yes RMS2 RMS1 Yes Yes Strong/Stable Yes Above Avg./Stable Yes RPS2 RPS1 Yes Strong/Stable Yes Above Avg./Stable RPS2 RPS2RPS1
Yes in the S&P column means that the servicer is on S&Ps Select Servicer List but has chosen not to reveal their rating. Select Servicers have a minimum rating of Average and an outlook of Stable. S&P defines term Alternative in the context of being an alternative loan compared to a closed-end first lien. This category includes closed-end second liens, HELOCs, FHA Title 1 Home Improvement loans and high loan-tovalue mortgages (125% LTV). Source: Fitch, Moodys and Standard & Poors
2
72
Subprime Moodys Fitch
Alt-A Moodys S&P

1
Special Fitch Moodys
Home Equity High LTV Fitch Moodys
(HELOC & 2nds) Fitch Moodys
Alternative2 S&P1
RPS2-
Yes Yes
RSS2RSS2 RPS2 RPS2 Above Avg./Stable
Yes SQ1 Strong/Stable Avg./Stable RSS1 SQ1 RPS1 SQ1 SQ1 (seconds) Yes Above Avg./Stable
Avg./Stable
SQ1
Strong/Stable
RSS2
SQ1
Above Avg./Stable
SQ1
Avg./Stable
RSS1
SQ2 Yes Above Avg./Stable Above Avg.
RPS3
RPS3
Yes
Yes RPS2+ SQ2 Yes Yes Above Avg. RSS2SQ3
Yes RPS2RPS1 Yes Above Avg./Stable RSS3 RSS2+ RPS2 RPS2 Above Avg./Stable
73
74
Section III Home Equity Handbook
Metrics
75
76
Prepayments
chapter 7
Measuring prepayments is important as it allows investors to forecast the average life of a loan. Prepayments are desirable for investors if interest rates have increased and undesirable if interest rates have fallen. Prepayment penalties may deter borrowers from prepaying their existing mortgages, however, the incentive to refinance increases as interest rates continue to decrease1. Another factor affecting prepayments is home prices. Prepayments tend to increase as home prices rise and borrowers refinance their mortgage to take equity out of their homes (called a cash-out refinancing)2. Prepayments also occur as subprime borrowers credit cure; even in a stable rate environment, subprime borrowers can achieve a lower interest rate if their personal credit profile improves. In this chapter, we look at prepayments in a rising rate environment and the affect on the available funds cap. We then analyze just how sensitive prepayments of fixed and adjustable rate mortgages are to interest rate changes.
HISTORICAL P ERFORMANCE O F H EL S IN A R ISING R ATE E NVIRONMENT
With Treasury yields increasing, the question most asked by investors concerns the likely prepayment speeds of HEL ABS collateral. More specifically, investors want to know the impact on available funds caps in HEL transactions in a rising interest rate environment; the concern is whether fixed rate collateral prepayments slow dramatically at the same time that hybrid ARM prepayments maintain their speeds (or slow only marginally), thereby increasing the ratio of fixed to floating rate collateral backing HEL ABS pools, and making the available funds caps more in the money. To examine this question, we analyzed historical HEL prepayment behavior. Unfortunately for analytical purposes, but fortunately for subprime borrowers (!!) there have not been many periods of rising interest rates in the past seven or so years since the HEL market took roughly its present form of consisting primarily of first lien debt consolidation loans to subprime borrowers. Nonetheless, it is instructive to look at history and ascertain the likely slowest prepayment speeds for fixed rate collateral and the likely fastest speeds for ARM collateral. Given these rough boundaries, we can apply those prepayment rates to get a sense of how the mix of fixed vs. ARM collateral is likely to change over time as rates rise.
Borrowers may finance the prepayment penalty, so while the penalty may deter prepayments, it would not eliminate them. Also, the penalty usually does not get imposed if the borrower sells his home. In a rising house price environment, there arguably is greater housing turnover which increases prepayments.
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Prepayments
Looking at History
There have been three prior periods of rising rates since 1998. These occurred: From 1998Q4 till 2000Q1, the 10-year Treasury increased 263 bp and the 2-year increased 286 bp. From 2001Q4 till 2002Q1, the 10-year increased 125 bp and the 2-year rose 143 bp. From 2003Q2 till 2003Q3, the 10-year Treasury increased 149 bp and the 2-year rose 96 bp. In addition, from November 1998 till June 2000, the slope of the Treasury curve, as measured by the difference between the 10- and 2-year Treasuries, flattened by 66 bp, prior to beginning a long sustained steepening in August 2003, when the steepness reached 290 bp. What did all of this mean for HEL prepayments? Exhibit 1 shows fixed rate prepayment speeds by cohort for 1997 through 2000 issue years, graphed against the 10-year Treasury yield and the 2s/10s differential3. Exhibit 2 similarly shows prepayment speeds for ARMs by cohort.
exhibit 1
FIXED RATE HEL PREPAYMENT RATES BY ISSUE COHORT
Source: Morgan Stanley, Loan Performance, Bloomberg Financial Markets
A few conclusions from Exhibits 1 and 2 are inescapable. For fixed rate HELs, the conclusions are that: When rates rose in 1998, fixed rate prepayments from the 1997 cohort fell from their peak of 33% CPR to about 25% CPR, but then continued to fall further as interest rates fell off their peak. The 1997 vintage hovered in the 17%-20% CPR range for 14 months in 2000-01, before successive declines in interest rates and the steepening yield curve brought speeds to the 30%-35% CPR range.
We excluded the more recent vintages from Exhibits 1 and 2 because their timing was such that they were not significantly influenced by the rising rate periods. Having examined graphically the relationship between these more recent vintages and interest rates (not included here), we chose to exclude them to avoid excessive clutter or additional excessive clutter (!!) in Exhibits 1 and 2.
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exhibit 2
ARM HEL PREPAYMENT RATES BY ISSUE COHORT
Source: Morgan Stanley, Loan Performance, Bloomberg Financial Markets
As rates rose in 1998, the 1998 cohort was still going through its seasoning period, so prepayment speeds on the 1998 vintage generally were rising, despite rising rates. In late 2001 to early 2002, when the 10-year rose 125 bp, the 1997, 1998, 1999 and 2000 vintages all prepaid in the range of 30%-35% CPR. Note, however, that even though rates rose, they increased from a point that was 260 bp below their previous peak in Jan 2000 and the 2s/10s steepened to almost 200 bp. By the time rates were at their low point in 2003, prepayment speeds on what we would have expected to be the most burned out, seasoned vintages were in the 35%-40% range. When rates did increase, prepayments dropped to 30%, then bounced off 30% as rates started to fall again. For the ARMs in Exhibit 2, we see that: Prepayments tend to be more calendar, than interest rate, related. As interest rates rose beginning in 1998, prepayment speeds on the 1997 vintage ARMs dropped from 50% to 40%, before resuming their upward climb to 60% CPR in 2000, typical of the speed reached after the end of the 2-year fixed rate/prepayment penalty period. When rates rose again in 2001, the 1997 and 1998 vintages already had settled into their post-reset prepayment speed range of 30%-45% CPR. The 1999 vintage remained in the 40%-50% CPR range not reaching as high a peak as earlier vintages, but remaining for the most part above 40% until 2003. Of course, even though rates rose, the yield curve remained at historically steep levels. The 2000 vintage has prepaid as well between 40% and 50% CPR.
79
Prepayments
Summarizing History
Based upon the historical response to rising interest rates seen in Exhibits 1 and 2, we would conclude that the likely slowest sustainable speed on fixed rate HELs is 17%-20%, while the likely fastest long-term speed on ARM HELs is 40%. We may be able to get a sense of how slow fixed rate subprime prepayment rates may go by looking at low FICO agency data. Exhibit 3 reports average WAC and FICO from agency MBS pools with average FICO below 625 for the indicated issue year cohorts, and compares these characteristics to the entire agency production from the same issue years. This table gives us a picture of the extent to which the lowest credit quality agency pools compare to the overall agency universe, and we can see just how low are the lowest FICO buckets and how much higher than average WAC these borrowers pay. It is noteworthy that these average FICOs are reasonably in line with the average FICOs from subprime pools, as shown in Exhibit 4. Exhibit 5 shows the differential between the subprime WACs and the agency average WACs to get a sense of how much lower subprime borrowers coupons would be if they credit cured into an agency qualifying mortgage.
exhibit 3
AGENCY POOLS WITH FICO < 625: WAC AND FICO COMPARED TO AGENCY AVERAGE
All Agency Pools Avg Avg WAC FICO 7.81 697 7.04 710 7.34 707 8.18 696 7.07 706 6.68 712 5.82 719 6.01 710 Difference Avg WAC Avg (bp) FICO 35 -84 48 -126 63 -93 45 -89 90 -82 91 -83 57 -91 56 -85
Issue Year 1997 1998 1999 2000 2001 2002 2003 2004
Pools with FICO <625 Avg Avg WAC FICO 8.16 613 7.52 584 7.97 614 8.63 607 7.97 624 7.59 629 6.39 628 6.57 625
Source: Morgan Stanley, Agency factor tapes
exhibit 4
AGENCY POOLS WITH FICO < 625 COMPARED TO SUBPRIME WAC AND FICO
Subprime Mortgages Avg Avg WAC FICO 10.47 621 10.01 611 10.18 612 10.64 605 10.01 623 8.69 634 7.62 641 7.48 649 Difference Avg Avg WAC (bp) FICO -231 -8 -249 -27 -221 2 -201 2 -204 1 -110 -5 -123 -13 -91 -24
Issue Year 1997 1998 1999 2000 2001 2002 2003 2004
Pools with FICO <625 Avg Avg WAC FICO 8.16 613 7.52 584 7.97 614 8.63 607 7.97 624 7.59 629 6.39 628 6.57 625
Source: Morgan Stanley, Loan Performance, Agency factor tapes
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exhibit 5
SUBPRIME WAC AND FICO COMPARED TO AGENCY AVERAGE

All Agency Pools Avg Avg WAC FICO 7.81 697 7.04 710 7.34 707 8.18 696 7.07 706 6.68 712 5.82 719 6.01 710 Difference Avg WAC Avg (bp) FICO 266 -76 297 -99 284 -95 246 -91 294 -83 201 -78 180 -78 147 -61
Issue Year 1997 1998 1999 2000 2001 2002 2003 2004
Subprime Mortgages Avg Avg WAC FICO 10.47 621 10.01 611 10.18 612 10.64 605 10.01 623 8.69 634 7.62 641 7.48 649
Source: Morgan Stanley, Loan Performance, Agency factor tapes
Finally, we consider Exhibit 6, which is similar to Exhibit 1, except it graphs fixed rate agency prepayment rates for pools with average FICO below 625. Despite the agency pools with average FICO somewhat similar to those from the subprime universe, we still see that the agency pools display greater prepayment sensitivity to interest rates than the subprime mortgages.
exhibit 6
AGENCY POOLS WITH FICO < 625: FIXED RATE PREPAYMENTS BY ISSUE COHORT
Source: Morgan Stanley, Agency factor tapes, Bloomberg Financial Markets
For example, in 2002-03, fixed rate subprime mortgages prepaid on the order of 40% CPR, while the agencies with FICO below 625 prepaid at about 55% CPR. When rates rose in the late 1990s, subprime mortgages prepaid between 17%20% CPR, while the low FICO agency pools came in at about 10%-12% CPR. The low FICO agency pools certainly display greater interest rate sensitivity, but what may explain the agencies slower speeds in the higher rate environment?
81
Prepayments
We believe that the answer lies in the fact that despite the low FICO agency and the subprime mortgages having relatively similar FICOs, their WACs are substantially different. This suggests to us either that there was inappropriate pricing of the relative risks of the lower quality agency borrowers and the subprime borrowers or there are other non-FICO characteristics that suggest that the subprime borrowers should be charged a significantly higher mortgage rate than the weaker agency qualifying borrowers. The implication of this is that in a rising rate environment as long as rates do not rise too much the subprime HEL borrowers still can have an opportunity for credit curing related prepayments. Consider HEL loans originated in 2003. We see from Exhibit 5 that these have an average gross coupon of 7.62%. The average HEL rate offered in 2004 has been 7.48%, so there is not much room to refinance profitably. On the other hand, if this borrower qualified for a lowFICO agency (sub-625 FICO) mortgage, he could get a rate of 6.57% (see Exhibit 4) and if he cured sufficiently to get a prime agency mortgage, his rate would be 6.01%. Therefore, there clearly is much greater room for credit curing for the HEL borrowers than for the agency borrowers. Now, if interest rates were to rise 50 bp, the low-FICO agency borrowers would have no opportunity to refinance in a credit curing scenario, but the HEL borrower still could improve his mortgage rate by more than 100 bp (7.62% minus 6.51%). For 2001 and 2002 subprime vintages, this differential would be even greater: rates could rise by a considerably greater amount before the credit curing aspect of HELs is swamped by rising rates. For this reason, we believe that the likely slowest speed that fixed rate HELs would achieve in a rising rate environment is the 17-20% range that they exhibited for 14 months in the 200001 period, unless interest rates spike several hundred basis points.
Conclusion
We considered the likely behavior of HEL fixed and ARM prepayment rates in a rising rate environment. We believe that because of the credit curing potential of subprime borrowers, fixed rate HEL prepayments should not get below 17%20% for a sustained period. The only exception to this would be if interest rates rose so much that the mortgage rate available to prime borrowers exceeded that of the mortgage in which the subprime borrower is already. For ARM borrowers, prepayments tend to be more calendar, than interest rate, dependent. That said, we would not expect ARM speeds to remain consistently above 40% for an extended period.
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PREPAYMENTS, R ISING R ATES A ND A VAILABLE F UNDS C AP
The impact of rising interest rates on prepayment speeds will determine the mix of fixed rate relative to ARM collateral in a transaction as it progresses through time, and thereby determine the impact of available funds caps. We calculate the evolution of the mix of fixed vs. ARM collateral in the event that fixed rate prepayments remain above 17% CPR and ARM collateral levels out at 40%, after falling from its reset period peak of 60%; and second, we examine the interaction of this prepayment behavior with available funds caps on impacting discount margins on HEL ABS.
Summary
Even in a stressed scenario of slow fixed rate/fast ARM prepayments, available funds caps Do not impact AAA HEL classes for even a 200 bp upward shift in forward LIBOR Only marginally impact the mezzanines with forward LIBOR up even 100 bp Still allow the subordinates to post strong triple digit returns as LIBOR evolves along the forward curve
Fixed and ARM Collateral
For our analysis, we will consider a representative HEL collateral pool comprising 30% fixed rate and 70% hybrid ARM collateral. The fixed rate collateral has a gross WAC of 6.95% and 30-year WAM, while the hybrid ARMs have 7.05% gross coupon and 30-year WAM. The Morgan Stanley ABS Research base case prepayment assumptions, used in several of our published analyses of HEL ABS, are shown in Exhibit 7. The fixed rate collateral is assumed to ramp up to 23% CPR over 12 months, while the hybrid ARMs are taken to prepay at 15% and then 20% CPR for years 1 and 2, before spiking to 60% CPR and drifting back down to 35% CPR. The stressed prepayment scenario of slow fixed/fast ARM speeds also is shown in Exhibit 7. The difference between the base case and stressed scenarios is that the fixed rate speeds are taken to get no higher than 17% CPR, and the hybrid ARMs are assumed to settle at 35% CPR after spiking to 60% CPR at reset.
83
Prepayments
exhibit 7
Fixed
Base: CPRs of 4% to 23% over 12 months Slower: CPRs of 4% to 17% over 12 months
PREPAYMENT ASSUMPTIONS IN BASE CASE AND STRESSED SCENARIOS
The question now is, how does the original composition of 70% hybrid ARM/30% fixed rate mortgages change over time in both the base case and stressed (i.e., slow fixed/fast ARM) prepayment scenarios? For this, consider Exhibit 8. In the base case, the ratio of ARM to fixed rate collateral drops from 70% at origination to 60% at 5 years and 40% at 10 years; in the stressed case, however, the ARM to fixed ratio drops to 45% at 5 years and 15% at 10 years. What does this mean for the available funds caps and resulting discount margins?
exhibit 8
EVOLUTION OF ARM/FIXED COLLATERAL RATIO IN BASE CASE AND STRESSED PREPAYMENT SCENARIOS
84
ARM
Base: CPRs of 15%, 20%, 60%,60%=>35%,35% Faster: CPRs of 15%, 20%, 60%,60%=>40%,40%
Representative HEL Transaction
For analysis of the impact of the slow fixed/fast ARM prepayment scenario on available funds caps, we first describe our representative HEL transaction. This is described in Exhibit 9 as having classes rated from AAA down to BB, plus overcollateralization. Representative pricing discount margins are shown as well in Exhibit 9. Our loss assumption is displayed in Exhibit 10. We assume that cumulative losses will reach 5% in the base case, with the distribution of losses occurring over time as described in Exhibit 10. These are the standard loss curve and cumulative loss assumptions used by Morgan Stanley ABS Research4.
exhibit 9
REPRESENTATIVE HEL CAPITAL STRUCTURE AND PRICING

Rating AAA AAA AAA AAA AA A ABBB + BBB BBB BB Percent of Deal 53.3 9.7 14.4 3.9 6.3 5.2 1.5 1.5 1.2 0.9 1.1 1.0 Pricing Avg Life (years) 2.30 2.42 1.59 5.47 4.60 4.44 4.38 4.36 4.35 4.31 3.95 Pricing (bp) 43.5 30 18 50 60 120 155 200 225 475 900
Class A1 A2 A3 A4 M1 M2 M3 B1 B2 B3 B4 O/C
See, for example, any of several of the analyses in this Morgan Stanley Home Equity Handbook 2004 Edition.
85
Prepayments
exhibit 10
Cumulative Losses 5%, Loss Vector LOSS ASSUMPTIONS Percent of Total Cumulative Losses 0% 10 48 16 10 6 10
Time Period 6 months constant Over 12 months, evenly Over 24 months, evenly Over 12 months, evenly Over 12 months, evenly Over 12 months, evenly Over 24 months, evenly
divided divided divided divided divided divided
It also is important to note for our analysis here that we assume in all cases that the performance triggers fail their tests and that the clean-up call is not exercised. This will add further stress to our analysis, in that the clean-up call and triggers will not be allowed to bail out, in some sense, the performance due to the slow fixed/fast ARM prepayment scenario. Consider first the analysis employing the base case prepayment and loss assumptions in Exhibits 7 and 10, respectively, as well as the current forward LIBOR curve. These are the discount margins reported in the column labeled No Shift in Exhibit 11. It is important to note that the current forward LIBOR curve implies that spot LIBOR in three years will be 5.06% and in five years will be 5.80%, compared to 1.24% today; therefore, even in the base case scenario with no curve shift, the analysis assumes that spot LIBOR will rise 382 bp in three years and 456 bp in five years as LIBOR evolves along the forward yield curve. Exhibit 11 also shows the resulting discount margins when the forward LIBOR curve is shifted up 100, 200 and 300 bp; the 300 bp upward shift in the forward curve would put spot LIBOR up to 4.24% today and to over 8% in three years5. Note also that the results reported in
Note that in Exhibit 11, there are some cases for which the discount margin increases when the forward LIBOR curve gets shifted upward. This is because the coupon margin step up due to not exercising the cleanup call would offset the impact of an available funds cap.
86
Exhibit 11 employ the base case prepayment scenario, even in the cases of the upward shifts in the forward LIBOR curve. We did this to isolate the impact of the slower prepayments on the realized discount margins, which we report in Exhibit 12.
exhibit 11
DISCOUNT MARGINS WITH BASE CASE PREPAYMENT ASSUMPTION

Forward LIBOR Curve +100 bp 43.5 30 18 50 67 124 160 208 234 183 NM +200 bp 43.5 30 18 50 57 117 143 175 NM NM NM +300 bp 26 24 17 34 37 103 124 39 NM NM NM
Class A1 A2 A3 A4 M1 M2 M3 B1 B2 B3 B4
No Shift 43.5 30 18 50 68 123 157 195 215 398 635
Note: Base case prepayment assumption is used even in scenarios of upward shifts in the forward LIBOR curve. Analysis assumes trigger tests are failed and clean-up call is not exercised. Source: Morgan Stanley
exhibit 12
DISCOUNT MARGINS WITH SLOW FIXED/FAST ARM PREPAYMENT ASSUMPTION

Forward LIBOR Curve +100 bp 43.5 30 18 50 67 124 160 171 40 58 NM +200 bp 43.5 30 18 50 8 91 120 146 NM NM NM +300 bp 25 20 16 22 NM 55 84 NM NM NM NM
No Shift 43.5 30 18 50 57 117 151 186 185 243 292
Note: The stressed prepayment assumption of slow fixed/fast ARM is used in all forward LIBOR curve scenarios. Analysis assumes trigger tests are failed and clean-up call is not exercised. Source: Morgan Stanley
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Prepayments
It is noteworthy that with the stressed prepayment assumption, the bonds perform reasonably well. The AAA classes return their pricing DM even with 200 bp increase in forward LIBOR, and the mezzanines actually do better with a 100 bp increase in forward LIBOR than in the current forward LIBOR scenario, because the coupon margin step up more than offsets the detriment of higher rates, stressed prepayments and the available funds cap. Further upward shifts of forward LIBOR begin to have a more detrimental impact on the mezzanines.
exhibit 13
DISCOUNT MARGIN COMPARISON: BASE CASE VS. STRESSED PREPAYMENTS

Prepayment Assumption Slow Fixed/Fast ARM 43.5 30 18 50 57 117 151 186 185 243 292 Difference 0 0 0 0 11 6 6 9 30 155 343
Base Case 43.5 30 18 50 68 123 157 195 215 398 635
Note: Comparison uses current forward LIBOR curve. Analysis assumes trigger tests are failed and clean-up call is not exercised. Source: Morgan Stanley
Exhibit 13 compares the discount margins using the base case prepayments in Exhibit 11 with the stressed slow fixed/fast ARM prepayments in Exhibit 12 for the current forward LIBOR curve. What is remarkable is how well these securities hold up even in the incredibly draconian scenario of slow fixed/fast ARM speeds that reduces the ARM share of the collateral pool to 45% by month 60: the AAA classes are untouched; the AA, A and A- mezzanines are off 6 to 11 bp, and the subs may take on bigger hits. But note that even in the stressed prepayment scenario with spot LIBOR climbing to almost 6% in five years, even the BB rated class returns almost 300 bp and the subs with BBB handles return 185 to 243 bp. We would conclude that while the available funds caps do come into play when fixed rate HEL prepayments slow and ARM speeds remain fast, the interaction that this stressed prepayment scenario and available funds caps have on the discount margin of floating rate HEL ABS is considerably less than one may have supposed prior to performing the analysis and looking at the numbers.
88
That said, we believe that this stressed prepayment scenario really is at the boundarys edge: we took speeds on fixed rate collateral never to get above 17%, and held it there. We also allowed the ARMs to spike to 60% at reset, and then slow down only to 40%. Moreover, we assumed that performance triggers failed and the bonds were not called. Since we consider this to be extreme outlier behavior, it suggests to us that these classes should hold up very well in the types of rising rate/slow fixed/fast ARM prepayment scenarios that more likely may actually occur. Clearly, successively upward shifts of the forward LIBOR curve that put spot LIBOR up over 8% in the context of stressed prepayments would ultimately have detrimental effects on performance, but in what we believe to be the more likely scenarios, these classes should not be cause for the sort of concern that we are hearing from some corners.
Conclusion
Even in a rising rate environment with egregious prepayment behavior, the HEL classes generally hold up pretty well. Clearly, the lowest rated classes, as expected, have the greatest propensity to get hurt, but the bonds hold up very well with the current forward LIBOR curve, which implies significantly higher rates over the next few years: despite the available funds caps coming a binding constraint, the subordinate classes still would post strong positive triple digit returns in the 185-300 bp area, while the mezzanines return 55-150 bp. The available funds cap would not come into play for the AAA rated classes with LIBOR evolving upward according to the forward curve, even with our stressed prepayment scenario; indeed, the AAAs would not be impacted under our stressed prepayment scenario even for 200 bp upward shift in forward LIBOR, a scenario that would imply spot LIBOR over 7% in three years.
89
Prepayments
PREPAYMENT R ATE S TABILITY: C ONVEXITY O F H EL ABS
Now, we look at and examine the convexity of home equity loan ABS. Some of our questions are: Just how much more stable are the prepayment rates, and resultant average lives, of fixed rate HEL vis--vis conventional mortgages? How much burnout have the seasoned fixed rate HELs experienced relative to conventional mortgages? How interest rate as opposed to reset date sensitive have adjustable rate HEL ABS been? Have these relationships changed over time?
Fixed Rate HEL Speeds are Remarkably Stable
Exhibits 14-17 compare fixed rate home equity loan ABS prepayment speeds to those of current coupon conventional mortgage pass-throughs originated in 1995, 1997, 1999 and 2001, respectively. To put the prepayment comparison into context, the graphs also include the 10-year Treasury yield.
exhibit 14
FIXED RATE HEL AND MBS PREPAYMENT COMPARISON: 1995 VINTAGE
90
exhibit 15
exhibit 16
A few items regarding Exhibits 14-17 are particularly striking: Fixed rate HEL prepayment rates at the cohort level are remarkably stable. They do exhibit some interest rate sensitivity, but it is dramatically less than that of agency conventional mortgages. For example, Exhibit 14 shows that 1995 originated FNMA 7.5% saw their prepayment rates shoot up from 16% to 50% CPR, only to fall back to 10% before spiking to 53%; in contrast, over the same time period, fixed rate HELs from the 1995 vintage had CPRs move from 27% to only 36%, drop to 21% and then rise to 31% CPR.
91
Prepayments
exhibit 17
Conventional mortgages not only display greater interest rate sensitivity than HELs, but the concept of burnout seems practically non-existent. This is in sharp contrast to prepayment behavior for conventional mortgage originations prior to the mid-1990s. For example, Exhibit 15 shows that FNMA 7.5% from 1995 saw prepayments reach successive peaks of 33%, 50%, 56% and 59% CPR, and remain today at 55% CPR; burnout would suggest that successive peaks would be decreasing, not increasing. This second point contrasts with prepayment behavior from prior vintages that displayed burnout. Exhibits 14, 15 and 16 make it clear that over time, burnout has become less significant for conventional mortgages, and has been immaterial for home equity loans. The implication of this is that the difference in negative convexity of conventional MBS actually has increased relative to that of HELs over time.
What Happened to Burnout?
Two factors have developed over the previous several years to make burnout less of an issue perhaps, a non-issue for the conventional MBS market. These factors are: Strong house price increases over several years lessen the likelihood that a borrowers mortgage is underwater, which could prevent him from refinancing, and make it attractive for low loan balance mortgages to be refinanced through a cash-out refinancing. Technological advances increased use of automated underwriting and credit scoring have increased the standardization and speed of the application process, and the more rapid dissemination of information have reduced the transaction costs involved in refinancing, making the process fairly frictionless and reducing the interest rate differential necessary to make refinancing attractive.
92
Adjustable Rate HEL ABS
Prepayments on adjustable rate HELs are likewise relatively interest rate insensitive. ARM HELs display greater correlation to the calendar, in that when they approach their two-year reset period (corresponding to the removal of prepayment penalties), prepayments spike. This is evident in Exhibits 18-20, which show HEL prepayments for 1997, 1999 and 2001 ARM HEL vintages, graphed against the 10-year yield.
exhibit 18
ADJUSTABLE RATE HEL PREPAYMENT HISTORY: 1997 VINTAGE
exhibit 19
93
Prepayments
exhibit 20
Conclusion
We examined the convexity of HEL ABS. Not only are fixed rate HEL ABS less negatively convex than conventional mortgages, but the convexity difference between the two has gotten greater over time. We conclude that: HEL prepayments are much more stable than conventional mortgages, resulting in more stable average lives. Adjustable rate HELs display date, rather than rate, sensitivity. Burnout has never been a concept applicable to HELs, but in recent years, conventional mortgages have not displayed burnout. HEL prepayment behavior has not changed much over time, but conventionals are displaying increased negative convexity.
94
Delinquencies
Delinquencies occur when a borrower misses a scheduled payment. When analyzing ABS transactions, investors generally look at the seriousness of the delinquency by classifying them into six categories: 30-60 days delinquent 60-90 days delinquent 90+ days delinquent Bankrupt Foreclosure REO Serious delinquencies are generally categorized as 60+ days delinquent, bankrupt borrower, loan in foreclosure or REO. In this chapter, we forecast the percentage of loans in each of the categories that we expect to default. We define a default as any loan that has incurred a loss or has paid down completely while 90 days delinquent, in the process of foreclosure, bankruptcy or real-estate owned1. We then go on to forecast the expected timing of a default for the various categories as well as for different vintages. At the end, we provide a chart with generic default liquidation timings.
PERFORMANCE B Y D ELINQUENCY S TATE Real-Estate Owned E
chapter 8
Unfortunately, determining the ultimate default rate proves difficult, as much of our collateral has not yet paid off. In Exhibit 1, REO default rates approach zero as the cohorts season, because the collateral has not yet had time to default.
exhibit 1
REO DEFAULT RATES SHOULD BE 100%
Please refer to Morgan Stanley Home Equity Handbook 2005 Edition, Chapter 5: Transition Roll Rate Matrix.
95
Delinquencies
Instead of only looking at loans that have already defaulted, we look at the percentage of loans that have not improved. Although the possibility remains that their status could improve in the future, we believe that most seriously delinquent loans that have not improved are very likely to default. Re-examining the REO bucket, we find that throughout the seasoning process, nearly 100% of REO loans end up in the same or worse position (Exhibit 2).
exhibit 2
REO LOANS DO NOT IMPROVE
Foreclosures
Using a similar approach for foreclosures, we find that 75-85% of foreclosures have not improved and therefore are very likely to default (Exhibit 3).
exhibit 3
75-85% OF FORECLOSURES WILL LIKELY DEFAULT
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Bankruptcies
In recent vintages, we find that a higher percentage of bankruptcy cases remain uncured2, making it difficult to apply a generic percentage of bankruptcies that will eventually default (Exhibit 4).
exhibit 4
BANKRUPTCIES HAVE WORSENED AND TAKE TIME TO CURE
Potential reasons for the increase in loans remaining bankrupt or worse include a recent hesitancy to enter bankruptcy unless absolutely necessary or possibly less leniency from the courts. The upward slope towards the end of each curve implies that it takes some time to cure bankruptcies and that collateral that has only recently encountered a bankruptcy needs more time to improve.
Although not shown here, data for 2001 resembles the 2000 vintage.
97
Delinquencies
90+ Day Delinquencies
Loans that are 90+ days delinquent show few improvements, with consistently 8090% of collateral remaining as seriously delinquent or worse (Exhibit 5). Collateral that is 60-90 days delinquent exhibits markedly better cure rates (Exhibit 6).
exhibit 5
90+ DAY DELINQUENCIES SHOW FEW IMPROVEMENTS
exhibit 6
60-DAY DELINQUENT COLLATERAL MAY NOT WORSEN
60-90 Day Delinquencies 9
The 60-90 days delinquent collateral has already displayed a tendency to remain static. In our previous examination, we found that 20% of collateral remained 60-90 days delinquent from month to month. Compared to the other serious delinquency categories, this collateral is considerably more likely to remain delinquent, but not default.
98
DEFAULT T IMING
Most investors realize that virtually all real-estate owned loans, for example, will eventually be liquidated. The timing of these cash flows, however, is less apparent. In certain instances, such as NIM analysis, loss timing can have a substantial impact. For each delinquency category, we calculated the percentage of defaults that would occur each month forward over the next 60 months. Not surprisingly, we find that the more seriously delinquent collateral liquidates quicker, with nearly 75% of REO loans liquidated within six months (Exhibit 7).
exhibit 7
CUMULATIVE DEFAULT TIMING BY DELINQUENCY STATUS
Note: Please refer to Exhibit 8 for a tabular presentation of this information. Source: Morgan Stanley, Loan Performance
99
Delinquencies
exhibit 8
Current 0.2% 0.4% 1.0% 1.8% 2.7% 3.9% 5.1% 6.6% 8.2% 10.0% 11.9% 14.0% 16.2% 18.6% 21.0% 23.6% 26.2% 28.9% 31.7% 34.5% 37.2% 39.9% 42.7% 45.5% 48.2% 50.9% 53.6% 56.3% 58.9% 61.5% 63.9% 66.3% 68.6% 70.9% 73.0% 75.0% 77.0% 78.8% 80.6% 82.3% 83.9% 85.5% 86.9% 88.3% 89.6% 90.7% 91.9% 92.9% 93.9% 94.8% 95.6% 96.3% 97.0% 97.7% 98.2% 98.7% 99.1% 99.4% 99.7% 100.0%
GENERIC DEFAULT LIQUIDATION TIMING (PLEASE REFER TO EXHIBIT 7)

60-89 Days Del 3.5% 6.3% 8.9% 11.6% 14.3% 17.1% 20.0% 23.0% 26.4% 29.6% 32.9% 36.3% 39.6% 43.0% 46.2% 49.3% 52.4% 55.3% 58.2% 60.8% 63.5% 66.0% 68.3% 70.4% 72.6% 74.6% 76.4% 78.1% 79.8% 81.3% 82.7% 84.2% 85.6% 86.8% 88.1% 89.2% 90.2% 91.1% 92.0% 92.9% 93.6% 94.2% 94.9% 95.5% 96.0% 96.5% 97.0% 97.4% 97.8% 98.1% 98.4% 98.7% 99.0% 99.2% 99.4% 99.5% 99.7% 99.8% 99.9% 100.0% 90+ Days Del 4.7% 8.9% 13.0% 17.2% 21.4% 25.5% 29.6% 33.8% 38.0% 42.2% 46.2% 49.9% 53.5% 57.0% 60.2% 63.2% 66.0% 68.6% 71.1% 73.4% 75.6% 77.6% 79.4% 81.2% 82.8% 84.2% 85.5% 86.8% 87.9% 89.0% 89.9% 90.8% 91.7% 92.5% 93.2% 93.9% 94.6% 95.1% 95.7% 96.1% 96.6% 97.0% 97.3% 97.6% 97.9% 98.2% 98.4% 98.6% 98.8% 99.0% 99.2% 99.4% 99.5% 99.6% 99.7% 99.8% 99.8% 99.9% 100.0% 100.0% Bankruptcy 2.7% 5.7% 8.9% 12.3% 16.0% 19.9% 23.9% 28.1% 32.5% 36.8% 41.1% 45.3% 49.4% 53.4% 56.9% 60.4% 63.6% 66.6% 69.4% 72.0% 74.5% 76.8% 78.9% 80.9% 82.8% 84.5% 86.0% 87.5% 88.7% 89.9% 91.0% 91.9% 92.9% 93.7% 94.4% 95.1% 95.8% 96.3% 96.8% 97.3% 97.7% 98.0% 98.3% 98.6% 98.9% 99.1% 99.3% 99.4% 99.5% 99.6% 99.7% 99.8% 99.8% 99.9% 99.9% 99.9% 100.0% 100.0% 100.0% 100.0% Foreclosure 4.5% 9.0% 13.8% 19.0% 24.2% 29.7% 35.1% 40.4% 45.3% 50.0% 54.5% 58.6% 62.3% 65.8% 68.9% 71.8% 74.4% 76.8% 79.0% 81.0% 82.8% 84.4% 85.9% 87.2% 88.4% 89.5% 90.5% 91.5% 92.3% 93.1% 93.8% 94.5% 95.1% 95.6% 96.1% 96.5% 96.9% 97.3% 97.6% 97.9% 98.2% 98.4% 98.6% 98.8% 99.0% 99.2% 99.3% 99.4% 99.6% 99.7% 99.7% 99.8% 99.8% 99.9% 99.9% 100.0% 100.0% 100.0% 100.0% 100.0% REO 16.7% 31.8% 44.8% 55.6% 64.4% 71.5% 77.2% 81.8% 85.3% 88.2% 90.4% 92.3% 93.7% 94.9% 95.8% 96.6% 97.1% 97.6% 98.0% 98.3% 98.6% 98.8% 99.0% 99.1% 99.3% 99.4% 99.5% 99.6% 99.6% 99.7% 99.7% 99.8% 99.8% 99.9% 99.9% 99.9% 99.9% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60
30-59 Days Del 0.5% 2.3% 4.1% 6.0% 8.2% 10.4% 12.8% 15.4% 18.1% 21.0% 24.1% 27.2% 30.4% 33.7% 36.8% 39.9% 43.1% 46.1% 49.0% 51.7% 54.5% 57.2% 59.8% 62.2% 64.6% 67.1% 69.3% 71.6% 73.7% 75.7% 77.5% 79.2% 80.8% 82.4% 83.9% 85.3% 86.6% 87.8% 89.0% 90.1% 91.1% 92.0% 92.8% 93.6% 94.4% 95.1% 95.7% 96.3% 96.9% 97.4% 97.8% 98.2% 98.5% 98.9% 99.1% 99.4% 99.6% 99.7% 99.9% 100.0%
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We believe that the distribution of the timing vector is considerably more useful (Exhibit 7), but for a rule of thumb, we also calculated the average time period that elapses before collateral from each category defaults (Exhibit 9).
exhibit 9
AVERAGE TIMING BEFORE DEFAULT
Category Current 30-59 Days Del 60-89 Days Del 90+ Days Del Bankruptcy Foreclosure REO
Timing (mos.) 27.2 21.8 19.0 15.2 15.7 13.0 5.4
Exhibits 7 and 9 are based on data derived from loans originated in 1998. Analysis of more recent vintages yields similar results, but the shorter performance history leads to a minimal reduction in the tail. We provide the periodic default timing for foreclosures (Exhibit 10), although other delinquency categories also produce similar results.
exhibit 10
VARIOUS VINTAGES PRODUCE SIMILAR PERIODIC DEFAULT TIMING
101
Delinquencies
USING E XCESS S PREAD T O M ONITOR D ELINQUENCIES
We recommend that investors supplement delinquency surveillance by monitoring excess spread. Although this analysis should never fully replace delinquency data, we believe that it offers an important alternative perspective. Given the importance and predominance of senior/subordinate structures, we want to take a look at the cushion that excess spread is providing for the subordinate classes. Moreover, we wanted to get a sense of when the narrowing cushion may portend future credit problems, so that investors can use the red flags thrown up by the narrowing cushion to make actionable trade decisions.
Methodology
With excess spread in the first loss position, it is the first line of defense in protecting the subordinate and mezzanine classes. The question we want to ask is, how much protection is currently provided by the excess spread? To answer this question, we compared the annualized excess spread to the reported current period loss percentage.
Case Study: ContiMortgage 1997-1 1
As an example of how the relationship between excess spread and current losses looks when a transaction is deteriorating, consider ContiMortgage 1997-1 B. The subordinate class B, originally rated BBB, had been downgraded several times until it defaulted when a portion of its principal was written off. Exhibit 11 shows the historical relationship between the excess spread and current losses on Conti 1997-1. In September 1998, current losses began to increase markedly, and in February 1999, they exceeded excess spread. The overcollateralization was eaten through in November 1999, and the subordinate class B started to take losses. The high amount of losses did not allow the excess spread to replenish the overcollateralization.
exhibit 11
CONTI 1997-1 B STARTED TAKING LOSSES IN SEPTEMBER 1999
102
exhibit 12
CWL 1998-1 EXHIBITS BETTER PERFORMANCE
Weakly performing transactions begin to show a deterioration in the excess spreadcurrent loss relationship several months before the transactions actually experience writedowns. Conversely, Exhibit 12 shows a strongly performing transaction with a healthy spread between excess spread and current losses. As deals season, the difference between excess spread and current losses tends to decline for two main reasons. First, the more highly rated and shorter average life classes pay down before the lower rated and longer classes, so that the remaining bonds will have on average a higher coupon, reducing the excess spread; and second, current losses, even in a transaction performing well, tend to increase as the transaction ages. Looking back at the Conti 97-1 transaction, we see that the difference between excess spread and current losses began to narrow in September 1998, even though the overcollateralization was not eaten through until November 1999 and the B class did not have writedowns until December 1999. The red flag should have gone up in 1998, as the narrowing difference between excess spread and current losses was a harbinger of the poor credit performance that was about to unfold.
Conclusion
We would argue that the red flag for weak performance should go up when the difference between excess spread and current losses narrows to about 100 bp. That is because when it passes through this level, hits to the overcollateralization are around the corner (more specifically, they are 100 bp around the corner!). While it is true that the excess spread and current loss statistics are annualized monthly numbers, so that a -200 bp differential really eats through only 16 bp of overcollateralization, rather than an entire 2% overcollateralization, a continuation of a negative differential eventually will gobble up the o/c and put the subordinate bond at risk.
103
104
Loss Severity
chapter 9
Loss severities measure how much of a mortgage is unrecoverable in the case of default. Loan size has likewise long been recognized as an important factor influencing loss severities on defaulted mortgages. The smaller the size of the loan, the greater the impact on severities of the fixed costs involved in foreclosing on a mortgage, and taking possession and then disposing of the property. In this chapter, we consider the impact of loan size on HEL loss severities, but take it a step further to investigate how important loan size was in explaining the poor performance of the 1997 and 1998 HEL vintages. Debates on the cause of the 1997-98 HEL debacle often revolve around the question of whether the culprit was bad origination or bad servicing. In this report, we introduce a third potential culprit: relatively small sized loans. Put differently, were the loans originated in those years that much worse than in other years, were they serviced that much worse than originations from other years, or was there simply a disproportionate share of very small loans originated in those years? We find that loan size alone irrespective of any other factor accounts for about half of the difference in loss severities between 1997 and 2002 originations.
WHY W ERE 1 997-9 8 V INTAGES S O B AD? 9
In analyzing the 1997-98 period in the HEL sector, many market participants ask, was the problem one of poor loan origination or poor loan servicing? Arguably, one could say the answer is both, but if those years were particularly weak in terms of the loans originated and how they were serviced, then the losses for those origination cohorts should be dramatically worse than those in other years. Indeed, the cumulative losses of the 1997-98 vintages are worse than for other vintages, but not as dramatically worse as one might have expected (Exhibit 1). For example, at month 72, the cumulative losses to date of the 1997 vintage is only 50 bp worse than the 1996 vintage1.
exhibit 1
CUMULATIVE LOSSES FOR 1997-98 VINTAGES ARE HIGH, BUT NOT DRAMATICALLY WORSE THAN OTHERS
Of course, these data are presented on an aggregated vintage average basis, and ignores that there are some issuers with dramatically worse performance, such as Southern Pacific, with 1997 vintage cumulative losses of 8.5% and 1998 losses of 11.4%. We have argued in other research reports that while cumulative losses are not dramatically different between the 1997-98 and more recent vintages, the dispersion of performance around the average is considerably greater for the 1997-98 origination years.
105
Loss Severity
There clearly are many differences between the quality of loans originated in 1997-98 versus those originated more recently. We have argued previously that the emergence and prominence of the dealer shelf programs has thus far resulted in better performance of the more recent vintages, and we would expect this to continue. Moreover, the 1997-98 period was characterized by thinly capitalized finance company lenders that relied on gain-on-sale accounting to generate stated income in an effort to optically enhance their income statements and with it, their equity market valuations. This provided an incentive for the issuers to generate volume at the expense of solid credit quality. The earlier vintages also were characterized by overly generous appraisals, which resulted in loss severities on those loans that did default that were greater than had been anticipated. And finally, we have seen more recently a market preference for servicing by deep pocketed entities that are able to withstand potential spikes in the amount of loan advances they may need to incur, should it become necessary.
IMPORTANCE O F L OAN S IZE
Exhibit 2 shows loss severities by loan size for each of the 1997 through 2002 vintages. Each box in the table reports the loss severity for that loan size/vintage combination, as well as the share of that vintages total issuance that falls into that respective loan size category. We also report the average loan-to-value ratio for each respective loan size/vintage combination to show that the high severities of the relatively small loan size buckets are not due to having relatively high LTVs (since they do not). Exhibit 2 includes only first lien, subprime mortgages.
exhibit 2
SMALLER LOANS HAVE HIGHER LOSS SEVERITIES THAN LARGER LOANS & OLDER VINTAGES HAVE A HIGHER SHARE OF SMALL LOANS
1997 Avg LTV Avg Severity % of Vintage Avg LTV Avg Severity % of Vintage Avg LTV Avg Severity % of Vintage Avg LTV Avg Severity % of Vintage Avg LTV Avg Severity % of Vintage Avg LTV Avg Severity % of Vintage Avg LTV Avg Severity % of Vintage Avg LTV Avg Severity % of Vintage Avg LTV Avg Severity % of Vintage 74.0 84 16.8 78.5 60 21.6 79.7 44 16.0 80.1 38 12.7 80.9 37 8.2 78.9 33 5.1 80.3 35 4.5 77.4 33 15.0 78.3 50.2 100 1998 73.9 82 16.9 78.7 59 20.2 79.7 46 15.7 81.4 39 12.0 82.0 35 8.6 80.7 33 5.2 80.8 35 4.4 79.6 34 17.0 79.0 49.7 100 1999 75.6 81 15.7 79.9 58 21.4 81.0 44 16.7 82.1 36 12.7 82.8 33 8.8 82.5 32 5.3 81.7 33 4.3 80.7 32 15.2 80.3 47.9 100 2000 72.4 79 13.0 77.7 57 19.8 79.5 42 16.4 81.1 34 13.4 81.8 31 8.7 82.0 29 6.0 80.0 29 4.9 80.1 27 17.9 78.9 43.6 100 2001 77.5 75 8.2 81.4 52 16.1 82.7 37 14.9 84.0 31 13.1 84.2 26 10.1 84.8 26 7.1 83.8 27 6.1 82.9 25 24.5 82.6 36.3 100 2002 77.8 70 4.7 81.5 48 12.9 82.5 30 12.9 84.0 26 11.9 84.0 23 10.2 84.9 24 8.1 84.0 21 6.7 84.3 22 32.7 83.4 29.3 100
Loan Size <=50,000 50,001-75,000 75,001-100,000 100,001-125,000 125,001-150,000 150,001-175,000 175,001-200,000 >=200,001 Vintage Average
106
Exhibit 2 shows us that relatively small loans clearly have a higher loss severity than the larger loans. Overall, loss severities on the more recent vintages are lower than on the older vintages, as the strong housing market and arguably, better lending and appraisal practices, have muted the severities. The average loss severities for the older vintages are greater than for the more recent vintages, but note how much greater the share of relatively small loans is for the older vintages: for the 1997 vintage, 38.4% of the loans had original size below $75,000 and 54.4% were below $100,000, compared to 17.6% below $75,000 and 30.5% below $100,000 for the 2002 vintage. We conclude that while loss severities for the more recent originations are lower than for previous vintages, some of the overall average vintage severity differential was due to the greater presence of small loans in the older vintages. How important for loss severities of the older vintages was the fact that they comprised a much greater share of small loans?
WHAT I F T ODAYS S IZE D ISTRIBUTION H AD Y ESTERDAYS S EVERITIES?
We want to break down the improvement in overall loss severities into the contribution due to the upward shift in the distribution of loan sizes and that due to the improvement in individual loss severities. To get at this, we computed the values in Exhibit 3. Exhibit 3 shows the theoretical resulting loss severities that would have occurred if there were no independent improvement in loss severity between 1997 and 2002, but rather the only difference between those vintages was the upward drift in loan size distribution. Put differently, if there were no improvement in underwriting standards, no improvement in the appraisal process, no emergence of dealer shelf programs, no improvement in servicing and no improvement in the housing market, and loss severities on the individual loan size buckets were the same each year from 1997 through 2002 and the only difference in those years was the move toward larger loan sizes, what would be vintage loss severities? Exhibit 3 computes the theoretical loss severities using the actual loan size distribution for each of 1997-2002 and the loss severities from the 1997 cohort2. Exhibit 3 shows that the shift in the loan size distribution from lower balance to higher balance loans alone lowers vintage loss severities by almost 9%. The actual decline in vintage loss severities from Exhibit 2 is almost 21%, so the decline due simply to the difference in the distribution of loan size is almost half 3.
exhibit 3
1997 SEVERITIES AND ACTUAL LOAN SIZE DISTRIBUTION LOWERS SEVERITIES BY ALMOST 9%
1997 50.2 1998 49.8 1999 49.7 2000 47.9 2001 44.3 2002 41.4
Vintage Avg Loss Severity
In the interest of space, we report in Exhibit 3 only the theoretical vintage average loss severities, but the entire table similar to Exhibit 2, except using the 1997 severities for each year 1997-2002 is available upon request. Exhibit 4 likewise reports only the vintage averages, but the entire table is available upon request. To be precise, the decline in vintage loss severities due solely to loan size is 42% = (50.2-41.4)/(50.2-29.3).
107
Loss Severity
HOW W OULD Y ESTERDAYS S IZE D ISTRIBUTION I MPACT OVERALL S EVERITIES?
In this section, we compute theoretical vintage average loss severities using the actual loss severities that resulted for each respective issue year/loan size bucket, but assuming the 1997 vintage loan size distribution remained unchanged from 1997-2002. The purpose of this is to see how much of the improvement in overall vintage average loss severity could be accounted for by the improvement in individual vintage/bucket severities, holding the loan size distribution constant. Put differently, if the distribution of loan sizes were unchanged from 1997 through 2002, but other factors that lowered loss severities such as improved underwriting, appraisals, servicing, housing market, emergence of dealer shelves, etc. had occurred, how would the vintage average loss severities look? This shows improvement due solely to improved severities.
exhibit 4
ACTUAL SEVERITIES AND 1997 LOAN SIZE DISTRIBUTION LOWERS SEVERITIES BY MORE THAN 12%
1997 50.2 1998 50.1 1999 48.4 2000 46.0 2001 42.1 2002 37.6
Vintage Avg Loss Severity
We see from Exhibit 4 that the improvement in the resulting theoretical vintage average loss severities due solely to improvements in the various aspects of the subprime mortgage and housing market discussed above holding loan size constant would have been more than 12%. The actual decline in vintage loss severities from Exhibit 2 is almost 21%, so the decline due simply to improvements in the mortgage and housing market is a bit more than half 4,5. We do recognize, of course, that the 1996 vintage has lower cumulative losses than those from subsequent years (Exhibit 1). The average severity for the 1996 vintage is 50% similar to that from the 1997 vintage and its loan size bucket severities and loan size distribution are broadly similar to those of 1997. The reason that its cumulative loss rate is lower than that of 1997-2000 is that its default rate is much lower than in those years in some cases by 200-300 bp. This suggests that the underwriting and lending process was considerably better for the 1996 vintage (prior to the dramatic increase in competition among lenders) compared to later origination years, but the appraisal process for 1996 originations may have been no better than in subsequent years as evidenced by the 50% average severity of the 1996 vintage. The analysis in this chapter examined severity in the event of default, rather than the causes of default, per se. While default and severity are the two components of loss rates for mortgages, we would argue that larger loan sizes are more likely to result in lower losses given default than are smaller loans.
4
To be precise, the decline in vintage loss severities due solely to improvements in the various aspects of the subprime mortgage and housing markets is 60% = (50.2-37.6)/(50.2-29.3). The 60% share attributable to improvements in the markets and market practices and the 42% share computed in the Footnote 3 do not add to 100% due to rounding, as slight differences in the numerator values can result in large changes in the calculated percentage attributions. Rather than focus on the exact percentages, it is more instructive to say that each accounts for about half (or slightly less than or greater than half, or 40%/60%). The specific percentages are less important than the realization that both aspects are important determinants of severity and loan size has not been previously discussed as a contributing factor to the credit performance of 1997-98 HEL vintages.
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CONCLUSION
Many different factors have been blamed for the very poor credit performance of the 1997-98 HEL vintages: bad underwriting practices, improper appraisals and weak servicing, to name a few. In this chapter, we advance another contributing factor, namely low loan balances for which the fixed costs involved in foreclosure, repossession and resale absorb a much larger percentage than with larger balance loans. We calculate that loan size alone accounts for almost half the improvement in vintage average loss severities from 1997 to 2002. While investors appreciate that relatively low loan balances contribute to better convexity characteristics, it is the higher balance, more negatively convex mortgages that should outperform from a credit standpoint based solely on their loan size, all else equal.
109
110
Credit Enhancement
The credit coordinates analysis (see chapter 22) has been helpful in comparing originator performance but one main flaw is that it does not incorporate credit enhancement levels. It is acceptable for certain originators to have worse credit performance, if the deals are structured to withstand it. In this chapter, we propose dividing current REO and foreclosure levels by the sum of current BBB subordination and annualized gross excess spread levels1. We felt that adding annualized gross excess spread to BBB subordination levels was appropriate since on average it takes approximately one year to liquidate a loan through the foreclosure/REO process. (FC+REO)/(BBB Subordination Levels + Gross Excess Spread).
ASSUMPTIONS
chapter 10
There are a couple of assumptions with this analysis about gross excess spread. Adding annualized excess spread to BBB subordination implies that LIBOR is constant for the next year, resulting in fairly stable excess spread for the next year. Since 2000, recently issued hybrid ARM deals have benefited from an increase in excess spread. Coupons on the bonds have declined as interest rates have fallen while the collateral remains fixed for the first two to three years. If interest rates increase, a reduction in excess spread could result for new hybrid ARM deals, assuming there is no interest rate hedge, as the collateral is typically fixed for the first two years. Although we have assumed that gross excess spread is constant, in fact, for older deals, gross excess spread may deteriorate. Typically, as lower-coupon more highly-rated bonds pay off, it leaves the structure with higher coupon bonds; thus, the gross excess spread typically deteriorates for older deals.
UNDERSTANDING T HE R ESULTS
We believe BBB investors should be paying attention to deals where the result is greater than 1 because we believe there could be real estate exposure (see Exhibit 1). We view this as a flag that should draw investors attention and prompt further investigation. We believe that investors should be asking servicers about 1) expected loss severities for the collateral and 2) the timing of liquidations. Understanding both of these items will be key to assessing whether there is true risk for the BBB bondholder. A low loss severity could eliminate most of the risk. For example, if you believe there will be a 25% loss severity on the foreclosure and REO properties, the ratio would then be reduced from 1.00 to 0.25. In addition, the timing of losses will be critical since a large amount of realized losses in a single month would potentially eat through excess spread, and into, or even through, overcollateralization. We recognize that servicer liquidation timelines can vary significantly but most try to adhere to the Freddie Mac foreclosure timelines. Although it might seem like a fairly safe assumption that liquidations occur at fairly stable pace throughout the year, reality is that some servicers may aggressively flush out the REO queue one month.
Gross excess spread is the excess spread available prior to the application of current losses.
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Credit Enhancement
exhibit 1
COMPARING BBB CREDIT ENHANCEMENT

