Fixed Income Research

The ABCs of HELs

Fixed-Income Research

December 8, 2004

Primary AuthorsDavid HeikeAkhil Mago

212-526-8312

StrategyDavid Heike

[email protected]

Akhil [email protected]

Sihan [email protected]

Quantitative ResearchDick Kazarian

[email protected]

Stefano [email protected]

Namit [email protected]

INTRODUCTIONThe Home Equity Loan (HEL) sector has grown exponentially since 2002 to formthe largest component of the ABS market. These bonds have increasingly becomea core holding for ABS investors due to their high liquidity and attractive spreadpickup over the benchmark auto and credit card sectors. However, HEL bondsdemand careful analysis because of their inherent mix of credit, prepayment, andstructural risks.

This article provides a broad overview of the HEL market to help ABS investors getacquainted with the opportunities and risks in the sector. We begin with a historicaloverview of the market evolution over the past decade to provide some perspectiveon the lending industry. We examine typical loan characteristics, discuss underwritingtrends and highlight the drivers of collateral performance. From a bond perspective,we discuss typical structural features of HEL ABS transactions and outline the keyrisk factors for ABS bondholders.

PLEASE SEE IMPORTANT ANALYST CERTIFICATION AT THE END OF THIS REPORT.

December 8, 2004 2

Lehman Brothers | MBS & ABS Strategies The ABCs of HELs

TABLE OF CONTENTS

Introduction ................................................................................................................... 3

Evolution of the HEL Market ........................................................................................ 4

Pre-1996 – Nascent ................................................................................................ 4

1996-1998 – Initial Growth ................................................................................... 5

1999-2001 – Consolidation ................................................................................... 6

2002 to 2004 – Expansion ...................................................................................... 6

Loan Characteristics ....................................................................................................... 8

Collateral Trends .......................................................................................................... 10

Collateral Performance ................................................................................................ 12

Voluntary Prepayments ....................................................................................... 12

Defaults and Delinquencies ................................................................................. 16

Severity Rates ........................................................................................................ 18

Originator/Servicer Effects .................................................................................. 19

Structural Features of HEL Securities ......................................................................... 20

Rating Agency Methodology ....................................................................................... 27

Risk Factors ................................................................................................................... 28

Interest Rate Risk ................................................................................................. 28

Housing Market Slowdown ................................................................................. 29

Predatory Lending/Servicing ............................................................................... 29

IO Credit Performance ........................................................................................ 30

Summary ....................................................................................................................... 31

Additional Reading ....................................................................................................... 32

Glossary ......................................................................................................................... 33


December 8, 2004 3

INTRODUCTIONIn this report, we define a home equity loan (HEL) as a subprime first-lien mortgage anduse these terms interchangeably. This is the most common convention among ABSinvestors, who equate HELs with first-lien mortgages made to borrowers with imperfector limited credit history. This somewhat peculiar terminology grew from the originalusage of the term in the ABS market, when it generally referred to second-lien mortgagestaken out by lower credit borrowers for debt consolidation purposes.

This classification is not universally accepted. Some market participants, including manymortgage lenders, apply the rubric of HELs to a broader universe of loans (Figure 1).Borrower characteristics, underwriting and performance vary widely among these relatedloan types. Most of these related sectors are relatively small; subprime first-lien mortgagesstill comprise over 95% of loan originations in this broader set. While we do not discussthese related loans types in this paper, we list them below for completeness:• Closed-end second-liens: Second-lien mortgage used by the borrower to cash out

the equity in the house. This was the traditional definition of a home equity loan inthe early-1990s. Simultaneous closed-end second-liens issued at the time of pur-chase (piggyback seconds) have recently gained in popularity.

• Home equity lines of credit (HELOCs): Revolving lines of credit backed byborrower equity typically made to a prime quality borrower. These could either befirst- or second-liens.

• High loan-to-value loans (HLTV): Mortgages with LTVs in excess of 100%, oftenup to 125%, taken to add/improve existing property. Home improvement loans(HIL) often have high LTVs and are classified in this category.

• Specialty loans: These loans exit regular mortgage pools due to various reasons.Non-performers/re-performers are bought out of existing pools due to early/first-pay defaults or delinquencies. Scratch and dent loans do not qualify the guidelinesoriginally established for the pool (guideline exceptions).

Figure 1. Historical Loan Originations, ($bn)

Source: Lehman Brothers, Inside B&C Lending

0

100

200

300

400

500

600

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004E

Subprime First Lien Second LienHELOC HLTVSpecialty

We define HELs as subprime first-lienmortgages

Other smaller loan types are sometimesincluded in this definition

December 8, 2004 4


Subprime mortgage characteristics fall on a credit continuum between prime/Alt-Amortgages and manufactured housing loans (Figure 2). An average subprime borrowerpays a mortgage rate 150-200bp higher than the conventional prime mortgage rate dueto poorer credit characteristics. The average borrower has a Fair Issac & Co. (FICO)credit score of 630, having either limited credit history or experienced credit problemsin fulfilling previous consumer or mortgage debt obligations. The average loan size isaround $170,000 with typical LTVs ranging between 80-85%.

EVOLUTION OF THE HEL MARKETThe HEL sector has changed dramatically since its early days. The market participantshave changed over time. Borrower, loan and structural characteristics seem to changeon an annual basis. We describe the evolution of the HEL market by dividing it into fourbroad phases (Figure 3):

• Pre-1996 – Nascent• 1996-1998 – Initial growth• 1999-2001 – Consolidation• 2002 to 2004 – Expansion

Pre-1996 – NascentHome equity loans in the early 1990s referred to second-lien loans made to credit-impaired borrowers. The market was dominated by a limited number of specializedlenders, because mainstream banks (which were the main source of mortgage financing)did not actively participate in the subprime sector (Figure 4). Activity was limited toportfolio lenders due to lack of secondary market liquidity through the capital markets.

Figure 2. Comparison versus Other Mortgage Products, 2H04

AverageGross Loan Average Average DTI Full Doc Fixed

Loan Type WAC (%) Size ($) LTV FICO Cutoff (%) (%) Underwriting Comments

Prime Conforming 5.75 200,000 70 740 < 36 95 70 Most marketable properties, agencyunderwriting

Prime Jumbo 5.95 450,000 71 740 < 38 90 20 Similar to Prime Conforming loansexcept for loan size.

Alt-A Conforming 6.20 200,000 82 700 < 45 35 70 Higher LTV than prime conforming,less docs, less primary occupied,more multi-family, more cash out

FHA/VA 6.25 125,000 100 640 < 42 95 90 Government insured, low andmoderate income borrowers

Alt-A Jumbo 6.45 450,000 76 700 < 42 35 35 Similar to Alt-A Conforming except forloan size

Home Equity Loans 7.25 170,000 82 630 < 50 65 30 Moderate income borrowers, limited(Subprime Mortgages) credit history or credit issues

Manufactured Housing 7.50 90,000 80 600-720 <50 90 95 Low income borrowers, usually(Land-home) located on private property

Second-Lien 9.60 40,000 95 685 <55 70 95 Same borrower leverage as HEL,superior borrower credit, higherdocumentation, more purchase

Manufactured Housing 9.75-12.00 45,000 90 600-720 <50 95 95 Low income borrowers, typically(Chattel) located in MH parks

Source: Lehman Brothers

We compare HEL characteristics to othermortgage products

The market participants, borrower, loanand structural characteristics have

changed dramatically over time

In the early 1990s, HELs consisted mostlyof second liens ...


