The downgrade environment.

Author:Esaki, Howard
Position:Secondary marketing of mortgage-backed securities

Drexel Burnham Lambert failed in 1989. A record number of thrifts and banks failed in 1990. Major U.S. and foreign banks have had their credit rating downgraded in the past year. How will these stresses to the financial system affect the credit quality of private mortgage-backed securities (MBS)?

Moody's Investors Service believes that although the strains on the financial system may have an adverse impact on selected mortgage pass-throughs, most highly rated private MBS are adquately protected against credit downgrades of affiliated financial institutions.

Private MBS: third-party risk

Private, residential, whole-loan pass-throughs are complex securities that frequently depend on a variety of external sources of credit support to obtain a high rating from Moody's. External or "third-party" credit support differs fundamentally from internal credit support, because the credit quality of the support may change as the rating of the entity providing support changes. Internal credit support, either in the form of cash or subordinated collateral, has the same value throughout the life of the security.

External support is primarily provided through pool insurance policies, letters of credit, corporate guarantees or surety bonds, all of which are used to protect against credit losses. In addition, external support is often used to cover risks from fraud, special hazard or borrower bankruptcy. A third party is also often involved in a mortgage pass-through transaction as an advancer and/or servicer, or in the role of trustee.

No "weak-link" approach

When rating a private MBS, Moody's takes into account all the ratings of involved parties, as well as the total amount of credit support available. Moody's goal is that two securities with the same rating have the same expected change in internal rate of return as a result of credit losses. (For more details of this approach, see "Credit Analysis of Structured Securities," Moody's Investors Service, 1991.)

The credit performance of a private MBS depends not only on the performance of the underlying mortgages but also on the conditions and extent to which third parties fulfill their obligations. In determining a rating, Moody's analyzes a wide range of possible economic and legal conditions that would define the amount of cast flow into the structure and assigns a probability to each scenario. The average of these probability-weighted cash flows are then examined to compute an expected loss, and the number derived is compared with expectations for other structured and corporate bond ratings.

Moody's does not use a weak-link approach in rating private mortgage-backed securities. In other words, the rating of a security is not necessarily the lowest rating of the entities supplying credit support. Instead, Moody's looks at both the combined value of all the forms of support and the value of...

To continue reading