Original Subordination Current Subordination BBB 1.3 1.6 4.0 3.5 80.3 77.7 44.0 39.0 AAA 98.4 53.6 AA 60.5 32.0 A 33.9 14.9 68.6 20.1 20.7 BBB 7.4 4.2 23.3 8.0 8.7 AAA 21.0 12.3 15.1 22.3 19.9 AA 12.5 7.6 9.2 15.4 12.2 A 7.1 3.8 4.6 10.0 7.6
Ticker 1999 ARM BSABS CWL MLMI NCHET SBM7 2000 ARM ABSLB AMSI CFAB CSFB CWL INHEL MLMI NCHET OOMLT SAST 2001 ARM ACE CFAB CFLAT INHEL SAST SBM7 2002 ARM CITHE CNFHE CXHE MLMI
19.0 20.0 14.2 18.0 14.2 15.2 14.8 22.0 21.0 17.8
11.5 11.8 8.6 11.8 7.9 10.4 10.3 14.3 13.8 9.7
5.8 7.3 3.8 6.5 3.8 5.8 6.0 7.8 8.3 4.3 2.1 2.0 3.3 3.5 2.2 2.5
54.6 68.5 54.4 62.5 54.8 47.6 65.8 77.2 82.3 61.2
34.4 40.2 35.7 43.0 32.4 33.1 45.7 50.0 53.9 36.1
18.9 24.8 19.8 26.6 18.2 18.8 26.8 27.2 32.3 19.6
5.4 8.6 7.0 6.3 5.2 5.2 8.9 11.4 13.7 9.9
13.7 11.3 10.7 4.5 16.0 20.0
6.0 5.9 6.5 2.3 8.3 11.5
5.0 2.3 2.8 2.8 6.3
3.0
38.0 23.0 26.9 10.6 42.1
16.8 13.2 16.9 5.8 24.7 19.8
7.6 6.5 8.1 1.6 12.3 10.8
8.2 2.9 3.1 1.1 6.2 6.0
3.5
34.5
17.1 20.8 17.6 25.0
10.8 13.5 10.6 18.0
5.4 7.5 5.8 10.8 6.0 3.0
27.7 27.7 22.7 38.2
19.1 18.9 16.8 27.5
11.9 11.7 10.3 16.4
4.7 6.3 2.7 9.2
1 Gross spread is net of servicing. Note: Data as of April 2003. Source: Morgan Stanley, Intex
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Current Bal 49,086,620 296,398,597 17,284,861 36,917,439 800,281,349
60+ Day Del 33.12% 21.07% 35.00% 17.20% 23.54%
F/C 13.07% 8.91% 6.40% 4.01% 7.23%
REO 4.41% 2.95% 7.60% 1.64% 3.55%
Curr Loss 4.42% 1.48% 4.60% 1.77% 3.45%
Cum Loss 3.45% 1.93% 1.35% 2.68%
Gross XS
FC+REO/ BBB Sub + XS 1.26 1.11 0.49 0.38 0.68
6.45% 6.47% 5.07% 6.77% 7.00%
417,239,537 414,758,163 353,018,164 335,829,725 666,743,266 200,373,793 77,150,712 122,521,421 25,511,457 351,871,203
33.10% 28.72% 16.39% 23.49% 22.97% 34.11% 22.64% 28.84% 25.95% 27.60%
10.70% 8.91% 8.10% 9.09% 10.30% 16.57% 7.36% 10.64% 13.48% 11.45%
7.13% 5.08% 2.16% 3.96% 3.03% 8.13% 2.71% 4.71% 6.66% 3.99%
3.49% 4.40% 1.95% 1.88% 3.48% 4.00% 3.80% 4.16% 4.31% 4.01%
1.41% 2.29% 1.28% 0.79% 1.87% 1.00% 0.91% 2.25% 0.79% 2.00%
8.30% 7.89% 7.87% 7.77% 7.36% 5.88% 6.83% 7.91% 8.09% 8.27%
1.30 0.85 0.69 0.93 1.06 2.23 0.64 0.79 0.92 0.85
224,000,082 1,295,131,399 531,421,228 338,025,706 579,535,226 14,641,651
22.60% 6.27% 8.84% 22.94% 17.41% 25.24%
7.88% 3.21% 4.68% 10.98% 7.49% 6.51%
3.75% 0.73% 0.91% 4.77% 2.43% 6.07%
0.48% 0.88% 1.04% 0.35% 2.55% 5.45%
0.33% 0.34% 0.22% 0.33% 0.70% 0.90%
8.16% 7.04% 5.99% 7.56% 8.17% 6.35%
0.71 0.40 0.65 1.83 0.69 1.02
409,503,744 169,871,652 1,068,202,743 128,107,825
7.82% 2.94% 2.34% 22.47%
2.02% 1.11% 0.98% 14.27%
0.71% 0.27% 0.15% 1.31%
0.32% 0.25% 0.02% 0.04%
0.03% 0.02% 0.01% 0.01%
6.37% 6.86% 7.13% 7.78%
0.25 0.10 0.12 0.92
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Credit Enhancement
exhibit 1
COMPARING BBB CREDIT ENHANCEMENT (CONTINUED)

Original Subordination Current Subordination BBB 3.8 1.8 4.6 3.0 AAA 50.2 37.6 23.0 34.0 37.1 32.7 AA 31.9 26.4 13.8 22.0 25.1 20.5 A 18.9 16.6 7.8 13.7 16.5 11.5 BBB 7.9 5.5 3.5 7.0 7.0 6.0 AAA 20.0 14.3 7.9 13.5 15.0 16.4 AA 13.0 10.1 4.3 9.6 9.0 10.3 A 8.0 5.6 1.8 6.8 4.8 5.8
Ticker 1999 Fixed ABFC BSABS CWL GECMS MLMI SBM7 2000 Fixed ABSLB CFAB CWL INHEL SAST 2001 Fixed ABFC BSABS CFAB CFLAT CNFHE CSFB RAFCO RASC SAST SBM7 2002 Fixed ABFS CFAB CITHE CNFHE CXHE
16.0 7.8 12.5 10.0 12.6
9.3 5.0 9.6 6.8 7.0
4.0 2.3 6.6 3.6 3.5 1.4 1.7
36.6 20.0 27.1 25.2 31.3
22.9 14.2 53.6 16.7 18.2
12.3 8.4 40.0 8.3 9.8
4.7 3.4 4.9 2.2 3.3
12.0 9.0 8.4 8.8 19.4 52.7 8.5 12.5 10.5
7.3 6.0 4.8 5.0 13.5 8.5 14.8 4.2 6.5 4.5
3.0 3.1 2.1 2.2 8.2 4.2 9.8 2.0 2.3 2.3 1.0 5.8 3.8
29.3 18.7 13.8 17.2 41.3 62.6 15.1 25.0 18.1
17.7 12.5 8.7 10.0 31.1 14.0 23.7 8.5 14.4 7.8
7.3 6.4 4.6 4.7 21.0 7.6 15.7 3.9 7.0 3.9
1.2 1.0 2.1 2.6 12.8 1.2 9.3 2.1 3.0 1.7
12.6 7.9 12.0 19.6 15.5
7.0 4.9 7.4 12.8 8.1
2.3 2.4 3.3 7.0 3.5 2.7 1.0
17.4 8.4 20.1 31.4 19.1
10.5 5.2 12.7 21.5 12.3
5.1 2.6 7.0 13.5 6.6
2.6 1.1 2.5 7.4 2.3
1 Gross spread is net of servicing. Note: Data as of April 2003. Source: Morgan Stanley, Intex
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Current Bal 50,157,479 110,593,348 192,876,967 375,154,377 49,874,261 100,572,034
60+ Day Del 15.70% 19.07% 10.55% 16.23% 13.91% 14.90%
F/C 2.99% 5.17% 3.89% 4.69% 3.98% 4.26%
REO 2.59% 2.64% 1.35% 2.45% 1.02% 1.89%
Curr Loss 3.77% 2.08% 2.09% 3.96% 3.51% 0.15%
Cum Loss 3.08% 3.08% 1.69% 2.01% 1.37% 3.77%
Gross XS
FC+REO/ BBB Sub + XS 0.60 1.17 1.00 0.83 0.59 0.63
1.50% 1.21% 1.70% 1.53% 1.49% 3.80%
184,970,599 200,043,519 170,843,217 166,953,485 534,823,534
26.28% 8.60% 12.43% 30.75% 22.62%
8.50% 4.28% 4.88% 14.95% 8.14%
5.46% 0.79% 0.94% 7.65% 4.15%
3.00% 1.73% 3.06% 3.76% 3.67%
1.32% 1.45% 2.08% 1.53% 2.97%
2.55% 1.78% 2.04% 2.21% 2.59%
1.93 0.98 0.84 5.16 2.10
95,754,734 173,234,712 549,818,281 689,931,741 661,436,430 133,158,479 552,560,129 1,083,774,486 536,950,669 41,233,550
13.75% 10.13% 4.31% 6.38% 7.78% 11.84% 12.07% 13.61% 14.63% 12.09%
3.82% 2.32% 2.04% 3.42% 7.03% 5.76% 3.39% 7.56% 6.46% 3.80%
2.12% 0.45% 0.53% 0.55% 0.00% 0.98% 1.31% 1.88% 2.66% 1.39%
1.62% 0.97% 0.92% 0.93% 2.29% 0.69% 1.02% 2.95% 1.73% 0.80%
0.39% 0.45% 0.30% 0.38% 1.50% 0.12% 0.47% 0.83% 0.87% 0.31%
3.38% 4.78% 2.86% 5.99% 4.38% 5.69% 5.23% 3.48% 3.12% 5.29%
1.29 0.48 0.52 0.49 0.41 1.05 0.32 1.69 1.49 0.74
686,250,928 1,201,434,964 1,055,624,128 814,626,384 770,023,668
3.18% 0.61% 8.24% 4.16% 2.23%
1.10% 0.31% 2.26% 2.68% 0.82%
0.07% 0.05% 0.64% 0.47% 0.27%
0.18% 0.10% 0.38% 1.15% 0.01%
0.01% 0.01% 0.10% 0.19% 0.02%
6.10% 3.21% 3.72% 6.36% 5.25%
0.13 0.08 0.46 0.23 0.14
115
116
Section IV Home Equity Handbook
The Structure
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118
Mezzanine & Subordinate Classes

In this chapter, we examine mezzanine and subordinate classes to ascertain their durability. We conclude that: Mezzanine and subordinate HELs perform very well even if trigger tests fail and the clean-up is not exercised. There is enough excess interest to withstand even a 300 bp increase in LIBOR. Although failing the trigger tests prevents the overcollateralization amount from being released, the coupon stepping up when the clean-up call is not exercised compensates for potential shortfalls due to cash flow timing and available funds caps. We derived an analytical framework of base case prepayment and loss scenarios based upon an examination of historical HEL ABS performance. We then stressed these base cases moving individual levers independently to isolate the impact of various elements on the performance of the securities.
Generic Transaction Structure
chapter 11
The collateral is a pool of 2/28 hybrid ARMs of 30-year maturity. We assume the note rate on the 2/28 ARMs is fixed at 8.6% for the first two years and then adjusts at LIBOR + 6.3% (with a floor of 8.9% and cap of 15.0%) in the subsequent years. We are using a representative HEL capital structure for our analysis: 80.75% AAA rated Class A, 6.50% AA rated Class M1, 5.00% A rated Class M2 and 5.75% BBB rated Class B, with 2% overcollateralization fully funded at issue and a NIM sized to 6.95% of the collateral balance1. The capital structure is shown in Exhibit 1.
exhibit 1
REPRESENTATIVE CAPITAL STRUCTURE OF HEL TRANSACTION
80.75% AAA
6.50% AA 5.00% A 5.75% BBB 6.95% NIM
2.00% O/C
In this analysis, we are ignoring prepayment penalties, which are pledged strictly to paying down the NIM.
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The coupon formulae for the bond classes are as follows: M1 (AA) M2 (A) B (BBB) 1 month LIBOR + 80 bp 1 month LIBOR + 140 bp 1 month LIBOR + 250 bp
Base Case Losses and Prepayments
Assumptions regarding prepayments and losses in the base case are listed in Exhibit 2. We arrived at these assumptions by examining prepayment and cumulative loss paths for several HEL transactions. For simplicity, the loss severity is 100%, so that defaults equal losses. The analysis can easily be modified upon request for any desired severity level by scaling the loss curve. The loss vector is presented as the percentage of total cumulative losses over the life of the deal occurring over an indicated time period. We assume that base case cumulative losses are 5%. Base case prepayments are taken to be 15% and 20% CPR, respectively, over the first two years, before jumping to 60% when the hybrid ARMs reset. After three months at 60% CPR, prepayments ramp down to 35%, where they remain for the life of the deal.
exhibit 2
BASE CASE PREPAYMENT AND LOSS ASSUMPTIONS

LOSS VECTOR Percent of Total Cumulative Losses Time Period
PREPAYMENT VECTOR CPR Time Period
15% 20 60 60=>35 35
12 months constant 12 months constant 3 months constant 12 months, evenly divided thereafter
0% 10 48 16 10 6 10
(%) 6 5 4 3 2 1
6 months constant Over 12 months, evenly Over 24 months, evenly Over 12 months, evenly Over 12 months, evenly Over 12 months, evenly Over 24 months, evenly
(%) 70 60 50 40 30 20 10 0 0 12 24 36 48 60 72 84 96
0 0 12 24 36 48 60 72 84
Note: Total cumulative losses over life of transaction assumed to be 5% in the base case. Source: Morgan Stanley
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Other Assumptions
Interest rates evolve according to the forward LIBOR curve. Of course, by using forward LIBOR, even the base case assumes that spot LIBOR will rise 175 bp over the next year, 320 bp in two years and 375 bp in three years. Our scenarios that shift LIBOR are in addition to the increases in LIBOR that already are embodied in todays forward LIBOR curve. Since mezzanine and subordinate classes are sensitive to credit, we made the following additional assumptions to stress our analysis: Delinquency trigger tests are failed Clean-up calls are not exercised Failing the delinquency trigger tests makes the principal payments sequential and causes the average lives of the mezzanine and subordinates to extend, but it also prevents the overcollateralization amount from being released, providing credit support to the subordinate classes2. Failure to exercise the 10% clean up call results in the coupon margin increasing by 1.5 times (for example, from 250 bp to 375 bp on the B class). Our base case results are displayed in Exhibit 3. This shows the principal paydown in percent of original class balance, for comparability for the mezzanine M1 and M2 and subordinate B. The discount margin for the M1 is 80 bp, while that of the M2 is 142 bp (2 bp above its margin) and of the subordinate is 274 bp. The DMs for the M2 and B classes increase because failing to call the deal results in their respective index margins increasing to 1.5 times their original level. For the M2, this is only relevant for seven payments, while for the B class, the stepped up coupon is in affect for its entire stream of 39 pay periods.
exhibit 3
BASE CASE PAYDOWN OF MEZZ AND SUB BONDS
In the particular scenarios that we ran, the average lives of the BBB rated Class B extended on the order of 2.5-4 years (depending upon the scenario), while the A rated Class M2 extended about 1-1.5 years, and the AA rated Class M1 generally either extended or shortened on the order of 0.5 year, depending upon the scenario.
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IMPACT O F L IBOR A ND P REPAYMENTS
We first isolate the impact of changes in LIBOR on the mezz and sub classes (i.e., assume that LIBOR shifts, but there are no resultant effects on prepayments). Then, we will isolate changes in prepayment speeds, assuming that interest rates are unchanged from the base case. By isolating these two factors, we will be able to zero in on the specific impacts of each. After we examine the partial effects of interest rates and prepayments, we will combine the two effects to analyze the mezz and sub classes under the more realistic case of changes in interest rates and prepayments.
LIBOR
Changing interest rates impacts the mezz and sub classes by affecting the size of the excess spread in the period prior to the collateral reset. As long as the collateral is in its pre-reset period, it is generating a fixed coupon, while the bond classes are subject to floating LIBOR. LIBOR falling or rising, then, increases or decreases the size of the excess spread. LIBOR movements are depicted as shifts in the forward LIBOR curve occurring over a 12-month period. We compare our base case scenario to three LIBOR scenarios: Down 100 bp Up 100 bp Up 300 bp The scenario in which LIBOR drops 100 bp is virtually identical to the base case, so we do not show it here separately. This makes sense: since the base case cash flow was sufficient to achieve all of the mezz and sub payments, lowering rates just gives the transaction a wider margin to meet its obligations, in terms of increasing the excess spread. Raising LIBOR 100 bp also results in cash flows that are virtually identical to the base case. Raising LIBOR 300 bp gets more interesting. Again, recall that the forward LIBOR curve already embodies an increase in spot LIBOR, and we are raising forward LIBOR by an additional 300 bp over 12 months. Since the collateral is generating a fixed coupon for the first two years, this situation results in the transaction hitting its available funds cap. Shortfalls in coupon accrue, but the failure of the trigger tests means that the overcollateralization amount is not released, and therefore cannot be used to make up shortfalls. None of the classes experiences a principal writedown, but the available funds cap does impact the discount margin, on the order of 12 bp for the M1, 20 bp for the M2 and 25 bp for the B. The average lives extend marginally, because there is less need to rebuild the overcollateralization amount, so less principal gets paid to the bond classes. These results are depicted in Exhibit 4.
Prepayments
Prepayments impact the mezz and sub classes in two ways: one, they reduce the amount of excess interest available to cover losses, and two, they more quickly reduce the bond balance at risk of loss.
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122
exhibit 4
MEZZ & SUB PAYDOWN WHEN LIBOR RISES 300 bp
Our prepayment scenarios adjust the base case speeds, but the time periods over which the speeds are applied are the same as in the base case. The following scenarios are shown in Exhibit 5: Faster: CPRs of 20%, 30%, 80%, 80%=>35%, 35% Slower: CPRs of 10%, 15%, 40%, 40%=>30%, 30% Base case: CPRs of 15%, 20%, 60%, 60%=>35%, 35%
exhibit 5
PREPAYMENT SCENARIOS
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The results of our fast prepayment scenario are shown in Exhibit 6 and the slow scenario in Exhibit 7. The average lives of the mezz and sub classes shorten and extend, respectively, relative to the base case, but not by a tremendous amount: 1.32 and 1.43 years for the M1, 1.51 and 1.67 years for the M2, and 1.30 and 2.08 years for the B. In neither scenario are there any principal writedowns or interest shortfalls. The paydown of the sub class under fast prepayments is the most interesting relative to the base case. Its average life shortens by 1.30 years compared to the base case, but it has a much longer tail; therefore, it receives the coupon step-up for a longer period of time. This results in its discount margin increasing by 13 bp relative to the base case. In the slower prepayment scenario, despite a slight extension of average life, the M1, M2 and B are similar to the base case, although the M2 and B have a slight reduction in DM due to the timing of cash flow.
exhibit 6
MEZZ & SUB PAYDOWN IN FAST PREPAYMENT SCENARIO
exhibit 7
MEZZ & SUB PAYDOWN IN SLOW PREPAYMENT SCENARIO
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LIBOR and Prepayments
Now that we have isolated the impacts of interest rates and prepayments, in this section we combine the two effects to get more realistic scenarios. The scenarios we consider are: LIBOR falls 100 bp and faster prepayments LIBOR rises 100 bp and slower prepayments LIBOR rises 300 bp and slower prepayments The results for the LIBOR rally/fast scenario are shown in Exhibit 8. The LIBOR rally/fast prepayment scenario for the M1 and M2 is very similar to their respective fast prepayment scenario. This is not too surprising, because recall that the impact of lower interest rates on their own was minimal. The situation for the sub class B is more interesting. Whereas in the fast scenario (with base case LIBOR), it experienced no writedowns, in the scenario that combines faster prepayments with a LIBOR rally, the sub class B faced a small writedown in months 101 and 102 totaling 0.5% of its original balance. This is due to the timing of fast prepayments diminishing the collateral base that generates excess spread relative to the evolution of losses. The interesting aspect is that, despite the small writedown of principal, the discount margin for the sub class B in this scenario is actually 9 bp higher than in the base case and only 4 bp lower than in the fast prepayment only (i.e., with base case interest rates) scenario. The step-up coupon owing to the failure to exercise the cleanup call offsets the drop in DM due to the writedown.
exhibit 8
MEZZ & SUB PAYDOWN IN LIBOR100/FAST PREPAYMENT SCENARIO
The scenario of slow prepayments in the context of a 100 bp LIBOR bear market results in bond cash flow not materially different from that of just the slow prepayment scenario. LIBOR rising, in and of itself, did not have a significant impact on the bonds, and when taken in conjunction with slower speeds, the overall affect was simply that of the slower prepayment scenario.
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On the other hand, the combination of slow prepayments and a 300 bp bear market shift in LIBOR had an interesting result. The DM and average lives of the mezz and sub classes are similar to the scenario of simply slow prepayments (with no shift in interest rates). However, compared to the scenario of only LIBOR up 300 bp (with base case prepayments), the DM profile is much better. The reason is that a 300 bp upward shift in rates with base case prepayments resulted in hitting the available funds cap, whereas with slower prepayment speeds, in addition to the rise in rates, the effect of hitting the available funds cap was offset by the step-up coupon and supplemental interest generated by the overcollateralization, as there is more collateral generating interest in the slow prepayment scenario. The cash flows are shown in Exhibit 9.
exhibit 9
MEZZ & SUB PAYDOWN IN LIBOR+300/SLOW PREPAYMENT SCENARIO
IMPACT O F C REDIT A ND L OSSES: M AGNITUDE A ND T IMING O F L OSSES
In this section, we consider explicitly the impact of credit by modifying the base case magnitude and timing of cumulative losses. When we consider changes in the magnitude of losses, we will keep the pattern in terms of percentage of total cumulative losses occurring over time unchanged. When we adjust the timing of losses, we will keep the magnitude of total cumulative losses unchanged.
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Magnitude
Exhibit 10 shows our scenarios for total cumulative losses as the following: Better credit: total cumulative losses drop to 3% of original balance. Weaker credit: total cumulative losses increase to 7% of original balance. Base case: total cumulative losses of 5% of original balance.
exhibit 10
Not surprisingly, lowering cumulative losses from 5% to 3% has a trivial effect on the mezz and sub cash flows. Average lives extend marginally because there is less need to rebuild the overcollateralization amount, requiring less bond paydown. What is more interesting is that when cumulative losses increase from 5% to 7%, M1 and M2 cash flows are almost identical to the base case. The B class extends about 0.5 year and its DM increases by 6 bp. The lack of a clean-up call has increased the index margin on the coupon, the effect being to raise the discount margin by 6 bp. Importantly, even in the 7% cumulative loss scenario, the sub class B does not experience any writedowns. This scenario is shown in Exhibit 11.
exhibit 11
MEZZ & SUB PAYDOWN IN WEAKER CREDIT SCENARIO
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Timing
Our scenarios for changes in the timing of the cumulative losses, with total cumulative losses the same as in the base case, are the following: Delayed losses: zero loss period for 12 months Accelerated losses: no zero loss period; losses begin immediately Base case: zero loss period for six months Accelerating or delaying the onset of losses had practically no impact on either the mezzanine or subordinate classes. Discount margins and average lives were at most trivially different from the base case, and the cash flows were likewise almost identical.
Summary of Scenario Results
Exhibit 12 compiles the various discount margins and average lives resulting from the scenarios that we ran; some of these are gathered from previous exhibits, while others that were similar to the base case did not appear explicitly in the text. These results will form the basis for our relative value discussion. The mezzanine and subordinate HELs performed very well under our stress scenarios, even assuming trigger tests fail and the clean-up call is not exercised. Failing the trigger tests prevents the over-collateralization amount from being released, providing an important source of credit support. Likewise, the coupon stepping up when the clean-up call is not exercised compensates for potential shortfalls due to cash flow timing and available funds caps. There is enough excess interest to withstand even a 300 bp increase in LIBOR.
exhibit 12
MEZZ & SUB SCENARIO SUMMARY: DISCOUNT MARGINS AND AVERAGE LIVES UNDER VARIOUS SCENARIOS
SCENARIOS Fast Prepay Slow Prepay
Class
Base Case
LIBOR100
LIBOR+100
LIBOR+300
M1 M2 B
80 4.17 142 5.09 274 6.72
80 4.16 142 5.09 275 6.72
80 4.17 141 5.10 272 6.73
68 4.32 122 5.37 249 7.71
80 2.85 143 3.58 287 5.42
80 5.60 141 6.76 270 8.80
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ANALYSIS O F S IX M EZZANINE & S UBORDINATE C LASSES
Many recent HEL deals have included six subordinate and mezzanine tranches (Exhibit 13). We believe that the inclusion of more intermediate tranches warrants further analysis as investors struggle to differentiate between single rating notches. In this section, we make adjustments for updated levels and the multiple degrees of credit risk currently available. Junior classes support above average cumulative losses. Mezzanine classes exhibit less extension risk. Classes usually weaken with faster prepayments. LIBOR and prepayment stresses produce similar cumulative loss breaking points. Collateral due-diligence remains important.
exhibit 13
Rating AAA AA A ABBB+ BBB BBBO/C
SAMPLE DEAL WITH SIX MEZZ/SUB TRANCHES

% of Deal 80.50% 6.40% 5.25% 1.75% 1.50% 1.05% 1.30% 2.25% Coupon 41 65 165 195 305 375 375 NA Price 100.00 100.00 100.00 100.00 100.00 98.87 83.93 NA DM 41 65 165 195 305 400 770 NA
SCENARIOS LIBOR100 Fast Prepay LIBOR+100 Slow Prepay LIBOR+300 Slow Prepay 7% Losses 3% Losses Delayed Loss Accelerated Loss
80 2.85 143 3.58 283 5.46
80 5.61 141 6.77 269 8.82
80 5.61 141 6.77 268 8.83
80 4.14 142 5.11 280 7.17
80 4.26 141 5.22 274 6.93
80 4.18 142 5.11 275 6.85
80 4.18 141 5.12 273 6.77
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exhibit 14
Statistic WAC Avg. Margin Avg. Balance WA LTV WA FICO ARM Source: Morgan Stanley
OTHER DEAL CHARACTERISTICS

Value 7.5% 5.6% $165,000 80% 600 78%
In addition to the structure above, we provide other basic characteristics that are representative of collateral backing current HEL ABS (Exhibit 14). Similar to many recent HEL deals, our collateral is predominately 2/28 adjustable-rate mortgages, but includes a substantial portion of fixed-rate mortgages. With regard to our loss curve, we use a timing curve identical to that used in previous examinations (Exhibit 15). Once again, we assume a 100% severity, so that defaults equal losses. Our prepayment curves for adjustable-rate mortgages have also been previously detailed. To adjust for the amount of fixed collateral currently included in the loan pool, we provide generic fixed-rate mortgage prepayment curves (Exhibit 15).
exhibit 15
PREPAYMENT AND LOSS ASSUMPTIONS

Prepayment Vectors ARM Fixed Base Case: CPRs of 4% to 23% over 12 months Faster: Base Case * 1.25 Slower: Base Case / 1.25
Base Case: CPRs of 15%, 20%, 60%, 60%=>35%, 35% Faster: CPRs of 20%, 30%, 80%, 80%=>35%, 35% Slower: CPRs of 10%, 15%, 40%, 40%=>30%, 30%
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With our sample deal detailed, we provide a framework for our analysis. All of our scenarios incorporate forward LIBOR. We felt that spot LIBOR did not provide an adequate or realistic stress. Forward LIBOR incorporates increases of approximately 100 bp per year over the next three years. Nevertheless, to further stress performance, later in this chapter we spike LIBOR an additional 300 bp on top of forward LIBOR over the next 12 months (Exhibit 15). We believe this to be a relatively extreme stress, as it would imply that LIBOR will exceed 5% within one year. Since mezzanine and subordinate classes are sensitive to credit, we made the following additional assumptions to stress our analysis: Delinquency trigger tests are failed Clean-up calls are not exercised Failing the delinquency trigger tests makes the principal payments sequential and causes the average lives of the mezzanine and subordinates to extend3. It also prevents the overcollateralization amount from being released, providing credit support to the subordinate classes. Certain subordinate bonds could perform worse if overcollateralization is first released, and then triggers fail. Nevertheless, we believe that most instances of severely underperforming collateral will cause triggers to fail.
Loss Vector Percent of Total Cumulative Losses 0% 10 48 16 10 6 10 Time Period 6 months constant Over 12 months, evenly divided Over 24 months, evenly divided Over 12 months, evenly divided Over 12 months, evenly divided Over 12 months, evenly divided Over 24 months, evenly divided LIBOR Assumptions Forward LIBOR Forward LIBOR +300 bp ramped-up over 12 months
Please refer to Chapter 14.
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Running the bonds to maturity, as opposed to exercising the clean-up call, allows for the full effect of losses. Failure to exercise the 10% clean-up call also results in the coupon margin increasing by 1.5 times (for example, from 305 bp to 457.5 bp on the BBB+ tranche). With our collateral and timing curves established, we calculate the resulting discount margin for each tranche as a function of final cumulative losses (Exhibit 16). The graph below depicts returns with the base prepayment curve, although we will discuss results under different prepayment assumptions later in this analysis.
exhibit 16
DISCOUNT MARGIN AS A FUNCTION OF CUMULATIVE LOSSES
Note: Negative returns not depicted in this graph Source: Morgan Stanley
As cumulative losses increase, the discount margins stay relatively constant; that is, however, until the breaking point. As expected, BBB- classes offer the highest discount margin with the lowest breaking point, while AA classes provide consistent returns under severe stresses. We should note that the resulting discount margins can become very negative, but we do not show negative returns for easier interpretation. There are some nuances to the graph which may not be easily interpretable. Many of the tranches exhibit a slight upward DM trend for a segment of rising cumulative losses. The reason for this is that the higher loss multiple extends the average life of the bond past the clean-up call date, allowing the coupon to step up.
exhibit 18
FASTER PREPAYMENTS WEAKEN BOND PERFORMANCE

First Principal Loss Base Fast Slow
AA A ABBB+ BBB BBB-
19.4 13.0 11.1 9.5 8.2 6.8
20.1 11.8 9.5 7.8 6.6 5.2
20.9 15.2 13.3 11.7 10.6 9.2
Note: NM = Not Meaningful as we did not calculate returns for AAA tranches in this exercise. Source: Morgan Stanley
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exhibit 17
SUBORDINATE TRANCHES CAN EXTEND WITH HIGH LOSSES
For some of the subordinate tranches, we notice a steep decline, followed by a period of relative steadiness, ending in a plummeting finish. While the final plunge represents principal write-downs, the initial descent is less obvious. In these instances, the available funds cap prevents each tranche from recognizing its full distributions. Under less severe loss scenarios, our collateral rebuilt overcollateralization and reimbursed cap shortfalls after cumulative losses peaked in period 102, but higher losses prevent the recouping of interest payments after the expiration of our loss curve. Extension risk is a concern to many investors and different tranches exhibit distinct payment behavior. Remember that our analysis assumes that the triggers fail, which automatically leads to the extension of subordinate classes. The most subordinate classes can extend quite rapidly, while mezzanine tranches retain comparable average lives in relatively severe loss scenarios (Exhibit 17). Exhibits 16 and 17 detailed performance for one set of assumptions, but prepayment speeds can have a profound effect. We calculate the cumulative losses for three significant events, finding that most bonds perform noticeably worse with faster prepayments (Exhibit 18).
DM Equals Zero Base Fast Slow
Higher Rated Tranche Outperforms Base Fast Slow
19.9 14.0 11.6 10.0 8.8 7.7
20.7 12.8 10.0 8.3 7.1 6.0
21.5 16.5 13.9 12.3 11.1 10.1
NM 13.7 11.1 9.6 8.4 7.2
NM 12.5 9.5 7.9 6.7 5.5
NM 16.1 13.4 11.8 10.7 9.6
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Under our base case assumptions, none of the rated classes will lose any principal unless cumulative losses reach 6.8%. Faster prepayments, however, lower this figure to 5.2%. Another significant threshold is the level of cumulative losses that cause the discount margin to reach 0 bp. This is depicted as crossing the x-axis in Exhibit 16. For example, BBB investors earn an effective return of LIBOR (0 DM) when cumulative losses reach 8.8% under the base case. We also calculated the point at which an investor would have been better off buying a higher rated tranche. This would be the point at which two lines cross in Exhibit 16. For example, under the base case, BBB- outperforms BBB with cumulative losses under 7.2%, even though some principal may be lost. As promised, we now consider performance after stressing forward LIBOR an additional 300 bp (Exhibit 19). Spiking LIBOR causes the breaking points to drop anywhere from 1.5-4.5% for each respective prepayment scenario. Under the most extreme stress, fast prepayments and spiking LIBOR, BBB- investors first incur principal losses if cumulative losses reach 3.7%. Nonetheless, we consider faster prepayments very unlikely in an environment of rapidly rising interest rates. It is difficult to ascertain the interest rate environment going forward, but we believe that HEL ABS investors are reasonably well protected in both environments. For example, with forward LIBOR and fast prepayments, BBBcan handle cumulative losses of 5.2% before incurring principal losses. On the other hand, with higher interest rates, prepayments would likely decelerate. Consequently, BBB- can handle cumulative losses of 5.9%. Bonds would really suffer from accelerating prepayment speeds and rising interest rates, but we consider that scenario unlikely.
exhibit 19
PERFORMANCE WEAKENS WITH LIBOR SPIKES

First Principal Loss Base Fast Slow
AA A ABBB+ BBB BBB-
15.6 10.1 8.3 6.7 5.6 4.5
16.4 9.3 7.4 5.9 4.8 3.7
17.0 11.5 9.7 8.1 7.0 5.9
Note: NM = Not Meaningful as we did not calculate returns for AAA tranches in this exercise. Source: Morgan Stanley
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Historical Performance
Exhibit 20 presents cumulative losses for various seasoned hybrid ARM issue year cohorts. We see from Exhibit 20 that cumulative losses on issue year cohorts do not often reach most of our calculated breaking points.
exhibit 20
CUMULATIVE LOSSES OF ARM HELS BY ISSUE YEAR COHORT
DM Equals Zero Base Fast Slow
Higher Rated Tranche Outperforms Base Fast Slow
16.0 11.0 8.6 7.1 5.9 5.0
16.7 10.2 7.7 6.2 5.1 4.2
17.5 12.6 10.1 8.5 7.3 6.4
NM 10.6 7.0 6.7 5.1 4.8
NM 9.8 6.6 5.8 4.4 4.0
NM 12.1 8.9 8.1 6.7 6.1
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To get greater detail on credit performance, Exhibit 21 presents a scatter plot of cumulative losses on all of the adjustable rate collateral groups from our HEL database. This scatter plot reports cumulative losses on 549 adjustable rate collateral groups from 491 HEL ABS transactions. Of the deals posting high cumulative losses, most are from originators that no longer securitize or are no longer in business, such as Superior, Amresco, Cityscape, Southern Pacific and UCFC, and are reflective of the relatively weak lending criteria of the late 1990s.
exhibit 21
CUMULATIVE LOSSES OF ARM HEL COLLATERAL GROUPS
136
NIMs
chapter 12
INTRODUCTION
Net interest margin (NIM) securities have become a staple of the home equity loan ABS sector. The NIM holder gets the excess interest cash flow after paying bond coupons and absorbing losses from a HEL transaction. Most, if not all, NIMs currently issued are backed by the cash flow from a single HEL transaction, whereas the previous generation of NIMs were backed by cash flow from multiple HEL transactions. Recent changes to the Net Interest Margin (NIM) bond structure make NIMs a more attractive investment. The first NIM bonds were created in 1994, backed by residual cash flows from manufactured housing securitizations. In 1997, NIM bonds backed by home equity residuals emerged. In this chapter, we will only discuss NIM bonds that are associated with home equity deals. To help investors remember the important aspects in analyzing and understanding NIMs, you can use the mnemonic (or as we like to call it, a NIM-onic) LOLLIPOP. LIBOR Movements in LIBOR affect the amount of excess interest available. Old NIM vs. New NIM New NIMs have prefunded overcollateralization, allowing the New NIMs to receive cash flow sooner. Losses Can affect excess interest and overcollateralization. Leverage Appetite for leverage will help determine the sizing of the bond. Interest Excess interest is one of the main sources of cash flow. Prepayments Prepayments can limit the amount of excess interest. Overcollateralization Releases of overcollateralization are another source of cash flow for the NIM. Penalty Fees Prevent many borrowers from prepaying and are a good source of income for the NIM.
OLD N IMS V S. N EW N IMS ( NIMLETS)
NIM structures have changed over time. For the purposes of this chapter, the term NIM will always refer to the New NIM or NIMlet structure, unless otherwise specified. The main difference between the Old NIM and New NIM is that the overcollateralization is prefunded for the New NIM. This allows the New NIM to start receiving cash flow right away, offering a superior structure to the Old NIM. The Old NIM required the underlying deals overcollateralization to build to its target level before cash flow could be released to the bondholder. The build-up of the overcollateralization was accomplished by paying the excess interest as principal to the underlying deals bonds. This limited the amount of cash paid to the Old NIM during the early years, a period when there are usually limited losses. As a result, the Old NIM structure only allowed investors to start receiving cash when losses were beginning to build. Losses would then limit the amount of cash available, affecting excess interest and overcollateralization. In addition, Old NIMs were often created after the underlying deal had aged. New NIMs are generally issued in conjunction with the underlying deal.
137
NIMs
In addition, New NIMs benefit from the advent of prepayment penalties. The current structure provides incentives for the issuers to enforce the collection of the prepayment premium.
FRAMEWORK F OR A NALYZING N IM S
There are three main factors in analyzing NIMs: 1) Prepayments 2) Losses 3) LIBOR These factors have an effect on the timing of the cash flow and the amount of cash available to pay down the NIM. In addition, these same factors have an effect on the original sizing of the NIM due to the rating agencies assumptions. Furthermore, the collateral characteristics (i.e., gross wac, prepayment penalties, quality of the collateral) and the structure affect the bonds cash flows. In this chapter, we will provide a framework for analyzing NIMs.
MAIN S OURCES O F C ASH F LOW F OR A N IM
The main sources of cash flow for a NIM are the following three items: 1) Excess interest 2) Prepayment penalties 3) Overcollateralization releases Currently, most of the collateral for the underlying deal consists of hybrid ARMs (which are commonly called 2/28 and 3/27 loans) and some fixed rate collateral. For the 2/28 loan, the interest rate is fixed for two years and then adjusts semiannually, indexed off 6-month LIBOR, for the remaining 28 years. The 3/27 loan is similar; it is fixed for the first three years and then adjusts semiannually,
exhibit 1
AN EXAMPLE OF A HEL STRUCTURE WITH A BB NIM
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indexed off 6-month LIBOR, for the remaining 27 years. The bonds for the underlying deal are typically floating rate, indexed off 1-month LIBOR. The NIM typically has a fixed coupon, but it can be floating rate if investors desire it.
Excess Interest
Excess interest is the difference between the net interest rate on the loans and the coupons on the bonds (see Exhibit 1, An Example of a HEL Structure with a BB NIM). In addition, excess interest is also generated from the overcollateralization, which does not have any corresponding bonds that accrue interest. During the past several years, interest rates paid by home equity borrowers have remained relatively steady. This contrasts with the decline in LIBOR in the short end of the curve which generates more excess interest by having lower coupons for the bonds. This greater portion of excess interest is due to the recent and successive Fed cuts. Exhibit 2 illustrates the projected difference in available excess interest due to stable interest rates paid by borrowers and the lower coupons paid on the underlying home equity deal. The liquidation of loans, whether or not losses are incurred, will decrease the amount of loans generating excess interest. In addition, if a defaulted loan generates a loss, excess interest will be used to limit the loss. Also, any excess interest will be used to bring the overcollateralization to its required level. In addition, prepayments limit the amount of excess spread available to the deal by limiting the amount of collateral available to generate interest. Prepayment penalties help to limit the amount of prepayments.
Prepayment Penalties
Before 1997, loan originators, who serviced the loans, often waived prepayment penalties in order to retain the borrower. Industry-wide enforcement of prepayment penalties became more common beginning in 1997-1998. Currently, the loan servicer/master servicer have an incentive to enforce prepayment
exhibit 2
AMOUNT OF EXCESS SPREAD HAS DRAMATICALLY INCREASED IN RECENT MONTHS
139
NIMs
penalties. If the loan servicer or master servicer does not collect the penalty from the borrower, the servicer or master servicer will have to pay the prepayment premium out of its own pocket. The prepayment penalty fees can create a significant amount of cash flow. Loan originators have sought a way to monetize this cash flow by creating a security, often called the class P, which is entitled to receive the prepayment premiums. These cash flows are not typically subordinate. We estimate 80-90% of current subprime collateral has prepayment penalties (see Exhibit 3). Prepayment penalties required by the borrower can vary. Typically, for prepayments in full, the prepayment penalty is six months interest on 80% of the loan balance. Generally, the borrower can prepay 20% of the balance per year without any penalty. The prepayment penalty period typically exists for the first 15 years of the loan, after which time the borrower can prepay without any additional cost.
exhibit 3
ISSUER
PERCENTAGE OF LOANS WITH PREPAYMENT PENALTIES

2000 1999 1998
First Franklin Long Beach New Century Option One Saxon
96 87 79 85 83
NA 88 79 84 75
NA 80 76 78 55
Note: Includes fixed and floating rate loans. Percentages for Long Beach and Option One based on loan balances funded during the year. Percentages for First Franklin, New Century and Saxon are based on loans securitized during the year. Source: Morgan Stanley, FFML prospectus, Long Beach, New Century, Option One, Saxon
Overcollateralization Releases
Overcollateralization of the underlying deal is funded at closing of that deal. Overcollateralization usually ranges from 1-3% of a deal. A portion of the overcollateralization can be released to the NIM during the life of the deal provided that certain conditions are met. Generally, before the step-down date (which usually occurs around the 36th month of the deal) overcollateralization releases to the NIM will not occur since the overcollateralization needs to be maintained at the original level. In the event that the NIM is not paid down, on or after the step-down date, overcollateralization may be released to the NIM according to certain formulas and trigger events for each deal. Assuming the NIM performs as expected, the NIM will likely be paid down before the 36th month since the NIMs average life is 0.8 to 1.0 years. Trigger events that would prevent the overcollateralization release are usually 60+ day delinquencies and/or cumulative losses reaching certain levels, respectively. These levels are determined in the prospectus. Tripping these trigger events could prevent the release of overcollateralization to the NIM.
140
INVESTOR-P AID M ORTGAGE I NSURANCE 1 P
The increase in investor-paid mortgage insurance has resulted in a decrease in loss coverage levels (i.e., subordination and overcollateralization). According to Standard and Poors, roughly 54% of the deals in first quarter of 2001 had investor-paid mortgage insurance. Although investor-paid MI is beneficial in reducing loss severities, it limits the amount of overcollateralization required at issuance; therefore, the amount of excess interest generated for the NIM is less, as well as the amount of overcollateralization that can be released to the NIM.
SIZING O F N IM
The sizing of the NIM is dependent on three parties: the rating agencies, investors and the dealer. This discussion of the rating agencies methodology touches on their analysis. For further discussion of each rating agencys methodology, please refer to the research pieces on their websites.
Rating Agencies
The rating agencies assumptions for losses, prepayments and LIBOR determine the size of the principal balance of the NIM. There are typically BB and BBBrated NIMs. The rating agencies use tougher stress case assumptions to obtain a BBB- NIM bond and as a result, a BBB- NIM has a smaller beginning principal balance. As part of these stress tests, the rating agencies also test the performance triggers that prevent the step-down or release of overcollateralization. The characteristics of each deal, the history provided by the originator of the loans, and whether prepayment penalties are guaranteed affect the assumptions that the rating agencies use. Although the loan characteristics influence the rating agencies assumptions for cumulative losses and severities the timing of the cumulative losses (see Exhibit 4) usually remains the same across different deals.
exhibit 4
EXAMPLE OF TIMING OF CUMULATIVE COLLATERAL LOSSES (AS % OF TOTAL LOSSES)1
S&P losses occur in monthly bullets for cash flow analysis and are only shown in the Timing of Cumulative losses graph. Source: Fitch, Moodys, S&P
1
For further discussion of investor-paid mortgage insurance, see chapter 16.
141
NIMs
The rating agencies will stress the cash flows to the NIM by using various levels of prepayments. The base case prepayment curves (see Exhibit 5 and 6) may change according to each rating agencys analysis of the loan characteristics and issuer history. In addition, the rating agencies may increase or decrease the value of the prepayment penalties based on rating level of the NIM bond, historical data and whether prepayment penalties are guaranteed. The amount of excess interest that is available can vary over time due to the difference in the interest rates paid on the underlying bonds and the interest rate paid by the borrower. Most of loans are hybrid ARMs, which are fixed for several years and then reset semiannually indexed off 6-month LIBOR while the bonds reset monthly indexed off 1-month LIBOR. This introduces an element of basis risk over the life of the deal. Fitch and Moodys use base case forward curve assumptions to analyze the excess spread (see Exhibits 7 and 8). In addition, the rating agencies will move these base case assumptions in order to address any potential basis risk that might limit the amount of excess interest spread. S&P uses a Monte Carlo simulation instead of forward curves to stress the amount of excess spread.
exhibit 5
EXAMPLE OF PREPAYMENT CURVE ARM
Source: Fitch, Moodys, S&P
exhibit 6
EXAMPLE OF PREPAYMENT CURVE FIXED
Source: Fitch, Moodys, S&P
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exhibit 7
1-MONTH LIBOR CURVES (AS OF 5/31/01)
Source: Morgan Stanley, Fitch, Moodys
exhibit 8
6-MONTH LIBOR CURVES (AS OF 5/31/01)
Source: Morgan Stanley, Fitch, Moodys
Investors & Dealers
Although the rating agencies determine the size through their deal-specific stress cases, investor appetite for leverage is an important determinant to NIM sizing. Since NIMs are typically private placements, investor input helps determine the sizing. If investors only want BBB- rated cash flows, then the size of the NIM will be smaller. Typically, the issuer will retain the post-NIM residual cash flows; thus, the issuer and the investors interests are aligned. The issuer will receive the residual cash flows after the NIM is paid in full; solid performance of the NIM benefits the investor and the issuer.
143
NIMs
ANALYZING P ERFORMANCE
A performance measure for analyzing NIMs is calculating how fast a deal delevers, i.e., how fast the principal pays down. Since most NIMs are private placements, it is difficult to have all the necessary information needed to analyze their performance. This exhibit provides information that is available on Bloomberg and these NIMs may or may not have all the characteristics that have been discussed in this piece, but we think it provides some data points for comparison. It is important to look at the three factors that influence NIM cash flows prepayments, losses and LIBOR individually. In addition, it is important to consider whether the factors would be positively or negatively correlated, i.e., is it likely that prepayments, losses and LIBOR move against you at the same time? The relationship between these factors (see Exhibit 9) generally holds true. As the economy slows, LIBOR is likely to decrease and prepayments are likely to rise if the borrower is beyond the prepayment penalty period. Losses are likely to rise more rapidly as home price appreciation slows and more borrowers are strapped for cash. The converse is likely in a growing economy.
exhibit 9
Factor
RELATIONSHIP BETWEEN FACTORS

Slowing Economy Growing Economy
Prepayments Losses LIBOR Source: Morgan Stanley
Increase Increase Decrease
Decrease Decrease Increase
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How NIMs are Impacted
We examine the mechanics of HEL NIM structures and how various factors, such as prepayments, interest rates and losses, impact the NIM cash flow. To consider the effects that each of these have on the NIM, we construct a generic NIM security and compute its cash flow and average life. We then adjust collateral parameters or market conditions, and compare the resultant cash flow and average life to those of the base case. We discuss the importance to NIM investment results of each of these factors.
Key Concepts
The most important factor impacting the NIM is the level of LIBOR. This impact can be ameliorated by the presence of a cap with the NIM. Prepayments were less important than LIBOR in determining NIM cash flow. Prepayments have two offsetting effects: faster speeds provide greater cash flow emanating from the prepayment penalties, but these ultimately get offset due to less collateral generating interest. Prepayment penalties are an important source of cash flow to the NIM. When we removed the cash flow from prepayment penalties from the loans in our collateral pool, the average life of the NIM extended considerably. The magnitude and timing of credit losses also affect NIM cash flows. Lower absolute levels of losses, and delays in the timing of realizing a given level of loss, result in faster paydown of the NIM.
Generic NIM Structure
Our NIM is backed by the cash flow from a generic HEL structure. The HEL is collateralized by a pool of 2/28 hybrid ARMs of 30-year maturity. We assume the note rate on the 2/28 hybrids is fixed at 8.6% for the first two years and then adjusts at LIBOR + 6.3% (with a floor of 8.9% and cap of 15.0%) in the subsequent years. We assume that 85% of the loans in the collateral pool have a prepayment penalty of six months of interest on 80% of the prepaid balance in the event that the borrower prepays his mortgage. The NIM is entitled to the prepayment penalty cash flow. The HEL transaction has an all-in coupon that adjusts to LIBOR + 67 bp, on a duration-weighted basis. The NIM was sized to 6.95% of the sum of the HEL bonds. We assume overcollateralization of 2%, all of which is present at the closing of the transaction.
145
NIMs
Assumptions regarding base case prepayments and losses are listed in Exhibit 10. These assumptions will be our working base case. We arrived at these assumptions by examining prepayment and cumulative loss paths for several HEL transactions. For simplicity, loss severity is taken to be 100%, so that defaults equal losses. Clearly, the analysis can be modified for any desired severity assumption by scaling the loss curve. The loss vector is presented as the percentage of total cumulative losses over the life of the deal occurring over an indicated time period. We assume that base case cumulative losses are 5%.
exhibit 10
BASE CASE PREPAYMENT AND LOSS ASSUMPTIONS