December 8, 2004 5

The absence of a proven credit grading system led to conservative loan programs thatfocused more on the strength of the collateral than the borrower’s credit quality. Thus,most loans made during this period carried small loan balances, low LTVs and shortamortization terms (less than 15 years). Lending was concentrated in the lower-tiersubprime market (referred to as “hard money” lending), with a high proportion of loansmade to seriously credit-impaired borrowers (foreclosure, bankruptcy bailouts, etc.).

1996-1998 – Initial GrowthThe HEL market grew rapidly between 1996 and 1998, almost tripling in yearly issuance.This was facilitated by three key factors:• A number of mainstream lenders entered the subprime market to boost volumes

following the drop-off in the conventional mortgage market in the 1994-1995 ratebackup. In addition, the subprime market offered attractive margins over conventionalmortgages due to low competition among the limited number of existing players.

Figure 4. Major HEL Lenders across Various Market Phases

Pre-1996 1996-1998 1999-2001 2002 to 2004

Money Store Associates First Capital Household AmeriquestBeneficial Household CitiFinancial New CenturyHousehold ContiMortgage Bank of America CitiFinancial

Guardian Savings and Loan IMC Washington Mutual HouseholdLongBeach Savings Money Store Option One Option One

Green Tree GMAC-RFC First FranklinAdvanta Countrywide Washington Mutual

GMAC-RFC First Franklin CountrywideNew Century GMAC-RFCAmeriquest Wells Fargo

Source: Lehman Brothers, Inside Mortgage Finance

Figure 3. HEL Loan Originations, ($bn)

Source: Lehman Brothers, Inside B&C Lending

0

100

200

300

400

500

600

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004E

Early Days Initial Growth Consolidation Expansion

... with conservative loan guidelines

The market expanded rapidly between1996 and 1998 ...

December 8, 2004 6


• The increasing use of securitization provided non-bank lenders an alternate sourceof funding, enabling them to enter the subprime sector.

• The evolution of credit scores helped lenders to better understand and priceborrower credit risk. This common benchmark provided lenders and investors withthe ability to analyze and compare credit performance across borrowers, whichincreased liquidity and facilitated the introduction of new loan types.

The entry of a number of new lenders had the following effect on the HEL market:• A number of new loan types with longer amortization terms up to 30 years were

introduced (for example, hybrid adjustable rate mortgages). As a result, the propor-tion of purchase borrowers increased and the market shifted from second-lienstowards subprime first-liens. The proportion of seriously credit-impaired borrowersdeclined, as more mainstream subprime borrowers were extended credit.

• Strong competitive pressures led to the loosening of underwriting standards and theintroduction of higher LTV programs by new lenders to capture market share.

1999-2001 – ConsolidationThere was a major shakeup among subprime lenders between 1999 and 2001. Three-fourths of the active lenders either exited due to financial problems or merged with largerplayers. Some of the notable issuers to exit during this period were ContiMortgage, FirstPlus, Bank of America and Superior Bank. Other lenders were acquired by larger players,such as The Money Store (by First Union), Green Tree (by Conseco) and Advanta(by JPMorgan).

The financial problems among lenders were caused by a combination of lax underwritingstandards, aggressive gain-on-sale income accounting, and unfavorable market conditionsafter the liquidity crisis in 1998. Most of the new non-bank lenders that entered themarket after 1996 were thinly capitalized. These lenders used gain-on-sale accountingwith aggressive assumptions around residual valuations to gain favorable access tofunding. However, poor collateral performance due to lax underwriting caused them totake large non-cash writedowns against their residual asset valuations. These financialproblems were magnified during the 1998 liquidity crisis, when market executionbecame unfavorable due to a widening in spreads. This led lenders to turn to whole loansales (to bank portfolios), which in turn lowered whole loan prices. HEL issuance growthstalled during this period (Figure 3). Most lenders used mortgage warehousing lines ofcredit for inventory financing. Financing was reduced following the liquidity crisis asthese warehouse facilities were either curtailed or eliminated.

2002 to 2004 – ExpansionThe HEL market has grown exponentially from 2002 to 2004. This surge in issuance isbased on several factors:• Historically low mortgage rates have driven the purchase markets to record highs.

The strength of the purchase market is evidenced by the growth in homeownershiptrends (Figure 5a). However, homeownership trends understate purchase demandin subprime, where overall market penetration has increased markedly more thanthe overall mortgage market.

• Refinancing volume remains high even in a environment of rising interest rates, dueto tighter margins. The increase in competition among a number of large lenders

... leading to new loan types andunderwriting standards

A majority of lenders faced financialdifficulties from 1999 to 2001 ...

... driven by lax underwriting andaggressive accounting

Issuance has grown exponentiallysince 2002 ...


December 8, 2004 7

has compressed subprime margins over the last year (Figure 5b). Subprime loanrates have been declining while conventional mortgage rates have risen modestly.

• Strong home price appreciation (HPA) has supported cash-out refinancingvolumes (Figure 5c). Please refer to the section on collateral performance for thelink between HPA and prepayments.

• The use of securitization as a funding mechanism has increased; approximately80% of new loan originations are being securitized (Figure 5d). This has reducedcapital constraints and enabled the entry of smaller lenders.

• The subprime market has expanded to include borrowers that were traditionallycovered by Alt-A lenders. This is evidenced by collateral trends in the 2002-2004vintages (Figure 10). Average loan size has increased by around 30%, while limiteddocumentation loans have increased from 27% to 38% from 2001 to 2004.

Servicing portfolio growth has mirrored the recent increase in issuance. Servicingportfolios have grown sharply for large originators that typically retain servicing of theiroriginations (Ameriquest, Countrywide etc.). Figure 6 lists the top issuers and servicersof subprime mortgages for 1H04.

The securitized market got a major technological boost in 2001 when issuers began tomonetize the senior component of the residual cashflow in the form of a NIM security.This enables ABS issuers to maximize deal issuance proceeds and reduce or eliminate

Figure 5. Issuance Growth Drivers

a. U.S. Homeownership Rate (%) b. Spread of Subprime Mortgage Rates to Conventional Prime (%)

c. U.S. Annual HPA (%) d. HEL Securitized Issuance vs. Loan Originations, ($bn)

0

1

2

3

4

1/98 1/00 1/02 1/04

Fixed

Hybrid

0

4

8

12

16

60

62

64

66

68

70

1968 1972 1976 1980 1984 1988 1992 1996 2000 2004

0

100

200

300

400

500

600

1996 1997 1998 1999 2000 2001 2002 2003 2004E

0%

20%

40%

60%

80%

100%Unsecuritzed

Securitized

Securitized % (RHS)

Source: Lehman Brothers, Inside B&C Lending, Freddie Mac, Federal Reserve, Loan Performance

1998 2000 2002 2004

1998 2000 2002 2004

%

%

%

%

%

... driving servicing portfolio growth

The growth of NIMs prompted dealerconduits to enter after 2001

December 8, 2004 8


their residual risk position. The rapid growth of NIM securitizations prompted anumber of Wall Street dealer conduits to enter the securitized HEL market after 2001.Dealer presence has been increasing and accounts for around 30% of the HEL market in2004. These dealer shelves aggregate collateral from originators through secondarymarket whole loan purchases. This improved liquidity and efficiency in the secondarywhole loan market has led to product standardization across issuers and greater third-party due diligence.

A growing number of mortgage originators have recently organized themselves asMortgage REITs. There are two key factors that have recently emerged to make REITconversion a more compelling option:• Lenders are seeking to reduce gain-on-sale earnings volatility accounting to boost

equity market valuations. Lenders who retain mortgages on balance sheet effec-tively convert one-time gain-on-sale income to spread income that is recognizedover the life of the mortgage. As a lender increases the on-balance-sheet portfolio,the tax-advantaged status for the REIT-eligible spread income starts to look moreattractive.

• The reception of the equity market to REIT IPOs has been extremely positive, asREIT stocks offer dividend yields of around 10-12%.

