By the Numbers
Moody’s methodology change may spur more upgrades
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
Proposed changes to the way Moody’s forecasts home prices in their private-label MBS ratings framework could result in lower initial credit enhancement for newly rated RMBS and upgrades for a meaningful portion of outstanding mezzanine and subordinate bonds. The changes, if adopted, could drive both greater primary issuance, tighten spreads and lift prices on mezzanine and subordinate classes of prime jumbo, agency investor and GSE credit risk transfer transactions, where Moody’s issues the majority of their ratings.
Moody’s has recently issued a proposal that looks to marry economic home price forecasts with observed, empirical home price data when ascribing expected losses to pools of MBS collateral. These changes could affect both new MBS transactions as well as ratings surveillance on outstanding ones. From a primary market perspective, the changes could lower initially required credit enhancement across the capital structure, reducing issuers’ cost-of-funds and potentially providing a catalyst to increased issuance. According to the agency’s guidance, anywhere from 10% to 20% of outstanding bonds currently rated below ‘Aaa’ could see a ratings upgrade.
The current framework
Under current private label ratings methodologies, agencies rely on a combination of loan attributes to predict a borrower’s propensity to default along with a series of economic and home price scenarios to determine the requisite level of credit support a bond needs to achieve a certain rating. These scenarios become increasingly severe to set subordination levels at higher points in the capital structure, driving up both borrowers’ probability of default as well as the loss generated by that default.
Under Moody’s current framework, the ‘Aaa’ scenario used to derive stressed portfolio losses is by and large more stressful than macroeconomic conditions observed between 2007 and 2009. Moody’s assumes that national home prices fall 30% over a 30-month horizon and remain at that trough for an additional 30-months before gradually increasing again. Individual MSAs can come under substantially greater stress under the current framework, falling anywhere from 30% to 60% over the initial 30-month forecast. These stressed scenarios will generate negative equity for many borrowers, which in turn will cause both the probability of default to spike and loss-given defaults to rise given lower valuations, applicable foreclosure discounts and any additional costs such as servicing advances made while the borrower was delinquent or in default.
The proposed changes
Under Moody’s recently published Request for Comment (RFC), the agency would look to migrate from relying solely on baseline economic forecasts to a combination of those scenarios coupled with ‘standardized house price forecasts informed by long-term house price trends’ to derive the base case expected loss for pools of securitized loans. The proposed scenario would employ a constant rate of 3.5% annual home price growth at both national and MSA levels.
Under benign market conditions, where observed delinquency rates are below a certain threshold, the base line economic forecasts and the 3.5% HPA scenario will be equally weighted when determining a pool’s base case expected loss. Deteriorations in economic or credit conditions would trigger a rebalancing of the forecast weightings, ascribing greater value to the forecasted scenario over the canned one. If 0.75% loans originated in the past three years fall more than 60 days past due, it would trigger an overweight in forecasted values. If the delinquency rate were to rise to 1.75%, expected losses would be completely driven by the forecasted scenarios. This, in practice, looks to allow the agency to dynamically tighten credit against the backdrop of weakening macroeconomic fundamentals.
The reasoning behind the proposed change is that the existing framework is very levered to changes in the forecast and that home prices are notoriously difficult to predict accurately. The combined effect of these two factors is greater levels of volatility in credit enhancement. The incorporation of a fixed scenario grounded in long-term, observed home price growth may prove to dampen the volatility in pool level expected losses.
Implications for primary and secondary markets
First order implications of these changes for the primary market are the implementation of less onerous and more stable forecasting assumptions should, all else equal, translate to lower levels of required credit enhancement. Lower amounts of subordination, should, in turn, translate to a lower cost-of-funds for sponsors. The combined effect of lower enhancement levels coupled with greater certainty around those levels in stable markets should allow sponsors to pay more for loans which could ultimately translate to a lower cost of mortgage debt for certain non-conforming borrowers.
With that said, there are some current elements of market structure that may dilute the impact of these changes. At present, Moody’s does not maintain a meaningful presence in major areas of the private label securitization market, namely non-QM loans and second liens so sponsors of securitizations backed by those cohorts of loans do not appear poised to benefit in the near term. Secondly, in areas where Moody’s does maintain a meaningful presence, namely the prime performing and CRT markets, the impact appears likely to be muted, albeit for different reasons. The prime jumbo and agency eligible investor markets both employ a super-senior construct, meaning that the overwhelming majority of ‘Aaa’ cash flows carry a fixed level of credit enhancement irrespective of where the ‘natural’ ‘Aaa’ attachment point is. Given this, the changes may only translate to creating structurally thicker ‘Aaa mezzanine’ classes and have limited impact on securitization economics. Benefits to CRT may also be muted given the majority of GSE issuance has migrated into investment grade debt which is already trading at tight nominal spreads.
Investors in secondary mezzanine and subordinate classes of prime jumbo and agency eligible investor deals may ultimately be the biggest beneficiary of the proposed changes, as some of these cashflows appear poised for ratings upgrades which should tighten spreads and lift valuations on those bonds. Seasoned bonds that have already experienced substantial deleveraging via prepayments appear the most likely candidates to be upgraded. Based on this, 2020 and 2021 vintage jumbo and investor mezzanine bonds look to be the profiles with the most upside.
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