LOSS VECTOR Percent of Total Cumulative Losses Time Period
PREPAYMENT VECTOR CPR Time Period
15% 20 60 60=>35 35
12 months constant 12 months constant 3 months constant 12 months, evenly divided thereafter
0% 10 48 16 10 6 10
(%) 6 5 4 3 2 1
6 months constant Over 12 months, evenly Over 24 months, evenly Over 12 months, evenly Over 12 months, evenly Over 12 months, evenly Over 24 months, evenly
(%) 70 60 50 40 30 20 10 0 0 12 24 36 48 60 72 84 96
0 0 12 24 36 48 60 72 84
Note: Total cumulative losses over life of transaction assumed to be 5% in the base case. Source: Morgan Stanley
Base case cash flows are depicted in Exhibit 11, which shows the paydown of the NIM under the base case assumption. Note that the pool is half paid down by month 9, 75% paid down by month 17 and completely paid down by month 33. The NIMs average life is 0.99 year, and it was priced to a 10.21% yield.
146
exhibit 11
BASE CASE NIM CASH FLOWS
Note: Yield is 10.21%, Avg Life is 0.99 year. Source: Morgan Stanley
Impact of LIBOR and Prepayments
We now can look at the impact of various deviations from the base case and how these affect the NIM cash flow. First, we will isolate changes in LIBOR (i.e., assume LIBOR shifts, but there are no resultant effects on prepayment rates). Then, we will consider the impact of having a LIBOR cap in the NIM. Next, we will isolate changes in prepayment rates (i.e., assume prepayment speeds deviate from the base case, but LIBOR is unaffected). These two isolated cases will allow us to zero in on the partial effects of interest rates and prepayments. Then, we will combine the two effects to get the more realistic case of changes in interest rates and in prepayment rates. For the LIBOR analysis, we look at the scenarios of LIBOR moving: Down 100 bp Up 100 bp Up 300 bp Base case The LIBOR movements are depicted as shifts in the forward LIBOR curve occurring over a 12-month period. The results are shown in Exhibit 12. Note that with interest rates down 100 bp, the NIM average life shortens to 0.79 year, with 75% of the NIM paid down by month 14 and the NIM completely paid down by month 23. This is because lower interest rates on the HEL classes allow more cash to be diverted to paying down the NIM. When rates go up, of course, the opposite situation occurs, with average life extending to 1.41 years in the +100 bp scenario. Seventy-five percent of the NIM does not pay down in this case until month 31, and the NIM is not paid off completely until month 48. In the +300 bp case, there is insufficient cash to pay down the NIM, so an average life calculation is meaningless. Indeed, the yield drops from 10.21% in the base case to -7.54% in the +300 bp scenario.
147
NIMs
exhibit 12
IMPACT OF INTEREST RATES: NIM CASH FLOWS IN LIBOR SHIFT SCENARIOS
Before moving onto the prepayment effects, we consider a NIM with a LIBOR cap. The LIBOR cap is external to the NIM, but the NIM must be resized to accommodate the cap. While the NIM will of necessity be larger in the examples in which it has a cap, we will continue to represent the NIM cash flow as a share of the original NIM balance. In our example, we add a cap to the NIM, with a strike level of spot LIBOR = 2.25%. When LIBOR reaches 2.25%, the NIM is compensated with cash flow again, the cap is external to the NIM to make up for the reduced cash flow being diverted from the HEL bond classes to the NIM. Consider first the NIM in our base case, but with a cap added. The NIM with a cap is bigger than our original NIM, but it also has to pay for the cap; the result is less cash flow on a per annum basis to the NIM, causing the bond to have a longer average life 1.11 years than the uncapped NIM 0.99 year. The cap comes into play because our interest rate path is for forward LIBOR, and at a future date, forward LIBOR implies a spot LIBOR over 2.25%. A similar situation results for the -100 bp scenario: the average life is 1.08, but, again, be mindful that this capped NIM is larger than our original uncapped NIM. A more interesting situation occurs when LIBOR increases. In these situations, the cap provides the NIM with cash flows to compensate for higher LIBOR having to be paid on the HEL bonds. The NIM in the +100 bp scenario is essentially the same as in the base case with a cap (1.14 vs. 1.11 years). What is more interesting is that in the +300 bp scenario, the NIM with a cap actually has a shorter average life 1.05 years than the base case NIM with cap. This is because LIBOR is sufficiently high that the cap is generating more cash flow to the NIM than is diverted from the NIM to pay the HEL bonds. The relationship to NIM cash flow of the different interest rate scenarios in the example of the NIM with a cap is shown in Exhibit 13.
148
exhibit 13
IMPACT OF INTEREST RATES: NIM (WITH CAP) CASH FLOWS IN LIBOR SHIFT SCENARIOS
We now consider shifts in the prepayment vector, holding interest rates constant. While this may seem to be counterintuitive, this can be thought of as either a secular shift in prepayments owing to a change in an external circumstance or a mistaken initial prepayment assumption (i.e., we made an assumption on prepayments and we were wrong!). An external circumstance that may have a secular effect on prepayment rates may be, for example, a change in the willingness of lenders to finance the prepayment penalties on subprime loans that they are refinancing. This could cause prepayment rates to increase or decrease in the absence of interest rate shifts. Our prepayment scenarios adjust the base case speeds, but the time periods over which the speeds are applied are the same as in the base case. The scenarios are the following: Faster: CPRs of 20%, 30%, 80%, 80%=>35%, 35% Slower: CPRs of 10%, 15%, 40%, 40%=>30%, 30% Base case: CPRs of 15%, 20%, 60%, 60%=>35%, 35%
149
NIMs
Faster principal payments do not go to paying down the NIM; rather, the faster speeds amortize the HEL classes faster. Faster speeds affect the NIM in two ways: cash flow from prepayment penalties increases, which increases the paydown on the NIM, and collateral gets paid down faster, which reduces the amount of interest that it generates, lowering the present value of the interestonly strip. Slower prepayment speeds, of course, have the opposite effect. The results of the prepayment shifts are shown in Exhibit 14. Note that we have now returned to analyzing our original NIM, that is, one without a cap. In our particular example, the faster speed scenario actually marginally increases the average life of the NIM, from 0.99 year to 1.01 years. While this result seems counterintuitive, the reasoning reflects the two different ways in which prepayments impact NIM cash flow: faster prepayments kick off more cash flow owing to the prepayment penalties, but eventually, there is less collateral generating interest, which tends to slow the NIM paydown. As we see in Exhibit 14, in our particular example, the crossover point is month 19: at this point, the NIMs remaining balance in the fast speed case begins to exceed that of the base case. The opposite situation occurs in the slow prepayment scenario: at month 15, the NIM balance in the slow prepayment scenario is reduced below that of the base case, for similar reasoning as above. The average life in the slow prepayment scenario is 0.97 year, slightly below that of the base case, and the NIM pays down in the slow prepayment scenario four months sooner than in the base case. The exact magnitudes of paydown, average life and remaining balance crossover will, of course, depend upon the specifics of collateral and structure, but this example illustrates nonetheless how prepayment speeds have two opposite influences on the NIM paydown.
exhibit 14
IMPACT OF PREPAYMENTS: NIM CASH FLOWS IN PREPAYMENT SCENARIOS
150
We now combine the prepayment and interest rate effects to get the most realistic shift scenarios. These scenarios are: LIBOR falls 100 bp and faster prepayment vector LIBOR rises 100 bp and slower prepayment vector Base case In the bull market scenario, the NIM average life shortens both because lower LIBOR requires less cash to pay the HEL bonds, leaving more to pay down the NIM, and faster prepayments initially generate more cash from the prepayment penalties2. The average life shortens from 0.99 year in the base case to 0.80 year in this scenario, with 75% of the NIM paid down in only 14 months and the entire NIM paid off in 23 months. The bear market scenario has the opposite effect, with average life extending to 1.35 years. These results are displayed in Exhibit 15. It is clear that in this example, the NIM average life shortening in the bull market scenario was due primarily to the lower level of LIBOR, rather than to the faster prepayment rates. Indeed, comparing the paydown of the bull market scenario (lower LIBOR and faster prepayments) to that of just lower LIBOR shows the following: while both scenarios result in the NIM paying down 75% by month 14 and completely by month 23, the average life of the scenario when only LIBOR is lower is essentially the same as that of when both LIBOR is lower and prepayments are faster: 0.79 vs. 0.80 year.
exhibit 15
IMPACT OF INTEREST RATES AND PREPAYMENTS: NIM CASH FLOWS IN BULL, BEAR AND BASE CASES
Impact of Prepayments on 2/28 Mortgages
Next we examine how prepayments on NIMs of 2/28 mortgages behave. Using aggregated loan level data, we find that the expiration of prepayment penalties is more influential on prepayments than the reset date. Also, we have never witnessed 2/28 collateral in a rising rate environment, but we have seen prepayments spike to similar heights, despite materially different incentives to refinance.
As we saw in our previous example, the effect of faster speeds generating prepayment penalties may be offset in later months by there being less collateral remaining to generate interest cash flow.
151
NIMs
We find that: Prepayment speeds can heavily influence subordinate and NIM performance. Expiration of prepayment penalty outweighs importance of reset date. Prepayments exhibit similar spike regardless of incentive to refinance. NIM pricing curves can differ substantially.
exhibit 16
PREPAYMENTS SPIKE WHEN THE PENALTY EXPIRES
Note: For a tabular presentation of this data, please refer to the Appendix. Source: Morgan Stanley, Loan Performance
We find that loans without prepayment penalties exhibit faster speeds prior to the reset date than loans with penalties. At the reset date, all of the curves surge, but loans with two-year penalties clearly experience the largest increase. Since the reset date coincides with the penalty expiration for two-year penalties, it is difficult to determine which aspect influences prepayments more. Turning to 2/28 loans with three-year penalties, we see that the penalty expiration is significantly more important than the reset date. Prepayments for loans with three-year penalties only increase approximately 10 CPR at the reset date, whereas speeds increase about 30 CPR when the prepayment penalty expires. After the expiration of a penalty, loans exhibit faster prepayment speeds than loans that never had one. We attribute this to burnout of loans without penalties, as most of the borrowers that never faced prepayment penalties have already had ample opportunity to prepay. Conversely, many of the borrowers with prepayment penalties never considered prepayment a possibility until the penalty expired. As we mentioned before, 2/28 collateral only became mainstream a few years ago. Therefore, it is difficult to predict prepayments in a variety of rate scenarios because we have only witnessed performance in a declining interest rate environment. Nonetheless, we find that prepayments seem to spike regardless of the incentive to refinance.
152
When 2/28 loans originated in 1998 reset in 2000, most borrowers had a large incentive to refinance (Exhibit 17). For example, the average borrowers rate reset to 12-13%, but they could refinance into another 2/28 with an initial interest rate of 8-10%. On the other hand, when the loans originated in 2000-2001 reset two years later, many borrowers actually faced higher interest rates by taking out another 2/28 instead of keeping the rate floating.
exhibit 17
THE INCENTIVE TO REFINANCE DECREASED FROM 1998
Although the huge incentive to refinance at the reset date seemed to disappear, loans originated in 2001 peaked very similarly to those originated in 1998 (Exhibit 18).
exhibit 18
PREPAYMENTS SPIKE REGARDLESS OF REFINANCING INCENTIVE
153
NIMs
Prior to the reset date, the 2001 vintage actually exhibited higher prepayments, as borrowers looked to evade the relatively high rates associated with the fixed portion of the hybrid loan. This analysis considers a situation in which the incentive to refinance disappeared, not higher interest rates. We have not yet experienced an environment in which 2/28 borrowers would face significantly higher interest rates by refinancing. The refinancing incentive may not be as large, but subprime borrowers still have plenty of reasons to refinance. Credit curing is always an obvious justification, and a strong housing market propels the use of cash-out refinancings. Also, borrowers who expected a quick rebound in interest rates would benefit by locking in the low rates for at least another two years.
Assumption Comparisons
We have previously shown the ramifications of prepayment assumptions for NIMs, as well as subordinate HEL ABS. Prepayments can heavily influence the amount of loss protection available to bondholders, as well as the cash flow available to the NIM. Pricing assumptions during a typical HEL transaction offer minimal guidance on 2/28 prepayments, as most dealers employ a static assumption, like 25 CPR. Although subordinate HELs can also be very sensitive to prepayment assumptions, dealers are more precise during the pricing of NIM transactions. Most NIM term sheets include more complex vector analysis when analyzing prepayments for 2/28 collateral. We examined the prepayment assumptions for six different NIMs, finding quite a large dispersion among the various dealer assumptions (Exhibit 19).
exhibit 19
TWO-YEAR PREPAY PENALTY: ACTUAL VS. ASSUMPTIONS
154
Regarding loans with prepayment penalties, we see that most of the prepayment assumptions are slightly slower than the actual experience. One of the assumptions, however, is considerably faster than the others. Faster prepayments are normally a more conservative assumption as they reduce available excess spread. Thus, there is less excess spread available as cash flow to the NIM, or as protection to protect the subordinates from losses. Towards the later months, observed prepayment speeds are actually higher than many of the assumptions. Bond performance is usually less sensitive to speeds later in the seasoning process, as much of the collateral has already paid down.
exhibit 20
NO PREPAY PENALTY: ACTUAL VS. ASSUMPTIONS
The loans without penalties tell a similar tale (Exhibit 20), although some of the pricing curves surge excessively at the reset date. Once again, we find that the assumptions employed by the first curve show consistently higher prepayments in the front end. After analyzing a generic NIM structure with the various prepayment curves, we actually found little difference in bond performance (Exhibit 21). This, however, speaks more to the strength of NIMs than the similarities between the curves. As we have shown before, NIMs perform very well in spite of significant stresses. We continue to recognize NIMs as one of the cheaper cash flows available. One of the primary reasons that the analysis did not differ materially despite significantly different curves is that much of the NIM has already paid down before the curves diverge. Considering loans with 2-year penalties, Assumption #1 diverges from the pack in month 10. By that time, NIMs, especially the higher rated structure with lower leverage that we have seen most recently, are largely paid off.
155
NIMs
The difference in these curves could have substantially more impact when analyzing NIMs with more leverage because cash flows can extend well past the first year. Either way, investors should be careful in using certain NIM assumptions when analyzing any 2/28 collateral, as some curves are significantly more conservative than others.
exhibit 21
NO PENALTY 10.2 13.4 16.9 22.5 24.4 26.4 30.1 32.2 32.5 34.2 36.4 41.6 47.8 48.6 46.5 48.2 47.1 44.3 44.8 43.4 43.8 45.5 44.9 48.9 53.8 56.1 52.0 49.7 44.2 44.7 44.5 46.0 40.6 41.5 41.4 41.1 41.1 39.3 40.6 36.9 33.9 35.4 34.3 35.3 34.4 35.7 33.4 34.1
HISTORICAL EXPERIENCE OF 2/28 COLLATERAL

2-YR PENALTY 3.7 7.9 11.7 10.5 11.8 12.2 14.0 15.6 17.9 19.2 20.8 25.5 28.3 30.0 31.1 30.4 30.4 29.2 29.0 28.9 28.3 27.0 23.7 61.3 85.4 81.9 73.5 66.3 60.6 58.1 54.9 51.6 50.9 50.7 48.6 48.8 49.0 46.8 47.6 44.9 43.5 43.8 42.7 42.8 43.7 42.4 41.9 43.2 3-YR PENALTY 1.5 12.7 15.8 14.1 15.3 15.4 18.0 18.4 19.9 22.2 24.7 29.6 33.6 34.6 34.8 34.5 35.3 33.5 34.8 35.1 36.1 39.0 38.1 41.8 45.2 47.4 42.6 40.1 37.8 36.7 35.6 35.2 33.7 30.7 29.0 46.5 61.6 58.0 54.0 47.0 46.0 41.0 40.3 37.8 35.4 40.0 39.8 40.8
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48
156
Impact of Credit and Losses: Magnitude and Timing of Losses
We can do a similar analysis of credit quality adjustments by modifying the base case magnitude and timing of cumulative losses. When we consider changes in the magnitude of total cumulative losses, we will keep the pattern in terms of percentage of total cumulative losses occurring over time unchanged. When we adjust the timing of losses, we will keep the magnitude of total cumulative losses unchanged. First, consider changes in the magnitude of total cumulative losses. These are: Better credit: total cumulative losses drop to 3% of original balance Weaker credit: total cumulative losses increase to 7% of original balance Base case: total cumulative losses of 5% of original balance
exhibit 22
IMPACT OF LOSS MAGNITUDE: NIM CASH FLOWS IN BETTER CREDIT , WEAKER CREDIT AND BASE CASES
157
NIMs
Losses are absorbed by excess interest, so higher losses drain cash away from the NIM, slowing its paydown. For the scenario with 7% cumulative losses, the average life extends to 1.13 years, while in the 3% loss scenario, average life shortens to 0.91 year; these bracket the base case, with a 0.99 year average life and 5% cumulative losses (Exhibit 22). We also considered changes in the timing of the cumulative losses, with the total magnitude of cumulative loss the same as in the base case. These scenarios are: Delayed losses: zero loss period for 12 months Accelerated losses: no zero loss period; losses begin immediately Base case: zero loss period for six months
exhibit 23
IMPACT OF LOSS TIMING: NIM CASH FLOWS IN DELAYED LOSS, ACCELERATED LOSS AND BASE CASES
The impact of the timing of losses is shown in Exhibit 23. Accelerating losses reduces cash flow to the NIM in the earlier months. The result in our example is that the NIM extends, with its average life in the accelerated loss case being 1.20 years, compared to 0.99 and 0.89 year in the base and delayed loss cases, respectively. Likewise, the NIM is fully paid down in 37 months in the accelerated loss case, compared to 33 and 26 months in the base and delayed loss cases, respectively.
Impact of Prepayment Penalties
We also examined the impact of prepayment penalties on NIM cash flows. Most of the subprime mortgages that have been originated over the past few years contain prepayment penalties. Recall that our base case assumption is that 85% of the loans in our collateral pool have prepayment penalties, whereby the borrower would have to pay six months of interest on 80% of the prepaid balance. To look at the impact of penalties, we compare the base case to a situation where there are no prepayment penalties. The two cases we examine are: None of the loans have penalties Base case: 85% of the loans have penalties
158
The NIM cash flows in these scenarios are shown in Exhibit 24. Prepayment penalties increase cash flow to the NIM, resulting in faster paydown. All else equal, the NIM in our example collateralized by loans that do not have prepayment penalties extends to 1.33 year, with 75% not being paid down until month 27 and complete paydown not until month 46. Even the release of the overcollateralization amount after month 36 is not sufficient to completely pay down the NIM in the no-penalty case; it requires an additional 10 months to fully retire the NIM.
exhibit 24
IMPACT OF PREPAYMENT PENALTIES: NIM CASH FLOWS IN ZERO AND BASE PREPAYMENT PENALTY CASES
Conclusion
We examined the mechanics of NIMs from HEL transactions and investigated how various factors impact NIM cash flow and average life. In some of the examples, the magnitude of the impact was small, but we were more concerned about the direction of movement. We found that the most important factor impacting the NIM is the level of LIBOR. This impact can be ameliorated by the presence of a cap with the NIM. For example, a serious bear market scenario that may result in a NIM without a cap not being completely paid off could turn out to have little or no detrimental impact to a NIM that has a cap. Prepayments, in and of themselves, were less important than LIBOR. Prepayments have two offsetting effects: faster speeds result in additional cash flow emanating from the prepayment penalties, but these ultimately get offset due to less collateral available to generate interest. Prepayment penalties are an important source of cash flow to the NIM. We found that when we removed the cash flow from prepayment penalties from the loans in our collateral pool, cash flow from the average life of the NIM extended considerably. The magnitude and timing of credit losses also affect the NIM cash flows. Lower absolute levels of losses, and delays in the timing of realizing a given level of loss, result in faster paydown of the NIM.
159
160
Clean-Up Calls
Several investors have asked about whether they should price HEL bonds to the call. We examined both the servicers incentives to call a deal and actual historical experience. New issue deals are typically priced to the call, while bonds in the secondary market may be priced using yield-to-worst assumptions. Yield-to-worst means that a premium bond is priced assuming it is called and a discount bond is priced assuming it is not called. We provide a table that shows at what level of delinquencies and loss severity paying par to the bondholders breaks down. If it appears uneconomic to pay par to bondholders, a negotiated call is possible if the most subordinate bondholders agree.
HOW T HE C LEAN-U P C ALL W ORKS U
chapter 13
The most common types of clean-up calls are the following: The servicer has the right to purchase the mortgage loans and the REO properties when the mortgage loan balance for the entire deal is equal to or less than 10%1. The servicer has to make the bondholders whole at par plus accrued and any unpaid interest. The price paid for the collateral is 1) par plus accrued and unpaid mortgage loans plus 2) the lesser of the appraised value and the unpaid principal balance of the REO properties plus 3) all unreimbursed P&I advances, servicing advances, and servicing fees. Another type of clean-up call gives the servicer the same option as stated above, but if the servicer doesnt actually exercise the option on the first distribution date when the collateral balance equals or is less than 10%, the trustee is required to auction the collateral. The trustee will sell the mortgage loans and the REO properties if the proceeds are sufficient to pay the outstanding certificate balances, accrued and unpaid interest, unreimbursed servicing advances, delinquency advances, and compensating interest as required by the prospectus. If the clean-up call is not exercised at the first eligible distribution date, then the bond coupons are required to step up, i.e., increase. The size of the increase can range from 1.5 to 2.0 times the initial margin on a floating rate bond, but this can vary depending on the deal.
Currently, most clean-up calls can be exercised when the collateral balance equals 10% or less, but there are deals where the threshold for exercising is when the collateral balance equals or is less than 5% or 15%.
161
Clean-Up Calls
WHICH B ONDS A RE A FFECTED?
The bonds outstanding when the clean-up call can be exercised will depend on whether the triggers are passing or failing. If the deal is passing the triggers for the life of the deal, the last pay AAAs, the mezzanine and the subordinate bonds could be affected by the clean-up call. If the deal is failing its triggers for the life of the deal, then some of the mezzanine bonds and the subordinate bonds could be affected, depending on the level of subordination for each class. As we have discussed previously, passing delinquency triggers can be a sign of solid deal performance, but high 60+ day delinquencies can result even when a deal is passing the trigger threshold. This may deter a deal from being called. Later in this chapter, we analyze when it becomes uneconomical to call a deal due to a high level of delinquencies, and loans in foreclosure and REO. Both the primary and secondary markets often assume a clean-up call, but historically, only 55% of eligible HEL deals have been called. Empirically, we find that clean-up calls have varied by issuer, and have largely depended on collateral credit performance. For many ABS products, the optional redemption, or clean-up call, is nearly a foregone conclusion. As soon as the collateral balance declines below 10%, investors expect the residual holder to call the bonds, and issuers seem obliged to comply. As a result of the optional redemption, bondholders are paid out in full, and the trust is effectively dissolved. In the mortgage universe, however, the clean-up call decision often has more to do with financial incentives than concerns over reputation. Consequently, investors regularly assume that issuers will only exercise the optional redemption if it makes economic sense to do so.
exhibit 1
SLIGHTLY MORE THAN HALF OF ELIGIBLE DEALS HAVE BEEN CALLED
162
HEL has ties to both the mortgage and ABS market, and not surprisingly, we see mixed results regarding clean-up calls. Looking back at the 307 deals issued since 1995 that are eligible for optional redemption, we find that issuers have exercised the call option approximately 55% of the time (Exhibit 1). Certain issuance years, such as 1998, show somewhat differing results. With nearly half of the deals eligible for clean-up calls still outstanding, optional redemption is far from a certainty. Clean-up calls mandate that bondholders be paid in full, which makes the remaining collateral value quite material.
BENEFITS T O C ALLING T HE D EAL
Tighter payment window for investors. Eliminates servicers fixed costs of maintaining a low balance trust. Eliminates cost of step-up coupon. If the purchased loans are used in a future securitization, the loans could have better convexity and credit characteristics. If a deal is performing well, it could release tied-up OC. Assuming an upward sloping yield and credit curves, a new deal could benefit from the addition of seasoned loans from a called deal, creating more bonds on the short end of the yield and credit curves.
TO C ALL O R N OT T O C ALL
There are three main items that can affect whether a deal is called. 1) Interest rate environment 2) Credit performance 3) WAC
Interest Rate Environment
Even in a static interest rate scenario, there can be enough excess spread generated from HEL collateral to justify calling a deal. In a lower interest rate environment, it makes even more sense for the servicer to exercise the clean-up call for fixed rate collateral. The collateral is worth more as a result of the decline in interest rates, and despite the decline in interest rates, the servicer only pays par plus accrued and any unpaid interest to the bondholders. It is assumed that the loans purchased in the clean-up call will be resecuritized at a much lower interest rate.
Credit Performance
Even in a low interest rate scenario, poor collateral performance may deter a servicer from exercising the clean-up call. Clean up calls mandate that bondholders be paid in full, which makes the remaining collateral value quite material. Since the servicer must pay par plus accrued to the bondholders, it may not make economic sense to pay par depending on the level of delinquencies and projected loss severities.
163
Clean-Up Calls
exhibit 2
CALLED DEALS EXHIBIT BETTER PERFORMANCE
exhibit 3
HIGH DELINQUENCIES MAKE IT UNECONOMICAL TO PAY PAR

Required Price for the Performing Collateral
Target Price for the Entire Bond Balance: 100
Non-performing %
Performing %
30% Loss Severity for NPLs No OC O.5% OC 3.0% OC
40% Loss Severity for NPLs No OC O.5% OC 3.0% OC
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
99 98 97 96 95 94 93 92 91 90 89 88 87 86 85 84 83 82 81 80 79 78 77 76 75
100.30 100.61 100.93 101.25 101.58 101.91 102.26 102.61 102.97 103.33 103.71 104.09 104.48 104.88 105.29 105.71 106.14 106.59 107.04 107.50 107.97 108.46 108.96 109.47 110.00
99.80 100.07 100.36 100.66 100.96 101.27 101.59 101.92 102.25 102.59 102.93 103.29 103.65 104.02 104.40 104.79 105.19 105.60 106.01 106.44 106.88 107.33 107.79 108.27 108.76
97.36 97.64 97.93 98.22 98.51 98.82 99.13 99.44 99.77 100.10 100.44 100.78 101.13 101.50 101.87 102.25 102.64 103.03 103.44 103.86 104.29 104.73 105.18 105.64 106.12
100.40 100.82 101.24 101.67 102.11 102.55 103.01 103.48 103.96 104.44 104.94 105.45 105.98 106.51 107.06 107.62 108.19 108.78 109.38 110.00 110.63 111.28 111.95 112.63 113.33
99.90 100.28 100.68 101.09 101.50 101.93 102.36 102.81 103.26 103.73 104.20 104.69 105.18 105.69 106.21 106.74 107.29 107.85 108.42 109.00 109.61 110.22 110.86 111.51 112.17
97.46 97.84 98.23 98.63 99.04 99.45 99.88 100.31 100.76 101.21 101.67 102.14 102.63 103.12 103.63 104.15 104.68 105.23 105.79 106.36 106.95 107.55 108.17 108.80 109.45
164
Credit performance should impact the price, and consequently, the decision to exercise the clean-up call. On average, called deals had serious delinquencies of 20%, while the other deals posted an average of 30% (Exhibit 2). Based solely on the averages, the link between optional redemption and performance is very apparent. When looking at the distributions, however, the gray area between the averages becomes noticeable. For example, the correlation between clean-up calls and credit performance is less clear for deals with delinquencies between 2030%. Exhibit 3 shows the required price for the performing portion of the collateral if you assume that a servicer would pay 70 and 60 cents on the dollar for the nonperforming portion of the collateral. This is the required price for the performing collateral in order to pay par to the remaining certificates. Depending at what price the servicer can liquidate the loans in the whole loan market, the price level paid for the performing loans breaks down as the level of delinquencies and loss severity increases. In addition, the more overcollateralization available, the lower the price required to be paid for the performing collateral. In the past year, we have seen newly originated whole loan HELs trade between 105 and 106. We would not expect seasoned collateral to trade at such a high premium. (Such as the loans in a deal that could be called.) One item that is not included in the above analysis is the cost of financing servicing advances. Even when delinquencies are high, the servicer is incented to call the deal because the high cost of financing the servicing advances eats into the profitability of servicing the deal.
165
Clean-Up Calls
exhibit 4
VERY LITTLE CORRELATION WITH WAC
WAC
In addition to credit performance, the weighted average coupon (WAC) of the collateral should impact the price. Most collateral, especially fixed rate, will look less attractive in a rising interest rate environment. Unfortunately, given the limitation of only experiencing declining interest rate environments, the information that we can glean so far is somewhat limited. Bearing in mind that no adjustments have been made for credit quality or timing of origination, which both heavily impact WAC, we find no clear distinction between WAC and optional redemption (Exhibit 4). Thus, we know that clean-up calls are dependent on price, and we know that price is related to WAC, but we are unable to find a clear empirical relationship between WAC and clean-up calls.
exhibit 5
Bloomberg Ticker AACOT 1997-1 AMT 1996-D AMT 1996-B AMT 1996-C AMT 1996-A AMT 1997-C AMT 1998-B AMT 1997-B AMT 1998-A AMT 1995-B AMT 1997-D AMT 1995-C AMT 1995-D AMT 1997-A AMT 1995-A Source: Morgan Stanley, Intex
BETTER PERFORMING AAMES DEALS WERE CALLED

60+ Day Del 33.55 26.24 25.68 23.10 18.82 18.72 17.60 16.70 16.09 15.38 14.80 11.88 9.66 8.46 2.43 Call Date NA NA NA NA Aug-03 Nov-03 Nov-03 Nov-03 Nov-03 Aug-03 Nov-03 Aug-03 Aug-03 Nov-03 May-03
166
WHAT H APPENS I F I T A T F IRST A PPEARS U NECONOMIC?
If the deal is performing poorly, the likely result is that the servicer would do one of two things. The servicer would likely either negotiate with the holder of the R certificate and/or the lowest rated outstanding bonds to collapse the deal or try to purchase the subordinate bonds from the investor. In all likelihood, the bondholder has marked the bond below par already and would be willing to negotiate the price they would receive if the deal were called or to sell the subordinate bonds to the servicer.
CONCLUSIONS
Credit performance remains the strongest identified influence to the optional redemption decision. There is some issuer specific data which seems to validate this theory. For example, considering only the deals issued by Aames, we find that the worst performing deals are the ones that remain outstanding (Exhibit 5).
exhibit 6
Company Cityscape ContiMortgage Delta Funding WMC IMC First Alliance Equivantage Option One Superior Bank GE Provident Bank Salomon Brothers Amresco Countrywide Aames GMAC Southern Pacific KeyCorp Merrill Lynch UCFC Access Financial Equicredit Advanta Saxon The Money Store
CALL OPTION RELATED TO ISSUER

Total 6 13 5 5 13 11 9 8 13 5 5 26 8 8 15 19 10 6 6 13 7 14 10 8 10 Called 0 0 0 0 1 1 1 1 5 3 3 16 5 5 11 14 8 5 5 11 6 12 10 8 10 Not Called 6 13 5 5 12 10 8 7 8 2 2 10 3 3 4 5 2 1 1 2 1 2 0 0 0 % Called 0% 0% 0% 0% 8% 9% 11% 13% 38% 60% 60% 62% 63% 63% 73% 74% 80% 83% 83% 85% 86% 86% 100% 100% 100%
Note: Minimum of five eligible deals. Source: Morgan Stanley, Intex
167
Clean-Up Calls
Stratifying the data by issuer, we find that some issuers are considerably more likely than others to exercise the optional redemption. Most probably, credit performance is once again playing an important factor in this analysis. Some of the issuers infamous for poor performance head the list of uncalled deals: Cityscape, ContiMortgage, Delta Funding, and IMC (Exhibit 6). Most investors would probably be surprised to see that The Money Store heads the list of most frequently called deals. Despite having very high losses, this collateral actually had relatively reasonable delinquencies. Also, as First Union ultimately acquired this portfolio, the residual holder had enough liquidity to be able to call the deals. At the end of this section, we include a complete list of deals with factors less than 20% (Exhibit 7). Deals not yet eligible for the clean-up call are shaded in gray, while the other deals are not colored, whether or not the clean-up call was exercised. If the factor reads zero, then the deal has been called. We thought it was important to keep all of the deals in one list, as opposed to separating out the deals already eligible for the clean-up call. As a result, investors receive the entire picture for each issuer. For example, referring back to The Money Store, investors looking at the four remaining outstanding deals can easily see that the other previous ten deals have already been called. In addition, some issuers have stated that they would call a deal even if it is uneconomic because the market expects the deal to be called.
168
exhibit 7
HEL DEALS WITH FACTORS LESS THAN 20%

Bloomberg AACOT 1997-1 AMT 1995-A AMT 1995-B AMT 1995-C AMT 1995-D AMT 1996-A AMT 1996-B AMT 1996-C AMT 1996-D AMT 1997-A AMT 1997-B AMT 1997-C AMT 1997-D AMT 1998-A AMT 1998-B AMT 1998-C AMT 1999-1 AFMLT 1996-1 AFMLT 1996-2 AFMLT 1996-3 AFMLT 1996-4 AFMLT 1997-1 AFMLT 1997-2 AFMLT 1997-3 ACCR 1996-1 AMLT 1995-1 AMLT 1995-2 AMLT 1995-3 AMLT 1996-1 AMLT 1996-2 AMLT 1996-3 AMLT 1996-4 AMLT 1997-1 AMLT 1997-2 AMLT 1997-3 AMLT 1997-4 AMLT 1998-1 AMLT 1998-2 AMLT 1998-3 AMLT 1999-1 ABFS 1996-2 ABFS 1997-1 ABFS 1997-2 Factor (%) 4 4 4 5 13 18 6 11 11 14 16 19 13 12 14 60+ Day Del (%) 34 2 15 12 10 19 26 23 26 8 17 19 15 16 18 15 28 25 26 36 29 35 47 52 15 9 12 15 13 18 18 19 19 18 19 21 21 19 20 23 13 7 8
Issuer Aames Aames Aames Aames Aames Aames Aames Aames Aames Aames Aames Aames Aames Aames Aames Aames Aames Access Financial Access Financial Access Financial Access Financial Access Financial Access Financial Access Financial Accredited Advanta Advanta Advanta Advanta Advanta Advanta Advanta Advanta Advanta Advanta Advanta Advanta Advanta Advanta Advanta American Business Financial Services American Business Financial Services American Business Financial Services
Note: Deals not eligible for optional redemption are shaded in gray. Factors of zero mean the deal has been called. Cleanup call of 10% assumed, unless otherwise known. Source: Morgan Stanley, Intex
169
Clean-Up Calls
exhibit 7
HEL DEALS WITH FACTORS LESS THAN 20% (CONTINUED)

Bloomberg ABFS 1998-1 ABFS 1998-2 ABFS 1998-3 ABFS 1998-4 AMHEL 1998-1 EAGLE 1998-1 EAGLE 1999-1 EAGLE 1999-2 AMSI 2000-1 AMSI 2000-2 AMSI 2001-3 AMRES 1996-1 AMRES 1996-2 AMRES 1996-3 AMRES 1996-4 AMRES 1996-5 AMRES 1997-1 AMRES 1997-2 AMRES 1997-3 AMRES 1998-1 AMRES 1998-2 AMRES 1998-3 NBASI 1997-1 NCHLT 1997-1 BAYV 2000-1 BAYV 2000-B BSABS 1999-1 CARG 1995-M1 ELT 1995-1 ELT 1995-2 CXHE 1998-1 CXHE 1998-2 CXHE 1998-3 CITHE 1997-1 CITHE 1998-1 ASHEL 1998-1 CITYH 1996-1 CITYH 1996-2 CITYH 1996-3 CITYH 1996-4 CITYH 1997-A CITYH 1997-B CITYH 1997-C Factor (%) 16 18 19 15 5 5 10 13 19 17 19 6 8 7 10 10 13 5 7 17 17 5 14 16 19 16 12 6 7 7 8 14 9 8 60+ Day Del (%) 13 12 11 6 21 37 19 24 32 36 32 26 16 15 19 37 26 24 33 41 39 28 55 23 3 11 23 33 21 18 16 20 19 21 16 8 46 54 54 45 52 64 59
Issuer American Business Financial Services American Business Financial Services American Business Financial Services American Business Financial Services American Residential American Residential American Residential American Residential Ameriquest Ameriquest Ameriquest Amresco Amresco Amresco Amresco Amresco Amresco Amresco Amresco Amresco Amresco Amresco Bank of America Bank of America Bayview Bayview Bear Stearns Cargill Cargill Cargill Centex Centex Centex CIT CIT Citigroup Cityscape Cityscape Cityscape Cityscape Cityscape Cityscape Cityscape
170
exhibit 7

Bloomberg CNFHE 2000-A GTHEL 1997-B GTHEL 1998-A GTHEL 1998-C GTHEL 1999-A CONHE 1995-1 CONHE 1995-2 CONHE 1995-3 CONHE 1995-4 CONHE 1996-1 CONHE 1996-2 CONHE 1996-3 CONHE 1996-4 CONHE 1997-1 CONHE 1997-2 CONHE 1997-3 CONHE 1997-4 CONHE 1997-5 CONHE 1998-1 CONHE 1998-2 CONHE 1998-3 CONHE 1998-4 CONHE 1999-1 CONHE 1999-2 CONHE 1999-3 CWL 1996-1 CWL 1997-1 CWL 1997-2 CWL 1997-3 CWL 1998-1 CWL 1998-2 CWL 1998-3 CWL 1999-1 CWL 1999-2 CWL 1999-3 CWL 1999-4 CWL 2000-1 CWL 2000-2 CWL 2000-3 CWL 2000-4 CWL 2000-5 ABSHE 1998-LB1 ABSHE 1999-LB1 Factor (%) 10 12 13 19 3 4 5 5 6 6 5 6 8 7 8 8 9 11 13 15 19 18 17 20 6 9 10 15 18 15 14 18 17 13 17 13 60+ Day Del (%) 11 10 8 9 9 50 43 42 52 44 34 45 40 47 46 42 44 40 41 39 43 38 45 42 39 20 23 30 12 15 16 9 19 20 24 28 26 28 32 30 5 22 27
Issuer Conseco Conseco Conseco Conseco Conseco ContiMortgage ContiMortgage ContiMortgage ContiMortgage ContiMortgage ContiMortgage ContiMortgage ContiMortgage ContiMortgage ContiMortgage ContiMortgage ContiMortgage ContiMortgage ContiMortgage ContiMortgage ContiMortgage ContiMortgage ContiMortgage ContiMortgage ContiMortgage Countrywide Countrywide Countrywide Countrywide Countrywide Countrywide Countrywide Countrywide Countrywide Countrywide Countrywide Countrywide Countrywide Countrywide Countrywide Countrywide CSFB CSFB
171
Clean-Up Calls
exhibit 7

Bloomberg ABSHE 2001-HE1 CSFB 2000-HE1 CSFB 2001-S13 DLJAB 2000-2 DLJAB 2000-3 DLJAB 2000-5 DLJMA 2000-S4 DELHE 1995-2 DELHE 1996-1 DELHE 1996-2 DELHE 1996-3 DELHE 1997-1 DELHE 1997-2 DELHE 1997-3 DELHE 1997-4 DELHE 1998-1 DELHE 1998-2 DELHE 1998-3 DELHE 1998-4 ACE 1999-LB1 ACE 1999-LB2 ACE 2001-AQ1 ACE 2001-NC1 EHELT 1997-1 EHELT 1997-2 EHELT 1997-3 EHELT 1997-4 EHELT 1998-1 EQCC 1995-1 EQCC 1995-2 EQCC 1995-3 EQCC 1995-4 EQCC 1996-1 EQCC 1996-2 EQCC 1996-3 EQCC 1996-4 EQCC 1997-1 EQCC 1997-2 EQCC 1997-3 EQCC 1998-1 EQCC 1998-2 EQCC 1998-3 EQCC 1998-4 Factor (%) 18 17 16 11 14 18 5 6 7 8 9 7 10 12 12 15 17 19 19 12 13 17 15 12 11 13 16 17 10 13 16 18 20 60+ Day Del (%) 34 34 15 27 37 36 1 24 25 36 37 38 33 32 30 19 28 27 25 31 32 35 33 8 9 8 8 10 27 39 30 51 51 52 46 52 51 55 57 58 58 55 57
Issuer CSFB CSFB CSFB CSFB CSFB CSFB CSFB Delta Funding Delta Funding Delta Funding Delta Funding Delta Funding Delta Funding Delta Funding Delta Funding Delta Funding Delta Funding Delta Funding Delta Funding Deutsche Bank Deutsche Bank Deutsche Bank Deutsche Bank Emergent Mortgage Emergent Mortgage Emergent Mortgage Emergent Mortgage Emergent Mortgage Equicredit Equicredit Equicredit Equicredit Equicredit Equicredit Equicredit Equicredit Equicredit Equicredit Equicredit Equicredit Equicredit Equicredit Equicredit
172
exhibit 7

Bloomberg EQCCF 1996-A EQCCF 1997-A EQCCF 1997-B EQCCF 1999-A EQVA 1995-1 EQVA 1995-2 EQVA 1996-1 EQVA 1996-2 EQVA 1996-3 EQVA 1996-4 EQVA 1997-1 EQVA 1997-2 EQVA 1997-3 EQVA 1997-4 FCMLT 2000-1 FIHEL 1997-1 FAMLT 1995-1 FAMLT 1995-2 FAMLT 1996-1 FAMLT 1996-2 FAMLT 1996-3 FAMLT 1996-4 FAMLT 1997-1 FAMLT 1997-2 FAMLT 1997-3 FAMLT 1997-4 FAMLT 1998-1A FAMLT 1998-1F FAMLT 1998-2F FAMLT 1998-3 FAMLT 1998-4 FAMLT 1999-1 FAMLT 1999-2 FAMLT 1999-3 FAMLT 1999-4 FFML 1997-FF2 FFML 1997-FF3 FFML 2000-FF1 FFML 2001-FF1 FGHET 1997-2 FGHET 1998-1 CSHET 1995-1 CSHET 1996-1 Factor (%) 10 19 6 6 7 7 8 7 7 10 14 13 5 6 4 4 3 5 5 5 7 5 11 10 11 14 15 14 15 14 2 2 12 14 17 18 60+ Day Del (%) 52 49 43 53 3 21 18 20 14 18 24 29 31 30 50 28 9 1 6 9 11 16 23 10 10 12 17 10 9 14 9 18 10 12 16 12 21 32 32 37 34 0 -
Issuer Equicredit Equicredit Equicredit Equicredit Equivantage Equivantage Equivantage Equivantage Equivantage Equivantage Equivantage Equivantage Equivantage Equivantage Fairbanks Fidelity First Alliance First Alliance First Alliance First Alliance First Alliance First Alliance First Alliance First Alliance First Alliance First Alliance First Alliance First Alliance First Alliance First Alliance First Alliance First Alliance First Alliance First Alliance First Alliance First Franklin First Franklin First Franklin First Franklin First Greensboro First Greensboro First Union First Union
173
Clean-Up Calls
exhibit 7

Bloomberg FUHEL 1997-3 FURST 1996-1 FURST 1996-2 FCHE 1998-1 FCHE 1998-2 BBHE 1998-1 BBHE 1998-2 FREHE 1999-1 FREHE 1999-2 FREHE 1999-3 GECMS 1995-HE1 GECMS 1996-HE1 GECMS 1996-HE2 GECMS 1996-HE3 GECMS 1996-HE4 GECMS 1997-HE1 GECMS 1997-HE2 GECMS 1997-HE3 GECMS 1997-HE4 GECMS 1998-HE1 GECMS 1998-HE2 GECMS 1999-HE1 GECMS 1999-HE2 GECMS 1999-HE3 GMACM 2000-HE3 GMACM 2001-HE1 GMACM 2001-HE4 RASC 1995-KS1 RASC 1995-KS2 RASC 1995-KS3 RASC 1995-KS4 RASC 1996-KS1 RASC 1996-KS3 RASC 1996-KS4 RASC 1996-KS5 RASC 1997-KS1 RASC 1997-KS2 RASC 1997-KS3 RASC 1997-KS4 RASC 1998-KS1 RASC 1998-KS2 RASC 1998-KS3 RASC 1998-KS4 Factor (%) 14 8 9 8 14 18 18 9 13 15 9 9 11 10 12 13 15 15 19 20 19 10 11 16 1 5 7 8 13 60+ Day Del (%) 23 15 23 16 32 12 9 51 48 31 4 4 3 16 16 15 17 15 15 15 13 20 22 18 4 2 2 NA NA 5 8 NA NA 13 NA 19 24 18 17 20 22 21 22
Issuer First Union First Union First Union FirstCity FirstCity Fleet Bank Fleet Bank Freemont Freemont Freemont GE GE GE GE GE GE GE GE GE GE GE GE GE GE GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC
174
exhibit 7

Bloomberg RASC 1998-RS1 RASC 1999-KS1 RASC 1999-KS2 RASC 1999-KS3 RASC 1999-RS1 RASC 1999-RS2 RASC 1999-RS3 RASC 1999-RS5 RASC 2000-KS2 RFMS2 1996-HS2 RFMS2 1997-HS5 RFMS2 1999-HS2 RFMS2 2001-HS1 RFMS2 2001-HS2 RFMS2 2001-HS3 GNABS 1998-GN1 GNABS 1998-GN2 GNABS 1998-GN3 GPHE 2000-1 RMLT 1998-1 HLIB 1998-P1 HLT 2000-1 IMCHE 1995-3 IMCHE 1996-1 IMCHE 1996-2 IMCHE 1996-3 IMCHE 1996-4 IMCHE 1997-1 IMCHE 1997-2 IMCHE 1997-3 IMCHE 1997-4 IMCHE 1997-5 IMCHE 1997-6 IMCHE 1997-7 IMCHE 1997-8 IMCHE 1998-1 IMCHE 1998-2 IMCHE 1998-3 IMCHE 1998-4 IMCHE 1998-5 IMCHE 1998-6 IMCHE 1998-7A INMHE 1996-A Factor (%) 13 14 17 18 16 14 11 17 20 9 14 16 11 15 18 9 10 17 18 6 7 6 7 8 8 8 10 6 12 6 13 6 14 15 8 16 19 16 60+ Day Del (%) 14 25 24 27 12 19 8 30 30 2 1 1 4 2 2 6 8 18 6 24 13 11 44 47 56 43 66 56 54 61 63 54 73 56 70 52 36 52 70 52 52 45 18
Issuer GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC GMAC Golden National Golden National Golden National Greenpoint Greenwich Capital Home Loan Investment Bank Home Loan Investment Bank IMC IMC IMC IMC IMC IMC IMC IMC IMC IMC IMC IMC IMC IMC IMC IMC IMC IMC IMC IMC Independent National Mortgage
175
Clean-Up Calls
exhibit 7

Bloomberg INMHE 1997-A INHEL 1998-A INHEL 1999-A CFAB 1998-1 CFAB 1998-2 CFAB 1999-1 CFAB 1999-2 CFAB 1999-3 CFAB 1999-4 CFAB 2000-1 CFAB 2000-2 CFAB 2000-3 CFLAT 2001-C1 CHAMP 1996-1 CHAMP 1996-2 CHAMP 1996-3 CHAMP 1996-4 CHAMP 1997-1 CHAMP 1997-2 CHAMP 1998-1 CHAMP 1999-1 CHAMP 1999-2 CHAMP 1999-3 ARC 2000-BC1 ARC 2000-BC2 ARC 2000-BC3 ARC 2001-BC1 ARC 2001-BC2 ARC 2001-BC3 LHELT 1995-5B LHELT 1995-7 LHELT 1996-2 LHELT 1996-3 LHELT 1997-1 LHELT 1997-2 LHELT 1998-2 LHELT 1998-3 SASC 1998-2 SASC 1998-3 SASC 1998-4 SASC 1998-8 SASC 1999-BC1 SASC 1999-BC2 Factor (%) 7 14 15 16 18 20 18 18 18 18 9 11 12 12 12 14 18 18 15 18 15 6 6 8 5 9 9 10 16 7 6 9 11 11 60+ Day Del (%) 12 26 30 9 14 12 17 18 17 15 19 20 18 14 15 15 13 10 9 11 15 14 21 22 26 31 31 40 26 8 17 21 3 11 3 20 11 31 33 32 28 30 19
Issuer Independent National Mortgage Indy Mac Indy Mac JP Morgan Chase JP Morgan Chase JP Morgan Chase JP Morgan Chase JP Morgan Chase JP Morgan Chase JP Morgan Chase JP Morgan Chase JP Morgan Chase JP Morgan Chase KeyCorp KeyCorp KeyCorp KeyCorp KeyCorp KeyCorp KeyCorp KeyCorp KeyCorp KeyCorp Lehman Brothers Lehman Brothers Lehman Brothers Lehman Brothers Lehman Brothers Lehman Brothers Lehman Brothers Lehman Brothers Lehman Brothers Lehman Brothers Lehman Brothers Lehman Brothers Lehman Brothers Lehman Brothers Lehman Brothers Lehman Brothers Lehman Brothers Lehman Brothers Lehman Brothers Lehman Brothers
176
exhibit 7

Bloomberg SASC 1999-SP1 LIFE 1998-1 MELIT 1997-1 MELIT 1998-1 MLMI 1996-1 MLMI 1998-FF1 MLMI 1998-FF2 MLMI 1998-FF3 MLMI 1999-H1 MLMI 1999-H2 MLMI 2000-FF1 MSAC 2000-1 MSC 1997-1 MLNHE 1998-1 MLNHE 1998-2 FAIT 1997-NMC1 FAIT 1998-NMC1 RBMG 1997-2 RBMG 1998-1 RBMG 1998-2 RBMG 1999-1 RBMG 1999-2 NCHET 1997-NC5 NCHET 1997-NC6 NCHET 1999-NCC NCHET 2000-NC1 NCHET 2000-NCB NASC 1995-2 NHEL 1997-2 NHEL 1998-1 NHEL 1998-2 NHEL 1999-1 NHEL 2000-1 NHEL 2000-2 OCWEN 1997-OFS2 OCWEN 1997-OFS3 OCWEN 1998-OAC1 OCWEN 1998-OFS1 OCWEN 1998-OFS2 OCWEN 1998-OFS3 OCWEN 1998-OFS4 OCWEN 1999-OFS1 BLOCK 1997-1 Factor (%) 15 12 11 20 9 11 18 19 17 18 4 15 16 14 13 10 16 15 6 8 12 16 17 18 13 13 7 8 10 12 18 7 60+ Day Del (%) 34 17 10 10 15 19 12 56 21 51 49 35 7 18 16 46 32 33 25 27 23 31 12 19 37 34 49 19 15 13 14 10 7 15 18 26 10 37 23 36 39 31 31
Issuer Lehman Brothers Life Financial Mellon Bank Mellon Bank Merrill Lynch Merrill Lynch Merrill Lynch Merrill Lynch Merrill Lynch Merrill Lynch Merrill Lynch Morgan Stanley Morgan Stanley Mortgage Lenders Network Mortgage Lenders Network National Mortgage Corp National Mortgage Corp Net.B@nk Net.B@nk Net.B@nk Net.B@nk Net.B@nk New Century New Century New Century New Century New Century Nomura Novastar Novastar Novastar Novastar Novastar Novastar Ocwen Ocwen Ocwen Ocwen Ocwen Ocwen Ocwen Ocwen Option One
177
Clean-Up Calls
exhibit 7

Bloomberg BLOCK 1997-2 BLOCK 1998-1 BLOCK 1998-2 BLOCK 1999-1 BLOCK 1999-2 OOMLT 1999-1 OOMLT 1999-2 OOMLT 1999-3 OOMLT 2000-1 OOMLT 2000-2 OOMLT 2000-3 OOMLT 2000-4 OOMLT 2000-5 OOMLT 2001-1 OOMLT 2001-2 OPCTS 1995-2 OPCTS 1996-1 PAHEL 1997-1 PAHEL 1998-1 PAHEL 1998-2 EQABS 1997-1 EQABS 1998-1 PBHET 1996-1 PBHET 1996-2 PBHET 1997-1 PBHET 1997-2 PBHET 1997-3 PBHET 1997-4 PBHET 1997-B PBHET 1998-1 PBHET 1998-2 PBHET 1998-3 PBHET 1999-1 PSSF 1996-1 SBM7 1996-3 SBM7 1996-8 SBM7 1996-AFF1 SBM7 1996-LB1 SBM7 1996-LB3 SBM7 1997-AQ1 SBM7 1997-AQ2 SBM7 1997-LB1 SBM7 1997-LB2 Factor (%) 8 10 15 15 19 15 10 9 12 12 14 15 12 17 4 4 10 12 15 6 8 9 10 11 14 17 20 10 60+ Day Del (%) 37 46 31 40 34 14 24 24 44 28 37 45 37 27 33 24 23 29 32 28 14 13 44 68 34 36 31 33 1 29 32 34 30 9 12 30 7 27 25 14
Issuer Option One Option One Option One Option One Option One Option One Option One Option One Option One Option One Option One Option One Option One Option One Option One Option One Option One Pacificamerica Pacificamerica Pacificamerica Popular North America (Equity One) Popular North America (Equity One) Provident Bank Provident Bank Provident Bank Provident Bank Provident Bank Provident Bank Provident Bank Provident Bank Provident Bank Provident Bank Provident Bank Prudential Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers
178
exhibit 7