LOAN CHARACTERISTICSHEL borrowers can choose between different combinations of interest payment options,amortization types and loan terms. We describe these in detail below.

Interest Payment TypesBorrowers can choose to pay a traditional fixed interest rate over the life of the mortgage,which is typically 30 years. They can also choose a fixed rate payment for an initial period,and reset into a floating rate over the remaining life of the mortgage.

Figure 6. Top Lenders and Servicers in 1H04

Market Origination Volume Market Servicing Portfolio1H04 Subprime Share ($bn) Primary Share ($bn)Rank Lenders 1H04 2003 1H04 Servicers 1H04 2003 1H04

1 Ameriquest 15.1% 39.0 38.2 Ameriquest 8.7% 49.0 71.82 New Century 8.2% 27.4 20.7 CountryWide 7.1% 39.3 58.03 CountryWide 6.5% 19.8 16.4 Household 6.8% 51.4 56.24 Household 6.5% 20.3 16.3 Citifinancial 6.6% 50.4 54.05 First Franklin 5.7% 20.1 14.4 Option One 5.9% 41.4 48.36 Washington Mutual 5.5% 19.9 13.9 Homecomings 5.9% 44.2 48.27 Option One 4.7% 20.1 11.9 Chase 4.4% 27.9 36.48 Wells Fargo 4.5% 16.5 11.4 Ocwen 4.2% 37.5 34.89 CitiFinancial 4.4% 21.4 11.1 HomeEq 4.1% 24.0 33.9

10 Fremont 4.3% 13.0 11.0 Wells Fargo 3.2% 12.7 26.111 GMAC RFC 4.3% 14.0 10.9 Washington Mutual 2.9% 19.3 23.712 WMC 2.9% 8.2 7.3 National City 2.7% 18.4 22.213 Accredited 2.3% 8.0 5.7 Select Portfolio 2.6% 28.6 21.014 Aegis 2.2% 8.2 5.6 New Century 2.5% 11.6 20.915 BNC 2.0% 7.0 5.0 Litton Loan 2.2% 12.3 17.9

Source: Inside B&C Lending

The REIT structure has been gainingpopularity among lenders

Borrowers can choose between fixed andhybrid interest rates ...


December 8, 2004 9

• Hybrid adjustable rate mortgages (Hybrid ARMs, 70% by issuance): These mort-gages have a fixed coupon for an initial period and a floating-rate coupon after aspecified reset date (typically indexed to 6-Mo LIBOR and reset every 6 months).Most common is the 2/28 hybrid (60% by issuance), which has a 2-year fixed-rateperiod and a 28-year floating-rate period. There are less popular variants where thelength of the initial fixed rate period is zero (pure ARM), three (3/27 hybrid), andfive years (5/25 hybrid). Hybrids are the dominant loan type for subprime mort-gages. Borrowers typically have a short time horizon, hoping to refinance into alower-rate prime mortgage due to improvement in their credit file.

• Fixed-rate (30% by issuance): These are fixed coupon, level pay mortgages withtypical loan terms of 30 years. These formed a large proportion of the market of themarket before 1996 (Figure 7).

Amortization TypeBorrowers can choose between two amortization schedules:• Level Pay: These are fully-amortizing mortgages where the length of the amortiza-

tion period is same as the term of the mortgage. Most fixed-rate and around 90%of hybrids are level-pay mortgages.

• Interest-only (IO) loans: The borrower pays interest only for an initial period(typically ranging from 2-10 years) with the amortization of principal over theremaining 20-28 years of the mortgage. For example, for a 5-year IO loan, theborrower only makes interest payments for the first five years with no principalamortization. At the end of five years, the borrower faces an increase in monthlypayments since principal begins to amortize based on a 25-year schedule. Sincealmost all recent IO loans are also hybrids, the borrower faces two payment resetsover the life of the loan – the rate reset (interest payments) and the amortizationreset (principal payments). IO products were traditionally used in the prime marketas a means of tax-advantage to borrowers and have gained popularity in thesubprime market since 2004 (15-20% of issuance). Please refer to the section on IOloans for more details.

Figure 7. Historical Loan Originations by Interest Payment Type, ($bn)

Source: Lehman Brothers, Loan Performance, Inside B&C Lending

0

100

200

300

400

500

600

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Pure ARM5/253/272/28FRM

... level pay and IO mortgages

December 8, 2004 10


Prepayment PenaltiesMost subprime mortgages (80% of Hybrids, 65% of FRMs) are originated with prepaymentpenalties during the first few years, which limit borrower prepayments and protect thelender’s interests. The lender compensates the borrower by charging a lower rate(typically 50-75bp lower). Fixed-rate mortgages typically have a penalty period for thefirst three years (around 65% of FRM penalty loans) while the length of the hybridpenalty period usually coincides with the initial fixed-rate period (Figure 8). The amountof the penalty is usually 6 months of interest payments on 80% of the prepaid balance(2.5 to 3 points).

Interest Rate Caps/FloorTo protect hybrid borrowers from large increases in interest-rates during the floating-rate period, hybrid loans are embedded with various interest rate caps. Hybrid loanstypically specify three interest-rate caps - initial caps, periodic caps and lifetime caps.• Initial caps limit the increase in coupon at the first-reset date over the initial fixed-

rate (typically 1.5%-3%).• Periodic caps limit the change in rate from the last period’s coupon to a specified

amount (typically 1%).• Lifetime caps limit the absolute level of interest rates to a specified maximum over

the life of the loan (typically 6% over the initial fixed rate).

Hybrid loans are also typically embedded with an interest rate floor which bounds theminimum mortgage rate to the initial fixed rate.

Property Type and Loan PurposeHEL collateral can be further segmented by loan purpose and property type (Figure 9).The composition of single-family and rate-refinance mortgages has remained largelyconstant across time.

COLLATERAL TRENDSThe subprime market has shifted to higher credit quality loans as evidenced by recenttrends in collateral characteristics (Figure 10). Since credit bottomed out in 2000-2001,

Figure 8. Overall Prepayment Penalty Distribution

Source: Lehman Brothers, Loan Performance

0%

20%

40%

60%

80%

100%

1998 1999 2000 2001 2002 2003 2004

12 Mo. 24 Mo. 36 Mo. 60 Mo.

Most loans are originated withprepayment penalties

Hybrid borrowers are protected from largerate increases due to embedded caps

Currently, the average subprimehomeowner has superior credit quality...


December 8, 2004 11

Figure 10. Average Historical FICO Scores and Loan Size

FICO Loan Size ($K)


540

580

620

660

1998 1999 2000 2001 2002 2003 2004

ARM

FRM

0

40

80

120

160

200

1998 1999 2000 2001 2002 2003 2004

ARM

FRM

FICO scores especially for fixed-rate product have risen by around 30 points1. Over thepast three years, overall loan sizes have increased from $120K to $150K. This shift awayfrom the lower-tier subprime borrowers has been prompted by two factors. First, due tothe fixed cost of liquidation (legal fees, refurbishing etc.), low-balance loans are associatedwith higher loss severities. Second, lenders have avoided the lower-tier subprime marketdue to growing predatory lending concerns around high-cost loans to weak creditquality borrowers.

The recent improvement in borrower quality has been accompanied by an increase inborrower leverage (Figure 11). This is evidenced by higher LTVs, falling loan-documentation levels and largely constant DTIs (even in a declining interest rateenvironment). Thus, subprime homeowner characteristics have evolved towards astronger credit quality, but a more levered borrower.

1 While the overall FICO population has drifted upwards, the improvement in HEL borrower characteristics hasdominated this larger trend.