Bloomberg SBM7 1997-LB3 SBM7 1997-LB4 SBM7 1997-LB5 SBM7 1997-LB6 SBM7 1997-NC1 SBM7 1997-NC2 SBM7 1997-NC3 SBM7 1997-NC4 SBM7 1997-NC5 SBM7 1998-AQ1 SBM7 1998-NC1 SBM7 1998-NC2 SBM7 1998-NC3 SBM7 1998-NC4 SBM7 1998-NC5 SBM7 1998-NC6 SBM7 1998-NC7 SBM7 1998-OPT1 SBM7 1998-OPT2 SBM7 1999-3 SBM7 1999-AQ1 SBM7 1999-AQ2 SBM7 1999-LB1 SBM7 1999-NC2 SBM7 1999-NC3 SBM7 1999-NC4 SBM7 1999-NC5 SBM7 2000-LB1 SAST 1996-1 SAST 1996-2 SAST 1997-1 SAST 1997-2 SAST 1997-3 SAST 1998-1 SAST 1998-2 SAST 1998-3 SAST 1998-4 SAST 1999-1 SAST 1999-2 SAST 1999-3 SAST 1999-4 SPSAC 1995-1 SPSAC 1995-2 Factor (%) 3 2 10 6 11 7 6 15 7 17 16 6 5 15 17 15 9 10 12 14 15 11 12 14 18 13 60+ Day Del (%) 19 28 26 13 9 19 22 36 34 19 19 23 16 36 14 19 20 32 27 14 26 32 37 21 31 24 26 34 6 18 17 12 20 19 20 22 23 29 25 34 33 55
Issuer Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Salomon Brothers Saxon Saxon Saxon Saxon Saxon Saxon Saxon Saxon Saxon Saxon Saxon Saxon Saxon Southern Pacific Southern Pacific
179
Clean-Up Calls
exhibit 7

Bloomberg SPSAC 1996-1 SPSAC 1996-2 SPSAC 1996-3 SPSAC 1996-4 SPSAC 1997-1 SPSAC 1997-2 SPSAC 1997-3 SPSAC 1998-1 SPSAC 1998-2 AFC 1995-1 AFC 1995-2 AFC 1995-3 AFC 1995-4 AFC 1995-5 AFC 1996-1 AFC 1996-2 AFC 1996-3 AFC 1996-4 AFC 1997-1 AFC 1997-2 AFC 1997-3 AFC 1997-4 AFC 1998-1 AFC 1998-2 AFC 1998-3 AFC 1998-4 AFC 1999-1 TMSHE 1995-A TMSHE 1995-B TMSHE 1995-C TMSHE 1996-A TMSHE 1996-B TMSHE 1996-C TMSHE 1996-D TMSHE 1997-A TMSHE 1997-B TMSHE 1997-C TMSHE 1997-D TMSHE 1998-A TMSHE 1998-B TMSHE 1998-C UCFC 1995-A1 UCFC 1995-B1 Factor (%) 3 9 10 4 4 4 4 6 6 9 8 11 12 15 17 18 11 12 14 17 60+ Day Del (%) 22 17 18 17 20 19 24 29 25 14 13 18 13 30 11 37 28 31 24 29 26 32 36 31 34 27 38 15 11 14 16 15 13 16 20 18 15 19 15 16 17 2 8
Issuer Southern Pacific Southern Pacific Southern Pacific Southern Pacific Southern Pacific Southern Pacific Southern Pacific Southern Pacific Southern Pacific Superior Bank Superior Bank Superior Bank Superior Bank Superior Bank Superior Bank Superior Bank Superior Bank Superior Bank Superior Bank Superior Bank Superior Bank Superior Bank Superior Bank Superior Bank Superior Bank Superior Bank Superior Bank The Money Store The Money Store The Money Store The Money Store The Money Store The Money Store The Money Store The Money Store The Money Store The Money Store The Money Store The Money Store The Money Store The Money Store UCFC UCFC
180
exhibit 7

Bloomberg UCFC 1995-C1 UCFC 1995-D1 UCFC 1996-A1 UCFC 1996-B1 UCFC 1996-C1 UCFC 1996-D1 UCFC 1997-A1 UCFC 1997-B UCFC 1997-C UCFC 1997-D UCFC 1998-A UCFC 1998-AA UCFC 1998-B UCFC 1998-C UPMLA 1997-1 UPMLA 1999-1 UPMLA 1999-2 NAAC 1998-HE1 WIMLT 1996-4 WIMLT 1997-2 WIMLT 1998-3 WMCM 1997-1 WMCM 1997-2 WMCM 1998-1 WMCM 1998-A WMCM 1998-B WMCM 1999-A WMCM 2000-A Factor (%) 5 5 16 18 18 5 11 7 5 5 6 6 9 19 20 60+ Day Del (%) 9 9 6 5 6 5 10 8 20 20 17 7 20 21 22 33 34 16 6 12 10 33 43 39 43 45 21 24
Issuer UCFC UCFC UCFC UCFC UCFC UCFC UCFC UCFC UCFC UCFC UCFC UCFC UCFC UCFC United Panam United Panam United Panam Wells Fargo Wilshire Wilshire Wilshire WMC WMC WMC WMC WMC WMC WMC
181
182
Triggers
chapter 14
HEL ABS with subordinate classes often employ triggers that can greatly impact average lives. These triggers help direct principal cash flows as well as determine required enhancement levels based on the collateral performance.
TYPES O F T RIGGERS
Triggers typically compare collateral performance to a predetermined target on a monthly basis. For example, a trigger may compare reported cumulative losses to a static number or a schedule based on seasoning. If cumulative losses exceed the benchmark, the trigger is said to be failing.
exhibit 1
TEST NAME
TRIGGER TEST PERFORMANCE AGAINST A SPECIFIED TARGET

ACTUAL TARGET PASS/FAIL
DEFINITION
Example: Deal has seasoned 48 months. Cumulative Losses Trigger event occurs if cumulative losses as a percentage of the original balance exceeds the following schedule
Deal Age (mo)
4.325%
4.000%
Fail
<=48 4.0% 49-60 5.0% 61-72 6.0% 73-84 7.0% 85+ 7.5% Trigger event occurs if 60+ day delinquencies 24.317% as a percentage of the current balance exceeds 40% of the prior periods senior enhancement percentage1
28.432%
Pass
Senior enhancement percentage is defined as: (Remaining Pool Balance Senior Certificate Balance)/Remaining Pool Balance. Source: Morgan Stanley, Intex
1
An example of a deal trigger is shown in Exhibit 1. The first trigger compares cumulative losses to a rising target. The current cumulative loss figure of 4.325% is greater than the target of 4.000% based on 48 months of seasoning, so this test failed. The second trigger is a common example of a soft trigger, which accounts for approximately 68% of delinquency triggers. These triggers compare 60+ day delinquencies to a percentage of the senior credit enhancement, usually 40% or 50%. In our example, actual 60+ day delinquencies are lower than the target, so this test passed. As a deal pays down, the senior credit enhancement will rise (ignoring losses). As a result, the tolerable level of delinquencies in a soft trigger will grow proportionately to senior credit enhancement.
183
Triggers
In a hard trigger, however, the target is a fixed number, such as 18%. Approximately 19% of deals have hard triggers, while the remaining 13% compare delinquencies to the minimum of 1) an absolute percentage of delinquencies (hard) and 2) a percentage of the senior enhancement level (soft). Normally, triggers are said to be failing if either trigger is failing. In our sample scenario, the triggers are considered to be failing because the deal did not pass the cumulative loss trigger. The designation of pass or fail is not sticky, as a trigger can toggle between passing and failing from month to month. Next month the cumulative loss target is scheduled to rise to 5.000%, which means that the deal could pass both tests if credit does not deteriorate.
exhibit 2
Trigger Type
DELINQUENCY TESTS ARE THE PREDOMINANT TRIGGER

Number Percent
Delinquency Cumulative Loss Other Total Source: Morgan Stanley, Intex
353 125 16 494
71.5 25.3 3.2 100.0
Of the 239 senior/subordinate deals we examined, there were 494 triggers. Delinquency tests make up almost 72% of the 494 triggers. After delinquency tests, cumulative loss tests are the most common trigger, comprising 25% of triggers (Exhibit 2). The following types of triggers help comprise the remaining 3%: Rolling 12-month losses Rolling 12-month 60+ day delinquencies Excess spread Draws on the financial guaranty
STEP-D OWN D ATE D
Prior to a specified point in time, typically referred to as the step-down or crossover date, triggers have no effect. After the step-down date, however, triggers help determine principal distributions and required overcollateralization levels. Step-down dates are typically calendar dates specified at issuance occurring approximately 36 months later. Occasionally, step-down dates are worded to include an extra condition on top of the actual date. For example, senior bonds must amount to less than 60% of the collateral balance or the senior enhancement percentage must be at least 14%. If these conditions are not satisfied, the step-down date has not occurred, and the trigger tests are not meaningful.
184
DETERMINING O VERCOLLATERALIZATION
Many deals are funded with an initial amount of overcollateralization, usually in the neighborhood of 1.5% of the original collateral balance. This amount is to be maintained until the step-down date. Afterwards, assuming the triggers have passed, overcollateralization can step down to the lesser of 1.5% of the original balance or 3.0% (2 x 1.5%) of the current collateral balance, but never below 0.50% of the original balance. If the triggers fail, overcollateralization should remain at 1.5% of the original balance, which means it increases relative to the current balance.
exhibit 3
STEP-DOWN TRIGGERS ARE MORE STRINGENT THAN STEP-UP TRIGGERS

CUMULATIVE LOSS TRIGGERS Step-down Trigger Step-up Trigger NA NA 3.65% 4.75% 5.50% 6.00% 1.95% 2.70% 4.65% 5.50% 5.75% 6.25%
Month 1 12 13 24 36 48 49 60 61 84 85+
There are some deals that force overcollateralization to step up, instead of simply preventing it from stepping down. In this situation, there are two sets of triggers. If all triggers pass, the overcollateralization will step down. If only the step-down triggers fail, the required overcollateralization will remain at the original level. If all of the triggers fail, additional overcollateralization would be required. The step-up triggers often test the same performance variables, but failure occurs with much worse collateral performance (Exhibit 3).
DIRECTING C ASH F LOWS
Prior to the step-down date, all principal payments are directed to the senior classes. Afterwards, a portion of the principal is directed towards subordinate classes, provided that the triggers have not yet been breached (Exhibit 4). The principal is typically distributed such that each class maintains twice its original credit enhancement level.
185
Triggers
exhibit 4
PRINCIPAL PAY PATTERN: TRIGGERS PASS ALWAYS
Note: Clean-up call is not exercised. Source: Morgan Stanley
If the deal shows signs of credit weakness, triggers will fail and the structure will pay down sequentially. Principal payments will be directed solely to the senior class until a zero balance is reached, regardless of the step-down date (Exhibit 5). These graphs depict paying down an ARM structure, but a fixed-rate group would perform similarly.
exhibit 5
PRINCIPAL PAY PATTERN: TRIGGERS FAIL ALWAYS
If the triggers fail, all of the bonds extend except for the senior class, which receives all incoming principal and shortens about 0.75 years. The AA bonds extend about 0.5-1.0 year, while the average life of the BBB-rated class nearly doubles (Exhibit 6).
186
exhibit 6
TRIGGERS CAN SUBSTANTIALLY CHANGE AVERAGE LIVES

ARM Triggers Pass Triggers Fail 2.10 6.24 7.73 10.35 FIXED Triggers Pass Triggers Fail 3.34 6.45 6.38 6.21 2.59 7.39 9.05 11.22
AAA AA A BBB
2.81 5.77 5.67 5.42
COMPARISON O F D IFFERENT I SSUE Y EARS
Overall, we found that 56% of groups are currently failing at least one trigger test (Exhibit 7). Even though the step-down date is not until the 36th month, we performed the test to see how the unseasoned deals are performing. It is not surprising that only 34% of 2001 groups are failing their triggers since delinquency levels are relatively low due to seasoning and cumulative losses have yet to ramp up due to the length of the foreclosure process. Currently, 81% of the 1999 groups are failing.
exhibit 7
Vintage 1997 1998 1999 2000 2001 Total
OVER 80% OF 1999 GROUPS HAVE FAILING TRIGGERS

Groups 44 55 52 67 92 310 Trigger Fail 28 27 42 45 31 173 Failing % 63.6% 49.1% 80.8% 67.2% 33.7% 55.8%
PREPAYMENTS A ND S OFT D ELINQUENCY T RIGGERS
Since 1997, most ARM deals have been backed by a large portion of 2/28 collateral1. The 2/28 collateral typically experiences rapid prepayments around the reset date, with average industry prepayments hitting 55% CPR. This rise in prepayments results in rapid paydown of the AAA bonds; hence, the senior enhancement percentage increases significantly before the step-down date on the 36th month. As discussed, soft delinquency triggers compare 60+ day delinquencies to either 40% or 50% of the senior credit enhancement.
For 2/28 collateral, the borrowers rate is fixed for the first two years and then becomes adjustable, resetting semiannually to six-month LIBOR.
187
Triggers
To analyze this, we used slow, base and fast prepayment scenarios on a sample ARM HEL deal with 18% initial subordination to assess how various prepayment levels would affect the senior enhancement level prior to the stepdown date, assuming no losses. We used a prepayment vector to reflect the 2/28 prepayment patterns (see Exhibit 8).
exhibit 8
PREPAYMENT SCENARIOS
Our prepayment scenarios adjust the base case speeds, but the time periods over which the speeds are applied are the same as in the base case. The scenarios are the following: Faster: CPRs of 20%, 30%, 80%, 80%=>35%, 35% Slower: CPRs of 10%, 15%, 40%, 40%=>30%, 30% Base case: CPRs of 15%, 20%, 60%, 60%=>35%, 35% The prepayment scenarios result in dramatic differences in the senior enhancement percentage (see Exhibit 9). For a test that compares delinquencies to 40% of the senior enhancement percentage, there is a 22.77% difference in the delinquency threshold between the fast and slow prepayment scenarios. The difference is 28.46% for a delinquency test that compares to 50% of the senior enhancement percentage.
188
exhibit 9
AAA ENHANCEMENT LEVELS PRIOR TO STEP-DOWN

TRIGGER THRESHOLD FOR DELINQUENCY TEST 40% 50% 17.23 27.10 40.00 21.54 33.88 50.00
Scenario Slow Base Fast
Sr. Enhancement % 43.08% 67.76% 100.00% (AAA pays off)
This means that for a slow prepayment environment in which there are more AAA bonds remaining, delinquencies must be significantly lower than in a fast prepayment environment in order to pass the delinquency test.
exhibit 10
SERIOUS DELINQUENCIES INCREASE DURING THE FIRST 36 MONTHS
Delinquency tests are an effective early indicator of deal performance, presaging future cumulative losses. Nevertheless, we have started to see more deals emerge with both delinquency and cumulative loss triggers (Exhibit 10).
189
Triggers
For ARM collateral, 76% of triggers that include hard thresholds are failing compared with fixed collateral, where 42% are failing. Interestingly, for both fixed and ARM collateral, 38% of triggers are failing the senior enhancement delinquency trigger (see Exhibit 11). Historically, ARM delinquencies have been much higher than fixed rate delinquencies, even though ARM cumulative losses have been lower. This contributes to why the ARM collateral typically fails the hard delinquency triggers. Obviously, passing/failing is also dependent on the threshold level that is set for either the absolute trigger or the minimum trigger.
exhibit 11
ARM TRIGGERS TYPICALLY FAIL AGAINST FIXED THRESHOLDS

% Failing the Trigger ARM Fixed
Absolute or Minimum Triggers Senior Enhancement Source: Morgan Stanley, Intex
76% 38%
42% 38%
TWO T ESTS A RE H ARDER T HAN O NE
Of the 239 senior/subordinate deals we examined, 60% have only a delinquency test and 33% have both a delinquency and a cumulative loss test. Only 2% of deals employ only a cumulative loss test and 5% of deals employ some other combination of tests to monitor deal performance (see Exhibit 12).
exhibit 12
STAND-ALONE DELINQUENCY TESTS ARE COMMON

Total Percent
Delinquency Test Only Cumulative Loss Test Only Both Cumulative Loss & Delinquency Tests Other/Other Combination of Tests Source: Morgan Stanley, Intex
144 4 78 13 239
60 2 33 5 100
When we examined deals with both delinquency and cumulative loss triggers that are currently past their step-down date, 97% of deals are currently failing one of their trigger tests (see Exhibit 13). This compares to only 37% of deals with just a delinquency test. If these two-test deals just had delinquency tests, 69% would fail and if they just had cumulative loss tests, 80% would fail.
190
exhibit 13
TWO-TEST DEALS ARE FAILING AFTER THE STEP-DOWN

Before Step-down Date Pass Fail Total After Step-down Date Pass Fail Total
Delinquency Only Delinquency & Cumulative Loss Source: Morgan Stanley, Intex
47% 40%
53% 60%
100% 100%
63% 3%
37% 97%
100% 100%
For mezzanine and subordinate investors, more stringent trigger tests can have mixed effects. Failing triggers cause the average lives to extend, but on a positive note, the release of overcollateralization is prevented, providing greater protection from losses.
DELINQUENCY T RIGGER T HRESHOLDS
Many investors pay close attention to the type of delinquency trigger used in the structure, realizing that performance can differ greatly by type. Historically, we find that soft delinquency triggers have had considerably higher passage rates. Going forward, we calculate the soft delinquency threshold in a variety of prepay environments, determining that soft delinquency thresholds will only be less lenient if prepayments slow down considerably.
Summary
Industry has largely switched to soft delinquency triggers. Soft triggers pass more often than hard triggers. Senior enhancement increases significantly after 2/28 reset date. Hard trigger more stringent unless considerably slower prepayments. Triggers can greatly impact HEL ABS performance by directing cash flows and setting overcollateralization requirements2. There are a variety of different types, and deals often include multiple triggers, but delinquency triggers are the most common. In looking to compare and contrast delinquency triggers, we will examine three basic types. Hard delinquency triggers are the simplest, comparing delinquencies to a static figure, such as 16% (Exhibit 14). Alternatively, soft triggers typically use a percentage of senior credit enhancement as a threshold. The third type of delinquency trigger that we will examine encompasses a combination of both hard and soft triggers. Historically, hard delinquency triggers were the most common, but since 2001, soft delinquency triggers have outnumbered the other types (Exhibit 15). Combo triggers remain infrequent, with usage dropping over the past few years.
For more information on the basics of HEL triggers, please refer to Morgan Stanley Home Equity Handbook 2004 Edition, Chapter 11: Trigger Mechanics.
191
Triggers
exhibit 14 Type Hard Soft Combo
THREE DIFFERENT TYPES OF DELINQUENCY TRIGGERS

Example 60+ Day Del > 18% 60+ Day Del > 40% Senior Enhancement 60+ Day Del > Min (40% Senior Enhancement or 18%)
Note: All of our examples specify 60+ day delinquencies, but other variations include 90+ day delinquencies or the three-month average of 60+ day delinquencies. Source: Morgan Stanley
exhibit 15 1995 18 0 0 18 1996 55 0 0 55
SOFT DELINQUENCY TRIGGERS ARE MORE COMMON NOW

1997 65 33 1 101 1998 101 53 6 160 1999 83 36 10 131 2000 75 50 7 136 2001 50 107 3 164 2002 2003 68 19 149 53 0 0 225 73 Total 534 481 27 1063
Hard Soft Combo Total
Moving to the historical performance of these triggers, we find that 67% of soft triggers are passing, while only 36% of hard triggers are currently passing (Exhibit 16). We believe that these figures are somewhat misleading, as the recent increase in the use of soft delinquency triggers influences the performance averages. Triggers of unseasoned deals are more likely to pass, thereby boosting the passage rate for soft delinquencies. Looking on a yearly basis, we find that the passage rate for unseasoned cohorts is roughly similar, but soft triggers do consistently show a higher passage rates in older vintages.
SOFT TRIGGERS POST HIGHER PASSAGE RATES
1997 18% 67% 100% 36% 1998 37% 58% 50% 44% 1999 28% 39% 10% 30% 2000 16% 38% 0% 24% 2001 32% 62% 0% 50% 2002 2003 90% 89% 80% 92% NA NA 83% 92% Total 36% 67% 19% 50%
exhibit 16 1995 6% NA NA 6% 1996 22% NA NA 22%
Hard Soft Combo Total
192
It is not surprising that the combo triggers post the lowest passage rates, as many come from older vintages. Also, the combo trigger is essentially testing both a hard and a soft delinquency trigger, and if either one fails, the combo trigger will fail.
Quantitative Comparison: Hard vs. Soft
We calculated that the soft delinquency trigger passage rate has been considerably higher for seasoned vintages. Realizing that this has been an environment of fast prepayments, we look to compare thresholds under a different prepayment environment. We start with some generic assumptions, including a typical capital structure and prepayment curves (Exhibit 17). The ARM prepayment curve is derived from a previous loan level examination of 2/28 collateral with two-year prepayment penalties3, while the fixed rate curve is loosely based on the 2000 vintage.
exhibit 17
GENERIC BASE CASE ASSUMPTIONS
Source: Morgan Stanley, Intex, Loan Performance
Please refer to Morgan Stanley ABS Perspectives, 2/28 NIM Assumptions, March 5, 2004.
193
Triggers
The fixed rate prepayments are slightly higher than the assumptions employed in most NIM pricing scenarios, but we believe that it reflects current fixed rate prepayment trends. We also factor in a 5% cumulative loss vector, which is not shown because small variations will not greatly impact senior credit enhancement. In addition, many deals employ cumulative loss triggers, so massive upward loss adjustments would make the delinquency triggers immaterial as the cumulative loss trigger would likely fail. Using these generic assumptions, we calculate the different delinquency thresholds as the deal seasons. In the earlier months, the soft delinquency trigger is more stringent, but as the deal seasons, the trigger threshold becomes significantly higher. After 41 months, the senior class has paid off and the threshold reaches the maximum of 40%4.
exhibit 18
SOFT DELINQUENCY THRESHOLDS ARE HIGHER AS STEPDOWN DATE APPROACHES
Source: Morgan Stanley, Intex, Loan Performance
It is important to note that these triggers do not actually have significant importance until after the stepdown date. Nevertheless, by showing that the threshold is higher for hard triggers in earlier months, we can reason why hard triggers may post a slightly higher passing percentage in unseasoned vintages. We also see that the soft delinquency trigger threshold will increase dramatically after 24 months, coinciding with faster prepayments at the 2/28 reset date (See Exhibit 18). A variety of adjustments can be made to our base case assumptions to quantify the effects of slower prepayments. For example, the analysis above assumed that eighty percent of collateral is ARM, with fixed-rate collateral as the remainder. Reducing the percentage of ARM collateral effectively lowers the prepayment speed. Another way to lower prepayment speeds would be to simply reduce the prepayment assumptions. In Exhibit 19, 50% of our assumptions would mean that we take a weighted average of half of the prepayment speeds shown in Exhibit 17. We calculated the soft delinquency thresholds at the stepdown date, finding that prepayment speeds would have to slow down considerably to be comparable to hard delinquency thresholds (Exhibit 19).
For simplicity, this graph assumes that the senior classes continue to pay down even after the stepdown date, implying that the triggers failed. If delinquencies were below the threshold, cash flow would start to be directed towards subordinate bonds, lowering senior credit enhancement and the trigger threshold.
194
It is important to note that the likelihood of a trigger failing should not be taken as an absolute negative or positive. We have simply calculated typical soft delinquency thresholds under a variety of prepayment scenarios and found that the soft delinquency threshold will be more lenient than the hard delinquency threshold in most prepayment environments.
exhibit 19
SOFT DELINQUENCY TRIGGERS ARE MORE COMMON NOW

Percentage of Prepayment Assumption
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
120% 40.0% 40.0% 38.6% 35.6% 32.8% 30.2% 27.9% 25.8% 23.8% 22.0% 20.4%
110% 38.7% 35.9% 33.3% 30.9% 28.7% 26.7% 24.8% 23.1% 21.5% 20.0% 18.6%
100% 32.9% 30.8% 28.7% 26.9% 25.1% 23.5% 22.0% 20.6% 19.3% 18.1% 17.0%
90% 28.0% 26.4% 24.8% 23.4% 22.0% 20.8% 19.6% 18.5% 17.4% 16.5% 15.5%
80% 23.9% 22.7% 21.5% 20.4% 19.3% 18.3% 17.4% 16.5% 15.7% 14.9% 14.2%
70% 20.4% 19.5% 18.6% 17.8% 17.0% 16.2% 15.5% 14.8% 14.2% 13.6% 13.0%
60% 17.4% 16.8% 16.1% 15.5% 14.9% 14.3% 13.8% 13.3% 12.8% 12.3% 11.9%
50% 14.9% 14.4% 14.0% 13.5% 13.1% 12.7% 12.3% 11.9% 11.5% 11.2% 10.8%
40% 12.8% 12.4% 12.1% 11.8% 11.5% 11.2% 11.0% 10.7% 10.4% 10.2% 9.9%
Percentage of ARM Collateral
195
196
Available Funds Cap

Available funds cap concerns have become increasingly common as rising interest rates appear inevitable. In a nutshell, investors fear the basis risk between floating rate bonds and collateral WACs that are either fixed or capped in some manner. We study the benefits of structurally embedded interest rate hedges, finding that they can effectively limit available funds cap exposure, even in extreme interest rate scenarios. Embedded interest rate hedges can limit exposure to available funds caps. Senior classes hold strong even with double digit LIBOR. Resilience of mezzanine bonds is similar to senior bonds. Subordinates have more available funds cap risk, but principal losses should be primary concern. Similar performance with slower prepayments, which are likely with rising interest rates. The available funds cap could roughly be equated to the politically correct version of a coupon shortfall. Instead of determining that the available cash flows can not fully support the specified coupon, the structure limits the coupon to available cash flow. This roundabout methodology is actually an important distinction. Bonds hitting the available funds cap are technically receiving full interest payments, as opposed to shortfalls, which could be equated to defaults.
COMPLEX C ORRIDORS
chapter 15
In order to study available funds caps, investors need to gain a complete understanding of the complex interest rate hedges incorporated into many HEL securities. These hedges are intended to combat potential shortfalls with fixed or capped collateral. The majority of HEL securities currently issue floating rate bonds backed with a mixture of fixed rate and hybrid ARM (2/28) collateral. Thus, the incoming interest rates are completely fixed for the first two years, while the outgoing bond cash flows float to one-month LIBOR. Even after two years, a portion of fixed rate collateral will remain, plus the hybrid ARMs are susceptible to periodic and lifetime caps that can impede incoming cash flows.
197
Available Funds Cap

The specifics of collateral and interest rate hedges can differ dramatically with each deal, so investors should be very careful when making generalizations. Nonetheless, we use a sample structure in an attempt to study the effects of these hedges (Exhibit 1).
exhibit 1
Class
GENERIC STRUCTURE USED FOR ANALYSIS

% of Deal Coupon Pricing DM
AAA AA A ABBB+ BBB BBBBB+ O/C Source: Morgan Stanley
81.50% 6.25% 5.25% 1.25% 1.50% 1.25% 1.00% 1.00% 1.00%
30 55 120 145 165 170 300 375 NA
30 55 120 145 165 170 300 800 NA
In our example, there are three separate corridors: one for the senior class (AAA), one for the mezzanine classes (AA, A, A-), and one for the subordinate classes (BBB+, BBB, BBB-, BB+). The separate corridors help account for the different coupons associated with each class. A corridor is very similar to a cap, except that the upside is limited. Both instruments protect holders if interest rates rise above the strike rate, but the corridor has no marginal benefit once interest rates rise above a predetermined ceiling. Effectively, a corridor is the same thing as buying a cap at one strike rate, and selling another cap at a higher strike rate. When interest rates rise above the lower strike rate, the first cap boosts cash flow to bondholders to help cover the additional coupon costs. If interest rates rise above the second strike rate, marginal cash flows are lost, limiting bondholder benefit to the difference between the two strike rates. Each corridor in our example will last for 36 months, and both the strike rate and ceiling will migrate over time. The senior corridor, for example, will initially have a strike rate of 6.25%, with a ceiling of 8.60%, and these figures will gradually rise to 9.25% and 10.25%, respectively (Exhibit 2).
198
exhibit 2
INTEREST RATE PROTECTION FROM SENIOR CORRIDOR
In general, the initial strike rates for our caps are determined by subtracting the weighted average bond coupon from the net WAC of the collateral. The upward adjustments in the corridor reflect the assumption that the interest rates on the loans will increase to the periodic and lifetime reset limits. Accordingly, our mezzanine corridor has an initial strike of 5.80%, with a ceiling of 8.15%, and a final strike of 8.45%, with a ceiling of 9.35%. The subordinate corridor has an initial strike of 4.15%, with a ceiling of 6.50%, and a final strike of 6.80%, with a ceiling of 7.70%. It is important to note that the corridors are not balance guaranteed. In other words, each monthly swap payment uses a notional balance equal to the expected collateral balance based on the pricing speed. As a result, any deviations from the pricing speed will cause the notional balance of the interest rate hedge to differ from the collateral balance. Many HEL deals use an unrealistic static pricing speed for ARM collateral, such as 25% CPR. In reality, prepayments will likely be slower at first, but considerably faster after 24 months, which coincides with the reset date and expiration of prepayment penalties for many loans. The initially slower prepayments will mean that the interest rate hedge may not cover all of the basis risk, because the actual collateral balance is higher than the balance predicted by the pricing curve. Overall, however, we expect prepayment speeds will likely be faster than the pricing speeds, and resultantly, the notional balances of the hedges should be appropriate for the collateral balance. Given the complexity of many moving parts, we look to analyze the available funds cap risk in a variety of interest rate scenarios.
199
Available Funds Cap

exhibit 3
PERFORMANCE ASSUMPTIONS INCLUDE DRAMATIC LIBOR INCREASES

Cumulative Loss Vector (5%) % of Total Cum. Loss 0% 10 48 16 10 6 10 over over over over over over 12 24 12 12 12 24 Time Period 6 months constant months, evenly divided months, evenly divided months, evenly divided months, evenly divided months, evenly divided months, evenly divided
Prepayment Vectors ARM Base Case: CPRs of 15%, 20%, 60%, 60% = > 35%, 35% ARM Slow: CPRs of 10%, 15%, 40%, 40% = > 30%, 30% Fixed Base Case: CPRs of 4% to 23% over 12 months Fixed Slow: Fixed Base Case / 1.25
QUANTIFYING T HE R ISK
In order to assess the ramifications of the available funds cap, we apply a variety of interest rate stresses to our structure defined above. We use generic prepayment and loss vectors that are consistent with many of our previous examinations (Exhibit 3). We include separate prepayment vectors for fixed-rate and ARM collateral, including both base case and slow prepayment scenarios. We did not feel that a fast prepayment vector was warranted, as this piece focuses on rising interest rates, where fast prepayments are less likely. It is important to separately apply fixed and ARM prepayment vectors, because a weighted average vector applied to all collateral would maintain a constant ratio of fixed and ARM collateral, whereas the more realistic curves increase the percentage of fixed collateral. Since fixed collateral will be more susceptible to available funds cap risk on floating-rate bonds, we start out with thirty percent of fixed collateral, but this percentage will rise as ARM prepayments increase.
200
LIBOR Assumptions Forward Forward Forward Forward Forward Forward LIBOR LIBOR LIBOR LIBOR LIBOR LIBOR + + + + + 100 200 300 400 500 bp bp bp bp bp
We are trying to isolate the risk associated with available funds caps, not measure credit risk, but it is crucial to include a loss curve. Losses will reduce excess spread, decreasing the amount of cash flow available to support bond coupons if the available funds cap is hit. We incorporate a generic timing curve that ultimately produces cumulative losses of five percent. LIBOR stresses will be the most significant factor in our analysis. We will study the discount margins for each class using forward LIBOR, as well as immediate upwards shifts to the curve. Investors should note that some of our scenarios are very extreme, with LIBOR approaching as high as twelve percent.
201
Available Funds Cap

In our first scenario, we consider the discount margins of each class under base case prepayments, passing triggers and an exercised clean-up call (Exhibit 4).
DISCOUNT MARGINS HOLD UP WELL UNTIL EXTREME SCENARIOS
0 100 Shift to Forward LIBOR 200 300 400 500
exhibit 4
Rating
Pricing DM
AAA AA A ABBB+ BBB BBBBB+
30 55 120 145 165 170 300 800
30 55 120 145 165 170 299 849
30 55 120 145 165 170 295 829
30 55 120 145 164 169 279 328
30 55 118 141 162 165 NA NA
25 53 107 126 144 NA NA NA
11 41 91 107 81 NA NA NA
Overall, we believe that most classes hold up very well, even as LIBOR approaches double digits. According to our analysis, senior bond holders do not incur any problems until forward LIBOR + 400 bp, and even then discount margins only suffer by 5 bp. Similarly most of the mezzanine tranches do not experience problems until our most extreme scenarios. The subordinate classes lose yield because of the available funds cap much earlier, but the losses are not substantial. For example, the BBB- class loses between 1-21 bp from available funds cap as interest rates rise, but compared to a coupon of LIBOR + 300 bp, the downside is not terribly substantial. The fields marked NA signify that discount margins suffered heavily from principal losses. Although some of the loss in yield is also attributable to available funds cap, we do not display the discount margin because much of the loss in yield is attributable to principal losses and we are trying to isolate available funds cap risk. In situations in which the class encountered principal losses, but the yield was still positive, we display the discount margin shaded in gray. For example, the BB+ class earns a discount margin of 328 bp with forward LIBOR + 200 bp (Exhibit 4). In these instances, some of the loss in yield is partially attributable to available funds cap, while the rest is a result of principal losses. Investors in the BB+ class should also notice that in certain instances, the discount margin can actually rise above the pricing discount margin. All of the other bonds are priced at par, while the BB+ is priced at a discount, so scenarios that impact average life will also impact the discount margin.
202
exhibit 5
FAILING TRIGGERS EXTEND BONDS INCREASING AFC RISK

0 100 Shift to Forward LIBOR 200 300 400 500
Rating
Pricing DM
30 55 120 145 165 170 300 800
30 55 120 145 165 170 296 696
30 55 120 145 165 170 285 681
30 55 120 144 163 168 265 NA
30 55 116 138 156 160 NA NA
27 51 97 112 131 NA NA NA
19 29 62 75 76 NA NA NA
Exhibit 4 assumes that the triggers pass, but if we change this assumption, the average lives of the subordinate bonds will extend (Exhibit 5). Along with the extension, the mezzanine and subordinate bondholders show greater likelihood of encountering limitations from the available funds cap.
exhibit 6
Triggers Passing Rating
MIXED RESULTS WITHOUT CLEAN-UP CALL
Pricing DM
100
200
300
400
500

Triggers Failing Rating
30 55 120 145 165 170 300 800
32 57 124 149 172 179 310 799
31 57 122 146 159 161 269 410
30 56 119 142 150 147 101 NA
26 53 113 134 138 108 NA NA
17 45 99 114 94 NA NA NA
0 30 79 91 NA NA NA NA
Pricing DM
100
200
300
400
500
30 55 120 145 165 170 300 800
30 55 123 156 183 194 265 480
30 55 123 151 167 165 228 165
30 55 121 139 147 136 117 NA
30 55 110 111 105 NA NA NA
27 50 75 52 22 NA NA NA
19 27 24 -16 NA NA NA NA
203
Available Funds Cap

exhibit 7
SIMILAR RESULTS WITH SLOWER PREPAYMENTS

Trigger Pass Shift to Forward LIBOR Rating Pricing DM 0 100 200 300 400 500
CLEAN-UP CALL
30 55 120 145 165 170 300 800
32 57 124 149 172 179 310 799
31 57 122 146 159 161 269 410
30 56 119 142 150 147 101 NA
26 53 113 134 138 108 NA NA
17 45 99 114 94 NA NA NA
0 30 79 91 NA NA NA NA
Shift to Forward LIBOR Rating NO CLEAN-UP CALL Pricing DM 0 100 200 300 400 500
30 55 120 145 165 170 300 800
32 57 123 148 168 172 301 795
31 57 123 148 168 172 301 805
31 57 123 148 168 172 303 814
27 53 114 138 158 164 221 NA
19 46 102 122 140 NA NA NA
-1 30 78 88 NA NA NA NA
Overall, we believe that the scenario of triggers failing produces slightly worse results, but nothing dramatically different. The BB+ tranche shows the most material difference, clearly benefiting when the triggers pass. Both of the previous exhibits assumed a clean-up call, but we can also modify this situation. Exhibit 6 details performance without a clean-up call for triggers passing as well as failing. In many of the scenarios, the discount margin is not only better than the previous scenarios, but even better than the pricing discount margin. The reason for this is that the coupon steps-up if the call is not exercised. The higher coupons later in the life of the transaction produce a better average return. Under more extreme stresses, however, performance suffers from extension similar to the effects of triggers failing. We ran all of the same analysis using a slower prepayment curve and obtained mostly similar results (Exhibit 7). There were, however, some substantial improvements in the performance of subordinate tranches. This has more to do with principal losses than the available funds cap. Slower prepayments increase the ability of excess spread to absorb losses.
204
Trigger Fail Shift to Forward LIBOR Rating CLEAN-UP CALL Pricing DM 0 100 200 300 400 500
30 55 120 145 165 170 300 800
30 55 120 145 165 170 298 658
30 55 120 145 165 170 293 657
30 55 120 145 164 168 273 631
30 55 116 138 156 160 247 NA
27 50 98 114 130 NA NA NA
14 28 62 75 NA NA NA NA
Shift to Forward LIBOR Rating NO CLEAN-UP CALL Pricing DM 0 100 200 300 400 500
30 55 120 145 165 170 300 800
30 55 122 154 179 189 338 635
30 55 122 153 178 188 338 642
30 55 122 154 178 188 341 603
30 55 112 121 125 112 102 NA
27 50 80 69 60 NA NA NA
14 26 29 2 NA NA NA NA
Overall, we believe that interest rate hedges can effectively limit an investors exposure to available funds caps. Although it may not have been made obvious from this analysis, coupon payments lost to the available funds cap will be reimbursed, with accrued interest, if the cash flow is available during future periods. Therefore, investors suffering from rising LIBOR could be made whole if LIBOR drops in the future after peaking.
205
206
Mortgage Insurance
Lender-paid mortgage insurance (MI) effectively provides another form of credit enhancement to HEL transactions that is used in conjunction with either subordination or a pool insurance policy. In this chapter, we discuss the different kinds of MI, how they work, and who the insurers are. Most importantly, we discuss under what circumstances an insurer may reject a claim. Investors in discount securities are sometimes fearful of wrapped paper, pointing to potential extension risk due to the guarantee of ultimate principal. In contrast, investors in premium securities are concerned about the monoline insurers collapsing deals through the purchase of bonds at par plus accrued. Many wrapped deals guarantee timely payment of interest and ultimate payment of principal. When the economy is in a recession and home equity deals have experienced an increase in delinquencies, investors have questioned what options the monoline insurers hold. As a result of these concerns, we examined the potential options that insurers have embedded in wrapped deals. Ultimately, the question is not if, but when will investors get their money back.
SUMMARY
chapter 16
Recent claim payment history of lender-paid MI appears strong, but the history is limited. Servicing is key to high claims payment rates. Origination and appraisal practices are critical. A wide dispersion of loss severities can impact the losses absorbed by the deal. Understanding what is not covered by the MI policy is as crucial as understanding what is covered. All wrapped deals are not the same; each insurance policy needs to be examined individually. The interests of the monoline insurers are aligned with those of investors. Extension risk is limited for HEL deals. Risk of significant acceleration of a deal is unlikely unless the transaction has seen severe deterioration in the performance of the underlying loans.
TYPES O F M I
Many borrowers with a greater than 80% LTV loan are required to purchase a standard MI policy at origination and to pay a monthly premium until the LTV reaches 80%. Borrower-paid MI has the standard coverage down to 75% LTV and lender-paid MI, or deep MI, covers down to 60%, 50%, or even as low as 40% LTV. Borrower-paid MI was initially created for the government sponsored entities (GSEs), protecting the agencies down to 75% LTV. Since March 1999, FNMA and FHLMC have reduced their protection by increasing the LTV levels. Depending on how the customer chooses to pay the insurance premium, loans with original LTVs of 95% only need to purchase protection down to 71% or 78% LTV, and loans with an original LTV of 90% only need to purchase protection down to 75% or 79% LTV. It is important to note that not all subprime lenders require borrower-paid MI.
207
Mortgage Insurance
exhibit 1
ACTIVE PLAYERS IN PRIMARY MORTGAGE INSURANCE

RATINGS Moodys S&P Fitch
PROVIDERS
General Electric Mortgage Insurance Co. Mortgage Guaranty Insurance Co. PMI Mortgage Insurance Co. Radian Guaranty Insurance Co. Triad Guaranty Insurance Co. United Guaranty Residential Insurance Co. Source: Morgan Stanley, Moodys, S&P Fitch ,
Aaa Aa2 Aa2 Aa3 Aa3 Aaa
AAA AA + AA + AA AA AAA
AAA AA + AA + AA AA AAA
Compared with standard MI, deep MI increases the cap of the insurers liability, protecting the lender/assignee down to a lower LTV, usually 60-50%. MI down to 40% LTV is unusual and not all insurers will provide this low coverage. In ABS transactions, the premium received by the insurer is paid by excess spread in the deal. In addition, an insurer typically only insures some of the loans in the deals. Deep MI was generally designed for subprime mortgages. Since the lender/issuer is the purchaser of the MI, economics will determine the issuers selection, choosing between deep MI, greater subordination, and a monoline wrap of the structure. The most well known insurers and their ratings are listed in Exhibit 1.
EACH S PECIFIC L OAN I S C OVERED
Each of these MI policies covers specific loans and the loans are not crosscollateralized. Therefore, the benefits are limited to the loans actually covered by the policy. In addition, each loan is limited to the specific coverage amount for that loan, i.e., a loan with a high loss severity will not benefit from another loan with a low loss severity where the insurer did not need to pay the maximum coverage amount. If, for some reason, the mortgage insurer is uncomfortable with any aspects of a loan, then the loan is not covered by the policy. Refer to Exhibit 2 for examples of coverage percentages.
exhibit 2
Original LTV
EXAMPLES OF COVERAGE PERCENTAGES

Standard 75% Deep to 60% Deep to 50% Deep to 40%
95% 90% 85% 80% 75% 70% Source: Morgan Stanley
21 17 12 6 0 NA
37 33 29 25 20 14
47 44 41 38 33 29
58 56 53 50 47 43
208
HOW M I W ORKS
In order to understand how MI works, we need to define several terms. Coverage Percentage = (Original LTV Covered LTV) / Original LTV Claim Amount = Unpaid Principal Balance + Accrued Interest + Expenses Expenses include the following: hazard insurance premiums, real estate taxes, property protection and preservation expenses and legal expenses The MI provider has several options when a claim is submitted: property acquisition, pay the coverage percentage of the claim amount, or a pre-claim sale. The insurer will choose the most lucrative option for the company. Property acquisition: The insurance company pays 100% of the claim amount, i.e., the sum of the unpaid principal balance, accrued interest and expenses. As a result, the insurance company acquires the property. The MI provider does this because it believes that it can sell the house for a higher price and/or incur lower future expenses. Percentage guaranty: The insurer pays the coverage percentage of the claim amount and the lender/assignee retains the property. Pre-claim sale: The insurer and the servicer work together to sell the property. The servicer is in charge of selling the property, but the insurer has to approve the sale.
CARVE O UTS I N M I
It is just as important to understand what is not covered in a MI policy as it is to understand what is covered. There are some important caveats to MI which supply the MI provider with some protections. Generally, MI does not cover special hazards, bankruptcy and fraud. In addition, there are some standard exclusions, but not all policies are the same. MI policies generally limit the amount of legal fees for the foreclosure process to 3% of the sum of the unpaid principal balance and accrued interest up to the date when the claim is filed. It is fairly common for legal fees to exceed the 3% limitation.
STANDARD E XCLUSIONS F ROM M I
Special hazards include earthquakes, mudslides, acts of war, hurricanes, acts of God, etc. Bankruptcy cramdowns Fraud, misrepresentations and negligence Loans in default before the effective date Balloon payment Incomplete construction Transfer of a loan or deal to a non-approved servicer. Generally, approval by rating agencies and insurer is required Physical damage A pre-existing environmental condition Down payment Second liens. There can be deals with second liens, but it is not the norm. Mortgage insurance for second liens is more expensive Breach of insureds obligations
209
Mortgage Insurance
WHAT S HOULD I NVESTORS F OCUS O N?
Some investors have expressed caution with respect to mortgage insurance due to past experiences with some of the mortgage insurers in 1993. Specifically, investors cited that some insurers did not pay on some pool policy claims. It is important to note that pool policies are different from MI, but the fear is the samethat the insurers will not pay in the case of extreme losses. We believe that investors should remain cognizant of the following two items:
Servicing
Deals will benefit from strong servicers. The servicers ability to foreclose on defaulted loans and process claims efficiently will have an effect on the deals. Insurers require servicers to take certain actions according to a prescribed timeline. If a servicer fails to perform these duties, it could result in a claims adjustment or denial.
Appraisals
In addition, appraisal practices that overstate the value of the home may lead to inadequate coverage of losses. The coverage amounts are based on the initial stated LTVs; therefore, an inflated initial LTV will ultimately lead to less coverage. In addition, the insurer does not cover fraud or misrepresentations; this includes appraisal fraud and misrepresentations by the borrower with regard to income or assets.
exhibit 3
EFFECTIVENESS OF MI IS IMPACTED BY THE DISTRIBUTION OF LOSS SEVERITIES

Scenario 1 100 $100,000 80% 60% 25% All loans default with 35% severity
Number of Loans Principal Balance of Each Loan LTV of Each Loan Covered Down to Insurance Coverage Level Severity Distribution
Average Severity Insurance Pays
35% 25% of loan principal balance
Loss Covered by Insurance Loss Not Covered by Insurance Source: Morgan Stanley
25.0% 10.0%
210
DISTRIBUTION O F L OSS S EVERITIES
The protection provided by MI may be limited if a deal experiences a wide distribution of loss severities. We have seen loss severities on loans in HEL transactions range from 0% to greater than 100% depending on the issuer and servicer. In the extreme case of ContiFinancial, loss severities averaged around 70%, with some loan loss severities as high as 100%. In Exhibit 3, we have demonstrated how varying distributions of losses can result in different amounts paid by the insurer. In all of these scenarios, the entire pool suffers an average 35% loss severity, but the distribution of losses varies.
Scenario 2 100 $100,000 80% 60% 25% 50% of loans default with 0% severity, and 50% of loans default with a 70% loss severity 35% 25% of the principal balance for loans with a 70% loss severity, and 0% for loans with 0% severity 12.5% 22.5%
Scenario 3 100 $100,000 80% 60% 25% 33% of loans default with 0% loss severity, 33% of loans default with 35% loss severity and 33% of loans default with 70% loss severity 35% 25% of the principal balance for loans with 70% and 35% loss severity and 0% for loans with 0% severity 16.66% 18.33%
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Mortgage Insurance
PERFORMANCE D ATA
Knowing what to look for is important, but nothing can replace the empirical data covering historical performance for some industry participants. To date, most of the data looks positive.
Radian
Radian Guaranty (Radian) disclosed its current claims, current denials/rescissions1, forecasted future claims and forecasted denials/rescissions on its first lien investor- and borrower-paid mortgage insurance business. To understand the mortgage insurance business, it is important to understand that most denials/rescissions are front loaded, as defaults that are the result of fraud usually occur early. For example, as shown in Exhibit 4, Radian projects 17% of claims are submitted by the end of the second year while almost 46% of all denials and rescissions occur by the end of the second year. By the end of the third year, almost 40% of all claims are submitted but almost 82% of denials and rescissions occur by the end of the third year. This is based on 26 years of business of providing primary mortgage insurance.
exhibit 4
Year
DEVELOPMENT OF CLAIMS AND RESCISSIONS/DENIALS

Percent of Claims Percent of Denials and Rescissions
0 1 2 3 4 5 6 7 Source: Radian Guaranty
0.87% 2.69% 17.49% 39.68% 60.36% 74.99% 84.27% 90.03%
2.09% 3.80% 45.60% 82.40% 94.50% 98.90% 100.00% 100.00%
exhibit 5
CLAIM AND DENIAL/ RESCISSION DEVELOPMENT
Source: Radian Guaranty
Loans that rescinded are generally the result of fraud, and loans that are denied are the result of servicer malfeasance such as forgetting to do something major, such as not notifying the insurer that the loan is delinquent or not giving the insurer clean title of the REO property.
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Using two different methodologies, Radian projects the future amount of claims and denials/rescissions for its book. The first methodology uses Radians actual historical claim and denial/rescission experience. Using this methodology, the highest percent of projected denied/rescinded loans is 1.55% in loans insured in 2000. The lowest percentage of projected denied/rescinded loans is 0.64% for loans insured in 2001 (Exhibit 6).
exhibit 6
DENIAL/RESCISSION EXPERIENCE OF RADIAN PRIMARY BOOK

Current Denial and Rescissions Forecast Denial/ Rescissions Percent of Denials and Rescissions
EXTRAPOLATION BASED OFF DEVELOPMENT FROM PRIOR BOOKS Certificate Year Curent Paid Claims Forecast Claims
1997 1998 1999 2000 2001 Source: Radian Guaranty
4,155 4,671 3,475 2,872 1,621
41 92 84 93 27
4,930 6,228 5,757 7,237 9,268
41 93 88 112 59
0.83% 1.49% 1.53% 1.55% 0.64%
The second methodology uses Radians internal default models Prophet and Sub Prophet to project expected claims. This model ignores Radians historical experience but Radian believes for the new books it gives a better indication of future expected claims and denials/rescissions. The expected claims range from 3.79% to 4.32% and the expected denials/rescissions range from 0.4% for the 2001 book to 1.3% for the 2000 book (Exhibit 7).
RADIAN EXPECTED CLAIMS RATES PROJECTED BY INTERNAL MODELS
Number of Expected Claims Forecast Denial/ Rescissions Percent of Denials and Rescissions
exhibit 7
BASED ON EXPECTED CLAIMS RATES Certificate Year Primary Certificates Expected Claims Rate
1997 1998 1999 2000 2001 Source: Radian Guaranty
180,762 306,428 241,333 194,718 358,811
3.84% 3.79% 3.99% 4.31% 4.32%
6,941 11,613 9,629 8,392 15,500
41 93 88 112 59
0.6% 0.8% 0.9% 1.3% 0.4%
213
Mortgage Insurance
MGIC and Other Insurance Providers
In data provided by Fitch, during 1999-2000, only 0.9% of Mortgage Guaranty Insurance Companys (MGIC) claims were adjusted and 0.1% were denied. Of the 0.9% adjusted claims, the majority (84.2%) were due to servicing errors. These resulted primarily in interest adjustments due to late foreclosure. Of the 0.1% of claims denied, 82.3% were due to hazard carrier losses related to the condition of the property. In an informal survey with some other MI providers, we tried to assess what their claims experience has been. It is important to note that most of the insurers did not provide a percentage of claims that were adjusted. One MI provider indicated that lender-paid MI claims that were denied in the past year were around 1.0%. Another stated that their experience with lender-paid MI is limited to 4-5 months of experience and that it is too early to tell. GEMICO stated that it has not denied a claim in the past five years.
Novastar
We examined Novastars recent historical experience for loans insured by either PMI or MGIC since January 2000 that have been resolved or liquidated as of February 2003. Novastars experience appears strong, with a 5.5% aggregate loss severity for insured loans after claims were resolved and liquidated (Exhibit 8). Novastar experienced 8.3% rescinded and adjusted claims, which compares well with the industry experience of 5-15%. The main highlights from Novastars recent MI performance are the following: MI Paid When MI claims were paid, the loss severity after MI was 3.7%. The loss severity before MI was 31.0%, resulting in a reduction in severity of 27.3%. Even though MI was paid on these loans, a slight loss severity may result due to one or a combination of four things: 1) interest advances after the claim is submitted, 2) a slight variation up or down in the actual sales price vs. the
exhibit 8 NOVASTAR MI CLAIM SUMMARY LOANS INSURED W/ PMI OR
Resolution Type MI Paid MI Acquired1 Not Filed-No Loss Not Filed-Other2 Settlement Fraud / Denied Loans 259 51 39 1 25 4 379
1 2
MGIC SINCE JANUARY 2000, RESOLVED & LIQUIDATED (2/28/03)