Figure 9. 2004 Issuance by Property Type and Loan Purpose

Property Type Loan Purpose


55%30%

14% 1%

Rate Refi Purchase Cash-Out Refi Other

77%

9%

8%5% 1%

Single-Family Planned Unit Development2-4 Unit CondoOther

... but higher borrower leverage

December 8, 2004 12


Figure 11. Historical LTV and Documentation Trends

LTV (%) Full Doc Loan (%)


74

76

78

80

82

84

1998 1999 2000 2001 2002 2003 2004

ARM

FRM

50

60

70

80

90

1998 1999 2000 2001 2002 2003 2004

ARM

FRM

COLLATERAL PERFORMANCEThe blend of prepayment and credit characteristics positions HEL as a unique cross-oversector between mortgage and asset backed securities. In this section we examinehistorical performance of HEL collateral and highlight the key performance drivers. Theanalysis of HEL securities is dependent on assumptions around four key performancevariables - voluntary prepayments, involuntary prepayments (defaults), delinquenciesand severity rates.

Voluntary PrepaymentsVoluntary prepayments can result from rate refinancing, cashout refinancing, creditcuring and housing turnover. These components have different drivers:• Rate refinancing: Caused by borrower prepayments due to a decline in prevailing

HEL loan rates.• Cashout refinancing: Prepayments where borrowers tap the built up equity in the

house by taking a larger loan.• Credit curing: An improvement in borrower credit can enable homeowners to

refinance in to a lower mortgage rate even as market rates remain constant.• Turnover: Caused by borrowers shifting residence and prepaying the mortgage on

the existing home.

The shape of the voluntary prepayment curve is largely dependent on loan type.Prepayments for fixed-rate HEL have historically increased over the first two years to25-35CPR before stabilizing at those levels. Hybrid prepayments follow a typical patternwhich is closely related to the length of the initial fixed-rate and the prepayment penaltyperiod (Figure 12). Hybrid voluntary prepayments are faster than fixed-rate due to aself-selection bias; many borrowers with a shorter time horizon choose a hybrid over a30-year fixed-rate product.

We examine historical performance ofHEL collateral and highlight the key

performance drivers

Voluntary prepayments are drivenby rate and cashout refinancing,

curing and turnover ...

... and are greatly dependent on loan type


December 8, 2004 13

Voluntary prepayments are driven by the following factors:

Borrower Characteristics: Rate-refinancing sensitivity is smaller for lower-credit borrowersthan it is for better-credit borrowers due to fewer financing alternatives and lowersophistication. The different dimensions of borrower credit quality (FICO, LTV, DTI etc.)can be largely captured by a single variable: the spread at origination (SATO). SATOmeasures the difference in the mortgage rate between the specified loan and a constantquality subprime mortgage rate. Assuming that lenders price borrower risk efficiently, ahigher SATO implies a worse credit borrower2. The refinancing sensitivity across a highand low quality borrower pool distinguished by SATO is shown in Figure 13.

2 SATO provides a reasonable measure of borrower quality; however, more precise prepayment and credit analysiscan be performed through borrower FICO, LTV, DTI data.

Figure 12. Voluntary Prepayments by Deal Age

FRM ARM


0%

15%

30%

45%

60%

1 13 25 37 49 61 73

1998 1999 20002001 2002 20032004

0%

20%

40%

60%

80%

1 13 25 37 49 61 73

1998 1999 2000 2001

2002 2003 2004

0 12 24 36 48 60 72 0 12 24 36 48 60 72

Figure 13. Rate Sensitivity by Borrower Credit Quality

Rate Incentive (%)

FRM: 3-year penalty penalty, 15-30 WALASource: Lehman Brothers, Loan Performance

0

10

20

30

40

50

-2 -1.5 -1 -0.5 0 0.5 1 1.5 2

Low SATO

High SATO

Better credit borrowers have higherrate-refinancing sensitivity

December 8, 2004 14


Prepayment Penalty: Loans with prepayment penalties prepay more slowly since the2.5-3.0 point penalty provides a significant disincentive during the penalty period.Moreover, borrowers with a low propensity to prepay self-select themselves into theseloans. Borrowers with penalty loans who postpone their prepayments typically prepayimmediately after the end of the penalty period, thereby causing a transitory spike inprepayments. Hybrid prepayments display a sharp spike after the prepayment penaltyperiod (which usually coincides with the initial fixed-rate period) and CPRs typicallyreach as high as 70-80 CPR for a few months. Fixed rate prepayments also demonstratea prepayment spike after 36 months of loan age, which is the typical penalty period(Figure 12).

Loan Size: Since the dollar refinancing incentive increases with higher loan sizes,prepayments sensitivity to interest rates is higher for larger loan sizes (Figure 14).

Loan Age/Seasoning: Voluntary prepayments increase with loan age for the followingthree reasons. First, cash out refinancing activity increases over time as borrowers buildup equity due to accumulated home price appreciation. Second, credit curing becomesviable after the borrower establishes a history of good credit for 2-3 years. Third,turnover increases with loan age as most homeowners do not shift within the first fewyears of taking a new mortgage.

Interest Rates: Prepayments of premium mortgages are a function of the amount of rateincentive, defined as the difference between the origination and the current market rate.Subprime prepayments are less sensitive to a change in interest rates than conventionalprime mortgages. This is largely explained by the lower loan balances (limits dollarincentive to refinance), higher fixed cost of refinancing (cost of origination) and lowersophistication of these borrowers. The typical relationship between voluntaryprepayments and rate incentive is as shown below (Figure 15).

Figure 14. Prepayment Sensitivity by Loan Size

Rate Incentive (%)

FRM: 3-year penalty penalty, 15-30 WALASource: Lehman Brothers, Loan Performance

0

10

20

30

40

50

-1.5 -1 -0.5 0 0.5 1 1.5

Small Size

Large Size

Prepayment penalties provide asignificant disincentive to prepay

Voluntary prepayments increasewith loan age ...

... falling interest rates ...


December 8, 2004 15

Home Price Appreciation: Cashout refinancings increase during periods of strong homeprice appreciation, as borrowers tap the built up equity in the house to retire moreexpensive debt or meet big ticket expenses. In addition, strong home price appreciationallows borrowers to reduce their mortgage rate even with unchanged market rates bylowering the LTV (Figure 16a). The impact of HPA varies with the interest rate environmentsince borrowers are more likely to be able to afford a larger mortgage and cash out if rateshave declined. Thus, the impact of HPA on prepayments is more pronounced for in-the-money mortgages and relatively muted out-of-the-money (Figure 16b).

Other Economic Variables: Other economic variables such as unemployment andincome growth also impact voluntary prepayments. An improving credit environmentwith low unemployment and strong income growth would boost turnover due to highereconomic activity and the increased ability to trade up to bigger houses.

Figure 15. Total Prepayments (CPR) by Rate Incentive (%)

Rate Incentive (%)

FRM: 15-30 month weighted average loan age (WALA), ARM: 15-20 WALA, prepayment penalty loansSource: Lehman Brothers, Loan Performance

0

10

20

30

40

50

-2.25 -1.50 -0.75 0.00 0.75 1.50

FRM

ARM

Figure 16. Total Prepayments (CPR) by HPA

a. CPR by Deal Age b. CPR by Rate Incentive (%)*

Deal Age Rate Incentive (%)

* FRM 3-year prepayment penalty, 15-30 WALASource: Lehman Brothers, Loan Performance

0%

10%

20%

30%

40%

50%

0 12 24 36 48 60 72

5% HPA

8% HPA

0

10

20

30

40

50

-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5

Normal HPA

Fast HPA

... and home price appreciation

December 8, 2004 16


Defaults and DelinquenciesForecasting involuntary prepayments (defaults) is critical for the credit analysis ofsubordinate and mezzanine HEL securities. Delinquency levels are particularly importantin HELs, since delinquency triggers are a key determinant of the deal principal paydown(please refer to the section on structural features of HEL securities). Historical defaultand delinquency performance by vintage is displayed below (Figure 17 and 18).

Defining DefaultsThe two most commonly-used definitions of defaults are (i) loan terminations withlosses, or (ii) loans terminating from the 60+ delinquency bucket. The definition ofdefaults is not standardized across issuers/servicers and varies by trust. In addition, anumber of trusts do not report defaults and severities individually, but instead state finalloss rates. It is important to specify a standard definition for defaults to compareperformance across different trusts and loan characteristics. Since accurate lossinformation is often not available at the loan level, we define defaults as loan terminationsfrom the 60+ delinquency bucket. This definition includes loan terminations which getresolved with no losses (due to adequate home equity or mortgage insurance), and thusresults in smaller effective severities.

Figure 17. Defaults (CDR) by Deal Age

FRM ARM

Deal Age Deal Age


0%

3%

6%

9%

12%

15%

18%

0 12 24 36 48 60 72

1998 1999 2000 2001

2002 2003 2004

0%

5%

10%

15%

20%

25%

0 12 24 36 48 60 72

1998 1999 2000 2001

2002 2003 2004

Figure 18. 60+ Delinquencies (% Cur Bal) by Deal Age, Incl. BK, FCL and REO

FRM ARM

Deal Age Deal Age


0%

10%

20%

30%

0 12 24 36 48 60 72

1998 1999 2000 2001

2002 2003 2004

0%

10%

20%

30%

40%

0 12 24 36 48 60 72

1998 1999 2000 2001

2002 2003 2004

Defaults and delinquencies are importantvariables for credit analysis

We define defaults as loan terminationsfrom the 60+ delinquency bucket ...


December 8, 2004 17

Defaults and delinquencies are driven by the following factors:

Borrower Characteristics: Indicators of borrower credit quality such as length ofemployment, credit history, debt-to-income ratio etc. provide an indication ofexpected default rates. Borrowers who have previously experienced major derogatorieson their credit reports (i.e., at least one 90-day delinquency) are more likely to default.First-time homeowners also default at higher rates than those who previously own aresidence. These dimensions of borrower credit quality can also be largely captured bySATO. Defaults and delinquencies for a high and low quality borrower pool(distinguished by SATO) are shown in Figure 19. The assumption that lenders priceborrower risk efficiently is reasonable, since SATO adequately differentiates the creditquality between loans.

Loan Age/Seasoning: Defaults are relatively rare during the first year of a loan due to therecency of underwriting and long liquidation timelines. Total delinquencies rise over timeand stabilize around three years of deal age, with 60+ delinquencies settling in at 25-30%(% current balance) for the overall deal. This high percentage is explained by a gradual shiftin the pool towards terminally delinquent borrowers. The borrowers who remain in thepool are typically of average credit quality, since the good quality borrowers usually prepayand the bad quality borrowers typically default as the deal seasons.

Home Price Appreciation: Home price appreciation is an important driver of defaults anddelinquencies since it determines the current loan-to-value ratio. At higher current LTVs,borrowers have less equity in the home, and the incentive to default becomes greater. Onaverage, using a cross-sectional MSA study, a decrease in HPA by 3% (difference of around10% in a loan’s current LTV at deal age 36) leads to an increase in default rates by around 20%.

Economic Conditions: Economic variables such as employment growth have a significantimpact on credit performance. A 2% decrease in local employment growth is estimatedto increase defaults and delinquencies by 3-4% (Figure 20).

Figure 19. Defaults and Delinquencies by Borrower Credit Quality

Defaults 60+ Delinquency (% Current Balance)

Deal Age Deal Age

FRM, 2000 vintage, no prepayment penaltySource: Lehman Brothers, Loan Performance

0

3

6

9

12

15

0 12 24 36 48 60

Low SATO

High SATO

0

5

10

15

20

25

0 12 24 36 48 60

Low SATO

High SATO

... and use SATO as a summary variablefor borrower quality

Defaults and delinquencies risewith deal age

Higher HPA lowers the borrowerincentive to default

December 8, 2004 18


Severity RatesLoss severity rates, which measure the percentage loss on liquidations are driven by threekey components (i) Liquidation expenses (legal fees, foreclosure fees etc.) (ii) Delinquentprincipal and interest (P&I) advanced by the servicer, and (iii) Property market valuedecline (if any). The length of the foreclosure process affects liquidation expenses and theP&I advanced, while accumulated home price appreciation determines the equitycushion available to cover market value declines. The historical severity rates by loan typeare shown below (Figure 21).

Severity rates are driven by the following factors:

Loan Size: Due to fixed costs such as legal fees, refurbishing etc. while liquidating units,severities are higher on smaller loan sizes on a percentage basis.

Figure 20. Defaults and Deliquencies by Employment Growth Buckets (%), HPA Adjusted

Defaults 60+ Delinquency (% Current Balance)

Deal Age Deal Age


0

3

6

9

12

15

18

0 12 24 36 48 60

0%

2%

0

5

10

15

20

25

0 12 24 36 48 60

0%

2%

Figure 21. Severity (Pre-MI ) by Deal Age

FRM ARM

Deal Age Deal Age


0%

25%

50%

75%

0 12 24 36 48 60 72

1998 1999 2000 2001

2002 2003 2004

0%

15%

30%

45%

60%

0 12 24 36 48 60 72

1998 1999 2000 2001

2002 2003 2004

Loss severities are determined byliquidation expenses, P&I advancing and

market value declines


December 8, 2004 19

Amortization Type: Loans with an initial IO period have a higher average principaloutstanding at the time of default. This amortization gap can result in severities beinghigher by 2-3% for IO loans.

Mortgage Insurance: Certain HEL deals utilize mortgage insurance policies to protectthe trust from a limited amount of loss (specified by the policy) in an event of default.The presence of mortgage insurance results in lower effective severity rates due toinsurance reimbursements by the mortgage insurer (please refer to the section onstructural features of HEL securities for more details).

Loan Age/Seasoning: Severity rates tend to increase with loan age and stabilize around30% by 30 months. This is explained by a higher proportion of long foreclosure timelineloans among defaulting loans later in the life of the deal. Longer liquidation timelinesentail higher P&I advancing, liquidation fees, and a possible lack of upkeep by thedefaulting borrower.

Accumulated HPA: Accumulated HPA reduces severity rates by providing an equitycushion to cover liquidation expenses and P&I advancing. In addition, loans with strongHPA typically have shorter liquidation timelines, since short sales are often used as theliquidation mechanism. This further reduces the liquidation cost.

Originator/Servicer EffectsThe variation in underwriting and verification practices across originators is an importantdeterminant of collateral performance which is often not evident from a loan tape.Subprime lenders use a variety of business practices to determine the accuracy andcompleteness of information while making a loan. The two key processes duringunderwriting are property appraisal and income verification. These are gaining increasingimportance due to the prevalence of limited/stated documentation and high LTV loans(Figure 10). The effectiveness of underwriting exceptions for fringe borrowers is anotherkey determinant of credit performance.

The relatively high delinquencies and defaults of subprime loans underscores theimportance of strong servicing capabilities for loss mitigation and recovery (Figure 22).The main goal of a servicer working on a delinquent loan is to maximize the present valueof the loan’s future cash flows to the trust. This is typically achieved through two parallelstrategies. On the one hand, the servicer tries to get the borrower back on track. Thiscould require some help in the form of a forbearance plan or a loan modification.However, if the borrower cannot cure the delinquency, so the servicer must follow thenecessary legal steps to liquidate the collateral to satisfy the borrower’s obligations. Abalanced execution of both these strategies is critical to maximize trust cashflow. Theseoriginator/servicer effects can lead to significant differences in performance across loansthat appear similar on paper based on stated characteristics.