Original Balance $ 27,024,117 $ 7,678,194 $ 6,042,905 $ 52,000 $ 2,922,242 $ 762,375 $ 44,481,833 % 60.8% 17.3% 13.6% 0.1% 6.6% 1.7% 100%
MI company acquired the property; servicer estimates loss severities before MI. Not Filed-Other refers other reasons such as fire that paid by property insurer. Source: Novastar
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servicers estimated sales price, 3) losses in excess of the covered amount and/or 4) some expenses may not be covered by the MI provider. The claim is submitted within 60 days of when the loan enters REO. The claim amount only includes interest advances up until the claim date, so any advances subsequent to claim date may result in a small loss. We estimate that five months is the average time in REO resulting in three months of unpaid interest or roughly a 2% loss severity2. As a result, we think that a good portion of Novastars 3.7% loss severity on loans where MI was paid can be attributed to interest advances after the loan is submitted. MI Acquired When the mortgage insurer acquires a loan that is submitted for a claim, the insurer believes that it can sell the house for a higher price than the servicer estimated and/or incur lower future expenses than the servicer estimated. The severity for the acquired loans after MI was paid was 3.3%. The MI reduced the loss severity by 16%. MI Not Filed No Loss There were 39 loans out of the 379 loans with MI that were not submitted to either PMI or MGIC because there was no loss on the mortgage. Rescinded/Adjusted Claims Investors are usually concerned with the mortgage insurers ability to deny or adjust claims on loans with mortgage insurance as it could create much higher severities and subsequently losses. Only 4 of 379 loans, or less than 2% of the loan balances, were rescinded, resulting in a loss severity of 33.1% for those loans. In addition, 25 of the 379 loans submitted for claim, or less than 7% of the loan balances, were adjusted, resulting in a 32.1% loss severity on those loans. The MI provided an 18.9% reduction in loss severity for the adjusted loans.
Severity Before MI 31.0% 19.2% 0.0% 2.5% 51.0% 33.1% 26.1%
Severity After MI 3.7% 3.3% 0.0% 2.5% 32.1% 33.1% 5.5%
MI Benefit 27.3% 16.0% 0.0% 0.0% 18.9% 0.0% 20.6%
The loss severity assumes 3 months unpaid interest on a $150,000 loan using 8.5% mortgage rate.
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Mortgage Insurance
MORTGAGE I NSURANCE M ECHANICS
In exchange for reduced loss severities, transactions with deep MI offer less subordination and excess spread. We look to provide a framework for analyzing these structures, calculating the protection required from mortgage insurance to offset the more aggressive capital structure. MI deals have less subordination and excess spread in exchange for reduced loss severities. Loan default rates similar regardless of MI. To achieve comparable protection, MI must reduce loss severities by 50-65%. Based on coverage percentages, we estimate that MI will reduce loss severities by 45-60%. Increased available funds cap and counterparty risk with MI. In order to conduct our analysis, we revisit the generic deal examined in Chapter 8. We continue with the same collateral pool, but now assume that approximately 50% of the loans have lender-paid mortgage insurance policies. The insurance policies cost about 160 bp, and since our analysis assumes that half of the loans have mortgage insurance, excess spread is effectively reduced by 80 bp. Also, based on the inclusion of deep MI, rating agencies allow for lower subordination levels (Exhibit 9).
exhibit 9
Rating Category
SUBORDINATION LEVELS ARE LOWER WITH MI

Structure A: No MI Structure B: With MI
Aaa Aa2 A2 A3 Baa1 Baa2 Baa3 Source: Morgan Stanley
19.50 13.10 7.85 6.10 4.60 3.55 2.25
15.00 10.00 5.50 4.50 3.25 2.00 1.25
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Cumulative Loss Breakpoints
Using the same performance vectors from our recent examinations, including forward LIBOR, we calculate the various breaking points for each class (Exhibit 10).
exhibit 10
CUMULATIVE LOSS BREAKPOINTS FOR EACH STRUCTURE

First Principal Loss DM Equals Zero Slow Base Fast Slow
Base
Fast
No MI AA A ABBB+ BBB BBBWith MI AA A ABBB+ BBB BBB14.1 9.1 8.4 7.0 5.5 4.6 13.7 7.7 7.0 5.7 4.1 3.3 16.3 11.1 10.4 8.9 7.4 6.6 14.5 10.1 8.6 7.5 6.1 5.1 14.1 8.5 7.2 6.1 4.6 3.8 16.9 12.3 10.6 9.5 8.1 7.1 19.4 13.0 11.1 9.5 8.2 6.8 20.1 11.8 9.5 7.8 6.6 5.2 20.9 15.2 13.3 11.7 10.6 9.2 19.9 14.0 11.6 10.0 8.8 7.7 20.7 12.8 10.0 8.3 7.1 6.0 21.5 16.5 13.9 12.3 11.1 10.1
The structure without mortgage insurance can incur more cumulative losses before any principal write-downs. This is to be expected as the very purpose of mortgage insurance is to reduce losses.
217
Mortgage Insurance
exhibit 11
CUMULATIVE LOSS BREAKPOINTS WITH 300 bp LIBOR SPIKE

Base
Fast
No MI AA A ABBB+ BBB BBBWith MI AA A ABBB+ BBB BBB11.3 6.5 5.8 4.4 3.1 2.5 10.9 5.8 5.2 3.8 2.6 1.9 13.1 8.0 7.2 5.8 4.3 3.6 11.6 7.0 5.9 4.6 3.4 2.7 11.1 6.2 5.2 4.0 2.8 2.2 13.4 8.8 7.4 6.1 4.7 4.0 15.6 10.1 8.3 6.7 5.6 4.5 16.4 9.3 7.4 5.9 4.8 3.7 17.0 11.5 9.7 8.1 7.0 5.9 16.0 11.0 8.6 7.1 5.9 5.0 16.7 10.2 7.7 6.2 5.1 4.2 17.5 12.6 10.1 8.5 7.3 6.4
We also include analysis detailing performance after stressing LIBOR (Exhibit 11). In this scenario, we consider performance after adding 300 bp to the forward LIBOR curve, over a 12-month time span. As a result, LIBOR would exceed 5% within the first year. Under the most extreme stress, fast prepayments and spiking LIBOR, the BBBclass of the MI structure incurs principal losses if cumulative losses reach only 1.9%. However, we consider accelerating prepayments very unlikely in an environment of rapidly rising interest rates. In the more likely LIBOR-spike scenarios, BBB- classes of the MI structure can handle cumulative losses between 2.5-3.6%.
Benefit Required From Deep MI
While the transaction without deep MI can withstand more losses, the real question is whether or not the mortgage insurance will lower cumulative losses enough to warrant the reduced credit enhancement. Using historical data, we find that the default rate for loans with primary mortgage insurance is similar to that for loans without mortgage insurance (see Exhibit 12). In other words, originators do not purchase mortgage insurance only for the bad loans (probably because if they could easily identify the bad loans, they wouldnt make them in the first place!).
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exhibit 12
LOANS WITH MI EXHIBIT SIMILAR DEFAULT RATES
14% 12
%
No MI MI
10% 8% 6% 4% 2% 0% 1997 1998 1999 2000 2001 2002
Given the similar default rates, we will assume that approximately half of the defaulted loans will benefit from mortgage insurance, in terms of reduced loss severity. Consequently, we can calculate the reduction in loss severity required from mortgage insurance to warrant the lower subordination levels (Exhibit 13).
exhibit 13
REQUIRED REDUCTION IN LOSS SEVERITY FROM DEEP MI

Base
Fast
Fwd LIBOR AA A ABBB+ BBB BBB55 60 49 53 66 65 64 69 53 54 76 73 44 54 44 48 60 57 54 56 52 50 61 68 64 67 56 53 70 73 43% 51% 47% 46% 54% 59%
Fwd LIBOR + 300 bp AA A ABBB+ BBB BBB55 71 60 69 89 89 67 75 59 71 92 97 46 61 52 57 77 78 55 73 63 70 85 92 67 78 65 71 90 95 47% 60% 53% 56% 71% 75%
219
Mortgage Insurance
As an example, for the BBB- bond under base case prepayments with forward LIBOR, mortgage insurance must reduce cumulative losses from 6.8% to 4.6%, or approximately 220 bp, to compensate for the more aggressive capital structure (See Exhibit 10). Once again, assuming that losses are equally distributed regardless of the presence of deep MI, then half of the initial losses, or 340 bp, will occur in loans without mortgage insurance and will not be affected. The 340 bp of losses occurring in loans with deep MI must be reduced to bring the total cumulative losses down to 4.6%. Therefore, the deep MI must lower losses on the applicable loans by 65%, or 220/340. If, for example, the loss severity prior to mortgage insurance is 40%, then the loss severity after mortgage insurance must be reduced to 14%. On average, most scenarios require deep MI to reduce loss severities by 50-65% (See Exhibit 13). The most extreme situation is for the most subordinate classes under a spiked LIBOR scenario. In that case, the mortgage insurance must eliminate approximately 90% of the losses in order to be comparable to buying a transaction without mortgage insurance.
Expected Benefit From Deep MI
Mortgage insurance is intended to reduce loss severities by reimbursing applicable losses up to a specified amount. Often referred to as the coverage percentage, this specified amount equals the (original LTV coverage LTV)/original LTV. To illustrate the effects of deep MI, we will consider loans with an original LTV of 80-90% and a coverage LTV of 60%, which is representative of the loans typically covered by deep MI. The coverage percentage for these loans would range from 25-33%. Exhibit 14 depicts some historical frequency data on loss severities for loans with an original LTV of 80-90%, weighted by loss amount. This graph may appear more skewed to the right than readers would expect. This is because loss severity graphs are typically weighted by the balance of the loan, not the loss amount. We are calculating the amount of losses that will be recovered via mortgage insurance, so a weighting by loss amount is appropriate.
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exhibit 14
DEEP MI ABSORBS SOME OF THE LOSSES
Note: Small balance loans account for the majority of the higher loss severities. Source: Morgan Stanley
For lower loss severities, the loss amounts are eliminated by deep MI, but for higher severities, only a portion of the loss is absorbed. For this distribution, mortgage insurance eliminates approximately 45% of the total losses assuming a 25% coverage percentage, whereas about 60% of the losses are recovered with a 33% coverage percentage. Looking back at Exhibit 13, we calculated that in order to offer comparable protection, mortgage insurance must reduce loss severities by approximately 5065%. From Exhibit 14, we determined that mortgage insurance should reduce loss severities by approximately 45-60%. Therefore, in most situations, both structures (with or without MI) offer roughly comparable protection from principal losses.
221
Mortgage Insurance
Increased Basis Risk With MI
The previous analysis examined principal losses, but the presence of mortgage insurance may also have other ramifications, such as increased basis risk. The fees associated with mortgage insurance reduce excess spread and increase the risk of hitting the available funds cap. The discount margins under the base case prepayment scenario with forward LIBOR are shown as a function of cumulative losses in Exhibit 15. In order to directly compare discount margins, we must equate cumulative losses depending on the presence of deep MI.
exhibit 15
CLASSES HIT AVAILABLE FUNDS CAP FIRST WITH MI
For the mortgage insurance structure, we adjusted cumulative losses downward 25%, such that the discount margin with 4% cumulative losses and no mortgage insurance is compared to 3% cumulative losses with mortgage insurance. Mortgage insurance reduces losses by 50% and applies to 50% of the collateral, such that a 25% downward revision is appropriate. In all of the points shown in Exhibit 15, no tranche is encountering principal losses. For example, the discount margin for the BBB- tranche without mortgage insurance is not displayed once cumulative losses reach 6.8%. However, with mortgage insurance, we cut the line once cumulative losses reach 6.1% (applying our 25% downward revision equates 6.1% to 4.6%, as shown in Exhibit 10). Although principal losses are not show in Exhibit 15, the transaction with mortgage insurance is often earning a smaller return. The cost associated with the mortgage insurance reduces excess spread, causing the classes to hit the available funds cap earlier, as LIBOR rises with the forward curve.
222
Bond Insurance
WRAPPED H EL M ARKET
chapter 17
In the ABS market, the HEL sector historically has been the largest market the monolines insured. Even though during the past year the portion of HEL deals using senior/subordinate structures has increased dramatically, the wrapped HEL market still makes up a large portion of the market (Exhibit 1).
exhibit 1
CUMULATIVE ISSUANCE OF WRAPPED HEL

Original Balance Current Outstanding Balance
Not Wrapped MBIA AMBAC FSA FGIC MGIC Total Note: As of February 1, 2001. Source: Morgan Stanley, Bloomberg
212.5 73.3 40.6 19.4 10.8 1.3 $357.9 BN
59.4% 20.5% 11.3% 5.4% 3.0% 0.4% 100.0%
80.3 21.5 23.4 9.2 6.1 1.2 $141.8 BN
56.7% 15.2% 16.5% 6.5% 4.3% 0.8% 100.0%
All Wrapped Deals Are Not the Same
In talking with the monoline insurers, none was willing to generalize about the features of wrapped deals because each insurance agreement has particular features and/or trigger levels that are specific to each deal. In addition, the insurance agreements have evolved over time and the features of current agreements may be different from earlier agreements. This chapter is based on several insurance agreements that we have researched, as well as conversations with several monoline insurers.
Pay Timely Interest & Ultimate Principaland Maintain Parity
Wrapped deals are required to adhere to the pooling and servicing agreement and make payments accordingly. As cash comes into the deal, the insurers are required to pay interest and principal as outlined in the pooling and servicing agreement. Although some deals guarantee the payment of timely interest and ultimate principal, many of these same deals guarantee to maintain parity between the collateral loan balance and the senior certificate balance. These two ideas seem incongruent at first glance. Maintaining parity means that in the event that the bond balance is greater than the collateral balance then the senior bond balance will be paid down until its balance equals the collateral balance. Generally, REMIC structures require that parity be maintained between the collateral and the bonds. Unlike REMIC deals, owner trusts or debt-for-tax deals are not legally obliged to maintain parity, but most HEL bond insurance agreements include a provision to maintain parity once a loss causes a mismatch in the amount of bonds outstanding and the collateral balance.
223
Bond Insurance
The term ultimate principal is often perceived to be that when a deal deteriorates, insurers will not pay any claims until final maturity, but this is false since insurers are required to maintain parity. As explained to us by the monoline insurers, the ultimate principal verbiage was intended to convey that insurers would not guarantee any particular prepayment speed. In addition, if at the final maturity date of a deal, the remaining loan(s) is (are) either delinquent, in foreclosure or REO, the insurer will pay any outstanding bond amount regardless of whether any payments have been received or liquidation proceeds have been realized for such loans. Thus, the term ultimate principal means that all principal will be received by the bondholders on the final maturity date of the bonds at the latest.
Extension Risk Limited for Most HEL Deals
The question is when the deal is performing so poorly that there is limited cash being generated from the collateral, how do their average lives perform? The requirement to maintain parity in many deals makes it difficult for the bonds to extend when collateral deteriorates. Actually, the WAL shortens due to the parity payments. One aspect that could affect the timing of cash flows due to parity payments is the timing of losses. If a deal deteriorates, losses could result in higher involuntary prepayments from recoveries and/or parity payments. Exhibit 2 demonstrates the stable average lives in a wrapped structure with parity payments. The stable average lives demonstrated in Exhibit 2 would also apply to a senior/subordinate structure as well since both structures are impacted in a similar manner from the timing of prepayments and losses. The example deal is called at the 10% clean-up call an option not controlled by the insurer. For this example, the default assumption is applied assuming 100% severity with the timing for losses applied to the deal as outlined in Exhibit 17. Prepayments were applied as a multiple of the prepayment curve displayed in Exhibit 2.
exhibit 2
FOR HIGH DEFAULTS, THE AVERAGE LIVES ACTUALLY SHORTEN FOR THE PARITY CASE
PREPAYMENT ASSUMPTIONS AND TIMING
Loss Curve (% of CDR occurring during these months)
TIMING OF LOSSES
Months
Months
CPR Curve
0-6 7-18 19-42 43-54 55-66 67-78 79-102 Total
0 10 48 16 10 6 10 100% of losses
0-1 2-12 13 until end of deal
4 Ramping from 4 to 24 24
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Exhibit 2 demonstrates that the weighted average life of the bonds actually shortens due to parity payments. For comparison, we created a deal that pays ultimate principal. The average life extended in the more extreme default and low prepayment cases. For the 40% default and 50% of the prepayment assumption, the weighted average life is 5.68 years in ultimate principal case compared with 3.86 years in the parity case.
Question of Economics with Accelerating or Purchasing of the Bonds in the Deal
It is important to note that the right of the insurer to collapse a deal can vary from deal to deal and insurer to insurer. In owner trust or debt-for-tax deals, insurers generally have the right to accelerate a deal with the potential to repurchase the bonds at par plus accrued. Extreme deterioration in the collateral would have to result for a deal to be accelerated or collapsed. Depending on the deal, the process of accelerating or collapsing a deal requires that the deal fail its triggers and certain remediation techniques are failing to ameliorate the situation. Furthermore, as a deal deteriorates and insurance claims are paid, the monoline gains voting rights. The subrogation rights of the insurer only exist if the insurer has paid claims and the insurers subrogation is only to the extent of its claims paid. In other words, the insurer will be given the right to vote in an amount equal to its claims outstanding, while the investors will retain their right to vote according to the amount of bonds outstanding.
EXAMPLE: WEIGHTED AVERAGE LIVES FOR DEAL THAT MAINTAINS PARITY

Prepayment Assumptions
Defaults 20% 25% 30% 35% 40%
50% 5.03 4.77 4.49 4.18 3.86
75% 3.62 3.43 3.25 3.08 2.93
100% 2.84 2.72 2.60 2.50 2.40
125% 2.34 2.27 2.19 2.13 2.07
150% 2.00 1.96 1.90 1.86 1.82
175% 1.75 1.72 1.69 1.66 1.63
225
Bond Insurance
Purchase of Bonds
An insurer might purchase the bonds at par plus accrued (or an agreed upon price) if its funding costs are lower than the bond coupon. This can only happen in two cases: 1) The insurer will not have this option unless all bondholders consent to sell their bonds to the insurer, which implies that the insurer must demonstrate that such a repurchase is also in the best interest of the bondholder. 2) The insurer has paid more claims than the remaining bonds outstanding. This is another extreme and unlikely case.
exhibit 3
At Issuance
EXAMPLE OF WHEN IT MAY MAKE SENSE FOR THE INSURER TO PURCHASE THE BONDS
Date X in the Future After Pool Deterioration
15% Coupon on Collateral 10% Bond Coupon 9% Cost of Funding for Insurer 5% Excess Spread
15% Coupon on Collateral 10% Bond Coupon 4% Cost of Funding for Insurer 5% Excess Spread if the deal is collapsed, 9% excess spread for the insurer to protect itself from losses
In the above example, the insurer purchases the bonds at par plus accrued to avoid paying claims or further claims. When the bonds are purchased at par plus accrued, the insurer is only benefiting from the excess spread between the collateral and its funding cost (9% in the example) as a means to cover the insurers expenses and safeguard it from paying a claim. If they do not purchase the bonds, the insurer only has 5% excess spread to protect itself from further claims. If there is any residual cash flow after the insurers expenses are paid, it ultimately goes to the residual holder. The main risk for investors, in the above example where the bonds are purchased, is reinvestment and duration risk.
Acceleration
Early amortization is not at the option of the insurer in their sole discretion. It is guided by the terms established at the time of origination of the transaction, but the insurer has the right to waive violations of the step-up provision. The step-up allows excess spread to pay down bond principal, thereby building additional overcollateralization to further protect against losses. For example, a HELOC deal could use the cash generated during its revolving period to pay down the bonds instead of purchase new receivables.
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Conclusion
The term ultimate principal used in wrapped deals is often misunderstood. Since most deals maintain parity between the bonds and collateral, extension risk is limited. The average life of a wrapped deal is similar to that of a senior/subordinate deal even in extreme deterioration of the collateral since the average life will be governed by prepayments and losses. The ability of the insurer to repurchase the bonds is limited to bondholder agreement or extreme deterioration where the insurer accumulated enough voting rights. Other forms of accelerating the deal (such as through step-up agreements) are generally stipulated in the insurance agreement. As a result, the average lives are very stable.
227
228
Section V Home Equity Handbook
Regulatory Environment
229
230
EITF 03-1
chapter 18
This chapter was co-authored by Laurent Gauthier and originally appeared in the ABS Perspectives, EITF Angst: Delayed but Not Gone, September 10, 2004. After all the spinning of wheels in mid-August 2004 caused by the sudden realization that EITF 03-1 was soon to be effective, FASB has postponed the implementation of its particularly vague Paragraph 16 until certain issues could be clarified. The FASB intends to have investors recognize market-related negative valuation moves on their securities holdings. The simple fact that FASB re-released a previously released document suggests FASBs seriousness on this issue. Despite some uncertainties, we still can see areas that should benefit. These are: floating rate HELs, unsecuritized whole loans, and near par-priced short duration MBS, such as current-coupon pass-throughs, certain short average life CMOs, CMO floaters and hybrid ARMs. While FASBs broad intent is clear, there are some uncertainties with the practical implementation of EITF 03-1 that prompted FASB to delay application of Paragraph 16 until it could provide some clarity. FASB staff has posted its recommendations on these issues to its website, and these were the basis of the FASB discussions at its meeting. These issues are1: The level of accounting for which an investor should assert its intent and ability to hold to a forecasted recovery. FASB staff recommended that an investor assert its intent and ability at the individual security level, as stated in paragraph 16 of FAS 115. The severity of impairment of a security, below which impairment would be considered temporary. FASB staff recommended that impairments that are minimal can effectively be considered temporary; the question then turns to what is meant by minimal. FASB staff offered two alternatives: impairments that would be eliminated by a greater than normal move in interest rates over a short period of time taken to be six months should be considered temporary, or alternatively, impairments of 5% or less could be considered temporary, in which case an investor need not assert its ability and intent to hold. From the FASB discussion, the bright red line of 5% seems to be gaining some legs, but minimal has not been determined definitively. Situations when there is an impaired security for which an investor had asserted its intent and ability to hold to a forecasted recovery and is subsequently expected to be sold prior to recovery. FASB staff recommended that certain changes in circumstances should not call into question the investors intent for the other securities. These changes in circumstance are unexpected and significant changes in liquidity needs or unexpected and significant increases in interest rates that cause the holding period to extend significantly. Separately, FASB staff recommended that impairment should be considered to be other than temporary when the investors assertion about its intent and ability to hold to a forecasted recovery is changed.
See the FASB website, www.fasb.org/board_handouts/09-08-04.pdf.
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EITF 03-1
SO W HAT D O W E D O?
Whatever the specific resolution of the above issues, certain types of instruments are likely to benefit and investors in securitized products should position themselves accordingly. Floating rate HELs. Floating rate securities in general should benefit at the margin relative to fixed rate securities. Investors who want mortgage exposure could get it via floating rate home equities rather than fixed rate MBS. In principle, investors could swap (part of) the fixed rate MBS into floating rate cash flows, but the cash flow timing uncertainty due to prepayments on fixed rate mortgages makes this somewhat impractical, particularly on a large scale. Also, note that while HELs are subject to available funds caps, the cost of these caps is trivial in highest rated classes.2 Unsecuritized whole loans relative to securitized products. Whole loan packages would benefit relative to their securitized form, because whole loans are not affected by EITF 03-1. On the other hand, securitized loans receive a more favorable riskbased capital treatment than whole loans, so there is some offset here. That said, banks in general are not at present capital constrained and have been acting as if differences in risk-based capital for different securities do not matter; should banks become constrained or invest such that they are optimizing their risk capital, then they would have to determine the appropriate balance between exemption from EITF 03-1 on the one hand and higher risk capital on the other. Near par-priced short duration MBS, such as current coupon pass-throughs, short CMOs, CMO floaters, hybrid ARMs and other short duration bonds relative to longer duration bonds. Banks could find short or intermediate structures more attractive than current coupon collateral or discounts because of the structures lower exposure to moves in interest rates. On the other hand, shorter duration bonds do not do much for insurance companies, which have much longer duration liabilities. Since the EITF flurry began a couple of weeks ago, the shorter part of the MBS market short CMOs, hybrid ARMs, floaters have apparently not richened relative to the longer duration sector. Another factor to consider is that short structures are typically premiums, and could suffer from an asymmetry of treatment because of that (see next section). MBS vs. callable corporates and agencies. Given a comparable duration, convexity and dollar price, we would not expect either one to be better off than the other relative to EITF 03-1. As premiums, both would be affected by the premium/discount asymmetry.
THE P REMIUM/DISCOUNT A SYMMETRY
As we mentioned above, MBS premiums normally trade at shorter durations than discounts, and should therefore be less likely to hit the 5% drop in mark-tomarket value. However, there is an asymmetry in the way premiums and discounts could recover from such a drop in value, which applies to MBS as well as other types of bonds.
See the Morgan Stanley ABS Perspectives, HEL Prepayments, Rising Rates and Available Funds Caps, June 11, 2004, and Complex Corridors and the Available Funds Cap, April 16, 2004.
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Let us run a simple comparison: suppose there are two fixed-rate bonds, a premium at 102.5 and a discount at 97.5, both with a 6-year duration. If rates back up 100 bps, the value of both drops by more than 5%, and they are determined to be non-temporarily impaired. Then, a determination must be made whether their cost (where they were purchased) can be recovered by holding them: For the discount, it is an easy argument: its price (now around 92) will mechanically converge towards par, and will therefore reach 97.5 at some point. Therefore, this bond can be kept in the AFS portfolio, but would not negatively affect earnings. The premium, on the other hand, will not automatically go back to 102.5. For that, it would now need a rally of 100 bps, which is difficult to argue right after a sell-off. As a result, it is likely that this premium will have to be marked down, generating a loss through earnings. Eventually, the premium will converge to par, or might even be sold at a premium price if indeed rates back up but the gain then generated does not fall down to earnings. In the particular case of MBS, short duration bonds are generally premiums, while longer durations are found in discounts. As a result, there should be some optimum between the two diverging trends: on one hand, a premium is less likely than a discount to see its value drop by 5%, but the premium is also likely to translate into a mark down if the 5% threshold is hit (while the discount will just have to be held until it recovers). This is why we think it is plausible that slight discounts would benefit, as well as short structures priced near par, relative to premiums or deep discounts.
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Basel II
chapter 19
This chapter is written by Sarah Barton and originally appeared in the European Securitized Perspectives, Basel II-ABS, September 13, 2004. The International Convergence of Capital Measurements and Capital Standards, otherwise known as Basel II, was published in its final iteration on June 26, 2004, by the Basel Committee on Banking Supervision (BCBS). The EU issued its own draft directive for implementing Basel II in Europe soon afterwards in the form of the Capital Requirements Directive (CRD). This directive will ultimately be transformed into national rules for European banks via their local regulators. In this chapter, we refer primarily to Basel II, so its worth noting that there are no significant differences between Basel II and the CRDs approach to ABS. Under Basel II, banks are required to hold less capital against residential mortgages and credit cards with mixed treatment of commercial loans. The capital arbitrage available to issuers funding themselves using securitization is reduced significantly, although we note that the issuers will be more incentivised under Basel II to securitize lower-quality commercial mortgages. However, significant savings are available to bank buyers of securitized assets with falling risk weights, and we believe that spreads of investment grade ABS may tighten with increased demand from this investor base. We are not anticipating a dramatic fall-off in bank issuance of securitized assets post-Basel II. Securitization will continue to offer issuers cheap funding and investor diversification, in our view.
SUMMARY
As risk weights fall for investment grade tranches, ABS spreads could tighten. We do not anticipate declines in issuance. We review the different approaches for the treatment of securitized assets. We have calculated the costs for originators and investors pre- and post-Basel II for typical RMBS, CMBS and credit card transactions.
INTRODUCTION
The 1988 Accord had practically no reference to capital charges for securitization. The risk weight is 100% for all securitized bonds, other than triple A residential mortgages, which are weighted at 50%. Under Basel II, different risk weights are applied for different ratings to any transaction that involves the tranching of credit risk under the securitization framework. Risk capital charges are evaluated following one of the two broad approaches the standardized approach and the internal ratings-based (IRB) approach. For securitization tranches only, different charges exist between originating banks and investing banks under Basel II for the higher-risk tranches (the noninvestment grade tranches). We describe the different approaches for securitization in this chapter, and then apply the theory. We have chosen generic RMBS, CMBS and credit card transactions and calculated how Basel II will impact both issuers and investors (at all ratings levels). We also provide some additional detail, separate to the risk weights, on the so-called Pillars 2 and 3 of Basel II, which relate to changes in the supervisory approach and also to disclosure by banks.
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Basel II
For readers who are interested in a brief introduction to Basel II, or wish to learn about the impact on other asset classes, our bank research team is in the middle of publishing a series of Basel II notes. These are all available on the Morgan Stanley website, ClientLink. Introducing Basel II, July 9, 2004 Ineke, Guillard, Finlayson Basel II Sovereigns, July 23, 2004 Ineke, Guillard, Finlayson Basel II: Banks, September 6, 2004 Ineke, Guillard, Finlayson Basel II: Covered Bonds, September 9, 2004 Ineke, Bradley
SECURITIZATION A PPROACHES U NDER B ASEL I I 1. Standardized Approach
The standardized approach is the simpler method of calculating capital requirements under Basel II, and we expect the less sophisticated banks to adopt this approach. Indeed, in order to implement the more advanced IRB approach, banks have to seek supervisory approval in terms of systems and models. For investing and originating banks, the weights under the standardized approach for exposures with long-term ratings are provided in Exhibit 1. The weights are predefined, based on classification and external rating.
exhibit 1
STANDARDIZED APPROACH RISK WEIGHTS (LONG-TERM RATINGS)

Investing 20 50 100 350 Deduction Originating 20 50 100 Deduction Deduction
% AAA to AAA+ to ABBB+ to BBBBB+ to BBB+ and below/unrated

Source: Morgan Stanley, Basel II
A deduction is required for banks using the standardized approach for unrated debt, unless this is the most senior tranche of a securitization. The senior position receives the average risk weight of the underlying exposure.
exhibit 2
STANDARDIZED APPROACH RISK WEIGHTS (SHORT-TERM RATINGS)

Investing and Originating 20 50 100 350
% A-1/P-1 A-2/P-2 A-3/P-3 Other ratings/unrated

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2. IRB Approach
IRB is a more complex approach, which allows banks to use internal risk estimates and historical performance data when calculating risk. However, banks using the IRB approach cannot rely on their own assessment of credit risk and need to rely on external ratings when using this approach for securitized assets. Generally, banks will be able to achieve lower risk-weightings under the IRB approach, in our view. We find that the risk weight for triple A tranches can fall to as low as 7%. Note that these risk weights will vary, as the IRB approach may be adopted in a variety of ways.
Different IRB Approaches for Securitization
Ratings-based approach (RBA) if a securitization exposure is rated, or the ratings can be inferred from the ratings of a reference entity subordinated to the exposure under consideration, the RBA must be used for capital calculations. Supervisory formula (SF) if an external rating is not available, investing and originating banks must use the SF. Internal assessment approach (IAA) if an external rating is not available, banks providing such facilities as a liquidity facility/credit enhancement to an ABCP programme can use IAA rather than SF. We review the treatment of liquidity facilities in Appendix I. If none of these exposures are suitable, then the exposure must be deducted from capital.
237
Basel II
Ratings-based approach
The risk weight calculation under the RBA approach is driven by the rating, as mentioned above. Three other parameters are also required for the calculation: Seniority of exposure Granularity of the underlying pool Long-term or short-term rating For a long-term rated super senior tranche of a synthetic securitization and the most senior tranche of a traditional securitization, the risk weights are as follows. The risk weights for short-term ratings (for investing and originating banks) are also included.
exhibit 3
Long Term AAA AA A+ A ABBB+ BBB BBBBB+ BB BBBelow BB- and unrated
RBA MOST SENIOR TRANCHE RISK-WEIGHTINGS (%)

Short Term A1/P-1 A-2/P-2 A3-P3 All other ratings/unrated
7 8 10 12 20 35 60 100 250 425 650 Deduction
7 12 60 Deduction
For other tranches, the risk-weightings for granular pools (number of exposures greater than or equal to six) are as follows:
exhibit 4
RBA GRANULAR POOLS (%)

12 15 18 20 35 50 75 100 250 425 650 Deduction
12 20 75 Deduction
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For non-granular pools, the risk-weightings are as follows:

exhibit 5
RBA NON-GRANULAR POOLS (%)

20 25 35 35 35 50 75 100 250 425 650 Deduction
20 35 75 Deduction
Supervisory formula (SF)
In the absence of external ratings, the investing and originating bank must use the supervisory formula (SF). The capital charge for a securitization tranche depends on five bank-supplied inputs. The drivers of credit risk are defined as follows: KIRB the capital charge had the assets not been securitized L credit enhancement T thickness of exposure N effective number of exposures LGD loss given default We cover this in greater detail in Appendix II
Internal assessment approach
For unrated liquidity facilities and credit enhancements to ABCP programmes (the programmes, however, must be rated), banks, subject to some conditions, can use their own assessment to evaluate risk weights. The internal ratings must be mapped to external ratings. The assessment procedure should be akin to the methods used by the rating agencies.
Pillar 2
The securitization risk weights prescribed under Pillar 1 provide opportunities for regulatory capital arbitrage due to risk-weight differences between originating mortgages and subscribing to securitized notes. However, bank supervisors have been empowered to act in such scenarios to deny the bank capital relief. Under Pillar 2, regulators can step in to prevent originators retaining/repurchasing securitized assets for capital-reduction purposes.
239
Basel II
Regulators are also expected to intervene when banks provide implicit support to their own securitized assets, thus failing to achieve the clean break criteria. The degree of residual risks retained by banks after securitization will be monitored by supervisors. In addition, banks are discouraged from having call provisions except the clean-up option for reducing the cost of servicing.
Pillar 3
A lot of qualitative and quantitative disclosures are required from banks. This includes a discussion of the banks objectives in securitizing, and the accounting policies and names of External Credit Assessment Institutions (ECAIs) used. Quantitative disclosures include outstanding exposures securitized by the bank by exposure type, amount of impaired loans securitized, losses recognized and the aggregate amount of securitization exposure retained or purchased (broken down by exposure type).
EXAMPLES A PPLICATION O F T HEORY RMBS Permanent Financing 1
We have taken the Permanent Financing 1 deal as an example for an analysis of an RMBS transaction. After initially analyzing the impact of Basel II from an issuers perspective, well calculate how much capital they need to hold against the assets pre- and post-Basel II prior to any securitization, and the economic impact on bank investors.
Originator capital requirements
Under the current accord, banks have to risk-weight residential mortgages on their balance sheets at 50%. Thus, the capital required to back a residential mortgage portfolio of $1,177 million is currently $47.08 million. If a bank uses the standardized approach under Basel II, the risk weight falls to 35% and the capital requirement would fall to $32.96 million. Under the IRB approach (we assumed a PD of 1% and LGD of 25%), the risk weight falls to 31.3%. The capital requirement falls accordingly to $29.47 million.
Impact on issuance - a different landscape
We do not anticipate falls in RMBS issuance volumes post-Basel II. Securitization will continue to offer issuers a cheap funding tool and investor diversification, in our view. However, we do believe that the landscape will change for RMBS issuance. We may find that some capital-constrained issuers will continue to use securitization, motivated by capital relief savings.
exhibit 6
RMBS PERMANENT 1
Present Cost (R.W.) 44 (50%) 3 (100%) 3 (100%) 50 Standardized Approach (R.W.) 18 (20%) 0.6 (20%) 3 (100%) 21 IRB (RBA) (R.W.) 11 (12%) 0.5 (15%) 2 (75%) 13 Incremental Capital Required by Investors (IRB) -33 -3 -0.8 -36
A B C Total
AAA AA BBB
Size ($MM) 1,100 38.5 38.5
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They may respond to the new regulation by selling all RMBS tranches including the reserve fund. Those banks who do not have capital constraints will focus on securitization for cheap funding, and adopt securitization in a new format. These issuers may sell the triple A tranche for cheap funding and hold the first loss piece. Issuers will not obtain capital relief in this format, but the mortgages will be transferred from the issuer via a true sale. Further, the FSA has recently suggested limiting the issuance of covered bonds by UK banks at 4% of their assets, and this gives us additional confidence that issuance of RMBS will not suffer post-Basel II.
Investor capital requirements
At the triple A level, we find that the saving borne by banks investing in the entire triple A tranche of $1,100 million is $33.44 million under the IRB approach.
Spreads can tighten
From here we can hypothesize that the benefits offered post-Basel II will generate greater appetite among bank investors, and this may drive spreads in. In addition, if we see less junior rated issuance, we anticipate that scarcity value will generate tighter spreads for these bonds.
Credit Cards Gracechurch Card Funding No 5
We use the Gracechurch Card Funding No 5 plc transaction to illustrate the impact of Basel II on credit card securitizations. The transaction size is $1 billion. Under the 1998 Accord, the capital requirement for the underlying pool would have been $80 million, as it is risk-weighted at 100%. Under Basel II, a bank using the standardized approach would have to use a risk weight of 75% for this class of asset. This corresponds to $60 million. We assume a PD of 4.02% and LGD of 75.68%. Under the IRB approach, the risk weight goes up to 79.6% and the capital requirement becomes $63.7 million. Thus, we reach the same conclusions for credit cards. We are not expecting issuance to fall and believe that, from Exhibit 7, the savings for investors may drive spreads tighter.
CREDIT CARDS GRACECHURCH CARD FUNDING NO 5 PLC
Size ($MM) 600 300 50 50 Present Cost (R.W.) 48(100%) 24(100%) 4(100%) 4(100%) 80 Standardized Approach (R.W.) 10 (20%) 5(20%) 2(50%) 4(100%) 20 IRB (RBA) (R.W.) 3(7%) 3(12%) 1(15%) 3(75%) 10 Incremental Capital Required by Investors (IRB) -45 -21 -3 -1 -70
exhibit 7
A1 A2 B C Total
AAA AAA A BBB
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Basel II
Morgan Stanley CMBS ELoC 19
We use the European Loan Conduit (ELoC) 19 originated by Morgan Stanley as an example to study the implications of Basel II on the CMBS sector. The conduit has 443 mortgage loans backed by 901 property leases totaling 619.30 million. The portfolio is diversified by property type and UK location.
Originator capital requirements
Standardized approach: the current capital requirement for a bank to hold the mortgage loans in the ELoC 19 transaction on balance sheet is 44.1 million under Basel I. The requirements do not change under the standardized approach. IRB approach: banks will use their own internal rating system to establish probability of default and their capital requirements under IRB. This will vary according to the quality of the commercial mortgages. Unfortunately, there is little data available on performance of commercial loans in the UK or Europe. We found that the capital requirement goes up for a bank under Basel II when we assume a PD for commercial loans consistent with a B rating, and falls when we assume a BB rating. Firstly, we assume the loans have a rating of B (PD = 6.38%). The loans have a weighted average LTV of 67.2% at origination, which results in an over-collateralization of 149%. Full LGD recognition can be used (required level is 140%). LGD is 35%, and the risk weight under the foundation IRB approach works out to be 127%. Thus, for a bank to hold the loans on its balance sheet, it would have to hold 56 million of capital against them higher than under Basel I. However, if we assume the loans have a higher rating, i.e., BB (PD = 1.2%), the risk weight is 77%, and required capital is 33.7 million lower than under Basel I. A banks motivation, from an economic perspective, to securitize its commercial loans post-Basel II will depend on the quality of the collateral. For the 619 million transaction example weve used here, a bank keeping the loans on its balance sheet would see its capital requirements fall or rise depending on the quality of the loans.
Growth in CMBS issuance
Securitization of commercial mortgages has been driven historically by funding rather than risk transfer. We note that many conduit vehicles have been set up as financing operations, in which commercial mortgage loans are made for the purpose of securitization. The higher capital requirements post-Basel II for lower-quality mortgages may generate growth in the CMBS market, in our view.
exhibit 8
CMBS ELOC 19
Present Cost (R.W.) 37.2(100%) 3.0(100%) 2.7(100%) Deduction 57.5 Standardized Approach (R.W.) 7.4(20%) 0.6(20%) 1.3(50%) Deduction 24.0 IRB (RBA) (R.W.) 4.5(12%) 0.5(15%) 0.5(20%) Deduction 20.0 Incremental Capital Required by Investors (IRB) -32.7 -2.6 -2.4
Class A B C RF Total
AAA AA A
Size ($M) 465.51 37.82 33.46 14.59 551.38
-37.5
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Investor capital requirements
The capital requirements are described for each tranche under the standardized and RBA (IRB) approaches for ELoC 19 in Exhibit 8. The savings for bank investors in CMBS post-Basel II are substantial. At the AAA level, the saving borne by banks investing in the entire AAA tranche of 466 million is 33 million, which is effectively a fall in risk-weighting from 100% to 12%. The benefit extends to all ratings classes with the exception of the BB class. We note that banks are not typically buyers of BB ABS currently and we note that they are much less likely to be buyers at this rating level under Basel II.
Spreads can tighten
From discussions with colleagues and clients, we know that banks represent a large percentage of buyers of senior classes. From here, we can hypothesize that the benefits offered post-Basel II will generate greater appetite among this class of investor, and this may drive spreads in. There are two caveats to this hypothesis: Most bank buyers have return on capital targets which could preclude them from buying bank paper at tighter levels, thus reducing the ability of the market to tighten spreads notably. We also note that larger banks are able to hold ABS in conduits and trading books, which means that they do not have to hold any capital against these positions.
RoE analysis required for Basel II changes
In a vacuum, we find that ABS is more appealing to bank buyers. However, risk-weightings on other asset classes may also change under Basel II. Once the bank research group has completed its notes on corporates, retail assets, equities and credit derivatives, in addition to the completed research on sovereigns, banks and covered bonds, we will undertake an RoE analysis for banks to analyst relative valuations.
APPENDIX I : L IQUIDITY F ACILITIES
Liquidity facilities that are currently not regulated are also subject to regulation under Basel II. This, of course, impacts liquidity facility providers only.
The Standardized Approach
Risk weight of unrated facility = 100%*risk weight of the lowest rating category for which the facility is available. Risk weight for an eligible facility < 1 year = 20%*risk weight corresponding to rating of facility. Risk weight for an eligible facility >1 year = 50%*risk weight corresponding to rating of facility. Risk weight of a facility available only in the event of market disruption = 0%.
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Basel II
IRB Approach
Risk weight of unrated facility = 100%*risk weight of the SF risk weight. If no data to use SF... Risk weight of unrated facility = 100%*risk weight of the standardized approach risk weight (with the lowest rating that the facility covers). Risk weight of rated facility = 100%*risk weight of the RBA risk weight. Risk weight for an eligible facility with maturity < 1 year = 50%*risk weight corresponding to rating of facility. Risk weight for an eligible facility with maturity >1 year = 100%*risk weight corresponding to rating of facility. Risk weight of a facility available only in the event of market disruption. Unrated facility = 20%*risk weight corresponding to SF.
APPENDIX I I: S UPERVISORY F ORMULA ( SF)
In the absence of external ratings, the investing and originating bank must use the supervisory formula (SF). The capital charge for a securitization tranche depends on five bank-supplied inputs. The drivers of credit risk are defined as follows. We have not worked through an example of SF capital charges, as unrated tranches, or tranches for which a rating cannot be inferred, are extremely rare. Indeed, they are unheard of in the institutional ABS markets.
KIRB L
The capital charge had the assets not been securitized Credit enhancement
Thickness of exposure. The ratio of the nominal size of the tranche to the total exposures of the pool. The value of L+T has to be less than or equal to 1. It is equal to 1 for the senior most tranche.
N
Effective number of exposures. N is calculated as the ratio of the square of the sum of individual exposures to the sum of squares of individual exposures. For the purpose of calculating N, all exposures to a single obligor must be consolidated.
LGD
Loss given default. This is a weighted average. For retail exposures, where the portfolio share of the largest exposure is no more than 3% of the underlying pool, Basel II allows usage of simpler methods for calculating the effective number of exposures and the exposure weighted LGD.
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The supervisory formula is given by the following expression:
S[L] = L if L<= Kirb , else, S[L]= Kirb +K[L] -K[Kirb] +(d. Kirb/w)(1- exp(w*( Kirb - L)/ Kirb)) Where h=(1- Kirb/LGD)N c=Kirb/(1-h) v=((LGD- Kirb) Kirb +0.25(1-LGD) Kirb )/N f=((v + Kirb2)/(1-h) - c2) + (((1- Kirb) Kirb - v)/(1-h)t) g=((1-c)c)/f -1 a=gc b=g(1-c) d=1-(1-h)(1-Beta[Kirb, a,b]) K[L]=(1-h)((1-Beta[L,a,b]L+ Beta[L,a+1,b]c) Beta [L,a,b] refers to the cumulative beta distribution with parameters a and b evaluated at L, t=1000 and w= 20
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Section VI Home Equity Handbook
Home Prices
247
248
Home Prices
chapter 20
In this section, we analyze the increase in house prices and consider the possibility of a housing bubble. We look at the performance of house prices in different MSAs and consider how house prices change in different interest rate environments. To address concerns of increasing house prices, we look at housing fundamentals such as affordability and demographics. We then look at house prices in real terms and find that while house prices have increased, the increase in real terms is substantially less than in nominal terms. As the Federal reserve has now begun to increase rates, and we believe will continue to increase rates over the near future, we look at how house prices in various MSAs act in a rising rates environment.
SUMMARY
House prices in real terms over the past several years have increased markedly less than in nominal terms. House prices tend to rise in a rising rate environment. House prices also rise in a falling rate environment. Exceptions to the general tendency for house prices to rise have occurred when a local economy or region has suffered a particular economic shock. Those shocks have tended to be more local or regional than general. Metropolitan areas with severely weak long-term local economic conditions nonetheless have exhibited rising house prices over long periods of time.
HOUSING F UNDAMENTALS
House prices nationally have grown at an annual rate of almost 6% since 1995. (Exhibit 1) Some areas of the country clearly have seen house prices grow at
exhibit 1
HOUSE PRICES NATIONALLY HAVE GROWN AT A RATE OF ALMOST 6% SINCE 1995
Source: Freddie Mac
249
Home Prices
even faster rates, as well as experienced considerable volatility in prices. The question is whether house prices have become so overheated that they are in danger of an imminent crash.
Affordability
House prices have grown faster than income since 1996, but falling interest rates have more than offset the rise in prices, resulting in better affordability. (Exhibit 2)
exhibit 2
HOUSE PRICES HAVE GROWN FASTER THAN INCOME
Source: National Association of Realtors, Office of Federal Housing Enterprise Oversight, United States Bureau of the Census
Housing affordability remains at levels that are elevated relative to its history, although it is off its peak. Housing affordability has clearly been helped by the low level of interest rates over the past few years, but importantly, the index
exhibit 3
BUT HIGHER PRICES HAVE BEEN OFFSET BY LOWER INTEREST RATES
Source: National Association of Realtors
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would still be well above historical levels if rates were to rise 100 bp. (Exhibit 3) Moreover, the percent of the median familys income spent on servicing a mortgage for the median priced house remains near its lowest levels. (Exhibit 4)
exhibit 4
SHARE OF INCOME SPENT ON HOUSING IS NEAR HISTORICAL LOWS
Source: Morgan Stanley, United States Bureau of the Census, Federal Housing Loan Mortgage Corporation, Office of Federal Housing Enterprise Oversight
Even though house prices have risen, the question is, what is the alternative? Renting, obviously, but nationally the cost of renting actually has increased faster than the cost of owning a home over the past decade. (Exhibit 5) Whereas several years ago, it was cheaper to rent than to buy, the impact of lower interest rates on the cost of owning a home has been passed through directly to homeowners, whereas landlords have not passed on those benefits to renters.
exhibit 5
COST OF RENTING HAS INCREASED RELATIVE TO OWNING HOME
Source: Morgan Stanley, National Association of Realtors, Federal Housing Loan Mortgage Corporation, Office of Federal Housing Enterprise Oversight, Freddie Mac, Bureau of Labor Statistics
251
Home Prices
Demographics
The housing market is supported by demographic factors showing immigration growth and rising home ownership levels among minorities and immigrants. The home ownership rate in the U.S. has risen from 64% to 68% over the past eight years. For blacks, home ownership has increased from 42% to 47% and for Hispanics, from 41% to 48%, over the same period. The available market data as indicated by the time that houses are on the market awaiting sale suggests that there is no indication of weakness, nor was there weakness generally throughout the recession. Exhibit 6 shows the strength of the housing market nationally from the declining supply of homes on the market.
exhibit 6
MONTHS SUPPLY OF HOMES ON THE MARKET
Source: National Association of Realtors
HOUSE P RICES G ROWTH: R EAL V S. N OMINAL
We next look at house prices in real terms and compare them to their nominal increase. We find that while house prices have increased, in real terms this increase is markedly less than in nominal terms. We examine the housing market at the MSA level and consider house prices in real terms. We find that while prices have increased, in real terms, they have not risen much more than in the 1990s. Our conclusions are: Nominal house prices have continued to increase despite last summers rate increase. House prices in real terms over the past several years have risen markedly less than in nominal terms. Despite the run-up in nominal house prices over the past several years, in many cases real house prices are only just above their levels of several years ago.
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This suggests that the housing market can support a modest rise in nominal house prices, so long as the rate of increase slows.
Analysis
For our analysis, we deflate the house price indices in each respective metropolitan area that we consider by the consumer price index for that MSA or for the region that encompasses the MSA. We find that in most cases, the increase in house prices in real terms is markedly more modest than in nominal terms and in many cases where there had been a cyclical decline in house prices, the run-up in nominal terms over the past several years has brought house prices in real terms only somewhat above their pre-decline levels. This suggests that the housing market in general is not a bubble; indeed, a slowing in the rate of increase of nominal house prices would be beneficial for housing market stability. We used for our analysis house price index data from Case Shiller Weiss (CSW), a vendor of house price data, information and indices. CSW provides repeat sale index data on house prices for 119 metropolitan statistical areas (MSAs). Of these MSAs, there are 35 for which, in addition to an aggregate price index, CSW provides price indices for three price tiers: low, middle and high, with roughly 1/3 in each price tier for each respective MSA.1 Of these 35, there are 11 for which CSW additionally provides indices for three price sub-tiers within the highest price tier: low high, middle high and high high, again dividing the high tier roughly into thirds. For our analysis, we examined the price indices for these 11 MSAs for which we have six price tiers, which also affords us the ability to compare the behavior of the highest price tiers to the lower price tiers for the respective MSA.2 The MSAs that we examined are3: Phoenix-Mesa, AZ Los Angeles-Long Beach, CA Orange County, CA San Diego, CA San Jose, CA San Francisco, CA Denver, CO Washington, DC Atlanta, GA Chicago, IL Boston-Worcester-Lawrence-Lowell-Brockton, MA Looking at the 2- and 10-year Treasury rates, we have identified eight periods of rising interest rates from 1980 through 2003. These periods are: June 1980 September 1981 December 1982 June 1984 August 1986 March 1989 April 1993 December 1994 December 1995 March 1997 September 1998 April 2000 October 2001 March 2002 June 2003 September 2003
1 2
The tiers and breakpoints between price tiers are specific to each respective MSA. These 11 MSAs have three tiers low, middle and high with the highest tier divided into three additional tiers low high, middle high and high high. Arguably, then, these MSAs could be considered to have five, rather than six, unique tiers since the highest three tiers are subsets of the high tier. To be completely accurate, the first 10 regions listed here are MSAs, whereas the last item is a NECMA, or New England County Metropolitan Area. For simplicity of exposition, we will refer to all 11 of these regions as MSAs.
253
Home Prices
The gray vertical bars on the graphs indicate periods of rising interest rates; periods of falling interest rates can be seen simply by looking at the period between the end of one rising rate period and the beginning of the next. Exhibits 7-17 show nominal price indices for the low and super high (i.e., the high high) price tiers for the 11 MSAs listed above, as well as the house price indices in real terms (denoted lowR and high highR). We computed the real price indices by deflating the nominal indices by the respective consumer price index (CPI) for its MSA and region. The CPI data comes from the U.S. Department of Labor, Bureau of Labor Statistics. A few observations are worth noting. Consider Exhibits 7 and 13, price graphs for Phoenix and Denver, respectively. For the past 15 or 20 years, nominal house prices have risen in these two metropolitan areas, irrespective of interest rate environment, as both cities have exhibited tremendous growth. Looking at these two graphs, one might wonder just how high house prices can get. In real terms, however, the story gets interesting. In real terms, house prices in Phoenix and Denver were falling through much of the 1980s. While nominal prices in Phoenix seemed to take off like a rocket from a plateau in February 1992, real prices increased much more modestly. From February 1992 till March 2004, nominal prices for the lowest priced homes increased 115% and for the highest priced homes 105%, while in real terms, the increases were a more modest 60% and 55%, respectively. This suggests that while house prices certainly have increased, they have done so at about half the pace apparent from the nominal prices. Denver is a similar story: from April 1991 till March 2004, nominal prices for the lowest priced homes increased about 250% and for the highest priced homes 120%, while in real terms, they increased only 150% and 60%, respectively. Lets consider Chicago (Exhibit 16). Nominal house prices have increased dramatically since March 1991, with the lowest price index up 115% and the highest price index up 75%. In real terms, the increases are much less dramatic: 55% and 30%, for the lowest and highest price indices, respectively. Finally, no discussion of house prices would be complete without an examination of California. In nominal terms, house prices in Southern California got crushed in the early 1990s, as the local economy bore the brunt of a cutback in government defense spending on the Reagan era Star Wars defense program. House prices got hit hard, despite interest rates falling dramatically in that period: the 2-year Treasury yield fell almost 600 bp and the 10-year yield fell almost 400 bp. Clearly, the past several years have been ones of tremendous price increases. What is interesting, however, is that while in nominal terms, house prices in Los Angeles (Exhibit 8), for example, are 110% above their levels of the early 1990s for low priced homes and 55% above for the highest priced homes, in real terms, prices are just 50% above their early 1990s levels for low priced homes and only 10% above for high priced homes. So, while prices are higher today and they clearly fell from their local peak in the early 1990s due to local economic factors they have not risen nearly as much in real terms.
254
exhibit 7
PHOENIX-MESA MSA: LOW AND HIGH HIGH PRICE INDICES IN NOMINAL AND REAL TERMS
Source: Morgan Stanley; Case Shiller Weiss; U.S. Department of Labor, Bureau of Labor Statistics; Bloomberg Financial Markets
exhibit 8
LOS ANGELES-LONG BEACH MSA: LOW AND HIGH HIGH PRICE INDICES IN NOMINAL AND REAL TERMS
exhibit 9
ORANGE COUNTY MSA: LOW AND HIGH HIGH PRICE INDICES IN NOMINAL AND REAL TERMS
255
Home Prices
exhibit 10
SAN DIEGO MSA: LOW AND HIGH HIGH PRICE INDICES IN NOMINAL AND REAL TERMS
exhibit 11
SAN JOSE MSA: LOW AND HIGH HIGH PRICE INDICES IN NOMINAL AND REAL TERMS
exhibit 12
SAN FRANCISCO MSA: LOW AND HIGH HIGH PRICE INDICES IN NOMINAL AND REAL TERMS
256
exhibit 13
DENVER MSA: LOW AND HIGH HIGH PRICE INDICES IN NOMINAL AND REAL TERMS
exhibit 14
WASHINGTON MSA: LOW AND HIGH HIGH PRICE INDICES IN NOMINAL AND REAL TERMS
exhibit 15
ATLANTA MSA: LOW AND HIGH HIGH PRICE INDICES IN NOMINAL AND REAL TERMS
257
Home Prices
exhibit 16
CHICAGO MSA: LOW AND HIGH HIGH PRICE INDICES IN NOMINAL AND REAL TERMS
exhibit 17
BOSTONWORCESTERLAWRENCELOWELL-BROCKTON NECMA: LOW AND HIGH HIGH PRICE INDICES IN NOMINAL AND REAL TERMS
Conclusion
Looking at real, rather than nominal, house prices paints a different picture regarding the sustainability of the housing market. While in nominal terms, house prices have risen dramatically, when expressed in real terms, not only has the increase been markedly less, in many cases the levels are not very far above the levels of the early 1990s.
HOUSE P RICES I N A R ISING R ATE E NVIRONMENT
With interest rates having reached their lowest levels in decades and the economy starting to pick up, the Federal Reserve has begun to raise rates. The fear of a housing bubble has become somewhat pervasive as investors are concerned that higher rates will choke off housing demand by increasing the cost of servicing home mortgages and deflate the housing market.
258
In this section, we look at the performance of house prices in a rising rates environment by examining several past periods of rising interest rates and the impact that rising rates had on the housing market. Moreover, we recognize that there is not a housing market, but rather several localized housing markets, so we perform this analysis on price data from several metropolitan statistical areas for which we were able to obtain house price indices on various price tiers of housing. For each of the periods from 1980 through 2003, we examined the house price movements from the trough to the peak levels of interest rates. We further examined graphs of the price indices to ascertain whether house price movements lagged the actual rise in interest rates and would provide a different picture than the price movements exactly over the trough to peak move in rates. Our conclusions are the following: House prices generally rise in a rising interest rate environment; in fact, house prices generally rise, period. Some MSAs have experienced short periods either rising rate or falling rate environments in which house prices did not rise; in these cases, it usually was due to economic factors specific to that region or metropolitan area. In situations in which the region or metropolitan area experienced a decline in house prices, declines were experienced usually across the board, from highest priced homes to lowest. There were situations, such as the Southern California experience of the early 1990s, where higher priced houses fell more than lower priced homes, but this type of relative price behavior is not uniform across MSAs, time periods or interest rate environments. Exhibits 18 through 28 show price index paths for the low and super high (i.e., the high high) price tiers for the 11 MSAs for which we have multiple price tiers. The gray vertical bars on the graphs indicate periods of rising interest rates; periods of falling interest rates can be seen simply by looking at the period between the end of one rising rate period and the beginning of the next. A few items are apparent from the graphs. One is that house prices generally rise in periods of rising interest rates. Indeed, in Phoenix, Denver, Atlanta and Chicago, house prices rose generally over the past 20 years, irrespective of whether interest rates were rising or falling (Exhibits 18, 24, 26 and 27). Washington posted a period of time in which low priced homes were relatively stable for about 10 years, while prices of higher end homes drifted downward over that same period (Exhibit 25). In contrast, the California MSAs Los Angeles, Orange County, San Diego, San Jose and San Francisco and Boston show much greater cyclicality (Exhibits 19 through 23 and 28). The cyclicality in house prices reflects the underlying economic conditions of those areas. Note that even within California, the price swings in Southern California differ from those in Northern California due to their respective economic conditions.
259
Home Prices
The Southern California MSAs show house prices dropping significantly in the early 1990s in response to the scaling back of Reagan era defense spending on the Strategic Defense Initiative (known informally as the Star Wars program). House prices in Southern California were devastated in the early 1990s, with low price houses falling 20% and the highest end homes falling 35% in the case of Los Angeles, despite the period from early 1989 till early 1993 being one in which the 2-year Treasury yield declined almost 600 bp and the 10-year Treasury yield fell almost 400 bp.4 Offsetting the positive impact of lower interest rates, the unemployment rate in Los Angeles doubled from 5.1% in 1988 to 10.2% in the early to mid-1990s. As we move up the coast, San Jose experienced a less severe downward price shock in the early 1990s, but had more price volatility in the dot com and post-dot com era. And slightly further north, we see San Francisco took even less of a hit than San Jose in the early 1990s, and had less volatility in the dot com and post-dot com environment. In the meantime, while the post-dot com collapse was wreaking havoc in Northern California, house prices in Southern California were on and have continued to be on a sharp upward path since the mid-1990s. We conclude from this that while interest rates clearly are an important factor in making houses more or less affordable, their impact is outweighed by local or regional economic factors that result in overall favorable or unfavorable conditions. Or, put differently, all housing markets are local. What about the differential impacts on high vs. low priced homes? The price indices shown in Exhibits 18 through 28 can provide guidance here, as well. In a research report in early 2003, we examined 104 MSAs and concluded that the MSAs with more modest priced homes withstood better the fallout from the house price recession in the early 1990s than did the MSAs with higher priced homes.5 The series employed in the earlier research report was MSA level median sale price data. The Case Shiller Weiss indices are based upon repeat sales of the same house, are constructed in a more reliable manner and in many cases are
exhibit 18
PHOENIX-MESA MSA: LOW AND HIGH HIGH PRICE INDICES
Source: Case Shiller Weiss
4 5
Peak to trough declines in the 2- and 10-year Treasuries were 587 bp and 392 bp, respectively. See the Morgan Stanley ABS Perspectives, House Prices and Home Eqs, March 14, 2003.
260
exhibit 19
LOS ANGELES-LONG BEACH MSA: LOW AND HIGH HIGH PRICE INDICES
exhibit 20
ORANGE COUNTY MSA: LOW AND HIGH HIGH PRICE INDICES
exhibit 21
SAN DIEGO MSA: LOW AND HIGH HIGH PRICE INDICES
261
Home Prices
exhibit 22
SAN JOSE MSA: LOW AND HIGH HIGH PRICE INDICES
exhibit 23
SAN FRANCISCO MSA: LOW AND HIGH HIGH PRICE INDICES
exhibit 24
DENVER MSA: LOW AND HIGH HIGH PRICE INDICES
262
exhibit 25
WASHINGTON MSA: LOW AND HIGH HIGH PRICE INDICES
exhibit 26
ATLANTA MSA: LOW AND HIGH HIGH PRICE INDICES
exhibit 27
CHICAGO MSA: LOW AND HIGH HIGH PRICE INDICES
263
Home Prices
exhibit 28
BOSTONWORCESTERLAWRENCELOWELL-BROCKTON NECMA: LOW AND HIGH HIGH PRICE INDICES
broken down into price tiers; indeed, Exhibits 18 through 28 present house price indices for the highest and lowest price tiers for the MSAs that we examined.6 While we conjectured and believed we had shown that high priced homes would be likely to feel the impact of a house price recession to a greater extent than lower priced homes, there is not clear evidence that this is the case across a range of MSAs and time periods. There are instances, such as San Francisco from April 2001 to the present, when both lower and higher priced homes had their prices dip, but the lower priced homes increased in value by 17% from January 2002 while the higher priced home prices trended downward. The fact that the lower priced homes in San Francisco rose while those of higher priced homes fell despite both high and low priced houses falling in nearby San Jose in the same period reflects the greater diversification in the San Francisco economy and the housing markets reaction to local economic conditions. Likewise, in the early 1990s, prices of the highest priced homes in the Los Angeles MSA fell about 35% from their local peak, while those of the lowest priced homes experienced a decline of only 20%. Other MSAs over other time periods and rate environments show different behaviors. We conclude that house prices generally rise over time across MSAs and interest rate scenarios except when local economic conditions get in the way.
HOUSE P RICES I N A REAS O F E CONOMIC D ECLINE
The question we want to examine now is less the cyclical behavior of rising, falling and then rising local economies, but rather the behavior of house prices in metropolitan areas that have experienced longer term economic decline. Examples of these latter areas would be cities that were highly dependent upon manufacturing in a single industry or a few industries that have experienced a secular downturn in their fortunes. We find that even in areas that have experienced long term economic weakness, house prices tend to rise.
In our earlier report on house prices, we indicated that a shortcoming of that analysis is that we had house price data only on the MSAs as a whole and that better data would break down house prices into tiers, such as the Case Shiller Weiss data.
264
Analysis
The MSAs we examine here are those that we identified as having experienced longer term economic weakness. The criterion that we used to classify these MSAs is that they had significantly higher than average unemployment rates in the early 1980s or posted unemployment rates well above average in the early 1990s and/or suffered from elevated levels of unemployment over an extensive period of time. The national unemployment rate (non-seasonally adjusted) peaked in January 1983 at 11.4%, declined and then reached a local peak of 8.2% in February 2002, then fell to a low of 3.6% in October 2000 and sits in December 2003 (the most recent date available) at 5.4%.7 The following is the list of MSAs that we identified as having longer term economic difficulty. This list is by no means exhaustive and other analysts may classify other MSAs within the CSW universe as belonging to this list or some on this list as not belonging on it but we believe that it is reasonably representative to examine the issue of house prices in metropolitan areas that have experienced secular declines in their fortunes.8 Bakersfield, CA Chico-Paradise, CA Merced, CA Riverside-San Bernardino, CA Salinas, CA Fort Pierce-Port St. Lucie, FL Lakeland-Winter Haven, FL Peoria-Pekin, IL Pittsfield, MA Detroit, MI Lansing-East Lansing, MI Atlantic-Cape May, NJ Jersey City, NJ Newark, NJ Buffalo-Niagara Falls, NY Akron, OH Canton-Massillon, OH Youngstown-Warren, OH Pittsburgh, PA Corpus Christi, TX El Paso, TX Exhibits 29 through 49 show the aggregate price index for each respective MSA, as well as time series of the MSAs unemployment rate and the national unemployment rate. The gray shaded areas of the graphs indicate periods of rising interest rates.
7
We compared the unemployment rates for the individual MSAs to the non-seasonally adjusted national unemployment rate because the MSA unemployment rates are available only in the non-seasonally adjusted form. Technically, Pittsfield, MA, is a NECMA New England County Metropolitan Area rather than an MSA, but for ease of exposition, we refer to all of these regions as MSAs.
265
Home Prices
exhibit 29
BAKERSFIELD MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
Source: Morgan Stanley, Case Shiller Weiss, Bureau of Labor Statistics, Bloomberg Financial Markets
exhibit 30
CHICO-PARADISE MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
exhibit 31
MERCED MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
266
exhibit 32
RIVERSIDE-SAN BERNARDINO MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
exhibit 33
SALINAS MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
exhibit 34
FORT PIERCE-PORT ST LUCIE MSA: . PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
267
Home Prices
exhibit 35
LAKELAND-WINTER HAVEN MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
exhibit 36
PEORIA-PEKIN MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
exhibit 37
PITTSFIELD MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
268
exhibit 38
DETROIT MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
exhibit 39
LANSING-EAST LANSING MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
exhibit 40
ATLANTIC-CAPE MAY MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
269
Home Prices
exhibit 41
JERSEY CITY MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
exhibit 42
NEWARK MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
exhibit 43
BUFFALO-NIAGARA FALLS MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
270
exhibit 44
AKRON MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
exhibit 45
CANTONMASSILLON MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
exhibit 46
YOUNGSTOWNWARREN MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
271
Home Prices
exhibit 47
PITTSBURGH MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
exhibit 48
CORPUS CHRISTI MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
exhibit 49
EL PASO MSA: PRICE INDEX AND LOCAL AND NATIONAL UNEMPLOYMENT RATES
272
Results
While the exhibits show local and national unemployment rates dating back to 1980, the price indices unfortunately begin generally only in 1984 or 1985; in some cases, the price series do not begin until the late 1980s and in a few, the indices begin in 1980. It therefore is unclear exactly how house prices behaved during the weak economy of the early 1980s contemporaneous with the peak in local unemployment rates. That said, at least for those price series that extend back to the early 1980s, and arguably from the others, it appears from examination of the price series that are provided that there has not been a long term permanent decline in the level of house prices. While without having explicit price data for those series that do not begin until later in the 1980s, we cannot for these MSAs positively rule out that house prices were higher in the late 1970s or early 1980s than they are today, it seems hard to believe that house prices in, say 1980 for Peoria, would have dropped from somewhere near their current index level of 250 to their first reported index value of about 75 representing a drop of 70% in six years. Likewise, for areas such as Buffalo for which we have price data back to 1983, it seems unlikely that house prices would have dropped about 60% in three years, which would have had to occur for there to have been a permanent decline in the value of houses in that metropolitan area. Six of the price series do extend back to 1980 and these MSAs have not experienced a permanent decline in the value of their houses. We also note that some MSAs, such as Salinas or Lakeland, display an incredible seasonal variability in their unemployment rates. If we were to draw a line in between each years peak and trough unemployment rates, we would get an average unemployment rate that still would be markedly higher than that of the national average.
Conclusion
We extended our previous analysis of house price behavior that primarily was concerned with the behavior of house prices in a rising interest rate environment. In this section, we consider house prices in metropolitan areas that have experienced long term economic weakness. We conclude that even in these cities, house prices over the long run tend to rise.
273
274
Section VII Home Equity Handbook
Analyzing Securitization Performance
275
276
Ratings Transition Matrix