Collateral performance is stronglyinfluenced by originator practices ...

... and servicing capablities

December 8, 2004 20


STRUCTURAL FEATURES OF HEL SECURITIESHEL securities are the most structurally complex of the core ABS sectors. The interactionof prepayments, defaults and delinquencies with the structure creates unique paydownmechanics for HEL securities. We discuss the major elements of deal structures below.

Prior to 1997, most HEL ABS transactions used bond insurance from AAA-ratedmonoline insurers as a form of credit enhancement. The growing liquidity in the ABSmarket after 1997 led to a gradual shift towards senior/subordinate structures. The 1998liquidity crisis temporarily halted this shift, but senior-subordinated structures grew inpopularity following the restructuring among lenders from 1999-2001. This recent shifttowards senior-subordinate structures has been fuelled in part by strong demand fromGSEs, foreign investors and structured finance CDOs. The securitized market has alsograduated from the use of mostly passthrough tranches at AAA level, to time-tranchingthe senior AAA-rated sequential securities. The typical capital structure of a new issueHEL deal is shown in Figure 23.

Most current home equity deals (around 90%) issue floating-rate securities (indexed to1MoLIB) backed by a combination of fixed and hybrid collateral. Deals use senior/subordinate structures, over-collateralization, excess spread, performance triggers,

Figure 22. Subprime Servicing Entitites

The HEL sector has three types of servicing entities with different responsibilities:• Primary servicer: Responsible for the different aspects of loan administration –

payment collection, loss mitigation, foreclosure, liquidation etc. The primary serviceris also responsible for submitting monthly remittance reports and advancing principaland interest to the trust. Most transactions have more than one primary servicer.

• Special servicer: Performs the specialized function of handling seriously delinquentloans. Thus, the special servicer focuses on loss mitigation, managing defaults andREO (real estate owned) properties.

• Master servicer: Responsible for overseeing the different sub-servicers (primary andspecial) present on the transaction. Thus, the master servicer monitors the monthlyremittance reporting and aggregation, tracks the movement of funds between thedifferent accounts. In addition, the master servicer handles the event of a sub-servicerbankruptcy/inability to service by handling servicing for an interim period beforeassigning a new sub-servicer.

Figure 23. Capital Structure by Issue Year, (%)

1998 1999 2000 2001 2002 2003 2004

AAA 92.3 93.8 91.8 91.2 89.0 85.5 83.5AA+ 0.0 0.0 0.0 0.1 0.0 0.1 1.3AA 3.0 2.3 3.1 3.2 4.0 5.2 4.2AA- 0.0 0.0 0.1 0.2 0.1 0.1 0.8A+ 0.0 0.0 0.0 0.1 0.0 0.1 0.7A 2.4 1.7 2.5 2.5 3.1 4.0 2.8A- 0.1 0.1 0.0 0.1 0.1 0.8 1.7BBB+ 0.0 0.0 0.1 0.1 0.3 1.0 1.5BBB 1.0 1.0 1.4 1.6 2.5 2.2 1.9BBB- 1.1 0.9 0.7 0.7 0.8 1.0 1.2BB+ 0.0 0.0 0.0 0.0 0.0 0.0 0.2BB 0.0 0.1 0.2 0.2 0.1 0.1 0.1BB- 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Source: Lehman Brothers, Intex

HEL transactions are shifting towardssenior/subordinate structures ...

... utilizing different forms of creditenhancement


December 8, 2004 21

mortgage insurance (MI) and external insurance (monoline wraps, letters of credit) asdifferent forms of credit enhancement. We describe each of these in detail in the sectionsbelow.The collateral backing the deal is usually divided into different groups with seniorbonds linked to the cashflow from a particular group. Subordinates are paid theremaining cashflow from all groups. The allocation of cashflow to securities is donethrough three different allocation waterfalls: interest, principal and excess cashflow. Wedescribe these payment mechanics for a typical HEL deal structure below (Figure 24).

Figure 24. Deal Waterfall Payment Mechanics

PRINCIPAL WATERFALL Bonds are paid principal in order of credit priority

HEL Collateral

Collateral Interest Cashflow Gross interest +

delinquent advancing + liquidation recovery

Collateral Principal Cashflow Scheduled and prepaid principal + delinquent advancing + liquidation recovery

Servicing + MI premium + bond

insurance fee

Bond Coupon Payments

AAA

AA

A

BBB

Embedded Hedges (Interest rate

corridors/swaps)

Excess interest flows into excess cashflow waterfall

Residual cashflow

Residual Holder/NIM

Turbo principal to attain target OC

Cover basis risk shortfalls

INTEREST WATERFALL

Bonds are paid interest to stated coupon

(1MoLIB+DM up to net WAC)

Cover Bond Losses

Hedge cashflow not used for basis risk shortfalls and bond losses flows to the residual holder/NIM

Hedge cashflow is available for basis risk shortfalls and bond losses not covered by excess interest

EXCESS CASHFLOW

WATERFALL Excess cashflow is

used to cover losses, meet basis risk

shortfalls and recoup bond losses

December 8, 2004 22


Interest WaterfallAvailable proceeds in the interest waterfall include the gross weighted average coupon(gross WAC) collected from the loans plus servicing advances for delinquent interest,and interest recovery from liquidations. Servicing fees, servicer interest advances, MIinsurance premiums (if any) and other fees (bond insurer etc.) are paid at the top of thewaterfall. The servicing fee is typically set at 50bp/year. Most servicers provide liquidityto the trust by advancing principal and interest (P&I) for delinquent loans as long as theadvanced amount is considered recoverable. The servicer recovers this P&I advancingeither through the monthly collections account when a loan becomes current, or fromthe liquidation proceeds following a default.

The amount remaining after meeting these payments (net WAC), flows into the interestwaterfall. Interest is typically paid to the bonds sequentially in order of priority up to thestated bond coupon. Floating-rate bonds are typically promised a coupon (1MoLIB+DM)which is limited to the net WAC of the collateral. This discount margin typically stepsup after the cleanup call distribution date if the option holder does not call the deal. Thelimit of the bond coupon to the net WAC of the collateral is also called the available fundscap (AFC) feature on these deals (we provide more detail on this in a later section).

The net interest collected from the collateral typically exceeds the coupon payment to thebonds early in the life of the deal. For example, if the collateral net WAC is 6.5% and theweighted average DM of the bonds is 50bp, the excess spread at origination (assuming 2.5%1MoLIB) is 3.5% (6.5% - (2.5%+0.5%)). The difference between the collateral net WACand the interest paid to the bonds (excess spread) flows into the excess spread waterfall.

Principal WaterfallThe scheduled principal, prepaid principal and principal recovery from liquidationsflows into the principal waterfall. The principal payment mechanism varies across thelife of the deal. During the first 36 months of the deal (lockout period), senior bonds arepaid principal sequentially in the order of credit priority with the mezzanine andsubordinate bonds being locked out. After the stepdown date, conditional on the dealpassing performance triggers (explained below), principal is allocated to maintain atarget current credit enhancement for the senior and subordinate bonds (typically twicethe initial credit enhancement). If the deal fails triggers in any month, the deal switchesback to paying sequentially. Bonds start to take losses from the bottom of the capitalstructure upwards in reverse credit priority when the collateral balance is reduced belowthe total outstanding bond balance.

The collateral balance backing the deal is typically higher than the total principal balanceof bonds outstanding. This over-collateralization (OC) serves as a form of creditenhancement as it provides a first cushion to absorb collateral losses. The OC mighteither be funded initially, or it may build up over time by applying excess spread to thepayment of bond principal (referred to as the “turbo” feature). Any collateral principalremaining after paying down all the securities (ending OC) is paid to the residual holder.

The deal paydown attempts to maintain the OC at a specified over-collateralizationtarget percentage. The OC target is typically specified as a percentage of the originalcollateral balance before the stepdown date. After the stepdown date, conditional ontriggers passing, the OC target is specified as a percentage of the current collateral

Senior fees and premiums are deductedfrom gross interest ...

... to pay bond coupon ...

... any excess spread flows into the excessspread waterfall

Principal payment mechanism variesacross the life of the deal

Over-collateralization serves as a form ofcredit enhancement ...

... and is maintained at a target level


December 8, 2004 23

balance. If the target OC after the stepdown date is lower than the initial target OC, theOC steps down to the new target, causing a release of principal to the residual/NIMholder (Figure 25). In addition, deals typically specify a minimum OC floor at 0.5% ofthe original balance.

Excess Cashflow WaterfallThe net collateral interest (net WAC) in excess of the amount required to pay bond interestflows into the excess spread waterfall. This excess spread is available to build over-collateralization, cover basis risk shortfalls and bond losses before paying the residualholder. In the event of the current OC being lower than the OC target (due to collaterallosses or initial OC ramp-up), any excess cashflow goes to pay principal to the bonds toattain the target OC (turbo principal). Thus, excess spread is available to meet any collaterallosses before the deal experiences an erosion in OC. There is some limited cross-collateralization among groups since the excess cashflow from one group can offset lossesof another group to maintain the overall over-collateralization target of the deal.

In the event of an interest shortfall due the bond coupon being limited to the net WACof the collateral (basis risk shortfalls), the excess spread is available to meet this shortfall.The excess spread also covers any unpaid basis risk shortfalls accruing from previouspayment months. Excess spread is also available to pay back any bond principal lossesexperienced in previous months. The excess spread remaining after meeting thesepayments goes to pay the residual/NIM holder.

Trigger MechanicsHEL deals contain provisions to release principal to the subordinate tranches after aninitial lockout period if the pool meets certain performance tests or “triggers”. Triggersprovide additional credit protection to the senior bonds by directing a larger proportionof the available cash flow to senior bonds if performance deteriorates. This enhancessenior credit support as the subordinate classes increase as a percentage of the totalcollateral.

Figure 25. OC Buildup Mechanics

Deal Age

}

0 12 24 36 48 60 72 84 96

OC at target (% of original

balance)

OC steps down at the stepdown date to new OC target (% of

current balance)

OC builds to target

OC at floor and growing as a percentage of

current balance.

Principal released to residual holder/NIM

Excess spread is available to covercollateral losses ...

... basis risk shortfalls and bond losses

Deals contain performance triggers ...

December 8, 2004 24


Transactions typically specify these performance tests based on both cumulative losses(“cumulative loss trigger event”) and current delinquencies (“delinquency trigger event”).• The cumulative loss trigger fails if the cumulative losses exceed a specified threshold. The

threshold is generally specified as a percentage of the original balance of the deal and followsa schedule typically stepping up from month 36 to month 72-84. The threshold of thecumulative loss trigger is static and does not change with the performance of the deal.

• The delinquency trigger threshold is typically specified as a percentage of the currentsenior enhancement of the deal. For example, the delinquency trigger might bespecifed to fail if the 60+ delinquencies are greater than 50% of the current seniorcredit enhancement. Thus, the 60+ delinquency trigger threshold changes dynami-cally based on the current senior enhancement.

The dynamic nature of the delinquency threshold causes this trigger to typically toggleintermittently between passing and failing over the life of the deal. This can be explained bylooking at the following example. In a payment month when the 60+ delinquency triggerfails, the deal pays principal sequentially. This leads to an increase in senior credit enhancement,which in turn increases the delinquency trigger threshold (specified as a percentage of thesenior enhancement). This delinquency threshold rises over the next few distribution datesto a level where the trigger passes. The reverse mechanism then takes effect as passing triggerscauses the senior credit enhancement to fall. The threshold falls to a level where the triggerfails for a subsequent payment date. At this point the cycle repeats again.

NIMsIssuance of a net interest margin security (NIM) allows the issuer to monetize a portionof the residual position while still maintaining economic exposure to the securitizationthrough a smaller secondary residual position. Thus, a NIM represents the resecuritizationof the more senior tranche of the residual (Figure 26). The growth in popularity of NIMstructures has led to recent transactions further tranching the NIM into a front-backstructure with a AA/A rated front-sequential and a high leverage back-sequential.

Figure 26. NIM Securitization Structure

AA AAA A

BBB BBBOC OC

ResidualResidual

AAA

NIM

Collateral Balance

AAA

... based on cumulative losses and currentdelinquencies

The delinquency trigger typically togglesbetween passing and failing

NIM represents the resecuritization of themore senior tranche of the residual ...


December 8, 2004 25

In a typical HEL structure, the NIM may receive cash flow from the following sources:• Excess spread: The residual holder is entitled to receive the remainder of monthly

excess spread once the target overcollateralization level has been reached, and basisrisk shortfalls and bond losses have been covered.

• Interest rate hedges: HEL transactions contain hedge instruments to partly offsetinterest rate risk (please refer to section on risk factors for more details). Paymentsunder these interest rate cap/swap hedge agreements (after application to coverbasis risk shortfalls and bond losses) are applied to NIMs.

• Over-collateralization release: This OC stepdown releases principal cash flow tothe residual holder (Figure 25).

• Prepayment penalties: The residual holder sometime holds the Class P security, whichconsists of prepayment penalty cash flow. While this security is completely separate fromthe residual and generally not subordinated, it is often included in a NIM securitization.

The risk for the NIM holder arises from a compression of excess spread. This can be dueto faster prepayments, higher losses, and increase in LIBOR. Higher prepayment speedsdecrease NIM cashflow due to a lower dollar amount of excess spread. However, this riskis partly mitigated by the offsetting impact of prepayment penalty cash flow which flowsto the NIM. The NIMs are also partly protected from losses since the principal paymentwindows on the NIMs are typically structured to end by month 24. Losses in HEL deals donot become prominent early in the life of the deal (refer to section on collateral performancedrivers). Thus, the NIM is only exposed to the front end of the loss curve. The risk fromrising interest rates is also mitigated by additional cashflow from the hedge instrument.

Mortgage InsuranceSome HEL deals utilize mortgage insurance (MI) as an additional form of creditenhancement. Mortgage insurance policies protect the trust against a limited amount ofloss (specified by the policy) in an event of default by the homeowner (Figure 27). MIpolicies lower effective trust severities and thus reduce the level of subordination andovercollateralization required. However, this is compensated by the lower excessinterest available in the structure due to payment of the insurance premium from theinterest cashflow (senior in the interest waterfall). Recent HEL transactions includemortgage insurance on high LTV loans (usually >80 LTV) which are associated withhigher default frequencies and loss severity rates.

There are two levels of MI policies used by HEL transactions:• Bulk / Lender-paid: This is the more common form of MI used in HEL transactions.

The trust purchases mortgage insurance to lower severity rates on defaults. In thiscase, the borrower is not aware of the existence of a mortgage insurance policy onthe loan. Since these are purchased by the trust, the mortgage insurance premiumis paid from the cashflow received by the trust (typically senior in the waterfall).Bulk policies are also referred to as “lender-paid” policies since the insurancepremiums are paid by the holder of the loans (trust) instead of the borrower.