METHODOLOGY
chapter 21
We examined all HEL ABS classes for which ratings either were upgraded or downgraded by Moodys, Standard & Poors or Fitch. Exhibit 1 reports the move from the bonds original rating to its current rating without taking into account any interim ratings changes. If a bonds rating is changed by more than one rating agency, then the bond is counted as having a change for each rating agency action
SUMMARY
Classes with certain original ratings are much more likely than others to experience rating changes, and these changes may be much more likely to be in one direction than the other: ratings changes on higher rated classes tend to be upgrades, while those on lower rated classes tend to be downgrades. Ratings downgrades due to poor collateral performance are more likely to show up sooner than ratings upgrades due to excellent collateral performance. When one class in a transaction is downgraded, there are on average about two tranches in that transaction that get downgraded, and each downgraded tranche averages about 3.5 notches of downgrade. Therefore, investors who purchase the BBB rather than BBB- in the belief that they will be markedly more insulated from downgrade risk may well be disappointed. Conseco/Green Tree accounts for 32% of the total number of HEL downgrades, but also accounts for 30% of the upgrades. Frequently, when B2 classes were downgraded, the M1 and M2 classes from the same transaction were upgraded, testimony to the validity of the capital structure of the transaction.
277

exhibit 1 TRANSITION MATRIX: ALL HISTORICAL HEL RATING
CHANGES TO DATE
AA AAA+
Original Rating
Current Rating AAA AA+ A ABBB+ BBB BBBBB+ BB
AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ CCC CCCCC C D Total Up Down 136 136 0 2 2 1 6 11 89 1 3 21
1 41
8 3 4 1 4 7 1 1 11 20 1 1 1 3 7 1 8 8 5 2 6 5 2 4 1 1 1 21 7 20 1 2 2 1 1 2 2 1 1 1 4
11
28
1 1
Upgrades
54 53 1
47 36 11
11 11 0
27 23 4
30 22 8
8 6 2
11 3 8
13 4 9
20 1 19
16 1 15
33 0 33
Source: Morgan Stanley, Moodys Investors Service, Standard & Poors, Fitch
WHATS I NTERESTING Direction of Change, Given Rating Change
It is interesting to note that classes with certain original ratings are much more likely than others to experience ratings changes, and these changes may be much more likely to be in one direction than the other. Part of this phenomenon is that there simply are more AAA, AA, A and BBB classes than, say, BBB+ or A- classes, although it is worth noting that for all the AAAs out there, only 9 have been downgraded. The classes with the most ratings changes are those with original ratings of single A (160 changes), BBB (154) and AA (147). Again, it is not too surprising that the flat letter ratings have experienced the most changes, but it is noteworthy that so few of the AAAs have ever been downgraded, even despite
278
Current Rating BBB+ B BCCC+ CCC CCCCC C D Total Up Down
9 15
0 11 130 2 7 91 1 2 33 4 1 9 0 0 6 0 0 2 0 0 0 0 299
9 4 17 1 3 69 23 30 121 41 7 30 1 0 28 17 1 0 2 1 0 0 405
Downgrades
1 2 4 5 5 1 1 1 1 3 2 4 11 5 4 2 10 1 16 4 1 5 14 3 4 3 2 1 1 2 2 4 2 3 3 28 4 4 18 7 4 1 1 7 8 1 3 1 1 6 1 6 1 1 2 1 14 15 1 2 1 18 2 6
147 3 10 160 24 32 154 45 8 39 1 0 34 17 1 2 2 1 0 0
20 3 17
4 0 4
29 0 29
33 0 33
3 0 3
37 0 37
16 0 16
64 0 64
26 0 26
66 0 66
704 299 405
the problems in the industry with the 1997-98 originations. More interesting is the direction of the ratings changes for given original rating: of the original AAs, almost 90% of their ratings changes have been upgrades. of the original single As, almost 60% of their changes have been upgrades. of the original BBBs, almost 80% of their changes have been downgrades. of the original sub-investment grades classes, almost 85% of their changes have been downgrades. It is clear that rating changes on the higher rated classes tend to be upgrades, while those on lower rated classes tend to be downgrades.
279

Bonds Go Bad Sooner Than They Go Good
It also is interesting how the various vintages have experienced ratings changes over time. This reflects both the seasoning of the transactions and the timing of collateral going bad vs. going better. Exhibit 2 compares ratings changes by transaction issue year from the present examination of ratings changes to those from our previous examination in 2002. With the exception of the 1994 and 1995 cohorts, which already were seasoned when we last analyzed ratings changes in 2002, upgrades as a share of total ratings changes has increased for each of the vintages since our previous analysis in 2002. This suggests to us that ratings changes due to poor collateral performance are more likely to show up sooner than ratings changes due to excellent collateral performance. On considering this, it makes intuitive sense. Losses on mortgages tend to increase in the second to third year after origination; very poor collateral usually shows much larger increases in losses over this period, and therefore transactions backed by this poorly performing collateral would be downgrade candidates, while very strong collateral performance would only be borne out over time, as the transaction deleverages, thus delaying an upgrade.
exhibit 2
RATINGS CHANGES BY VINTAGE

As of September 2004 As of June 2002 Upgrade 17 6 17 44 25 1 0 0 NA NA NA 110 Downgrade 12 9 28 97 40 14 4 0 NA NA NA 204 Upgrade as % of Changes 59 40 38 31 38 7 0 NM NA NA NA 35
Vintage 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Total
Upgrade 21 6 32 72 62 34 33 24 0 0 0 284
Downgrade 22 15 39 132 81 47 35 28 0 0 0 399
Upgrade as % of Changes 49 29 45 35 43 42 49 46 NM NM NM 42
Note: The number of ratings changes does not add up to the number of ratings changes in Exhibit 1 because this exhibit excluded transactions issued prior to 1994. Source: Morgan Stanley, Moodys Investors Service, Standard & Poors, FitchRatings
Downgrades Are Contagious
It is noteworthy that when one class in a transaction is downgraded, it frequently is the case that other classes will also be downgraded: of the 132 deals experiencing downgrades, 57 had more than one class downgraded. Moreover, when one class in a transaction is downgraded, there are on average 1.87 tranches in that transaction that get downgraded, and each downgraded tranche averages 3.57 notches of downgrade.1,2 The practical significance of this is that an investor who prefers to own a BBB class, rather than the BBB-, in the belief that if the collateral performs poorly, the BBB- may get downgraded to sub-investment grade, but the BBB should be
1
To be completely clear, given that one class gets downgraded, on average a total of 1.87 tranches in the transaction get downgraded (not 1.87 additional tranches). When a BBB- gets downgraded, it averages 4.17 notches of downgrade, while the BBB averages 3.52 notches of downgrade.
280
protected, may be in for disappointment: there is a 43% chance that the BBB would get downgraded as well, and if it experiences the average notch downgrade, then it, too, would fall to sub-investment grade. Therefore, investors who are comfortable in the BBB class but avoid the BBB- because of downgrade fears should generally take the extra spread offered in the lower rated tranche.3
The Conseco Effect
Play Word Association, and the first word that comes to mind after saying Conseco is downgrade. Well, possibly bankrupt comes first, but downgrade would be a reasonably close second. It seems reasonable to ask, then, how much of these downgrade numbers are due to Conseco? When Conseco/Green Tree was in the process of having its corporate credit rating downgraded, it triggered an automatic downgrade on the B2 classes of its securitized transactions, because Conseco/Green Trees limited corporate guarantee on these classes caused the tranche ratings to be higher than would have been achieved by structure alone. With the provider of the guarantee downgraded, the guaranteed classes were downgraded; over time, many of these were downgraded further owing to weak collateral performance. What is interesting is that while Conseco/Green Tree accounts for 32% of the HEL downgrades, it also accounts for 30% of the upgrades. While the B2 classes frequently were downgraded several times initially, owing to the downgrade of the guarantor and later due to poor collateral performance frequently the B1 classes maintained their original ratings, which were based upon structure and not a corporate guarantee. With a few exceptions, the M1 and M2 mezzanine classes accounted for the upgrades there were 91 Conseco/Green Tree upgrades in all while the B2 subordinate tranche accounted for the vast majority of the downgrades, of which there were 128. Moreover, it is noteworthy that in many cases where the B2 tranche was downgraded, the M1 and M2 tranches of the same transaction were upgraded, validating the strength of the capital structure.
Whats in a Name?
What is interesting is that despite the association of Conseco/Green Tree with downgrades and bankruptcy, the upgrade/downgrade ratio of GE Mortgage actually is much worse. The rating agencies downgraded 63 tranches on GECMS deals and did not upgrade any, with all but 6 downgrades suffered by subordinate classes. Indy Mac likewise was shut out on the upgrade side, but suffered 36 downgrades, while ContiMortgage experienced 53 downgrades and only 4 upgrades.
BBBs Experienced the Most Downgrades
Triple-Bs remain the most downgraded rating category, with 192 downgrades to only 39 upgrades (see Exhibit 1). BBBs are the most leveraged part of the capital structure, so it is not surprising that this occurred. Moving up the capital structure, we noted an improvement in the downgrade to upgrade ratio. Single-As experienced an almost equal number of downgrades to upgrades, with 99 downgrades to 95 upgrades. Of the subordinate and mezzanine classes, double-As remain inherently the safest. There were 22 downgrades to 143 upgrades.
Of course, if the BBB- class is downgraded, the BBB tranche will trade like it has been downgraded, irrespective of whether or not it has been downgraded, and the investor will experience a negative mark-to-market.
281
282
Credit Coordinates
Analyzing home equity loan collateral performance requires examining both losses and delinquencies, neither of which should be considered in isolation. Combining the two performance measurements into a framework supplies a more accurate picture. We applied a scatterplot to the data and created four quadrants with the industry average as the boundary point that separates the quadrants. Issuer performance falls into one of four quadrants (see Exhibit 1). Even though most issuers cluster close to the industry average, technically they fall into one of the four different quadrants. We believe more focus should be placed on the outliers within a quadrant than on the list of issuers within a quadrant.
exhibit 1
chapter 22
SCATTERPLOT KEY
ABOUT T HE D ATA
The delinquencies and losses represent those from transactions issued off the respective issuers shelf. For example, loans originated by a finance company and sold to an investment bank that subsequently securitizes the loans will show up under an investment banks shelf. If a finance company issues a deal off its shelf, the deals will be listed under the finance companys name. There are some caveats that may apply, but we believe that this analysis will still prove to be a useful exercise. For example, most subprime issuers use the OTS1 method for reporting subprime delinquencies, while a select few employ the MBA method. Also, in some graphs Conseco seems to be outperforming the industry. While this is possible, we believe that its loan modification policies may be significantly influencing performance. It may be well after the conclusion of bankruptcy preceedings before a true picture emerges, but already we have noticed a ramp up in losses over the past year.
LOWER L EFT A ND U PPER R IGHT: S IMPLE T O I NTERPRET
The lower left-hand quadrant (low losses and low serious delinquencies) and the upper right-hand quadrant (high losses and high serious delinquencies) are easy to interpret2. Issuers that fall into the lower left-hand quadrant are solid
1
The MBA delinquency method counts a loan as delinquent if its payment is not received by its due date. A loan due December 1st would be delinquent if its payment was not received by December 1st and it would fall in the 1-29 day delinquency bucket. The OTS method would not consider the loan delinquent until the payment had not been received on January 1st. We define serious delinquencies as loans that are 60+ days delinquent plus any loans in foreclosure or REO and borrowers who have filed for bankruptcy.
283
Credit Coordinates
performers and less risky. Issuers that land in the upper right-hand quadrant are the riskiest, with losses above the industry average and a large pipeline of delinquencies that could boost losses even more. Deals that are in the upper right-hand quadrant hopefully have more subordination and overcollateralization than deals in the lower left-hand quadrant.
UPPER L EFT A ND L OWER R IGHT: N EEDS M ORE A NALYSIS
The upper left-hand quadrant (high losses and low serious delinquencies) and the lower right-hand quadrant (low losses and high serious delinquencies) are tougher to analyze and not all the data may be readily available to provide a proper analysis. These issuers probably require closer surveillance. For example, in order to analyze the upper left-hand quadrant, you need to understand whether the velocity of loan resolution is making losses high while maintaining low delinquencies or whether delinquency performance has stabilized after a chunk of bad loans was resolved. The lower right-hand quadrant needs to examine whether delinquencies have stabilized, grown or declined in the past few months to determine whether the company is curing or liquidating the delinquencies. Roll rate analysis could be key to determining the future health of the deals, but this is not always readily available.
284
exhibit 2
CREDIT COORDINATES VARIOUS VINTAGES
1998 ARMS
1998 FIXED
1999 ARMS
1999 FIXED
285
Credit Coordinates
exhibit 2
CREDIT COORDINATES VARIOUS VINTAGES (CONTINTUED)
2000 ARMS
2000 FIXED
2001 ARMS
2001 FIXED
286
Industry Performance Comparison

In this chapter, we examine equity collateral performance in terms of cumulative losses, serious delinquencies and prepayment rates. We examine the industry performance as a whole, as well as compare performance of the top issuers, and include a report for each of the major issuers comparing collateral performance of their respective transactions with that of the industry for similar vintage.
SUMMARY
chapter 23
Cumulative losses of HEL collateral have been well behaved. Even the worst performing 1998-99 cohorts have loss trajectories that likely would result in ultimate cumulative losses on the order of 6%. The trajectory of the better performing 2000 cohort likely would put its ultimate cumulative losses at about 3%. For perspective, the Morgan Stanley ABS Research base case loss scenario is 5%. Serious delinquencies for subprime are high relative to prime mortgage standards, but it is noteworthy that the 2000-01 subprime vintages are showing higher age-adjusted delinquencies than the weak performing 1998-99 vintages, even though the cumulative losses of the 2000-01 cohorts are on a trajectory for much lower losses than the 1998-99 year classes. HEL prepayments for ARM and mixed collateral pools are highly dependent upon the reset date and expiration of prepayment penalties. Prepayments for all HEL collateral types have been elevated for the more recent vintages owing to the interest rate environment of the past three years. The top issuers in the home equity sector over the past two years are listed in Exhibit 1, while the leading dealer shelf issuers are reported in Exhibit 2.
exhibit 1 Rank 1 2 3 4 5 6 7 8 9 10
LEADING HEL ABS ISSUERS, 2003-2004*

Volume ($BN) 62.44 47.15 43.74 40.94 20.42 18.85 18.84 17.10 12.63 12.35
Issuer GMAC-RFC Ameriquest Lehman Bros. Countrywide Morgan Stanley CSFB First Franklin Long Beach Bear Stearns New Century
* Through September 14, 2004 Source: Morgan Stanley, Asset Backed Alert
exhibit 2 Rank 1 2 3 4 5
LEADING HEL DEALER SHELF ISSUERS, 2003-2004*

Volume ($BN) 43.74 20.42 18.85 12.63 10.90
Issuer Lehman Bros. Morgan Stanley CSFB Bear Stearns Goldman Sachs
* Through September 14, 2004 Source: Morgan Stanley, Asset Backed Alert
287

COLLATERAL P ERFORMANCE: C UMULATIVE L OSS A ND SERIOUS D ELINQUENCIES
Cumulative losses at the industry level have been very well behaved (Exhibit 3). The 1998-99 vintages clearly are the worst performing: cumulative losses for these cohorts are in excess of 100 bp more than losses for the 2000 cohort. What is interesting is that even for the 1998 cohort, which is the worst performer and was the victim of serious appraisal problems, misaligned incentives owing to gain-on-sale accounting and a host of other problems, cumulative losses as of month 68 still are below 5%. A continuation of the 1998 cumulative loss line would likely result in ultimate losses for the cohort on the order of 6%, although there clearly is dispersion of loss rates among transactions in the cohort.
exhibit 3
INDUSTRY CUMULATIVE LOSSES: EVEN THE WORST VINTAGES SHOULD NOT EXCEED 6%
While the 1998-99 vintages have been beset by significant problems in the industry, the more recent cohorts, in contrast, have benefited tremendously from several factors: extremely strong housing market, falling (until recently) interest rates, emergence of dealer shelves that have rationalized pricing in whole loan transactions. The latter item appears to have resulted in better underwriting and appraisals for the industry generally, while the former have reduced severities and default rates. A continuation of the 2000 cohort loss curve in Exhibit 3 would suggest that cumulative losses on that vintage would likely asymptote at 3%, which is 300 bp below the level that 1998-99 cohort losses will likely materialize. We therefore have long believed that 5% cumulative losses is the long term normal expected loss rate for home equity collateral, and it is this level that we have used as our base case in our scenario analyses1. The serious delinquency picture looks a bit different from the loss graph: while the 1998-99 cohorts show the highest levels, the 2000-01 vintages are showing higher serious delinquencies on an age adjusted basis. As of month 32, the 2001 vintage has serious delinquencies that are 5% above that of both the 1999 and 2000 cohorts, and 10% above the 1998 vintage (Exhibit 4)2. The
See, for example, any number of the analyses in this Home Equity Handbook. Serious delinquencies are defined as 60+ day delinquencies, plus bankruptcies, foreclosures and REO.
288
2000 vintage has serious delinquencies that are 300 bp above those of 1999 and about 200 bp above those of 1998. The path of serious delinquencies on the 2000-01 vintages bears watching.
exhibit 4
INDUSTRY SERIOUS DELINQUENCIES: 2000-01 VINTAGES ARE ON TRAJECTORY TO EXCEED 1998-99 COHORTS
DEALER S HELVES
So-called dealer self-shelf home equity loan programs arose from the smoldering ashes of the late 1990s, which saw many of the largest finance company HEL issuers collapse under the weight of overly aggressive gain-onsale accounting. The nature of gain-on-sale required the issuers to pump out volume, which in many cases, compromised the appraisal and lending process. Thus arose the self-shelf programs, which provided thinly capitalized finance companies with a liquidity option away from securitization. The dealer programs since have evolved from simply purchasing loan pools to incorporating their own due diligence, re-appraisal and re-underwriting procedures to improve the credit quality of the purchased loans, rejecting loans that do not fit the respective dealers criteria and leaving the dealer with presumably higher quality loans3,4. That said, we would expect that over time, the collateral performance of the transactions issued off the dealer shelves should be better than the industry average. Until now, the history of these transactions was too limited to draw any conclusions. We now have enough historical performance on the 2000-2001 originations to draw the conclusion that the dealer self-shelf transactions are performing better than the industry average. The more recent originations still have limited histories. We will continue to monitor the relative collateral performance of the self-shelf transactions vis--vis the industry average. The relevance of the performance differential is significant. Self-shelf transactions can trade at a slight concession to non-dealer securitizations. The spread differential is most often attributed to liquidity, as investors perceive that dealers support their own respective transactions more aggressively, and understand them better, than those of other dealers.
The due diligence, underwriting and appraisal processes vary from dealer to dealer, but the intent of all of these programs is to improve the quality of the loans that the dealers purchase. Morgan Stanley is an active issuer of HEL ABS off its own shelf.
289

In addition, the differential also points to the fact that the dealer programs have not really been tested from a collateral performance standpoint. While the data presented in this report show that thus far the dealer shelf transactions appear to be performing better than the non-dealer programs, it will require more history to state definitively that the mezz and subclasses from dealer shelf programs are undervalued relative to their collateral performance. Exhibit 5 compares the cumulative losses of the dealer shelves to that of the industry excluding dealer shelves for 1999 through 2002. For 2000, cumulative losses on dealer shelf transactions are 140 bp below those of the non-dealer issuers, while 2001 dealer shelves have losses that are 40 bp lower than the nondealers. For 2002, dealer and non-dealer losses are the same, but there is only two years of data and we would expect there to be more of a divergence over the next 12 months.
exhibit 5
DEALER SHELVES VS. REST OF INDUSTRY: DEALER CUMULATIVE LOSSES ARE LOWER THAN NON-DEALER LOSSES
While Exhibit 5 looks at the cumulative loss performance of issuers in aggregate, Exhibits 6 and 7 compare the cumulative losses of the top 5 nondealer and dealer issuers, respectively. The top issuers graphed in Exhibits 6 and 7 were chosen from the league tables in Exhibits 1 and 2 for leading issuers in 2003-04, although the cumulative loss data in Exhibits 6 and 7 show cumulative losses for the 2002 vintage so that there is enough history to be meaningful.
290
Exhibit 6 shows that among the top five non-dealer issuers, Countrywide has had the lowest cumulative losses to date on their 2002 cohort of 26 bp, while GMAC-RASC has posted the highest cumulative losses to date of 1.90%.
exhibit 6
NON-DEALER SHELF CUMULATIVE LOSSES: COMPARISON AMONG TOP 5 NON-DEALER ISSUERS, 2002 COHORT
For the dealer shelves in Exhibit 7, the lowest cumulative losses on the 2002 vintage to date have been turned in by Morgan Stanley with 67 bp, followed closely by Lehman at 73 bp. The highest so far has been Bear Stearns at 1.04%.
exhibit 7
DEALER SHELF CUMULATIVE LOSSES: COMPARISON AMONG TOP 5 DEALERS, 2002 COHORT
291

PREPAYMENTS
Exhibits 8-10 report prepayment rates on HEL collateral, for ARM, fixed and mixed collateral pools, respectively. We show each type separately, because of the changed significance of ARM, fixed and mixed collateral pools over time.
exhibit 8
INDUSTRY ARM PREPAYMENT RATES
exhibit 9
INDUSTRY FIXED RATE PREPAYMENT RATES
292
exhibit 10
INDUSTRY MIXED COLLATERAL POOL PREPAYMENT RATES
Vintage prepayments generally have been higher in the first two years for the more recent cohorts, which is not surprising given the interest rate environment of the past three years. As we have noted previously, ARM prepayments are very calendar dependent, with spikes coming around the reset dates, which generally coincide with the expiration of prepayment penalties. To some extent, the spikes are muted owing to age dispersion among the underlying loan pools.
exhibit 11
PREPAYMENT RATES FOR TOP 5 NON-DEALER ISSUERS: ALL COLLATERAL, 2002 VINTAGE
Exhibits 11 and 12 compare the prepayment rates for the top 5 non-dealer and dealer issuers, respectively, for the 2002 vintage. We combine all collateral types for these prepayment graphs because of the increased use of mixed collateral pools in the past few years.
293

exhibit 12
PREPAYMENT RATES FOR TOP 5 DEALER ISSUERS: ALL COLLATERAL, 2002 VINTAGE
The prepayment paths are similar in shape, although Ameriquest shows a bit faster path for most of the first 24 months, at which point First Franklin spikes above the others. We have to be careful not to generalize too much because in aggregating pools, we may be masking some underlying dispersion in loan age and other characteristics. In terms of the dealer shelf prepayment speeds in Exhibit 12, speeds generally are consistent among the issuers, with the exception that Bear Stearns has the flattest profile, faster than the others for the first 12 months and slower than the rest for the later months. Likewise, Goldman Sachs is a bit faster around the reset date than the others.
294
Separating the Good from the Bad

Beware of the Outliers. Long our motto of choice for HEL investors, we sometimes struggle to differentiate a blip from a trend. One or two basis points of cumulative losses early in a deal does not necessarily spell disaster, but consistently higher losses several months later cannot be ignored. We look to establish the point at which credit performance data becomes meaningful.
SUMMARY
chapter 24
Little dispersion in credit during early months CONHE 1998-4 performed acceptably for first 16 months Performance forecasts are much more reliable after 24 months of seasoning Possible evidence that new issue could be cheap to one year seasoned paper, but probably not in this environment Virtually all deals start with identical performance (no losses or delinquencies), but the dispersion of credit performance increases dramatically as deals season. Even as the numbers first become large enough to differentiate, we find that seemingly good deals can reverse course quite rapidly.
exhibit 1
SPSAC 1998-1 LOSSES WERE LOWER THAN INDUSTRY FOR FIRST 14 MONTHS
To illustrate our point, we display one of the worst performing deals ever, Southern Pacific 1998-1 (Exhibit 1). After one year, SPSAC 1998-1 had experienced 6 bp of cumulative loss, while the average deal in the industry had 10 bp of loss. Less than five years later, this deal has posted cumulative losses over twice the industry average.
295

exhibit 2
TMSHE 1998-B ALWAYS HAS HAD LOWER THAN AVERAGE DELINQUENCIES
Cumulative losses take some time to appear, but delinquencies could differentiate collateral more quickly. There are, however, examples like The Money Store 1998-B. This deal has never posted 60+ day delinquencies higher than the industry average, but losses are over 40% worse than the industry (Exhibit 2).
exhibit 3
CONHE 1998-4 LOOKED OK AFTER 16 MONTHS

After 16 Months CONHE 1998-4 6.61 0.34 Industry 7.72 0.28 Ratio 0.86 1.19 Current Performance CONHE 1998-4 39.94 8.10 Industry 23.22 4.63 Ratio 1.72 1.75
60+ Day Del Cum. Loss
For those arguing that a combination of losses and delinquencies will accurately forecast future performance, we offer ContiMortgage 1998-4. After 16 months of seasoning, delinquencies were 14% below average and cumulative losses were only 6 bp higher than the industry. As of the latest remittance report, however, both delinquencies and losses are approximately 75% higher than the industry average.
296
HOW L ONG I S L ONG E NOUGH?
Although the data on CONHE was inconclusive after 16 months of seasoning, we do believe that a combination of delinquency and loss comparisons is the best approach. In order to address predictive ability, we set up a linear regression with a dependent variable of final cumulative losses of the deal as a percentage of comparable industry average losses. For example, if the final cumulative loss for a deal is 6%, and the industry average is 4%, then our independent variables would hopefully predict a value of 1.5. For each month of seasoning, our independent variables include current credit performance statistics as a ratio of current industry performance. Referring back to Exhibit 3, for example, we would use the credit performance ratios of 1.19 and 0.86 to try and predict 1.75 in our linear regression. Our universe for this analysis consisted of deals originated in 1998, because most of the deals have paid down substantially and the majority of losses should already have been incurred. We performed a linear regression for each month of seasoning, and not surprisingly, our predictive ability increased as the deals seasoned (Exhibit 4).
exhibit 4
R-SQUARE RISES WITH TIME
297

By definition, the R-square of our linear regression should approach 100%, because we are trying to predict final cumulative losses using current cumulative losses. Thus, towards the end of the deal, we are basically using final cumulative losses to predict final cumulative losses. We are happy to see, however, that after only two years of seasoning, compared to over five years of life in the deal, we have achieved an R-square of 75%. Another way of presenting this data is to show scatter plots for various months of seasoning, looking for a relationship. In Exhibits 5 through 10, the x-axis signifies the credit performance ratios as of that month of seasoning (diamonds are current deal delinquencies/industry average delinquencies and squares are current deal cumulative losses/industry average cumulative losses). The y-axis shows the final loss ratio (final deal cumulative losses/final industry cumulative losses). We are looking for a linear relationship starting at the origin and continuing up and to the right. This would mean that the current ratio of deal performance to industry performance is similar to the final ratio. Points to the upper left would mean that current deal performance is relatively good compared to the final performance and points at the lower right have poor current performance compared to the final results. With six months of seasoning many of the deals have not accumulated any losses yet, and thus, these points lie on the y-axis. Delinquencies are a considerably better predictor at six months, but there is still a large amount of dispersion with many points approaching the upper left and lower right. The linear relationship between performance as of that month of seasoning and the final performance increases with time. At 24 months or later, we believe that there is a clear linear pattern for both delinquencies and losses. We attribute this to the increased amount of information available from seasoning, plus the closer proximity to the final performance date. With both the R-square and scatter plot analysis, we feel comfortable that forecasts are relatively accurate after about 24 months of seasoning. There is some correlation prior to that date, but there is also increased likelihood for misleading interpretations, such as we had with CONHE 1998-4.
298
exhibit 5
LINEAR RELATIONSHIP IS CLEARER WITH SEASONING 6 MONTHS OF SEASONING
exhibit 6
exhibit 7
299

exhibit 8
exhibit 9
exhibit 10
300
ROLL I NTO T HE N EW?
Realizing that early performance information may not be entirely useful, we begin to contemplate the relative value of new issue deals versus minimally seasoned deals. The previous analysis implies that performance information during the first year may not accurately reflect future performance. In considering some of the most subordinate bonds, one could argue that the first year could almost be considered a free IO period. By this, we mean that investors are virtually guaranteed to receive a substantial coupon with subordinate bonds (say roughly LIBOR + 300 bp), and there should be little differentiation in credit. This would imply that investors may want to consider rolling out of deals that have seasoned one year, if spreads are comparable to new issue prints. However, this premise only holds true if the upcoming year is expected to be similar to the previous year. Although this has become an annual speech, the forward LIBOR curve tells us that interest rates are unlikely to remain as low as they have during the past year. The 2003 vintage has benefited from low interest rates, and resultantly high prepayment speeds. WACs have continued to decline and with rising interest rates, 2004 deals are unlikely to delever as fast as the 2003 vintage. Even though deals issued in 2003 and 2004 will face the same environment going forward, many 2003 deals have greatly delevered, allowing them to outperform during stress analysis.
301
302
Aames
Company Averages
40.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 1 7 Com 60+ Del Com Cum Loss 13 19 25 31 37 43 Ind 60+ Del Ind Cum Loss 4.0 3.0 2.0 1.0 0.0 0.0 5 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 12 18 24 30 36 42 48 54 60 10.0 5.0 20.0 15.0 30.0 25.0 35.0 5.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 (Avg) 1997 2000 30.0 25.0 20.0 15.0 1.5 6.0 4.0 2.0 0.0 1 7 Com 60+ Del Com Cum Loss 0.6 0.5 0.4 0.3 0.2 0.1 0.0 1 Com 60+ Del Com Cum Loss 7 Ind 60+ Del Ind Cum Loss 13 19 Ind 60+ Del Ind Cum Loss 1.0 0.5 0.0 1 Com 60+ Del Com Cum Loss 12.0 10.0 8.0 6.0 4.0 2.0 0.0 (Avg) 1997 2000 1995 1998 2001 1996 1999 2002 Ind Cum Loss Ind 60+ Del 7 13 19 25 31 10.0 5.0 0.0 (Avg) 1997 2000 1995 1998 2001 1996 1999 2002 2.0 8.0 2.5 3.0 1995 1998 2001 1996 1999 2002
Deals
1999
40.0
Credit Performance By Cohort

2000
6.0
Cumulative Loss
5.0
4.0
3.0
2.0
1.0
0.0
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97
Series 1996-B 1996-C 1996-D 1997-1 1998-C 1999-1 1999-2 2000-1 2000-2 2001-1 2001-2 2001-3 2001-4 2002-1 2002-2 2003-1 2001
3.5 16.0
Cum Factor Loss 0.03 3.45 0.03 4.29 0.04 4.85 0.03 5.36 0.09 4.32 0.13 4.81 0.15 5.33 0.15 4.85 0.14 4.54 0.20 5.58 0.24 5.50 0.25 3.35 0.24 1.70 0.33 1.30 0.43 0.60 0.61 0.49 2002
0.6 0.5 0.4 0.3 0.2 0.1 0.0 14.0 12.0 10.0
60+ Del 24.05 24.28 23.93 34.29 18.54 34.75 34.46 38.48 38.38 34.37 30.95 29.41 21.54 19.03 7.92 9.17
Life CPR 33.72 33.12 32.99 35.57 30.77 31.24 30.27 35.15 38.20 33.93 33.12 33.81 36.86 32.18 33.69 33.82
45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0
Transaction Monitoring
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97
70.0
3 mo CPR
2003
60.0
50.0
40.0
30.0
20.0
10.0
0.0
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97
chapter 25
303
304
chapter 25
American Business Financial Services

Company Averages
35.0 5.0 4.0 25.0 20.0 15.0 10.0 5.0 0.0 1 7 13 Com 60+ Del Com Cum Loss 19 25 31 37 43 Ind 60+ Del Ind Cum Loss 3.0 2.0 1.0 0.0 1 7 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 13 19 25 31 37 43 49 55 30.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 (Avg) 1999 2002 30.0 25.0 20.0 15.0 10.0 5.0 0.0 6 12 18 24 30 36 42 48 54 60 66 72 78 84 90 (Avg) 1999 2002 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 1 1998 2001 Com 60+ Del Com Cum Loss 7 Ind 60+ Del Ind Cum Loss (Avg) 1999 2002 1997 2000 2003 0.0 0.0 0.0 1997 2000 2003 1998 2001 Com 60+ Del Com Cum Loss 1 7 13 19 25 31 Ind 60+ Del Ind Cum Loss 1.0 0.5 0.0 5.0 0.0 1 7 Com 60+ Del Com Cum Loss 13 19 Ind 60+ Del Ind Cum Loss 1997 2000 2003 1998 2001
Deals
1999
35.0

2000
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
3.0
Cumulative Loss
2.5
2.0
1.5
1.0
0.5
0.0
(0.5)
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91
25.0
60+ Day Delinquencies 2001

2.5 2.0 1.5
20.0 15.0 10.0
2002
0.6 0.5 0.4 0.3 0.2 0.1 0.0
20.0
15.0
Series 1998-1 1998-2 1998-3 1998-4 1999-1 1999-2 1999-3 1999-4 2000-1 2000-2 2000-3 2000-4 2001-1 2001-2 2001-3 2001-4 2002-2 2002-3 2002-4 2003-1 2003-2
Cum Factor Loss 0.12 1.46 0.14 1.64 0.13 2.00 0.11 0.51 0.18 1.74 0.19 2.00 0.19 1.89 0.19 1.28 0.17 3.26 0.19 2.65 0.18 3.00 0.20 2.38 0.21 2.20 0.22 1.87 0.25 2.05 0.26 1.88 0.34 0.66 0.38 0.00 0.42 0.24 0.45 0.08 0.64 0.10
60+ Del 11.25 16.49 11.40 6.97 11.96 11.03 12.36 10.65 18.64 19.95 16.43 15.61 10.83 13.48 16.24 10.97 21.14 22.01 18.20 11.42 12.85
Life CPR 25.02 24.71 26.88 29.48 24.87 25.64 26.41 27.31 30.66 30.35 32.71 32.49 33.63 33.88 33.60 35.57 34.12 34.51 34.29 35.90 31.06
10.0
5.0
0.0
60.0
3 mo CPR
2003
0.1 0.0 0.0
50.0
40.0
30.0
20.0
10.0
0.0
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91
Ameriquest
Company Averages
40.0 5.0 4.0 25.0 20.0 15.0 1.0 0.5 0.0 1 7 Com 60+ Del Com Cum Loss 13 19 25 31 Ind 60+ Del Ind Cum Loss 10.0 5.0 0.0 1.5 3.0 2.0 1.0 0.0 1 7 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 13 19 25 31 37 43 30.0 2.0 2.5 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 (Avg) 2002 2003 2000 2001 13 19 25 31 37 43 49 55
Deals
2000
35.0

2001
6.0
Cumulative Loss
5.0
4.0
3.0
2.0
1.0
0.0
(1.0)
40.0 0.6 0.5 5.0 4.0 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss 7 0.4 0.3 0.2 0.1 0.0 -0.1 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 6.0
2003
0.1 0.0 0.0 0.0 0.0 0.0 Ind 60+ Del Ind Cum Loss
35.0 30.0 25.0
20.0
15.0
10.0 5.0 6 (Avg) 2002 2003 2004 2000 2001 12 18 24 30 36 42 48 54
0.0
18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0

2004
7 13 2000 2003 2001 19 25 31 37 43 49 55 (Avg) 2002
80.0
3 mo CPR
70.0
60.0 50.0
40.0
30.0
20.0 10.0
0.0
Cum Series Factor Loss 2000-1 0.13 4.85 2000-2 0.12 4.84 2001-1 0.12 0.82 2001-2 0.15 0.83 2001-3 0.09 1.78 2002-1 0.19 0.90 2002-2 0.23 1.16 2002-AR1 0.19 0.66 2002-3 0.24 0.92 2002-C 0.27 0.66 2002-4 0.28 0.40 2002-5 0.23 0.20 2002-D 0.31 0.29 2003-AR1 0.38 0.49 2003-1 0.36 0.45 2003-2 0.39 0.33 2003-3 0.42 0.38 2003-4 0.44 0.24 2003-5 0.53 0.12 2003-6 0.46 0.24 2003-AR2 0.47 0.21 2003-AR3 0.50 0.16 2003-7 0.47 0.08 2003-W1 0.55 0.09 2003-W2 0.55 0.15 2003-8 0.51 0.11 2003-W3 0.61 0.08 2003-9 0.58 0.10 2003-W4 0.56 0.02 2003-W5 0.66 0.05 2003-10 0.59 0.06 2003-IA1 0.81 0.00 2003-W6 0.67 0.05 2003-W7 0.67 0.02 2003-11 0.59 0.03 2003-W8 0.67 0.06 2003-12 0.63 0.06 2003-W9 0.68 0.04 2003-13 0.64 0.04 2003-W10 0.72 0.04 2004-W1 0.77 0.02 2004-R1 0.67 0.01 2004-W2 0.80 0.00 2004-W3 0.76 0.03
60+ Del 32.00 37.86 33.61 36.90 39.92 19.47 21.69 20.55 21.91 19.18 17.53 8.13 14.04 14.71 15.10 14.79 13.20 11.17 5.51 11.37 11.80 10.74 9.15 8.95 7.99 9.43 7.43 6.84 4.75 4.77 5.64 0.45 5.60 5.86 7.25 5.91 6.66 6.03 5.86 5.11 4.51 5.03 4.04 4.49
Life CPR 35.52 37.42 44.61 44.32 54.22 44.82 44.03 50.11 46.46 45.34 46.13 51.14 43.59 38.84 41.90 39.63 38.49 38.45 30.64 38.16 37.17 36.79 40.41 35.24 35.67 38.96 32.05 34.46 38.91 29.34 35.92 14.78 30.63 30.04 38.22 32.46 36.30 31.41 35.05 29.18 26.27 37.71 25.10 29.33
305
306
chapter 25
Bank of America
Company Averages
40.0 5.0 30.0 25.0 20.0 15.0 2.0 10.0 5.0 0.0 1 7 13 Com 60+ Del Com Cum Loss 19 25 31 Ind 60+ Del Ind Cum Loss 1.0 0.0 1 7 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 13 19 25 31 37 43 49 55 4.0 3.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 13 19 25 31 37 43 49 55 61 67 73 79 85 (Avg) 2001 2002 2003 1997 1999
Deals
1999

2001
2.5 2.0 1.5 1.0 0.5 0.0 -0.5
5.0
Cumulative Loss
4.0
3.0
2.0
1.0
0.0
(1.0)
1 7
70.0 20.0 15.0 10.0 5.0 0.0 6 12 18 24 30 36 42 48 54 60 66 72 78 84 1 Com 60+ Del Com Cum Loss 7 (Avg) 2001 2004 1997 2002 1999 2003 13 19 Ind 60+ Del Ind Cum Loss

0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0
6.0 5.0 4.0 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss 7
2003
0.1 0.1 0.0 0.0 0.0 0.0 0.0 Ind 60+ Del Ind Cum Loss
60.0
50.0
40.0
Cum Series Factor Loss 1997-1N 0.05 A 1997-1 0.03 2.61 1999-1 0.20 4.37 2001-AQ1 0.15 1.72 2002-WF1 0.19 0.67 2002-SB1 0.33 2.85 2002-NC1 0.26 0.69 2002-OPT 0.25 0.62 2002-WF2 0.29 0.28 2003-WF1 0.45 0.11 2003-AHL 0.52 0.34 2003-OPT 0.53 0.11 2003-WM 0.58 0.06 2004-OPT 0.67 0.03 2004-AHL 0.70 0.00 2004-OPT 0.67 0.00 2004-OPT 0.72 0.00 2004-OPT 0.88 0.00 2004-FF1 0.93 0.00 2004-HE1 0.91 0.00 2004-OPT 0.96 0.00
60+ Del 23.17 53.77 32.17 26.67 18.67 27.89 19.71 17.12 12.62 6.83 9.60 7.91 7.17 4.99 5.82 2.98 2.15 2.12 1.87 1.19 0.03
Life CPR 28.62 37.81 25.53 39.43 45.33 33.18 42.21 45.51 42.21 35.78 31.87 35.52 39.34 34.64 37.78 40.73 38.33 22.44 15.29 22.96 22.43
30.0
20.0
10.0
0.0
80.0
3 mo CPR
2004
70.0
60.0 50.0
40.0
30.0
20.0 10.0 7 13 19 25 31 37 43 49 55 61 67 73 79 85 (Avg) 2001 2002 1997 1999 2003
0.0
Bear Stearns
Company Averages
35.0 6.0 5.0 4.0 3.0 15.0 2.0 1.0 0.0 1 7 Com 60+ Del Com Cum Loss 13 19 25 31 37 43 Ind 60+ Del Ind Cum Loss 10.0 5.0 0.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 49 55 20.0 3.0 25.0 4.0 30.0 5.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 (Avg) 2001 2002 2003 1999 2000 19 25 31 37 43 49 55 61
Deals
1999
35.0

2000
6.0
Cumulative Loss
5.0
4.0
3.0
2.0
1.0
0.0
35.0 30.0 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1 Com 60+ Del Com Cum Loss 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 7 13 1999 2002 2003 2000 Com 60+ Del Com Cum Loss 19 25 31 37 43 49 55 61 (Avg) 2001 1 7 Ind 60+ Del Ind Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 1 0.0 7 Com 60+ Del Com Cum Loss 0.1 0.1 0.1 0.0 0.0 0.0 13 4.0 2.0 6.0 8.0 25.0 20.0 15.0 10.0 5.0 0.0 6 (Avg) 2001 2004 1999 2002 2000 2003 12 18 24 30 36 42 48 54 60 14.0 12.0 10.0 16.0
2002
0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 19 Ind 60+ Del Ind Cum Loss
30.0
25.0
20.0
15.0
10.0
Cum Series Factor Loss 1999-1 0.11 4.68 1999-2 0.17 5.74 2000-1 0.17 4.93 2000-2 0.30 5.36 2001-2 0.22 1.20 2001-3 0.33 5.60 2002-1 0.28 1.30 2002-2 0.27 1.06 2003-1 0.42 0.60 2003-2 0.55 0.24 2003-ABF 0.52 NA 2003-3 0.64 0.29 2003-HE1 0.66 NA 2004-HE1 0.65 NA 2004-HE2 0.70 NA 2004-HE3 0.72 0.03 2004-HE4 0.79 0.00 2004-HE5 0.83 0.00 2004-FR1 0.88 0.00 2004-HE6 0.89 0.00 2004-FR2 0.91 0.00 2004-HE7 0.92 0.00 2004-HE8 0.93 0.00
60+ Del 29.39 30.15 30.09 19.36 14.22 32.88 15.32 18.04 18.57 17.54 15.89 16.36 5.05 4.14 3.30 3.20 4.99 1.70 1.55 2.28 0.84 1.10 1.22
Life CPR 32.64 27.75 29.06 24.04 32.32 28.79 35.85 41.22 36.95 32.22 39.92 28.73 32.96 36.71 34.14 35.21 32.82 30.08 26.01 24.10 24.50 21.51 23.19
5.0
0.0

2003 2004
60.0
3 mo CPR
50.0
40.0
30.0
20.0
10.0
0.0
307
308
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CDC
Company Averages
35.0 2.5 2.0 15.0 10.0 1.0 0.5 0.0 0.0 1 7 Com 60+ Del Com Cum Loss 13 19 Ind 60+ Del Ind Cum Loss 1 7 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 13 19 25 31 5.0 1.5 20.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 (Avg) 2002 2003 2001 13 19 25 31 37
Deals
2001

2002
1.4
Cumulative Loss
1.2
1.0
0.8
0.6
0.4
0.2
0.0
0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0
Cum Series Factor Loss 2001-HE1 0.16 1.17 2002-HE1 0.28 1.13 2002-HE2 0.25 1.21 2002-HE3 0.28 1.05 2003-HE1 0.37 0.25 2003-HE2 0.48 0.21 2003-HE3 0.53 0.07 2003-HE4 0.61 0.07 2004-HE1 0.68 0.00 2004-HE2 0.82 0.00 2004-HE3 0.91 0.00
60+ Del 32.25 19.73 22.44 20.64 14.26 12.03 10.04 8.03 5.00 3.77 3.51
Life CPR 45.08 37.03 43.84 44.88 42.39 36.61 37.55 35.57 36.52 27.45 24.37
35.0 8.0

0.1 0.1 0.0 0.0 0.0 0.0 0.0 1 Com 60+ Del Com Cum Loss 7 Ind 60+ Del Ind Cum Loss
2004
30.0
25.0 4.0 3.0 2.0 1.0 0.0 7 (Avg) 2003 2004 2001 2002 13 19 25 31 37
20.0
7.0 6.0 5.0
15.0
10.0
5.0
0.0
90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0 7 13 (Avg) 2002 19 25 31 2001 2003 37
3 mo CPR
Centex
Company Averages
35.0 6.0 5.0 4.0 3.0 15.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss 7 13 19 25 31 37 43 Ind 60+ Del Ind Cum Loss 10.0 5.0 0.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 49 55 20.0 3.0 25.0 4.0 30.0 5.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 (Avg) 2000 2003 30.0 2.5 2.0 1.5 8.0 1.0 6.0 4.0 2.0 0.0 1 7 Com 60+ Del Com Cum Loss 0.1 0.0 0.0 0.0 0.0 0.0 1 Com 60+ Del Com Cum Loss 7 Ind 60+ Del Ind Cum Loss 13 19 Ind 60+ Del Ind Cum Loss 0.5 0.0 1 Com 60+ Del Com Cum Loss 6.0 5.0 4.0 3.0 2.0 1.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 (Avg) 2000 2003 1998 2001 1999 2002 Ind Cum Loss Ind 60+ Del 7 13 19 25 31 25.0 20.0 15.0 10.0 5.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 (Avg) 2000 2003 1998 2001 2004 1999 2002 1998 2001 1999 2002
Deals
1999
35.0

2000
6.0
Cumulative Loss
5.0
4.0
3.0
2.0
1.0
0.0
35.0 16.0
2002
0.6 0.5 0.4 0.3 0.2 0.1 0.0
30.0
25.0
20.0
14.0 12.0 10.0
15.0
10.0
5.0
0.0

2003 2004
Series 1998-1 1998-2 1998-3 1998-4 1999-1 1999-2 1999-3 1999-4 2000-A 2000-B 2000-C 2000-D 2001-A 2001-B 2001-C 2002-A 2002-B 2002-C 2002-D 2003-A 2003-B 2003-C 2004-A 2004-B 2004-C 2004-1 2004-D
Cum Factor Loss 0.11 4.49 0.12 4.98 0.15 5.37 0.16 5.58 0.17 5.18 0.18 5.56 0.22 6.00 0.24 5.65 0.24 5.96 0.26 6.29 0.26 4.82 0.26 3.39 0.29 3.52 0.32 2.59 0.33 1.87 0.35 1.35 0.35 1.02 0.37 0.96 0.44 0.45 0.49 0.21 0.56 0.11 0.61 0.04 0.70 0.01 0.79 0.00 0.90 0.00 0.93 0.00 0.98 0.00
60+ Del 18.81 20.41 19.97 18.40 22.67 23.04 22.66 26.58 30.37 29.66 30.33 27.59 27.43 26.94 24.72 18.68 15.68 20.29 15.62 9.38 8.72 6.17 3.68 3.35 2.11 0.92 0.24
Life CPR 26.65 26.72 24.93 25.36 25.34 25.25 24.18 23.98 24.98 25.47 26.50 27.56 27.62 26.94 28.88 29.70 31.35 34.27 33.27 32.73 31.37 31.59 31.04 25.76 17.94 15.42 8.50
50.0
3 mo CPR
40.0
30.0
20.0
10.0
0.0
309
310
chapter 25
Conseco
Company Averages
35.0 5.0 4.0 25.0 20.0 15.0 10.0 5.0 0.0 1 7 13 19 Com 60+ Del Com Cum Loss 25 31 37 43 Ind 60+ Del Ind Cum Loss 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 49 55 30.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 (Avg) 1999 2002 30.0 25.0 20.0 15.0 10.0 5.0 0.0 6 12 18 24 30 36 42 48 54 60 66 72 78 84 90 1 Com 60+ Del Com Cum Loss 7 13 (Avg) 1999 2002 1997 2000 1998 2001 19 25 31 Ind 60+ Del Ind Cum Loss 1997 2000 1998 2001
Deals
1999
35.0

2000
5.0 4.0 3.0 2.0 1.0 0.0
6.0
Cumulative Loss
5.0
4.0
3.0
2.0
1.0
0.0
Series 1997-B 1998-C 1999-A 1999-C 1999-D 1999-F 2000-B 2000-C 2000-D 2000-F 2001-A 2001-D 2002-A 2002-B 2002-C 2001
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 1 7 Com 60+ Del Com Cum Loss 13
Cum Factor Loss 0.07 5.14 0.10 4.88 0.15 4.50 0.16 4.60 0.18 5.36 0.00 4.62 0.21 7.18 0.18 2.88 0.00 6.16 0.22 5.43 0.24 6.07 0.28 3.62 0.31 3.06 0.34 2.74 0.36 2.23
60+ Del 5.24 7.42 8.23 9.20 9.75 NA 10.98 8.81 NA 11.10 10.92 11.19 8.75 8.36 13.94
Life CPR 28.23 28.64 27.19 27.44 25.91 100.00 26.57 31.52 100.00 29.50 29.33 32.27 33.45 33.27 33.15
14.0
2002
1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 19 Ind 60+ Del Ind Cum Loss
12.0
10.0
8.0
6.0
4.0
2.0
0.0
50.0
3 mo CPR
40.0
30.0
20.0
10.0
0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 (Avg) 1999 2002 1997 2000 1998 2001
ContiMortgage
Company Averages
1999
8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 49 55
Deals
8.0
Cumulative Loss
7.0
6.0 5.0
4.0 3.0
2.0 1.0
0.0 (Avg) 1997 1998 1999 1995 1996
45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103
60.0
50.0
Series 1995-1 1995-2 1995-3 1995-4 1996-1 1996-2 1996-3 1996-4 1997-1 1997-3 1997-4 1997-5 1998-1 1998-2 1998-3 1998-4 1999-1 1999-2 1999-3
Cum Factor Loss 0.03 6.11 0.03 5.79 0.03 6.76 0.04 5.64 0.04 5.93 0.04 6.27 0.04 6.90 0.05 7.62 0.06 8.55 0.06 7.68 0.06 7.57 0.07 7.18 0.08 7.07 0.09 6.87 0.11 7.50 0.14 8.95 0.12 7.62 0.13 8.75 0.14 7.21
60+ Del 51.91 36.76 32.77 47.27 44.98 31.31 41.22 41.28 38.35 38.56 40.43 36.00 38.95 37.84 42.60 37.51 40.89 39.40 39.58
Life CPR 29.73 28.62 28.99 29.43 28.70 29.55 30.65 31.24 29.87 30.89 31.43 31.23 30.04 29.76 28.54 26.78 29.56 29.24 29.60
40.0
30.0
20.0
10.0
0.0 (Avg) 1997 1998 1999 1995 1996

(Avg) 1997 1998 1999 1995 1996
1 7 1319 25 31 37 43 49 55 61 67 73 79 85 91 97103109115
50.0
3 mo CPR
40.0
30.0
20.0
10.0
0.0
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103
311
312
chapter 25
Countrywide
Company Averages
35.0 5.0 4.0 25.0 20.0 15.0 10.0 5.0 0.0 1 7 13 19 Com 60+ Del Com Cum Loss 25 31 37 43 Ind 60+ Del Ind Cum Loss 3.0 2.0 1.0 0.0 1 7 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 13 19 25 31 37 43 49 55 30.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 (Avg) 1998 2001 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 1 Com 60+ Del Com Cum Loss 6.0 5.0 4.0 3.0 2.0 1.0 0.0 7 (Avg) 1998 2001 1996 1999 2002 13 19 25 31 37 43 49 55 61 67 73 1997 2000 2003 1 Com 60+ Del Com Cum Loss 7 Ind 60+ Del Ind Cum Loss 0.0 0.0 0.0 13 (Avg) 1998 2001 1996 1999 2002 1997 2000 2003 13 19 25 31 37 43 49 55 61 67 73 7 19 25 31 Ind 60+ Del Ind Cum Loss 1.0 0.5 0.0 1996 1999 2002 1997 2000 2003
Deals
1999
35.0

2000
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
3.5
Cumulative Loss
3.0
2.5
2.0
1.5
1.0
0.5
0.0
35.0

2.5 2.0 1.5
16.0
2002
0.6 0.5 0.4 8.0 6.0 4.0 2.0 0.0 1 7 Com 60+ Del Com Cum Loss 13 19 Ind 60+ Del Ind Cum Loss 0.3 0.2 0.1 0.0 14.0 12.0 10.0
30.0
25.0
20.0
15.0
10.0
5.0
0.0
80.0
3 mo CPR
2003
0.1 0.0 0.0
2004
70.0
60.0 50.0
40.0
30.0
20.0 10.0
0.0
Cum Series Factor Loss 1998-2 0.07 2.58 1998-3 0.07 2.54 1999-1 0.09 3.14 1999-2 0.11 2.98 1999-3 0.10 2.67 1999-4 0.08 3.40 2000-1 0.12 3.31 2000-2 0.12 3.04 2000-3 0.00 3.22 2000-4N 0.11 A 2001-BC1 0.17 1.13 2001-1N 0.13 A 2001-BC2 0.14 1.08 2001-2 0.11 0.55 2001-BC3 0.17 0.61 2001-3 0.11 0.73 2001-4 0.14 0.32 2002-BC1 0.19 0.58 2002-1 0.18 0.29 2002-BC2 0.22 0.39 2002-2 0.22 0.40 2002-BC3 0.27 0.83 2002-4 0.30 0.58 2002-3 0.25 0.29 2002-S4 0.33 0.00 2002-6 0.41 0.09 2002-5 0.34 0.16 2003-BC1 0.34 0.10 2003-1 0.41 0.12 2003-BC2 0.40 0.13 2003-2 0.47 0.04 2003-3 0.52 0.04 2003-BC3 0.50 0.26 2003-4 0.49 0.08 2003-BC4 0.50 0.04 2003-BC5 0.58 0.03 2003-5 0.63 0.08 2003-BC6 0.60 0.04 2004-1 M7 0.71 0.02 2004-2 0.76 0.03 2004-3 0.81 0.02 2004-4 0.84 0.02 2004-BC1 0.69 0.04 2004-BC2 0.64 0.00
60+ Del 19.56 9.74 19.27 21.38 24.06 34.12 27.64 33.56 NA 33.95 26.34 29.37 37.88 36.46 32.10 32.53 22.96 23.56 17.95 20.55 13.72 17.17 12.10 14.38 0.96 8.45 7.48 11.39 6.52 7.51 6.21 5.63 7.91 5.60 5.12 4.96 4.14 4.74 3.39 3.63 2.81 2.77 4.15 2.70
Life CPR 33.97 35.37 32.54 31.31 34.59 38.65 34.81 36.42 100.00 41.80 35.87 41.32 41.68 45.20 40.96 48.62 46.94 42.54 45.49 42.54 44.78 42.22 41.23 45.18 41.27 35.25 40.91 21.76 37.66 42.11 35.75 34.85 36.67 38.65 39.83 34.23 34.44 39.60 32.73 29.47 23.22 21.88 38.57 48.34
CSFB
Company Averages
35.0 5.0 4.0 3.0 2.0 1.0 0.0 2 1 Com 60+ Del Com Cum Loss 13 19 25 31 37 43 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 8 14 20 26 32 38 44 50 56 7 Ind 60+ Del Ind Cum Loss 0.0 1.0 0.5 2.0 1.5 3.0 2.5 3.5 4.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 (Avg) 2000 2003 35.0 2.5 25.0 20.0 15.0 10.0 5.0 0.0 1 7 Com 60+ Del Com Cum Loss 0.1 0.0 0.0 0.0 0.0 0.0 1 Com 60+ Del Com Cum Loss 7 Ind 60+ Del Ind Cum Loss 13 19 Ind 60+ Del Ind Cum Loss 2.0 1.5 1.0 0.5 0.0 1 7 Com 60+ Del Com Cum Loss 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 7 (Avg) 2000 2003 1998 2001 1999 2002 13 19 25 31 37 43 49 55 61 Ind Cum Loss Ind 60+ Del 13 19 25 31 30.0 25.0 20.0 15.0 10.0 5.0 0.0 6 12 1998 2001 2004 1999 2002 18 24 30 36 42 48 54 60 66 (Avg) 2000 2003 1998 2001 1999 2002 19 25 31 37 43 49 55 61 45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0
Deals
1999 2000
4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
Cumulative Loss
2002
0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0
45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0

2003 2004
70.0
3 mo CPR
60.0
50.0
40.0
30.0
20.0
10.0
0.0
Cum Series Factor Loss 1999-LB1 0.09 3.17 2000-2 0.08 1.86 2000-LB1 0.15 5.40 2000-3 0.08 3.22 2000-5 0.12 2.84 2000-HE1 0.11 2.38 2000-7 0.17 1.17 2001-HE8 0.16 2.62 2001-HE1 0.11 2.92 2001-HE1 0.13 2.02 2001-S13 0.09 8.17 2001-HE2 0.14 2.26 2001-HE1 0.19 2.42 2001-HE1 0.21 2.17 2001-HE2 0.20 2.82 2001-HE3 0.14 1.33 2001-HE2 0.20 1.98 2001-HE2 0.18 2.00 2001-HE3 0.23 1.60 2002-HE1 0.23 2.08 2002-HE1 0.20 1.49 2002-HE4 0.21 1.70 2002-HE1 0.24 1.20 2002-HE1 0.24 1.10 2002-HE2 0.22 1.30 2002-1 0.25 1.04 2002-2 0.25 0.85 2002-3 0.30 0.85 2002-HE3 0.28 1.03 2002-4 0.27 0.75 2002-5 0.36 0.50 2003-HE1 0.36 0.44 2003-1 0.38 0.54 2003-2 0.47 0.53 2003-HE2 0.44 0.23 2003-3 0.52 0.26 2003-HE3 0.49 0.12 2003-4 0.55 0.12 2003-HE4 0.53 0.11 2003-HE5 0.54 0.13 2003-5 0.64 0.02 2003-6 0.64 0.17 2003-HE6 0.63 0.03 2003-7 0.69 0.02
60+ Del 24.82 28.96 39.10 37.41 36.11 38.85 37.33 24.39 38.73 38.00 16.82 37.82 38.46 34.86 40.06 27.05 38.36 34.42 32.08 29.72 24.80 29.52 26.01 24.44 27.42 21.34 24.29 19.66 23.30 20.22 16.58 19.52 14.34 15.00 11.71 10.89 9.11 6.34 8.09 8.35 11.42 8.76 5.07 8.43
Life CPR 35.57 42.66 35.42 43.81 39.95 42.50 35.34 37.29 44.67 43.23 47.53 42.22 37.81 36.74 39.09 44.64 39.02 42.45 38.12 38.79 42.02 41.81 41.23 42.58 43.59 42.44 43.23 41.26 44.18 45.41 40.02 40.55 39.35 34.94 38.41 32.15 36.90 32.20 37.13 36.54 28.47 30.96 33.66 29.06
313
314
chapter 25
Delta Funding
Company Averages
35.0 5.0 4.0 3.0 2.0 1.0 0.0 0.0 1 7 13 19 Com 60+ Del Com Cum Loss 25 31 37 43 Ind 60+ Del Ind Cum Loss 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 49 55 10.0 5.0 20.0 15.0 30.0 25.0 35.0 40.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 (Avg) 1997 2000 30.0 25.0 20.0 15.0 10.0 5.0 0.0 1 Com 60+ Del Com Cum Loss 6.0 5.0 4.0 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss 1996 1999 2002 7 Ind 60+ Del Ind Cum Loss (Avg) 1997 2000 1995 1998 2001 0.0 0.0 0.0 7 13 19 25 31 Ind 60+ Del Ind Cum Loss 1995 1998 2001 1996 1999 2002
Deals
1999

2000
6.0 5.0 4.0 3.0 2.0 1.0 0.0
6.0
Cumulative Loss
5.0
4.0
3.0
2.0
1.0
0.0
(1.0)
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103
40.0

3.0 2.5 2.0 1.5 1.0 0.5 0.0
2001
16.0
2002
35.0 30.0 25.0
20.0
15.0
10.0 5.0
0.0 (Avg) 1997 2000 1995 1998 2001 1996 1999 2002
0 6 12 18 24 30 36 42 4854 60 66 72 78 84 90 96 102108
Series 1995-2 1996-1 1996-2 1996-3 1997-1 1997-2 1997-3 1997-4 1998-1 1998-2 1998-3 1998-4 1999-1 1999-2 1999-3 2000-1 2000-2 2000-3 2000-4 2001-1 2001-2 2002-1 2002-2 2002-3 2002-4 2003-1 2003-2 2003-3 2003-4 2004-1 2004-2 2004-3 2003
0.1 0.0 0.0
Cum Factor Loss 0.05 4.00 0.06 4.40 0.06 4.60 0.06 5.09 0.05 5.95 0.07 5.41 0.09 5.14 0.09 4.35 0.10 4.10 0.12 4.04 0.14 3.70 0.14 3.50 0.15 4.24 0.15 4.17 0.17 4.44 0.20 5.33 0.16 5.31 0.17 5.39 0.19 6.27 0.25 4.31 0.31 2.54 0.31 1.23 0.35 0.50 0.40 0.39 0.48 0.21 0.52 0.06 0.63 0.10 0.75 0.01 0.77 0.00 0.88 0.00 0.94 0.00 0.98 0.00
60+ Del 23.58 25.33 34.47 33.27 35.83 32.34 30.16 30.15 20.89 27.48 28.47 27.51 31.13 31.74 33.07 34.46 38.85 41.03 45.21 28.74 2.97 21.73 19.12 15.77 9.77 8.82 7.30 4.92 3.91 3.74 1.11 0.27
Life CPR 26.42 26.51 27.84 28.50 30.33 28.39 27.42 27.89 27.62 26.88 26.33 27.37 27.65 28.08 28.80 27.98 32.89 33.26 16.76 31.54 29.83 33.98 33.86 32.77 30.26 29.94 25.96 19.67 21.46 15.30 10.86 8.81
60.0
3 mo CPR
2004
50.0
40.0
30.0
20.0
10.0
0.0
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103
Deutsche Bank
Company Averages
60.0 5.0 4.0 25.0 20.0 15.0 1.0 0.5 0.0 1 7 Com 60+ Del Com Cum Loss 13 19 25 31 Ind 60+ Del Ind Cum Loss 10.0 5.0 0.0 1.5 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 49 55 30.0 2.0 50.0 40.0 30.0 20.0 10.0 0.0 7 (Avg) 2002 2003 1999 2001 13 19 25 31 37 43 49 55 61
Deals
1999
35.0 2.5

2001
4.0
Cumulative Loss
3.5
3.0 2.5
2.0 1.5
1.0 0.5
0.0
60.0 0.6 0.5 0.4 0.3 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss 7 0.2 0.1 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 4.0 5.0 6.0

7.0
2003
50.0
Cum Series Factor Loss 1999-LB2 0.09 3.63 2001-NC1 0.08 1.11 2001-AQ1 0.10 1.05 2001-HE1 0.16 0.62 2002-HE1 0.25 1.09 2002-HE2 0.23 0.57 2002-HE3 0.31 0.33 2003-FM1 0.35 0.28 2003-TC1 0.42 0.04 2003-HS1 0.57 0.17 2003-NC1 0.55 0.05 2003-HE1 0.53 0.15 2003-OP1 0.67 0.02 2004-FM1 0.60 0.04 2004-HS1 0.73 0.04 2004-HE1 0.73 0.08 2004-OP1 0.82 0.00 2004-IN1 0.79 0.00
60+ Del 33.91 29.16 41.28 25.67 27.99 14.74 12.00 15.27 9.50 12.85 9.14 8.29 3.64 5.64 6.33 8.58 3.60 2.87
Life CPR 35.98 48.07 46.83 44.31 42.93 48.65 44.23 47.51 45.68 34.07 39.11 41.27 32.45 42.42 30.50 33.18 24.78 32.57
40.0
30.0
20.0
10.0 6 12 1999 2003 2004 2001 18 24 30 36 42 48 54 60 (Avg) 2002
0.0
18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0

2004
7 13 1999 2003 2001 19 25 31 37 43 49 55 61 (Avg) 2002
80.0
3 mo CPR
70.0
60.0 50.0
40.0
30.0
20.0 10.0
0.0
315
316
chapter 25
Equicredit
Company Averages
70.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 1 7 13 Com 60+ Del Com Cum Loss 19 25 31 Ind 60+ Del Ind Cum Loss 60.0 50.0 40.0 30.0 20.0 10.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 (Avg) 1997 2001 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 16.0 1995 1998 2002 1996 1999 1 7 13 19 25 31 37 43 49 55
Deals
1999

2001
3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0
9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0
Cumulative Loss
Series 1997-B 1997-3 1998-1 1998-2 1998-3 1998-4 1999-A 1999-1 1999-2 1999-3 2001-1F 2001-2 2002-1N 2002
0.6 0.5 0.4 0.3 0.2 0.1 0.0 1 7 Com 60+ Del Com Cum Loss 13 19 Ind 60+ Del Ind Cum Loss
Cum Factor Loss 0.00 4.79 0.00 5.48 0.09 7.27 0.11 7.81 0.13 6.67 0.14 7.23 0.14 4.15 0.15 9.07 0.17 9.82 0.16 8.47 0.23 2.15 0.23 3.85 0.52 AN
60+ Del NA NA 59.04 53.14 57.27 54.88 51.13 55.57 59.70 65.39 20.61 33.24 AN
Life CPR 100.00 100.00 26.62 26.64 26.46 25.98 27.20 26.69 26.69 28.39 37.79 38.41 A
70.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 (Avg) 1997 2001 1995 1998 2002 1996 1999
60.0
50.0
40.0
30.0
20.0
10.0
0.0
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91
50.0
3 mo CPR
40.0
30.0
20.0
10.0
0.0 (Avg) 1997 2001 1995 1998 2002 1996 1999
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91
First Alliance
Company Averages
35.0 5.0 4.0 3.0 2.0 1.0 0.0 1 7 Com 60+ Del Com Cum Los s Ind Cum Loss Ind 60+ Del 13 19 25 31 37 43 49 55 30.0 25.0 20.0 15.0 10.0 5.0 0.0 (Avg) 1997 1998 1999 1995 1996
Deals
1999
0.4
Cumulative Loss
0.4
0.3 0.3
0.2 0.2
0.1 0.1
0.0
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103
25.0
Series 1995-2 1996-1 1996-2 1996-3 1996-4 1997-1 1997-2 1997-3 1997-4 1998-1F 1998-1A 1998-2F 1998-3 1998-4 1999-1 1999-2 1999-3 1999-4
Cum Factor Loss 0.04 0.13 0.05 0.11 0.03 0.11 0.03 0.25 0.02 0.38 0.04 0.24 0.03 0.29 0.04 0.24 0.05 0.47 0.08 0.06 0.04 0.45 0.08 0.10 0.08 0.54 0.10 0.11 0.10 0.28 0.10 0.46 0.11 0.22 0.10 0.10
60+ Del 0.00 5.04 3.58 14.19 23.65 28.80 4.13 8.08 4.87 7.29 4.31 10.23 12.84 17.89 13.74 4.06 9.49 16.83
Life CPR 29.42 28.42 33.02 33.11 37.07 33.62 37.00 34.82 33.41 30.24 38.69 31.51 32.56 30.95 32.57 33.54 33.40 36.27
20.0
15.0
10.0
5.0
0.0 (Avg) 1997 1998 1999 1995 1996

(Avg) 1997 1998 1999 1995 1996
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103
80.0
3 mo CPR
70.0
60.0 50.0
40.0
30.0
20.0 10.0
0.0
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103
317
318
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First Franklin
Company Averages
40.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 1 7 13 Com 60+ Del Com Cum Loss 19 25 31 Ind 60+ Del Ind Cum Loss 1.0 0.5 0.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 85 7 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del (Avg) 2001 2002 2003 1997 2000 1 13 19 25 31 37 43
Deals
2000

2001
2.5 2.0 1.5
1.2
Cumulative Loss
1.0
0.8
0.6
0.4
0.2
0.0
(0.2)
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5

16.0
2002
0.6 0.5 0.4 0.3 0.2 0.1 0.0 1 7 Com 60+ Del Com Cum Loss 13 19 Ind 60+ Del Ind Cum Loss
2003
14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 85 (Avg) 2001 2004 1997 2002 2000 2003
Cum Series Factor Loss 1997-FF2 0.01 NA 1997-FF3 0.01 NA 2000-FF1 0.08 0.96 2001-FF1 0.07 0.90 2001-FF2 0.18 0.78 2002-FF1 0.23 0.39 2002-FF2 0.25 0.24 2002-FF3 0.34 0.17 2002-FF4 0.44 0.11 2003-FFA 0.34 0.00 2003-FF1 0.56 0.16 2003-FF2 0.54 0.16 2003-FF3 0.59 0.02 2003-FF4 0.61 0.06 2004-FF1 0.69 0.01 2004-FFH 0.85 0.01 2004-FF2 0.80 0.01 2004-FF3 0.88 0.00 2004-FF4 0.89 0.00 2004-FF6 0.92 0.00 2004-FF5 0.95 0.00 2004-FF7 0.97 0.00 2004-FFH 0.98 0.00 2004-FF1 0.99 0.00
60+ Del 5.52 26.03 41.40 41.45 20.55 15.04 15.12 9.33 6.70 2.53 7.34 4.74 5.21 3.35 2.90 4.69 2.27 1.28 2.30 0.84 1.87 0.42 0.09 0.06
Life CPR 43.74 47.27 45.35 49.47 42.61 42.84 45.40 40.19 33.43 43.89 29.14 33.75 30.60 32.66 36.16 18.83 27.56 18.86 20.14 17.71 10.95 9.52 7.18 5.67
45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0
90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 85 (Avg) 2001 2002 1997 2000 2003
3 mo CPR
2004
GMAC GMACM
Company Averages
30.0 2.5 2.0 1.5 1.0 0.5 0.0 1 Com 60+ Del Com Cum Loss 7 13 19 25 31 Ind 60+ Del Ind Cum Loss 25.0 20.0 15.0 1.5 1.0 0.5 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 0.0 5.0 10.0 10.0 5.0 0.0 7 13 2000 2003 2001 19 25 31 37 43 (Avg) 2002 2.0 15.0 2.5 20.0 3.0 25.0
Deals
2000
3.5 30.0

2001
1.4
Cumulative Loss
1.2
1.0
0.8
0.6
0.4
Cum Series Factor Loss 2001-HE1 0.00 0.65 2001-HE4 0.10 0.45 2002-HE2 0.14 0.54 2002-GH1 0.15 0.07 2002-HE3 0.74 0.21 2002-HE4 0.21 0.32 2003-HE2 0.36 0.20 2003-HE1 0.93 0.10
60+ Life Del CPR NA 100.00 3.14 51.16 5.24 49.80 2.24 48.39 0.91 49.35 3.01 50.00 1.34 41.65 0.46 47.21
0.2
0.0
5.0 0.5 5.0 4.0 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss 7 0.4 0.3 0.2 0.1 0.0 1 7 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 13 19 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 7 13 2000 2003 2001 19 25 31 37 43 (Avg) 2002

16.0 0.6 6.0
2002
2003
4.0
3.0
2.0
1.0
0.0

7 (Avg) 2002 2003 2000 2001 13 19 25 31 37 43
70.0
3 mo CPR
60.0
50.0
40.0
30.0
20.0
10.0
0.0
319
320
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GMAC RAMP
Company Averages
6.0 0.1 0.0 0.0 0.0 0.0 0.0 1 7 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 5.0 4.0 3.0 2.0 1.0 0.0 7 13 2003 19 (Avg)
Deals
2003

2004
1.2
Cumulative Loss
1.0
0.8
Cum Series Factor Loss 2003-RS4 0.59 NA 2003-RS5 0.62 NA 2003-RS7 0.70 NA 2003-RS8 0.72 NA 2004-RS1 0.81 NA
60+ Del 9.92 8.99 6.51 5.35 4.59
Life CPR 27.78 26.74 22.11 22.28 19.25
0.6
0.4
0.2
0.0
12.0
10.0
8.0
6.0
4.0
2.0 13 2003 2004 19
0.0 7 (Avg)
50.0
3 mo CPR
40.0
30.0
20.0
10.0
0.0 7 13 2003 (Avg) 19
GMAC RASC
Company Averages
35.0 5.0 4.0 25.0 20.0 15.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss 7 13 19 25 31 37 43 Ind 60+ Del Ind Cum Loss 10.0 5.0 0.0 3.0 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 49 55 30.0 4.0 5.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 85 (Avg) 1997 2000 30.0 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1 Com 60+ Del Com Cum Loss 6.0 5.0 4.0 3.0 2.0 1.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 85 Com 60+ Del Com Cum Loss (Avg) 1997 2000 1995 1998 2001 1996 1999 2002 1 7 Ind 60+ Del Ind Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 1 25.0 20.0 15.0 10.0 5.0 0.0 6 12 18 24 30 36 42 48 54 60 66 72 78 84 90 (Avg) 1997 2000 1995 1998 2001 1996 1999 2002 1995 1998 2001 1996 1999 2002
Deals
1999
35.0

2000
5.0
Cumulative Loss
4.0
3.0
2.0
1.0
0.0
35.0
2002
1.2 1.0 0.8 0.6 0.4 0.2 0.0
30.0
25.0
20.0
15.0
10.0
5.0
0.0
18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 7 Com 60+ Del Com Cum Loss 13 19
Ind 60+ Del Ind Cum Loss

2003
0.1 0.1 0.1 0.1 0.0 0.0 0.0
70.0
3 mo CPR
2004
60.0
50.0
40.0
30.0
20.0
10.0
0.0
Cum Series Factor Loss 1997-KS2 0.01 1.81 1998-KS1 0.04 2.54 1998-KS2 0.05 3.51 1998-KS3 0.06 4.10 1998-RS1 0.10 1.58 1998-KS4 0.10 3.95 1999-KS1 0.10 4.33 1999-RS1 0.12 1.52 1999-KS2 0.12 4.21 1999-RS2 0.11 2.06 1999-KS3 0.13 4.58 1999-KS4 0.14 5.00 1999-RS5 0.12 3.77 2000-KS1 0.15 4.88 2000-KS2 0.14 4.91 2000-KS3 0.16 5.37 2000-KS4 0.15 4.72 2000-KS5 0.16 4.78 2001-KS1 0.18 4.74 2001-KS2 0.22 3.10 2001-KS3 0.23 2.64 2001-KS4 0.22 2.77 2002-KS1 0.30 2.88 2002-KS2 0.30 NA 2002-KS3 0.29 1.26 2002-KS4 0.34 NA 2002-KS5 0.34 0.84 2002-KS6 0.41 1.38 2002-KS7 0.37 0.67 2002-KS8 0.49 1.17 2003-KS1 0.43 0.62 2003-KS2 0.53 NA 2003-KS3 0.56 0.30 2003-KS4 0.58 0.44 2003-KS5 0.61 NA 2003-KS6 0.60 0.14 2003-KS7 0.67 NA 2003-KS8 0.69 NA 2003-KS9 0.69 NA 2003-KS1 0.72 NA 2003-KS1 0.74 NA 2004-KS1 0.79 NA 2004-KS2 0.81 NA 2004-KS3 0.84 NA
60+ Del 11.98 18.26 21.01 19.44 13.23 21.77 23.61 9.99 24.35 22.67 26.20 25.10 28.86 28.00 28.33 32.10 29.79 30.91 31.49 27.72 25.92 26.70 21.54 20.53 22.50 20.10 20.32 17.81 19.01 11.50 15.81 9.84 9.76 8.05 7.16 7.40 6.03 5.22 4.33 3.49 3.64 2.61 2.76 2.56
Life CPR 46.46 37.88 36.68 35.74 30.15 31.66 32.11 29.15 31.61 32.22 32.00 31.30 NA NA 33.47 33.14 35.90 36.45 36.12 34.32 35.90 39.40 32.88 35.08 37.79 34.78 36.61 31.82 37.21 28.97 34.66 29.92 28.66 27.98 27.42 29.31 NA 25.10 25.96 25.17 25.22 21.57 21.72 19.32
321
322
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GMAC RFMS2
Company Averages
30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 (Avg) 1999 2001 2003 Com Cum Loss Ind Cum Loss 1996 1997 Com 60+ Del Ind 60+ Del 1 13 19 25 31 37 43 49 7 1 0.0 7 13 Com 60+ Del Com Cum Loss 19 25 31 Ind 60+ Del Ind Cum Loss 5.0 10.0 15.0 1.0 0.5 0.0 20.0 25.0
Deals
1999
30.0

2001
2.5 2.0 1.5
3.0
Cumulative Loss
2.5
Cum Series Factor Loss 2001-HS2 0.09 1.00 2001-HS3 0.10 0.08 2003-HS3 0.60 0.12
60+ Del 4.50 2.92 0.42
Life CPR 49.12 NA 33.12
2.0
1.5
1.0
0.5
0.0
4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
5.0 5.0 4.0 3.0 2.0 1.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 (Avg) 1999 2001 2003 1996 1997 Com 60+ Del Com Cum Loss 1 7 Ind 60+ Del Ind Cum Loss

6.0
2003
0.1 0.1 0.1 0.1 0.0 0.0 0.0 0.0 0.0
4.0
3.0
2.0
1.0
0.0
90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0 7 (Avg) 1999 2001 1996 13 19 25 31 37 43 49 55 61 67 73 79 1997 2003
3 mo CPR
Goldman Sachs
Company Averages
16.0 0.6 6.0 0.1 0.0 0.0 0.0 0.0 0.0 1 7 Com 60+ Del Com Cum Loss Ind 60+ Del Ind Cum Loss 5.0 4.0 3.0 2.0 1.0 0.0 0.5 0.4 0.3 0.2 0.1 0.0 1 7 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 2003 13 19 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 7 (Avg) 2002 13 19 25
Deals
2002 2003
0.8
Cumulative Loss
0.7
0.6 0.5
0.4 0.3
0.2 0.1
0.0
20.0
15.0
Cum Series Factor Loss 2002-NC1 0.25 0.49 2002-WM 0.20 0.82 2002-WF 0.30 0.30 2003-NC1 0.47 0.17 2003-FM1 0.48 0.12 2003-HE1 0.47 0.22 2003-HE2 0.60 0.06 2003-SEA 0.58 0.33 2003-AHL 0.65 0.02 2003-SEA 0.72 0.00 2003-HE2 1.00 NA 2004-FM1 0.65 0.04 2004-FM2 0.70 0.01 2004-SEA 0.72 0.03 2004-NC1 0.79 0.01 2004-HE1 0.83 0.01 2004-SEA 0.87 0.01 2004-AR1 0.87 0.00 2004-HE2 0.92 0.00 2004-AR2 0.92 0.00
60+ Del 18.76 19.61 12.60 5.65 9.84 12.88 6.81 24.34 3.85 2.17 NA 4.94 3.07 18.11 4.81 4.60 27.25 2.62 2.47 1.79
Life CPR NA NA NA 33.14 33.53 37.33 31.06 32.30 29.75 23.38 NA 37.10 37.34 34.44 28.67 23.52 23.54 23.25 17.48 20.37
10.0
5.0
0.0 6 (Avg) 2003 2004 2002 12 18 24

7 13 2002 2003 19 25 (Avg)
90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0
3 mo CPR
323
324
chapter 25
Household
Company Averages
35.0 5.0 30.0 25.0 20.0 15.0 2.0 10.0 5.0 0.0 1 7 13 Com 60+ Del Com Cum Los s 19 25 31 Ind 60+ Del Ind Cum Loss 1.0 0.0 1 7 Com 60+ Del Com Cum Los s Ind Cum Loss Ind 60+ Del 13 19 25 31 37 43 49 55 1.0 0.5 0.0 4.0 3.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 (Avg) 2002 2003 1999 2001 19 25 31 37 43 49 55 61
Deals
1999

2001
2.5 2.0 1.5
2.5
Cumulative Loss
2.0
1.5
Cum Series Factor Loss 1999-1 0.17 2.32 2001-1 0.20 1.96 2001-2 0.22 1.56 2003-1 0.47 0.21 2004-HC1 0.87 0.00
60+ Del 8.10 7.93 7.59 3.41 0.39
Life CPR 27.83 34.94 36.85 42.24 34.34
1.0
0.5
0.0

16.0
2002
0.8
6.0 5.0 4.0 0.4 0.3 0.2 0.1 0.0 3.0 2.0 1.0 0.0 0.7 0.6 0.5
2003
14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 6 12 (Avg) 2002 2003 2004 1999 2001 Com 60+ Del Com Cum Los s 18 24 30 36 42 48 54 60 7 1 13 19 Ind 60+ Del
9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0
0.1 0.1 0.1 0.1 0.1 0.0 0.0 0.0 0.0 0.0 2 Com 60+ Del Ind Cum Loss Com Cum Los s 8 Ind 60+ Del Ind Cum Loss
60.0
3 mo CPR
2004
50.0
40.0
30.0
20.0
10.0 7 13 1999 2003 19 25 31 37 43 (Avg) 2002 49 55 61 2001
0.0
Indy Mac
Company Averages
35.0 5.0 4.0 3.0 2.0 1.0 0.0 1 7 1 Com 60+ Del Com Cum Loss 13 19 25 31 37 43 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 13 19 25 31 37 43 49 55 7 Ind 60+ Del Ind Cum Loss 0.0 1.0 0.5 2.0 1.5 3.0 2.5 3.5 4.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 (Avg) 2000 2003 40.0 2.5 2.0 1.5 8.0 1.0 6.0 4.0 2.0 0.0 1 7 Com 60+ Del Com Cum Loss 0.1 0.0 0.0 0.0 0.0 0.0 1 Com 60+ Del Com Cum Loss 7 Ind 60+ Del Ind Cum Loss 13 19 Ind 60+ Del Ind Cum Loss 0.5 0.0 1 7 Com 60+ Del Com Cum Loss 6.0 5.0 4.0 3.0 2.0 1.0 0.0 7 (Avg) 2000 2003 1998 2001 1999 2002 13 19 25 31 37 43 49 55 61 Ind Cum Loss Ind 60+ Del 13 19 25 31 1998 2001 1999 2002 13 19 25 31 37 43 49 55 61
Deals
1999 2000
3.5
Cumulative Loss
3.0
2.5
2.0
1.5
1.0
0.5
0.0
45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0
Series 2000-A 2000-B 2000-C 2001-A 2001-B 2001-C 2002-A 2002-B 2003-A 2004-A 2004-B
Cum Factor Loss 0.14 3.01 0.14 3.90 0.15 3.53 0.19 2.75 0.15 1.85 0.19 2.10 0.22 0.87 0.31 0.41 0.52 0.04 0.87 0.00 0.97 0.00
60+ Del 37.47 35.79 45.27 45.32 44.56 30.71 27.11 16.64 9.43 3.26 0.41
Life CPR 34.02 35.64 36.69 35.27 41.84 41.78 42.78 40.49 38.00 23.38 12.18
50.0

16.0
2002
0.6 0.5 0.4 0.3 0.2 0.1 0.0
40.0 20.0 15.0 10.0 5.0 0.0 7 13 1998 2001 2004 1999 2002 19 25 31 37 43 49 55 61 (Avg) 2000 2003
30.0
35.0 30.0 25.0
14.0 12.0 10.0
20.0
10.0
0.0

2003 2004
70.0
3 mo CPR
60.0
50.0
40.0
30.0
20.0
10.0
0.0
325
326
chapter 25
JP Morgan Chase
Company Averages
35.0 5.0 4.0 25.0 20.0 15.0 10.0 5.0 0.0 1 7 13 19 Com 60+ Del Com Cum Loss 25 31 37 43 Ind 60+ Del Ind Cum Loss 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 49 55 30.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 (Avg) 2000 2003 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 (Avg) 2000 2003 6.0 5.0 4.0 3.0 2.0 1.0 0.0 7 (Avg) 2000 2003 1998 2001 13 19 25 31 37 43 49 55 61 67 73 1999 2002 1 Com 60+ Del Com Cum Loss 7 Ind 60+ Del Ind Cum Loss 0.0 0.0 0.0 1998 2001 2004 1999 2002 Com 60+ Del Com Cum Loss 1 7 13 19 25 31 Ind 60+ Del Ind Cum Loss 1.0 0.5 0.0 1998 2001 1999 2002
Deals
1999
35.0

2000
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
3.0
Cumulative Loss
2.5
2.0
1.5
1.0
0.5
0.0
25.0

2.5 2.0 1.5
16.0
2002
20.0
15.0
10.0
5.0
0.0
Cum Series Factor Loss 1998-1 0.05 2.31 1998-2 0.05 2.66 1999-1 0.06 3.07 1999-2 0.06 2.99 1999-3 0.13 3.04 1999-4 0.14 2.62 2000-1 0.13 2.81 2000-2 0.11 2.75 2000-3 0.12 2.43 2001-1 0.15 2.26 2001-C1 0.11 1.31 2001-2 0.18 1.96 2001-C2 0.17 1.23 2001-FF1 0.13 1.09 2001-3 0.19 1.25 2001-AD1 0.27 1.80 2001-C3 0.12 0.86 2001-4 0.27 0.91 2002-C1 0.17 0.23 2002-1 0.33 0.59 2002-2 0.33 0.67 2002-3 0.36 0.51 2002-4 0.44 0.35 2003-1 0.46 0.21 2003-2 0.53 0.18 2003-3 0.61 0.09 2003-C1 0.50 0.21 2003-4 0.68 0.06 2003-5 0.74 0.02 2003-6 0.81 0.02 2004-1 0.81 0.00 2004-2 0.89 0.00 2003
0.1 0.0 0.0
60+ Del 9.59 11.17 11.44 13.76 19.69 15.70 16.57 15.72 19.94 20.28 23.07 18.91 13.63 16.45 14.67 10.39 15.87 11.21 7.75 6.60 7.40 7.54 5.53 5.43 2.86 2.70 3.78 1.87 1.41 0.79 1.13 0.61
Life CPR 36.49 38.25 38.46 39.70 31.97 32.08 34.81 37.82 39.02 38.89 43.42 38.10 39.18 45.59 39.63 32.84 50.21 34.59 46.61 33.44 36.36 35.85 31.98 32.45 30.62 25.81 36.86 22.65 20.23 17.60 21.63 19.74
90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0
3 mo CPR
2004
Lehman Brothers
Company Averages
35.0 5.0 4.0 25.0 20.0 15.0 10.0 5.0 0.0 1 Com 60+ Del Com Cum Loss 7 13 19 25 31 37 43 Ind 60+ Del Ind Cum Loss 0.0 1.0 0.5 2.0 1.5 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 49 55 3.0 2.5 30.0 3.5 4.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 (Avg) 1997 2000 35.0 2.5 2.0 1.5 1.0 0.5 0.0 1 Com 60+ Del Com Cum Loss 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss 7 Ind 60+ Del Ind Cum Loss (Avg) 1997 2000 1995 1998 2001 1996 1999 2002 Ind Cum Loss Ind 60+ Del 7 13 19 25 31 1 30.0 25.0 20.0 15.0 10.0 5.0 0.0 1995 1998 2001 1996 1999 2002
Deals
1999
35.0

2000
4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 (0.5)
Cumulative Loss
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103
40.0
2002
0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0
35.0 30.0 25.0
20.0
15.0
10.0 5.0
0.0
18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 7 Com 60+ Del Com Cum Loss 13 19
0 6 12 18 24 30 36 42 48 54 60 66 72 78 84 90 96102 108 (Avg) 1997 2000 1995 1998 2001 1996 1999 2002
Ind 60+ Del Ind Cum Loss

2003
0.1 0.1 0.1 0.0 0.0 0.0 0.0
70.0
3 mo CPR
2004
60.0
50.0
40.0
30.0
20.0
10.0
0.0
Cum Series Factor Loss 1995-5B 0.00 1.24 1995-7 0.00 3.78 1996-2 0.06 3.39 1997-1 0.06 0.42 1997-2 0.06 0.46 1998-2 0.05 3.88 1998-3 0.04 2.98 1998-2 0.07 2.87 1998-3 0.10 1.19 1998-8 0.06 3.74 1999-SP1 0.11 7.58 2000-BC1 0.10 1.20 2000-BC2 0.12 1.72 2000-BC3 0.12 1.95 2001-BC1 0.10 1.31 2001-BC3 0.10 0.58 2001-BC4 0.11 1.80 2001-BC5 0.13 1.54 2001-BC6 0.17 1.31 2001-1 0.22 0.57 2002-BC1 0.22 0.97 2002-BC2 0.20 0.98 2002-HF1 0.30 1.14 2002-BC3 0.26 0.64 2002-BC4 0.27 0.81 2002-BC5 0.23 0.93 2002-BC6 0.26 0.90 2002-BC7 0.27 1.13 2002-BC8 0.30 0.62 2002-HF2 0.37 1.83 2002-1 0.28 0.14 2002-BC9 0.31 0.70 2002-BC1 0.34 0.87 2002-BC1 0.33 0.44 2003-BC1 0.47 2.68 2003-BC1 0.37 0.36 2003-BC2 0.42 1.14 2003-BC2 0.39 0.37 2003-BC3 0.43 0.40 2003-AM1 0.47 0.25 2003-1 0.41 0.10 2003-BC5 0.44 0.23 2003-BC4 0.47 0.47 2003-BC6 0.51 0.13
60+ Del NA NA 16.80 2.42 6.19 34.94 34.64 24.00 16.36 30.60 34.68 25.12 29.03 32.25 37.61 29.51 36.32 38.27 35.55 9.97 22.77 26.41 17.93 17.00 18.33 18.55 18.85 22.13 18.12 31.75 5.53 18.40 23.39 16.81 45.07 11.08 25.32 11.85 9.79 9.52 6.37 8.60 9.92 8.74
Life CPR 100.00 100.00 26.16 28.73 30.65 34.72 37.11 31.86 27.69 34.30 31.74 37.23 36.27 38.52 45.35 46.12 45.01 44.80 42.71 37.85 40.58 44.56 36.78 40.55 40.40 45.07 43.04 43.92 41.93 36.01 44.79 42.94 39.80 42.48 32.10 41.41 36.81 40.69 39.33 35.46 40.69 39.52 37.42 37.34
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103
327
328
chapter 25
Long Beach
Company Averages
2000
40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 1 7 13 Com 60+ Del Com Cum Loss 19 25 31 Ind 60+ Del Ind Cum Loss
Deals

2001
3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 7 13 2000 2003 Com Cum Loss Ind Cum Loss 2001 Com 60+ Del Ind 60+ Del 19 25 31 37 43 2 15 21 27 33 39 45 (Avg) 2002 9
Cumulative Loss

25.0 20.0 15.0 10.0 5.0 0.0 7 13 2000 2003 2004 2001 Com 60+ Del Com Cum Loss 19 25 31 37 43 1 7 (Avg) 2002 13 19 Ind 60+ Del Ind Cum Loss
2002
0.6 0.5 0.4 0.3 0.2 0.1 0.0
7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss 7
2003
Series 2000-1 2001-1 2001-2 2001-3 2001-4 2002-1 2002-2 2002-3 2002-4 2002-5 2003-1 2003-2 2003-3 2003-4 2004-1 2004-2 2004-3 2004-5 2004-4
Cum Factor Loss 0.14 4.24 0.17 4.26 0.19 4.59 0.21 3.39 0.23 3.01 0.23 1.36 0.26 1.58 0.24 1.04 0.31 0.80 0.34 0.80 0.39 0.37 0.43 0.37 0.49 0.22 0.54 0.11 0.70 0.01 0.85 0.00 0.91 0.00 0.96 0.00 0.96 0.00
60+ Del 40.08 39.52 37.72 35.31 33.96 27.07 30.41 26.13 20.22 18.42 11.42 14.61 12.70 7.10 3.05 2.65 1.25 0.76 0.65
Life CPR 38.01 37.74 38.54 38.11 38.71 41.77 41.18 45.22 40.90 40.06 39.71 38.86 37.49 34.23 33.94 23.48 16.53 10.58 13.90
45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0
80.0
3 mo CPR
2004
70.0
60.0 50.0
40.0
30.0
20.0 10.0 7 13 2000 2003 19 25 31 (Avg) 2002 37 43 2001
0.0
Merrill Lynch
Company Averages
35.0 5.0 60.0 50.0 40.0 30.0 2.0 20.0 10.0 0.0 1 Com 60+ Del Com Cum Loss 7 13 19 25 31 37 43 Ind 60+ Del Ind Cum Loss 0.0 1.0 0.5 1.0 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 49 55 2.0 1.5 3.0 2.5 3.5 4.0 3.0 4.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 19 25 31 37 43 49 55 61 67 (Avg) 2000 2002 2003 1998 1999
Deals
1999 2000
3.0
Cumulative Loss
2.5
2.0
1.5
1.0
0.5
0.0
60.0 25.0 20.0 15.0 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss 7 10.0 5.0 0.0 6 12 18 24 30 36 42 48 54 60 66 1998 2002 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 1999 2003 1 13 19 (Avg) 2000 2004 7 4.0 5.0 6.0

30.0
2002
7.0
2003
0.1
50.0
Cum Series Factor Loss 1999-H1 0.07 1.91 2002-AFC 0.30 3.36 2002-NC1 0.23 0.51 2002-HE1 0.30 0.28 2003-WM 0.32 0.58 2003-BC1 0.44 0.50 2003-WM 0.42 0.43 2003-BC2 0.56 0.44 2003-BC3 0.66 0.13 2003-HE1 0.61 0.01 2003-OPT 0.62 0.04 2003-BC4 0.76 0.04 2004-WM 0.69 0.01 2004-WM 0.79 0.00 2004-BC2 0.91 0.00 2004-HE1 0.88 0.00 2004-FM1 0.86 0.00 2004-OPT 0.94 0.00 2004-HE2 0.96 0.00
0.1 0.1 0.1 0.0 0.0 0.0 0.0 0.0 Ind 60+ Del Ind Cum Loss
60+ Del 33.32 45.81 20.01 14.05 13.21 17.62 8.63 9.82 8.28 7.94 5.04 4.69 4.08 2.62 3.65 1.33 1.48 1.12 1.28
Life CPR 36.54 32.80 42.53 43.09 46.00 NA 38.89 31.46 27.88 34.17 35.12 25.23 42.40 37.32 16.68 25.53 36.53 28.93 20.46
40.0
30.0
20.0
10.0
0.0
0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0

2004
7 13 19 25 31 37 43 49 55 61 67 1998 2002 2003 1999 (Avg) 2000
90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0
3 mo CPR
329
330
chapter 25
Morgan Stanley
Company Averages
40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 1 7 13 Com 60+ Del Com Cum Loss 19 25 31 Ind 60+ Del Ind Cum Loss 30.0 25.0 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 20.0 15.0 10.0 5.0 0.0 7 13 1997 2002 2003 2000 19 25 31 37 43 49 (Avg) 2001 3.5
Deals
2000
4.0 35.0

2001
2.5 2.0 1.5 1.0 0.5 0.0
4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
Cumulative Loss
40.0

0.6 0.5 0.4 0.3 0.2 0.1 0.0 1 Com 60+ Del Com Cum Loss 7 13 19 Ind 60+ Del Ind Cum Loss
2003
35.0 30.0 25.0
20.0
15.0
10.0 5.0 6 (Avg) 2001 2004 1997 2002 2000 2003 12 18 24 30 36 42 48
0.0
18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0
80.0
3 mo CPR
2004
70.0
60.0 50.0
40.0
30.0
20.0 10.0 7 13 1997 2002 19 25 31 37 (Avg) 2001 43 49 2000 2003
0.0
Cum Series Factor Loss 2000-1 0.12 4.16 2001-WF1 0.12 2.58 2001-NC1 0.14 2.11 2001-NC2 0.14 1.85 2001-AM1 0.15 2.13 2001-NC3 0.15 1.49 2001-NC4 0.19 1.55 2002-AM1 0.19 2.09 2002-NC1 0.21 0.82 2002-AM2 0.23 0.71 2002-NC2 0.21 0.68 2002-HE1 0.25 0.86 2002-HE2 0.27 0.54 2002-NC3 0.27 0.57 2002-OP1 0.25 0.58 2002-NC4 0.28 0.69 2002-NC5 0.30 0.57 2002-AM3 0.34 0.58 2002-NC6 0.30 0.45 2002-HE3 0.41 0.55 2003-NC1 0.33 0.43 2003-NC2 0.40 0.19 2003-NC3 0.43 0.18 2003-NC4 0.46 0.14 2003-NC5 0.47 0.16 2003-NC6 0.49 0.17 2003-HE1 0.51 0.19 2003-NC7 0.51 0.15 2003-HE2 0.58 0.05 2003-NC9 0.50 0.05 2003-NC8 0.56 0.06 2003-NC1 0.56 0.13 2003-HE3 0.64 0.06 2004-NC1 0.63 0.02 2004-HE1 0.69 0.03 2004-NC2 0.69 0.00 2004-NC3 0.77 0.01 2004-HE2 0.76 0.03 2004-NC4 0.81 0.00 2004-HE3 0.79 0.00 2004-HE4 0.85 0.00 2004-NC5 0.85 0.00 2004-HE5 0.86 0.00 2004-NC6 0.87 0.00
60+ Del 35.06 35.34 34.22 34.75 33.30 35.23 31.58 37.39 24.55 20.21 24.51 22.37 20.74 19.91 18.39 22.74 19.92 17.29 18.23 16.43 15.43 10.63 9.53 8.36 9.11 9.51 9.96 7.40 5.96 7.48 7.43 6.23 4.34 3.34 4.40 4.46 3.58 3.70 3.23 3.72 3.16 3.36 2.05 1.45
Life CPR 38.29 43.06 42.39 43.69 44.45 45.50 42.30 42.53 43.04 41.56 43.70 41.73 41.74 42.12 43.99 42.69 42.48 38.58 43.00 34.39 43.47 38.32 37.45 36.28 37.65 37.19 35.75 36.80 32.68 39.76 36.57 38.98 30.62 38.50 35.68 35.15 32.06 33.50 29.63 31.94 27.31 26.09 29.07 27.53
New Century
Company Averages
35.0 5.0 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1 Com 60+ Del Com Cum Loss 7 13 19 25 31 37 43 Ind 60+ Del Ind Cum Loss 4.0 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 49 55 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 85 (Avg) 2000 2003 30.0 2.5 2.0 1.5 1.0 0.5 0.0 1 Com 60+ Del Com Cum Loss 6.0 5.0 4.0 3.0 2.0 1.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 85 (Avg) 2000 2003 1997 2001 1999 2002 Com 60+ Del Com Cum Loss 1 7 Ind 60+ Del Ind Cum Loss 0.0 0.0 0.0 Ind Cum Loss Ind 60+ Del 7 13 19 25 31 1 25.0 20.0 15.0 10.0 5.0 0.0 6 12 18 24 30 36 42 48 54 60 66 72 78 84 (Avg) 2000 2003 1997 2001 2004 1999 2002 1997 2001 1999 2002
Deals
1999 2000
3.5
Cumulative Loss
3.0
2.5
2.0
1.5
1.0
0.5
0.0
45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0
50.0
2002
0.6 0.5 0.4 0.3 0.2 0.1 0.0
40.0
30.0
20.0
10.0
Cum Series Factor Loss 1997-NC5 0.09 2.51 1997-NC6 0.09 3.13 1999-NCA 0.14 3.77 1999-NCB 0.15 3.24 1999-NCD 0.18 2.31 2000-NC1 0.11 4.06 2000-NCA 0.15 2.50 2000-NCB 0.10 1.41 2001-NC1 0.16 1.42 2001-NC2 0.17 1.52 2002-A 0.23 1.21 2002-1 0.14 0.85 2003-1 0.42 0.15 2003-2 0.35 0.24 2003-3 0.50 0.05 2003-4 0.64 0.02 2003-A 0.63 0.07 2003-5 0.77 0.00 2003-B 0.58 0.03 2003-6 0.69 0.04 2004-1 0.85 0.00 2004-2 0.92 0.00 2004-A 0.96 0.00 2004-NC2 0.95 0.00 2004-3 0.98 0.00
18.0 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0 7 Com 60+ Del Com Cum Loss 0.1 0.0 0.0 13 19 Ind 60+ Del Ind Cum Loss

2003 2004
60+ Del 15.15 20.89 25.68 25.62 28.61 37.34 46.42 49.97 33.04 31.54 25.51 23.12 7.12 14.62 7.39 3.94 5.89 1.15 6.41 4.84 2.49 1.23 0.49 0.39 0.24
Life CPR 26.85 27.71 29.29 29.67 28.39 36.64 33.91 40.38 40.76 42.06 40.46 49.88 35.78 44.89 36.00 29.50 29.87 18.88 38.98 30.17 20.94 13.86 8.39 19.17 8.90
0.0
90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0
3 mo CPR
331
332
chapter 25
Novastar
Company Averages
35.0 5.0 4.0 25.0 20.0 15.0 10.0 5.0 0.0 1 7 13 19 Com 60+ Del Com Cum Loss 25 31 37 43 Ind 60+ Del Ind Cum Loss 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 49 55 30.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 (Avg) 1999 2002 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 1 Com 60+ Del Com Cum Loss 6.0 5.0 4.0 3.0 2.0 1.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 (Avg) 1999 2002 1997 2000 2003 1998 2001 1 Com 60+ Del Com Cum Loss 7 Ind 60+ Del Ind Cum Loss 0.0 0.0 0.0 13 (Avg) 1999 2002 1997 2000 2003 1998 2001 2004 7 19 25 31 Ind 60+ Del Ind Cum Loss 1.0 0.5 0.0 1997 2000 2003 1998 2001
Deals
1999
35.0

2000
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
4.0
Cumulative Loss
3.5
3.0 2.5
2.0 1.5
1.0 0.5
0.0
30.0

2.5 2.0 1.5
16.0
2002
0.6 0.5 0.4 8.0 6.0 4.0 2.0 0.0 1 7 Com 60+ Del Com Cum Loss 13 19 Ind 60+ Del Ind Cum Loss 0.3 0.2 0.1 0.0
25.0
Series 1997-2 1998-1 1998-2 1999-1 2000-1 2000-2 2001-1 2001-2 2002-1 2002-2 2002-3 2003-1 2003-2 2003-3 2003-4 2004-1 2004-2 2004-3
14.0 12.0 10.0
Cum Factor Loss 0.04 3.00 0.05 4.02 0.09 3.73 0.11 4.04 0.11 1.19 0.10 0.73 0.15 0.97 0.18 0.56 0.24 0.46 0.27 1.00 0.35 0.20 0.49 0.29 0.59 0.12 0.69 0.06 0.74 0.05 0.83 0.01 0.91 0.00 0.97 0.00
60+ Del 17.02 22.13 19.50 24.88 16.81 18.12 12.80 16.69 12.63 10.82 8.08 6.20 3.36 2.22 2.37 2.44 1.53 0.59
Life CPR 35.55 35.12 31.43 30.08 36.80 41.49 39.99 41.27 41.59 40.45 38.12 31.51 28.50 24.42 23.60 21.06 15.98 11.78
20.0
15.0
10.0
5.0
0.0
70.0
3 mo CPR
2003
0.1 0.0 0.0
2004
60.0
50.0
40.0
30.0
20.0
10.0
0.0
Option One
Company Averages
40.0 6.0 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1 Com 60+ Del Com Cum Loss 7 13 19 25 31 37 43 Ind 60+ Del Ind Cum Loss 5.0 4.0 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 49 55 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 (Avg) 1997 2000 30.0 2.5 2.0 1.5 8.0 1.0 6.0 4.0 2.0 0.0 1 7 Com 60+ Del Com Cum Loss 0.1 0.0 0.0 0.0 0.0 0.0 1 Com 60+ Del Com Cum Loss 7 Ind 60+ Del Ind Cum Loss 13 19 Ind 60+ Del Ind Cum Loss 0.5 0.0 1 Com 60+ Del Com Cum Loss 6.0 5.0 4.0 3.0 2.0 1.0 0.0 (Avg) 1997 2000 1995 1998 2001 1996 1999 2002 Ind Cum Loss Ind 60+ Del 7 13 19 25 31 25.0 20.0 15.0 10.0 5.0 0.0 (Avg) 1997 2000 1995 1998 2001 1996 1999 2002 1995 1998 2001 1996 1999 2002
Deals
1999 2000
8.0
Cumulative Loss
7.0
6.0 5.0
4.0 3.0
2.0 1.0
0.0
45.0 40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103
60.0

16.0
2002
0.6 0.5 0.4 0.3 0.2 0.1 0.0
50.0
40.0
14.0 12.0 10.0
30.0
20.0
10.0
0.0

2003 2004
0 6 12 18 24 30 36 42 48 54 60 66 72 78 84 90 96102 108
Series 1995-2N 1996-1N 1998-2 1999-1 1999-2 1999-2 1999-3 2000-1 2000-2 2000-3 2000-4 2000-5 2001-1 2001-2 2001-3 2001-4 2002-1 2002-2 2002-3 2002-4 2002-5 2002-6 2003-1 2003-2 2003-3 2003-4 2003-5 2003-6 2004-1 2004-2 2004-3
Cum Factor Loss 0.03 A 0.03 A 0.11 7.46 0.12 8.96 0.10 4.02 0.14 8.97 0.07 2.24 0.06 2.36 0.08 2.25 0.07 2.30 0.07 1.33 0.10 3.36 0.07 1.44 0.08 1.71 0.10 0.95 0.13 0.98 0.22 0.56 0.20 0.77 0.24 0.64 0.24 0.68 0.27 0.66 0.33 0.25 0.43 0.23 0.48 0.13 0.52 0.19 0.55 0.09 0.60 0.14 0.65 0.10 0.73 0.02 0.84 0.00 0.97 0.00
60+ Del 21.72 25.05 36.34 41.57 29.76 41.71 33.34 52.79 31.70 41.26 32.14 39.57 35.20 36.90 32.35 31.45 17.39 20.97 20.80 15.50 19.13 12.34 9.67 8.07 8.24 6.43 7.00 4.96 4.73 4.37 0.74
Life CPR 31.54 33.11 27.86 29.21 32.81 31.36 40.52 44.23 41.94 44.85 46.30 42.31 48.56 49.50 48.42 47.52 39.77 44.70 40.83 43.40 42.21 39.41 34.96 33.80 31.74 32.21 29.82 30.96 28.93 22.03 16.95
100.0
3 mo CPR
80.0
60.0
40.0
20.0
0.0
1 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 97 103
333
334
chapter 25
Popular North America (Equity One)

Company Averages
35.0 5.0 4.0 25.0 20.0 15.0 10.0 5.0 0.0 1 7 13 19 Com 60+ Del Com Cum Loss 25 31 37 43 Ind 60+ Del Ind Cum Loss 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 49 55 30.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 85 (Avg) 1999 2002 30.0 25.0 20.0 15.0 10.0 5.0 0.0 6 12 18 24 30 36 42 48 54 60 66 72 78 84 1 Com 60+ Del Com Cum Loss 6.0 5.0 4.0 3.0 2.0 1.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 85 (Avg) 1999 2002 1997 2000 2003 1998 2001 1 Com 60+ Del Com Cum Loss 7 Ind 60+ Del Ind Cum Loss 0.0 0.0 0.0 7 13 (Avg) 1999 2002 1997 2000 2003 1998 2001 2004 19 25 31 Ind 60+ Del Ind Cum Loss 1.0 0.5 0.0 1997 2000 2003 1998 2001
Deals
1999
35.0

2000
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
3.5
Cumulative Loss
3.0
2.5 2.0
1.5 1.0
0.5 0.0
(0.5)
35.0

2.5 2.0 1.5
16.0
2002
30.0
25.0
Series 1997-1 1998-1 1999-1 2000-1 2001-1 2001-2 2001-3 2002-1 2002-2 2002-3 2002-4 2002-5 2003-1 2003-2 2003-3 2003-4 2004-1 2004-2 2004-3 2004-4
Cum Factor Loss 0.08 1.66 0.10 0.51 0.16 1.67 0.20 3.02 0.25 3.16 0.24 1.40 0.27 1.14 0.27 0.98 0.33 0.69 0.29 0.74 0.36 0.53 0.35 0.49 0.42 0.34 0.52 0.18 0.59 0.08 0.68 0.02 0.79 0.00 0.84 0.00 0.93 0.00 0.97 0.00
60+ Del 16.62 13.31 24.38 27.55 32.07 26.72 22.35 20.41 16.65 17.30 11.29 15.24 13.28 6.81 5.63 4.07 2.03 1.41 0.69 0.24
Life CPR 27.22 27.85 26.71 29.16 31.27 34.07 34.11 36.47 33.54 37.46 35.05 37.95 37.18 31.80 30.50 27.10 23.21 23.19 14.80 11.00
20.0
15.0
10.0
5.0
0.0
60.0
3 mo CPR
2003
0.1 0.0 0.0
2004
50.0
40.0
30.0
20.0
10.0
0.0
Provident Bank
Company Averages
40.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss 7 13 19 25 31 37 43 Ind 60+ Del Ind Cum Loss 35.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 49 55 10.0 5.0 20.0 15.0 30.0 25.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 (Avg) 1998 1999 2000 1996 1997 35.0
Deals
1999
7.0 40.0

2000
10.0
Cumulative Loss
8.0
6.0
4.0
2.0
0.0
Series 1997-1 1997-2 1997-3 1997-4 1998-1 1998-2 1998-3 1998-4 1999-1 1999-2 1999-3 2000-1 2000-A 2000-2
Cum Factor Loss 0.04 7.66 0.05 8.00 0.06 6.08 0.07 5.58 0.08 6.97 0.11 6.46 0.12 6.37 0.14 7.10 0.15 6.13 0.16 6.78 0.18 7.83 0.20 8.40 0.11 1.68 0.21 9.73
60+ Del 34.32 37.73 31.91 33.48 30.14 32.50 33.07 33.64 31.59 35.05 37.45 37.85 1.01 42.64
Life CPR 33.13 32.24 30.71 30.83 29.35 28.34 28.00 27.52 27.76 27.88 27.45 27.81 NA 28.40
70.0
60.0
50.0
40.0
30.0
20.0
10.0 7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 (Avg) 1998 1999 2000 1996 1997
0.0

7 13 19 25 31 37 43 49 55 61 67 73 79 85 91 (Avg) 1998 1999 2000 1996 1997
90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0
3 mo CPR
335
336
chapter 25
Salomon Brothers
Company Averages
35.0 5.0 4.0 3.0 2.0 1.0 0.0 0.0 1 7 13 19 Com 60+ Del Com Cum Loss 25 31 37 43 Ind 60+ Del Ind Cum Loss 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 49 55 10.0 5.0 20.0 15.0 30.0 25.0 35.0 40.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 19 25 31 37 43 49 55 61 67 73 79 85 (Avg) 1998 2002 20.0 15.0 10.0 5.0 0.0 6 12 18 24 30 36 42 48 54 60 66 72 78 84 1 Com 60+ Del Com Cum Loss 7 (Avg) 1998 2002 1996 1999 2003 1997 2000 13 19 Ind 60+ Del Ind Cum Loss 1996 1999 2003 1997 2000
Deals
1999

2000
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
Cumulative Loss
50.0
2003
40.0
30.0
20.0
10.0
0.0
0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0
Cum Series Factor Loss 1997-LB4 0.02 2.20 1997-LB5 0.02 1.53 1997-LB6 0.07 2.97 1997-NC5 0.04 3.56 1998-NC1 0.05 4.66 1998-AQ1 0.08 3.44 1998-NC2 0.04 3.31 1998-NC3 0.10 4.28 1998-OPT 0.04 3.70 1998-OPT 0.04 3.24 1998-NC4 0.05 4.88 1998-NC6 0.12 5.62 1998-NC7 0.11 4.29 1999-AQ1 0.10 4.54 1999-NC1 0.15 4.90 1999-NC2 0.07 3.48 1999-NC3 0.06 3.05 1999-NC4 0.08 2.95 1999-AQ2 0.12 4.58 1999-NC5 0.09 2.58 2000-LB1 0.10 2.78 2001-1 0.26 3.84 2002-WM 0.19 1.75 2002-CIT1 0.40 1.18 2002-WM 0.22 1.13 2003-UP1 0.47 0.48 2003-HE1 0.48 0.03
60+ Del 39.44 29.84 14.86 23.58 21.89 19.17 11.35 16.26 30.72 26.74 37.99 18.75 21.70 28.54 19.58 23.42 31.25 29.02 30.49 27.32 31.51 19.58 32.17 16.68 21.56 8.85 7.07
Life CPR 41.66 42.82 30.07 35.67 35.39 NA 38.97 28.40 39.13 40.69 37.03 27.76 29.65 32.16 27.12 37.29 38.92 37.22 33.84 37.63 37.92 34.40 42.87 29.28 48.87 33.35 34.58
80.0
3 mo CPR
70.0
60.0 50.0
40.0
30.0
20.0 10.0 7 13 19 25 31 37 43 49 55 61 67 73 79 85 (Avg) 1998 2002 1996 1999 2003 1997 2000
0.0
Saxon
Company Averages
35.0 5.0 4.0 25.0 20.0 15.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss 7 13 19 25 31 37 43 Ind 60+ Del Ind Cum Loss 10.0 5.0 0.0 3.0 3.0 2.0 1.0 0.0 1 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 7 13 19 25 31 37 43 49 55 30.0 4.0 5.0 30.0 25.0 20.0 15.0 10.0 5.0 0.0 7 13 (Avg) 1998 2001 30.0 25.0 20.0 15.0 1.5 6.0 4.0 2.0 0.0 1 7 Com 60+ Del Com Cum Loss 0.1 0.1 0.0 0.0 0.0 0.0 0.0 1 Com 60+ Del Com Cum Loss 7 Ind 60+ Del Ind Cum Loss 13 19 Ind 60+ Del Ind Cum Loss 1.0 0.5 0.0 1 Com 60+ Del Com Cum Loss 6.0 5.0 4.0 3.0 2.0 1.0 0.0 7 (Avg) 1998 2001 1996 1999 2002 1997 2000 2003 13 19 25 31 37 43 49 55 61 67 Ind Cum Loss Ind 60+ Del 7 13 19 25 31 10.0 5.0 0.0 6 12 18 24 30 36 42 48 54 60 66 72 (Avg) 1998 2001 1996 1999 2002 1997 2000 2003 2.0 8.0 2.5 3.0 14.0 12.0 10.0 1996 1999 2002 1997 2000 2003 19 25 31 37 43 49 55 61 67
Deals
1999
35.0

2000
5.0
Cumulative Loss
4.0
3.0
2.0
1.0
0.0
35.0 3.5 16.0
2002
0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0
30.0
Series 1999-2 1999-3 1999-5 2000-1 2000-2 2000-3 2000-4 2001-1 2001-2 2001-3 2002-1 2002-2 2002-3 2003-1 2003-2 2003-3 2004-1 2004-2
Cum Factor Loss 0.10 4.30 0.11 4.63 0.17 5.07 0.13 5.22 0.14 4.86 0.14 4.86 0.15 4.28 0.18 4.67 0.22 3.38 0.21 2.73 0.28 1.49 0.32 0.85 0.36 0.75 0.47 0.27 0.54 0.11 0.63 0.09 0.77 0.02 0.93 0.00
60+ Del 29.98 26.36 22.87 27.11 32.34 34.11 36.53 29.22 23.54 28.10 16.79 15.45 12.83 9.95 6.27 5.34 4.34 1.44
Life CPR 33.26 32.83 28.52 33.62 34.70 36.60 37.99 36.19 35.19 38.53 36.67 36.88 38.25 34.53 31.98 30.14 25.98 15.96
25.0
20.0
15.0
10.0
5.0
0.0

2003 2004
60.0
3 mo CPR
50.0
40.0
30.0
20.0
10.0
0.0
337
338
chapter 25
Southern Pacific
Company Averages
30 25 20 1 5 1 0 5 0 0.0 0 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 6 1 1 24 30 36 42 48 54 60 66 72 78 2 8 0 6 6 1 1 24 30 36 42 48 54 60 66 72 78 84 90 2 8 1995 1996 1997 1998 0 1 2 1 24 30 36 42 48 54 60 66 8 Com 60+ Del Com Cum Loss Ind 60+ Del Ind Cum Loss 2.0 1.0 5 4.0 3.0 1 0 1 5 6.0 5.0 20 7.0 25
Deals
1996
8.0 30

1997
8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0
12.0
Cumulative Loss
10.0
8.0
Series 1995-2 1997-2 1997-3 1998-1 1998-2
Cum Factor Loss 0.01 NA 0.03 7.65 0.10 7.27 0.10 11.01 0.12 11.56
60+ Del 54.87 15.75 24.42 26.34 26.04
Life CPR 40.14 41.44 31.11 32.71 31.85
6.0
4.0
2.0
0.0
40 35 30 25 20 1 5 1 0 5 0 0 Com 60+ Del Com Cum Loss 6 1 2 1 8 24 30 36 42 48 54 Ind 60+ Del Ind Cum Loss

40 12.0 10.0 8.0 6.0 4.0 2.0 0.0
1998
35
30 25
20
1 5
1 0 5
0 1995 1996 1997 1998
6 1 1 24 30 36 42 48 54 60 66 72 78 84 90 2 8
60
3 mo CPR
50
40
30
20
1 0
0 1995 1996 1997
6 1 1 24 30 36 42 48 54 60 66 72 78 84 90 2 8 1998
Superior Bank
Company Averages
30 6.0 5.0 4.0 3.0 2.0 1 0 5 0 0 Com 60+ Del Com Cum Loss 6 1 2 1 24 30 36 42 48 54 60 66 8 Ind 60+ Del Ind Cum Loss 0.0 1.0 1.0 0.0 0 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 6 1 1 24 30 36 42 48 54 60 66 72 78 2 8 1 5 2.0 20 3.0 25 4.0 30 5.0 25 20 1 5 1 0 5 0 6 1 1 24 30 36 42 48 54 60 66 72 78 84 90 2 8 1995 1998 1999 2000 1996 1997
Deals
1996
35 6.0

1997
7.0
Cumulative Loss
6.0
5.0
4.0
3.0
2.0
1.0
0.0
40 30 5.0 4.0 3.0 2.0 1.0 0.0 0 0 6 1 2 1 8 Com 60+ Del Com Cum Loss 24 0 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 6 1 2 1 8 24 30 36 42 48 54 1 0 5 1 5 20 30 25 25 20 1 5 1 0 5 0 6 1 1 24 30 36 42 48 54 60 66 72 78 84 90 2 8 1995 1998 1999 2000 1996 1997 35

35 6.0 40
1998
1999
7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 30 36 42 Ind 60+ Del Ind Cum Loss
35
30 25
20
Series 1995-4 1995-5 1996-1 1996-2 1996-3 1996-4 1997-1 1997-2 1997-3 1997-4 1998-1 1998-2 1998-3 1998-4 1999-1 1999-2 1999-3 1999-4 2000-1 2000-2 2000-4
Cum Factor Loss 0.05 3.79 0.04 3.78 0.06 4.30 0.06 3.97 0.06 4.00 0.07 4.18 0.07 3.97 0.07 3.76 0.10 5.57 0.09 6.08 0.13 5.33 0.15 6.04 0.18 6.05 0.19 6.53 0.20 7.05 0.28 8.64 0.32 7.06 0.35 6.72 0.35 6.29 0.36 2.87 0.44 2.18
60+ Del 16.05 25.15 22.81 35.05 24.06 29.87 25.98 30.07 25.63 32.97 32.33 27.00 33.19 33.25 35.88 46.11 35.01 36.80 40.39 42.66 44.72
Life CPR 29.61 31.83 30.43 30.91 31.97 30.91 32.59 33.18 30.76 32.35 29.97 29.25 27.51 27.68 27.86 24.59 23.52 23.46 24.31 25.33 24.17
1 5
1 0 5

40 35 30 25 20 1 5 1 0 5 0 6 1 1 24 30 36 42 48 54 60 66 72 78 84 90 2 8 1995 1998 1999 2000 1996 1997 Com 60+ Del Com Cum Loss 0 1 0 1 6 22 28 34 Ind 60+ Del Ind Cum Loss
60
3 mo CPR
2000
3.0 2.5 2.0 1.5 1.0 0.5 0.0
50
40
30
20
1 0
339
340
chapter 25
The Money Store

Company Averages
25 20 5.0 4.0 3.0 1 0 5 0 0 6 1 2 1 24 30 36 42 48 54 60 66 8 Com 60+ Del Com Cum Loss Ind 60+ Del Ind Cum Loss 2.0 1.0 0.0 0 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 6 1 1 24 30 36 42 48 54 60 66 72 78 2 8 1 5 1 5 1 0 5 0 6 1 1 24 30 36 42 48 54 60 66 72 78 84 90 2 8 1995 1996 1997 1998 6.0 20
Deals
1996
7.0 25

1997
7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0
7.0
Cumulative Loss
6.0
5.0
4.0
Series 1997-C 1997-D 1998-A 1998-B 1998-C
Cum Factor Loss 0.10 7.90 0.12 6.91 0.13 6.30 0.16 6.70 0.19 5.30
60+ Life Del CPR 15.12 NA 18.92 29.50 15.10 29.00 15.52 NA 16.20 NA
3.0
2.0
1.0
0.0
20 25 20 1 5 1 0 5 0 6 1 1 24 30 36 42 48 54 60 66 72 78 84 90 2 8 0 Com 60+ Del Com Cum Loss 6 1 2 1 8 24 1995 1996 1997 1998 30 36 42 48 54 Ind 60+ Del Ind Cum Loss

7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0
1998
1 5
1 0
45 40 35 30 25 20 1 5 1 0 5 0 6 1 1 24 30 36 42 48 54 60 66 72 78 84 90 2 8 1995 1996 1997 1998
3 mo CPR
UCFC
Company Averages
50 30 6.0 5.0 4.0 3.0 2.0 1.0 0.0 0 Com 60+ Del Com Cum Loss 6 1 2 1 24 30 36 42 48 54 60 66 8 Ind 60+ Del Ind Cum Loss 25 20 1 5 1 0 5 0 40 5.0 4.0 3.0 2.0 1.0 0.0 0 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 6 1 1 24 30 36 42 48 54 60 66 72 78 2 8 30 20 1 0 0 6 1995 1996 1997 1998 1 1 24 30 36 42 48 54 60 66 72 78 2 8 6.0
Deals
1996
7.0

1997
7.0
Cumulative Loss
6.0
5.0
4.0
3.0
2.0
Series 1997-A1 1997-C 1997-D 1998-AA 1998-A 1998-B 1998-C 1998-D
Cum Factor Loss 0.06 5.29 0.06 5.13 0.05 4.38 0.13 4.53 0.17 5.54 0.20 5.45 0.19 4.83 0.26 5.07
60+ Del 9.97 20.15 20.79 19.79 17.35 20.72 21.43 12.78
Life CPR 32.45 35.15 37.68 29.22 24.92 23.96 25.40 22.78
1.0
0.0
60 5.0 4.0 3.0 2.0 1.0 0.0 0 Com 60+ Del Com Cum Loss Ind Cum Loss Ind 60+ Del 6 1 2 1 8 24 30 36 42 48 54 20 1 5 1 0 5 0 6 1995 1996 1997 1998 1 1 24 30 36 42 48 54 60 66 72 78 2 8

25
1998
50
40
30
20
1 0

6 1995 1996 1997 1998 1 1 24 30 36 42 48 54 60 66 72 78 2 8
70
3 mo CPR
60
50
40
30
20
1 0
341
342
Appendix Home Equity Handbook
Glossary of Terms
343
344
Glossary Of Terms
2/28 Mortgage Classified as an adjustable rate mortgage. It is fixed for the first two years and then becomes adjustable, resetting semiannually, to 6-month LIBOR. Referred to as a hybrid ARM because it has both fixed and adjustable periods. 3/27 Mortgage Classified as an adjustable rate mortgage. It is fixed for the first three years and then becomes adjustable, resetting semiannually, to 6-month LIBOR. Referred to as a hybrid ARM because it has both fixed and adjustable periods. ABCP (Asset Backed Commercial Paper)
Appendix
Short-term promissory notes (usually between 30 days in tenor and no more than 270 days) issued by a commercial paper conduit and collateralized by ABS. Loans with a variable interest rate.
Adjustable Rate Mortgage (ARM)
Alt A These are high credit quality loans where often the borrower is willing to pay a higher price for the convenience of reduced documentation. Amortization
The repayment of a financial obligation over a period of time in a series of periodic installments. Specifically, this is the payback of the principal owed to the lender. The effect of amortization is to build up the paper value of the investors (owners) equity and to reduce the debt obligation. It should be noted that a portion of each payment consists of a blend of interest and amortization of principal. The interest portion is tax deductible, whereas the amortization is not.
Appraisal
The value that is assigned to the home, typically, when the loan is originated. It is the value in the term loan-to-value (LTV).
AVM (Automated Valuation Model) AVMs use real estate transaction information to calculate the percentage change in the value of a particular property. The calculation is performed through the examination of local market factors (the index method) or by using information about comparable properties to estimate value based on statistical regression tools (the hedonic method). These extrapolations help to determine whether a property in early payment default needs a review appraisal.
The rating agencies often require that some non-affiliated entity other than the initial servicer become the servicer in the event of termination of the initial servicer. Often, the trustee will take on this responsibility and will be required to hire a new servicer in the event of servicer termination.
Back-up Servicer Balloon Loan
A mortgage with a balloon payment, which is a large payment due at the end of the loan term to pay off the balance. Typically, balloon loans have a 30-year amortization schedule and a final maturity of 5, 10 or 15 years.
BPO (Broker Price Opinion) A BPO consists of an exterior inspection of the subject property and an exterior inspection of all comparable sales used to support an opinion of value. The BPO includes estimate of repairs to obtain fair market value, neighborhood information, and value estimate (90, 120, 180 day marketing time for as is and as repaired values). It can also include photos of the property.
345
Home Equity Handbook Appendix
Glossary Of Terms
Broker A state-licensed agent who, for a fee, acts for property owners in real estate transactions. Cashout Refi Channel
When a refinancing allows the borrower to take equity out of the newly originated mortgage.
The form through which an issuer obtains a loan. The four main origination channels are correspondent, broker, retail and wholesale.
Clean-up Call The right of the issuer/servicer to purchase the collateral in the securitization when they have reached a low level compared to the outset of the transaction. Under FAS 125, a clean-up call is permissible when the amount of outstanding assets falls to a level at which the cost of servicing the assets becomes burdensome. For HEL deals, the clean-up call is typically around 10%. Closed-end Home Equity Loan
A type of loan in which the entire balance is fully disbursed to the borrower at closing. The repayment schedule typically takes place over 5 to 30 years.
Combined Loan-To-Value (CLTV) The sum of the first, second and any subsequent liens divided by the appraised value of the home. Concentration Risk One of the principal benefits of securitization is diversification of the obligors. Concentration risk may be based on factors other than the identity of the obligor, such as geographic location. Conforming Loan
A mortgage loan that is eligible for purchase by FNMA or FHLMC.
Conforming Balance
Mortgage loan balances that are below Fannie Mae and Freddie Macs permitted loan balance.
Credit Enhancement A source of capital that takes a risk of loss that is disproportionately greater than more senior positions in a securitization. Sources of credit enhancement include one or more of the following: overcollateralization, excess spread, reserve accounts, letter of credit, subordinated interests, agreements to purchase defaulted loans, financial guarantees, surety bonds and primary mortgage insurance. Credit Grade
A grade of A, B, C, or D that is given to a borrower based on their credit history. The basis for credit grades varies across different issuers.
Cross-Collateralization
Cross-collateralization can only exist in deals with more than one mortgage pool. It is a form of credit enhancement where one collateral group can be used to support and fund shortfalls in a different collateral group. Cumulative losses are measured as total losses during the deals life as a percentage of the original deal balance. Partial prepayment of a mortgage loan. Beginning date from which accrued interest is calculated.
Cumulative Losses Curtailment Dated Date
A mortgage that is used to purchase and/or refinance a home that also consolidates the borrowers other consumer debt into the balance of the mortgage. This allows the borrower to take advantage of the tax deductibility of
Debt Consolidation
346
the interest portion of the mortgage payment, as well as lower interest rates on mortgages relative to other forms of consumer debt. If the loan has a greater than 100% LTV, only the portion below 100% is tax deductible.
Deed In Lieu Of Foreclosure A special purpose deed used by a borrower (mortgagor) who is in default to convey the property to the lender (mortgagee) in order to eliminate the need for a foreclosure. Delinquencies Delinquencies are measured as current amount delinquent as a percentage of the current deal balance. Documentation Level The amount of documentation used when the loan was originated. Generally, more documentation is better.
An item of value, money, or documents deposited with a third party to be delivered upon the fulfillment of a condition. For example, the deposit by a borrower with the lender of funds to pay taxes and insurance premiums when they become due, or the deposit of funds or documents with an attorney or escrow agent to be disbursed upon the closing of a sale of real estate.
Escrow Escrow Account The account in which a mortgage servicer holds the borrowers escrow payments prior to paying property expenses. Excess Spread or Excess Interest
The interest cash flow that remains after deducting monthly interest for the bonds, servicing fees, trustee fees, any credit enhancement fees, and losses from the monthly interest collected from the borrowers. Excess interest is used to shield investors in any spikes in losses, to build up the reserve fund or spread account to the required level.
FHA Title I Loans Title I loans are partially insured by the Federal Housing Administration (the FHA), an agency of the U.S. Department of Housing and Urban Development (HUD), pursuant to the Title I credit insurance program of the National Housing Act of 1934. FICO Score Fair Isaacs and Company score is a measurement designed to indicate the credit quality of a borrower. FICO scores range from 300 to 850. The higher the score, the lower the predicted credit risk for lenders. Along with other factors, the FICO score takes into consideration payment history, the amount the borrower currently owes, length of the borrowers credit history, new credit the customer may be taking on, and types of credit use. First Lien
A mortgage holding priority over the claims of subsequent lenders against the same property. It has the primary claim on the mortgaged property by the lender for satisfaction of outstanding debt. The legal process in or out of court to extinguish all rights, title and interest of the owner(s) of a property in order to sell the property and satisfy a lien against it.
Foreclosure
HELOC (Home Equity Line of Credit) Similar to a credit card, money used from that account is borrowed against the equity of the home. It can have an interest only period. It can have a balloon payment or the drawn amount can be amortized with any future draws adjusting the payment rate to ensure that the loan is fully amortized.
347
Glossary Of Terms
High CLTV (Combined Loan-To-Value) Loan The combination of the first, second and any subsequent loans to the appraised value of the home exceeds 100%. Jumbo Loan
A loan that exceeds Fannie Maes legislated mortgage amount limits. Also called a nonconforming loan. Jumbo loans generally carry a higher interest rate. The borrower provides only partial documentation to
Limited Doc(umentation)
secure the loan.
Loan Purpose The reason the borrower takes out a mortgage loan. Typical reasons include refinancing, debt consolidation, purchase, and cashout. Loan-to-Value The relationship between the principal balance of the mortgage and the appraised value or sales price of the property. For example, a $100,000 home with an $80,000 mortgage has an LTV of 80 percent. Master Servicer The entity who oversees the activities of the primary servicer(s). These functions typically include tracking the movement of funds between the primary and master servicer accounts, ensuring orderly receipt of the servicers monthly remittance and servicing reports, monitoring the collection comments, foreclosure actions and REO activities, aggregate reporting and distribution of funds to trustees/investors, having the authority, if necessary to remove and replace a servicer.
Under the MBA method, a loan would be considered delinquent if the payment had not been received by the end of the day immediately preceding the loans next due date (generally the last day of the month in which the payment was due). Using the example above, a loan with a due date of August 1st would have been reported as delinquent on the September statement to certificateholders. Foreclosure and REOs are treated identically under both MBA and OTS methods.
Mortgage Banker Association (MBA) Delinquency Calculation Method Monoline Insurer An insurance company that solely writes financial guaranty insurance, principally for structured securities, municipal bonds and first mortgage bonds for utility assets. The main monoline insurers in the United States are, in no particular order, Financial Security Assurance (FSA), Ambac Assurance Corporation (Ambac), MBIA Insurance Corporation (MBIA), Financial Guaranty Insurance Company (FGIC) and XL Capital Assurance (XL). Net Mortgage Rate or Net Weighted Average Coupon (NWAC)
The annual percentage rate paid by the borrower less servicing fees, insurance premiums, and trustee fees.
348
NIM (Net Interest Margin) Bond A bond that is typically paid down by the excess interest available after losses have been applied between the net WAC on the collateral and the coupons on the bonds. In addition, the NIM typically has pledged to it prepayment penalties and overcollateralization releases. Nonconforming Loan A loan that exceeds the FNMA or FHLMC legislated mortgage amount limits (jumbo loan) or that has credit characteristics that lie outside the bounds for agency purchases. Office of Thrift Supervision (OTS) Delinquency Calculation Method
Under the OTS method, a loan is considered delinquent if a monthly payment has not been received by the close of business on the loans due date in the following month. The cut-off date for information under both OTS and MBA methods is as of the end of the calendar month. Therefore, a loan with a due date of August 1st, with no payment received by the close of business on August 31st, would be reported as current on the September statement to certificates. Assuming no payments are made during September, the loan would be reflected as delinquent on the October statement.
Origination Fees or Points The fees or points a lender charges to process a loan. Usually based on the amount of the loan, one point equals one percent of the loan balance. Overcollateralization
Overcollateralization is the amount the collateral balance exceeds the bond balance. Overcollateralization can be completely funded at the beginning of the transaction or can build over time. Overcollateralization can build by using excess interest to pay down the bond principal. The homeowner uses the home as their primary residency.
Owner Occupied
Prefunding Excess funds held in a prefunding account and used periodically to acquire from the originator additional eligible receivables as they are originated. Prepayments
Payments that pay the mortgage in full before the final payment date.
Prepayment Penalty A fee that may be charged to a borrower who pays off a loan before it is due. The duration of the prepayment penalty is typically less than five years. Predatory Lending Creditors or brokers can undertake predatory lending. It involves engaging in deception or fraud, manipulating the borrower through aggressive sales tactics or taking unfair advantage of the borrowers lack of loan terminology knowledge. The result is that the lender provides the borrower with a loan for money that the borrower cannot afford to pay back, adds unfair charges to the principal and costly and unnecessary loan insurance. Primary Mortgage Insurance
Mortgage insurance that is provided by a private mortgage insurance company to protect lenders against loss if a borrower defaults. Most lenders generally require MI for a loan with a loan-to-value (LTV) percentage in excess of 80 percent.
349
Glossary Of Terms
Primary Servicer The entity typically responsible for the collection of monthly payments, remitting of funds to the trust account or master servicer, ongoing maintenance of escrow accounts, following up on all delinquent borrowers including loss mitigation efforts, initiating foreclosure proceedings when necessary, disposing of the real estate owned (REO) property and delivering investor reports and default management activity. Real Estate Owned (REO)
of foreclosure.
Property which is in the possession of a lender as a result
Real Estate Settlement Procedures Act (RESPA) Remaining Term
A consumer protection law that requires lenders to give borrowers advance notice of closing costs.
The original amortization term minus the number of payments that have been applied. A mortgage that is originated by an employee of the issuer of the bonds, as opposed to a loan that was purchased from the originator. Loans that are typically missing some form of documentation. A mortgage that has a lien position subordinate to the first mortgage.
Retail Originated Loan
Scratch and Dent Loans Second Lien
Sequential Bond
A structure where the bonds pay in sequential order. For example, the second bond will not begin to receive principal until the first bonds balance reaches zero. The third bond will not receive principal until the second bonds balance reaches zero, etc. The legal entity responsible for administering and servicing the loans. Section 32 loans are a subset of loans that are in violation of Section 32 because they are high cost. HOEPA requires additional disclosures and restricts some loan agreement provisions that can cause hardship on borrowers. A portion of the deal is subordinate to the senior portion of the deal with respect to interest and principal payments. Losses are first allocated to the most subordinate class.
Servicer
Section 32 Loans
Senior/Subordinate (Sr/Sub)
Short Sale (or Short Pay) A loss mitigation technique for a borrower that is having difficulty paying their mortgage. In this situation, the fair market value of the property is less than the loan value. The lender authorizes the borrower to sell the property for what the home is currently worth even if the home is worth less than the mortgage. Subsequently, the lender will get all the proceeds from the sale. The short sale generally relieves the borrower of their mortgage debt. In some cases, the lender may want the borrower to pay a portion of the mortgage shortfall.
350
Soldiers and Sailors Civil Relief Act Shortfalls If a borrower is called to active duty and active duty results in a loss of income for the borrower, a maximum of six percent on mortgage debt may be charged during active duty in the U.S. military reserves or National Guard. As a result, loans to reservists and members of the National Guard may result in shortfalls of interest. Upon the release from active duty, the interest rate returns to the original contract rate. The guarantors will not cover the Soldiers and Sailors Civil Relief Act shortfalls. The Soldiers and Sailors Civil Relief Act was passed by Congress in 1940 but has a history that dates back to the Civil War. It has been tested all the way to the U.S. Supreme Court as well. Special Servicer A special servicer focuses on managing delinquent loans after a specified stage of delinquency. The special servicer is responsible for performing default management, loss mitigation for loans and real estate-owned management. Stated Income A loan where there is no documentation verifying the borrowers income. Trustee
Legal entity, usually a commercial bank that is not affiliated with the issuer. The trustee typically holds the trust assets, including legal documentation of interest in the assets in a segregated account for the benefit of the investors. The trustee also monitors the servicers fulfillment of its obligations. A federal law that requires lenders to fully disclose, in writing, the terms and conditions of a mortgage, including the annual percentage rate (APR) and other charges.
Truth in Lending Act (TILA)
Underwriting
The process of evaluating a loan application to determine the risk involved for the lender. Underwriting involves an analysis of the borrowers creditworthiness and the quality of the property itself.
Utilization Rate Ratio of the outstanding home equity line of credit (HELOC) balance divided by the maximum credit limit of the line of credit. VA Mortgage A mortgage that is guaranteed by the Department of Veterans Affairs (VA). Also known as a government mortgage. Wrap (Insurance Policy or Surety Bond)
A financial guaranty issued by a monoline insurance company generally covering the ultimate payment of principal and the timely payment of interest.
351
Disclosures
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Charles N. Schorin
United States
Director of Global SPG Research
(212) 761-1452
chip.schorin@morganstanley.com
Charles N. Schorin Kenneth Lee Vishwanath Tirupattur Jae Choi Monica Mehra Marielle Jan de Beur Masumi Goldman Victor Yeung Laurent Gauthier Ambika Bisla Varchas Prasad Christina Jenq
Europe
ABS ABS ABS ABS ABS CMBS CMBS CMBS MBS MBS MBS MBS
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2005 EDITION

Home Equity Handbook

Editors: Charles Schorin Monica Mehra

Home Equity Handbook

Editors: Charles Schorin Monica Mehra

Home Equity Handbook

SECTION II. THE COLLATERAL 2 COLLATERAL T YPES

Parameters Migration Patterns Distribution Analysis Cumulative Loss Projections

Factors Affecting Default Default Prediction Regression

Delinquency Migration Patterns

Rating Criteria Types of Servicing Product Distinction

SECTION III. METRICS 7 PREPAYMENTS

Performance by Status Default Timing Excess Spread Surveillance

Loan Size Impact

Stressing Subordination Levels

SECTION IV. THE STRUCTURE 11 MEZZANINE & S UBORDINATE C LASSES

Sources of Cash Flow Primary Mortgage Insurance Sizing Analyzing Performance

Mechanics Benefits of Calling Call Timing

Types Mechanics Impact of Prepayments Delinquency Trigger Thresholds

Types Key Factors Loss Severity Distribution Insurer Performance Data

Wrapped Market Major Insurers

277 2 81 283 2 86 287 2 94 295 3 01 303 3 41

INDUSTRY P ERFORMANCE C OMPARISON SEPARATING T HE G OOD F ROM T HE B AD

Forecasting Ultimate Loss Rates

Home Equity Handbook

Section I Home Equity Handbook

Introduction to the Home Equity Market

Please refer to important disclosures at the end of this material.

Home Equity Handbook

HEL ABS ISSUANCE AND HEL SHARE OF ABS MARKET

Source: Morgan Stanley, Intex, Asset-Backed Alert

LARGEST ISSUERS OF HEL ABS IN 2004

Source: Morgan Stanley, SDC

Home Equity Handbook chapter 1

CAPITAL S TRUCTURE O F S ECURITIZED H ELS

REPRESENTATIVE HEL CAPITAL STRUCTURE

Source: Morgan Stanley

Please refer to important disclosures at the end of this material.

Home Equity Handbook chapter 1

REPRESENTATIVE SUBPRIME UNDERWRITING MATRIX SUMMARY

Source: Various transaction prospectuses

Note Rate (%)

HIGHER SUBPRIME CREDIT GRADES

Please refer to important disclosures at the end of this material.

Section II Home Equity Handbook

Please refer to important disclosures at the end of this material.

Home Equity Handbook

HEL COLLATERAL DISTRIBUTION FOR 2004 TRANSACTIONS

Source: Morgan Stanley, Asset-Backed Alert

TRADITIONAL S UBPRIME M ORTGAGES

The following characteristics are typical of traditional subprime mortgages.

Home Equity Handbook chapter 2

COLLATERAL CHARACTERISTICS OF REPRESENTATIVE SUBPRIME MORTGAGE TRANSACTIONS

2003-1 2003-BC1 2003-1 2003-KS1 2002-4 2003-1 2003-1 2003-NCI 2003-1

NA 50.9 0.0 NA 0.0 0.0 NA 70.3 NA

NA 12.5 0.0 NA 0.0 0.0 NA 2.7 NA

73.9 63.4 0.0 100.0 0.0 0.0 69.2 76.2 72.1

26.1 36.6 100.0 0.0 100.0 100.0 30.8 23.8 27.9

145,485 142,740 300,571 125,634 102,561 399,599 166,463 156,117 167,180

77.3 87.6 9.8 86.5 89.5 25.5 67.0 77.3 79.4

100.0 100.0 100.0 100.0 89.1 100.0 93.5 100.0 99.3

551-575 581-600 NA 560-579 541-580 NA 561-580 526-550 NA

601-625 621-640 NA 600-619 581-620 NA 621-640 576-600 NA