• Borrower-paid: At the time of making the loan, the lender sometimes requires amortgage insurance policy before extending credit to the homeowner. Whileorigination level policies are commonly used by prime mortgage originators, theyare not very common among subprime lenders. These are typically referred to as“borrower-paid” MI policies since the borrower explicitly agrees to pay the insur-ance premium to the insurance provider.

... and recieves cashflow from excessspread, hedges, OC release and

prepayment penalties

The risk of excess spread compression ismitigated by several features

MI provides credit enhancement bylowering trust severities

HEL deals typically uselender-paid MI policies

December 8, 2004 26


It is important to have a strong originator and servicer since claims on covered loans canbe rejected (rescissions) or adjusted in case of fraud, bankruptcy, incomplete loan filesor servicer errors. The credit risk of the MI provider is not a significant risk factor sincethe major MI providers (MGIC, Radian, PMI) are AA-rated. In addition, the trust holdscancellation rights in the event of a MI provider rating downgrade.

Figure 27. MI Claim Calculation

To calculate the payment against the MI claim, loans are specified to the covered down toa target LTV. For example, for a loan with an initial LTV of 90%, the target LTV might bespecified as 60%. The MI coverage percentage is calculated as the (Original LTV-TargetLTV)/Original LTV. Thus, the coverage percentage for the above example is 33.3%((90-60)/90). In the event of default, the lender submits a claim to the MI provider. Theclaim amount is sum of the unpaid principal balance, P&I advanced and expenses (legalfees, real estate taxes, property maintenance expense etc.). The MI provider has thefollowing options:• Pay the full claim amount and obtain title to the property.• Pay the coverage% of the claim amount.

The MI provider makes an economic decision in choosing between the two options, basedon the expected sale price of the property. This can be demonstrated by the followingexample.

Original Loan TermOriginal Property Appraisal 100,000Original Loan Value 90,000Original LTV 90%MI PolicyTarget LTV 60%Coverage % 33.3%MI Claim CalculationUnpaid principal balance on default 80,000P&I advanced 10,000Other expenses (legal, property tax etc.) 20,000Total Claim Amount 110,000

Property sale value (current) 85,000MI Provider OptionsOption1: Pay total claim and obtain title to propertyAmount Paid 110,000Amount recovered through property sale 85,000Net Cost 25,000Option2: Pay coverage% of the claim amountNet Cost (110,000 * 33.3%) 36,667Breakeven property sale value 73,333

The MI provider would choose to obtain title to the property since the net cost ($25,000)is lower than the payment under the second option ($36,667).

If the sale price of the property is more than (100%-Coverage%)*Claim Amount ($73,333),then the MI provider would choose to obtain title to the property and pay the full claimamount. The trust thus incurs no loss on the default as long as the property sale price ishigher than this amount. If the property value falls lower than this value, the MI providerwill choose Option2. The payment against the MI policy is then capped out at $36,667,and the trust incurs the loss in excess of this MI payment.

The credit risk of the MI provideris minimal


December 8, 2004 27

RATING AGENCY METHODOLOGYRating agencies estimate two key variables before rating a transaction. First, they reviewloan level data to calculate base case losses for a pool. Losses will depend primarily oncollateral characteristics, but other factors, such as an originator’s past performance, willalso affect base case loss estimates. The expected cumulative net loss estimate serves asthe foundation for the amount of credit support needed for a given rating category. Therating level assigned represents a multiple of cumulative credit losses expected over thelife of the deal. Second, rating agencies determine the amount of excess spread availableto build credit enhancement or cover losses.

In addition to losses, the other important assumptions when calculating excess spread creditare interest rates, loss timing, prepayments, collateral WAC deterioration, and triggers.

Interest RatesLIBOR stresses are used to assess the basis risk present in HEL transactions (please refer tosection on risk factors for more details). Current HEL transactions typically have 20%-35%fixed-rate loans backing mostly floating-rate bonds. When rates rise, a transaction will haveless excess spread if it does not have adequate hedge protection. Therefore, steeper LIBORcurves will impose a higher level of stress. In response to growing concerns around the basisrisk, all three rating agencies introduced more stressful interest rate vectors in 2004, whichare significantly steeper than the forward curve3 (Figure 28). This has resulted in anincrease in OC levels and subordination for transactions rated using the new methodology.

Timing of LossesThe timing of losses can have a dramatic effect on the credit protection of a subordinatebond. Since excess spread is highest in the first few years of a transaction, a flat CDR orfront-loaded loss curve will boost the cumulative losses that a transaction can absorb.Back-loaded loss curves are more stressful for credit (except for NIM bonds). The losscurve assumptions may vary to maintain realistic default rates depending on the totallevel of prepayments.

3 We convert the S&P curve to an equivalent upward-sloping vector to facilitate comparison.

Rating agencies size subordination byestimating collateral losses and excess

spread credit

Excess spread is determined by LIBOR,loss timing, prepayment, triggers and

WAC deterioration assumptions

Figure 28. AAA Interest Rate Stresses, 1 MoLIB

0%

2%

4%

6%

8%

10%

0 20 40 60 80 100 120

New Moodys New S&P S&P Equivalent

New Fitch Forward

Deal Age

December 8, 2004 28


PrepaymentsThe key for more conservative prepayment assumptions is to create basis risk by usinga faster prepayment curve for ARMs and slower speeds for FRMs. Fitch and Moody’s aremore conservative and achieve a greater basis risk stress by assuming faster hybridprepayments. S&P’s base case voluntary prepayment curve (CRR) is based on thespecific deal prospectus pricing curve and the involuntary component (CDR) ofprepayments is dependent on total cumulative losses.

WAC DeteriorationThe collateral WAC will tend to decrease over time as borrowers with higher interestrates prepay (voluntarily or involuntarily) faster than the average subprime borrower.The WAC may also deteriorate as the mix of fixed- and floating-rate collateral changesover time.

TriggersThere are practically no differences among rating agency approaches regarding triggers,which are assumed to fail in most cases. They can have a significant effect on cash flowsand credit enhancement levels. In some transactions, overcollateralization levels areallowed to step down when triggers pass after the lockout period ends. While somesubordinate securities may receive principal at this time, enhancement levels drop andsubsequent losses may actually be more stressful for the remaining tranches.

RISK FACTORSHEL securities carry risks arising from structural features, macroeconomic conditions,regulatory provisions and credit performance. The degree of these risks varies acrossdifferent vintages and transactions.

Interest Rate RiskHEL investors are exposed to rising interest rates due to the basis risk between floating-rate bonds and a combination of fixed-rate and hybrid collateral. HEL transactions areat risk on two fronts. First, the floating-rate bond coupon is capped at the net weightedaverage coupon (net WAC) on the collateral. Thus, HEL floaters contain embeddedshort interest rate caps with the strike dependent on the net WAC of the collateral. Thisis also known as available funds cap (AFC) risk. Second, the excess spread available tocover losses/basis risk shortfalls falls as the collateral coupon rises less than the couponon the floating-rate bonds with rising interest rate environment.

Certain structural features partly offset the interest rate risk inherent in deals:• The risk of being capped out at the net WAC is partly mitigated by the presence of

a carryforward feature. The carryforward feature allows the basis risk shortfall to bepaid from any excess spread available in the deal in the current month or any latermonth. This raises the effective AFC strike of the short caps embedded in thesefloaters, since bonds can still receive full coupon (1MoLIB + DM) if excess spreadexists in the deal.

• Deals contain embedded interest rate hedges to offset the interest rate exposure.Deals commonly use interest rate corridors/swaps which provide cashflow to thetrust as LIBOR increases. The hedge cashflow is available to cover basis riskshortfalls (if any).

HEL investors are exposed to rising interestrates due to basis risk ...

... which is partly offset bystructural features


December 8, 2004 29

The basis risk inherent in the structure typically increases with deal age.• During the first two years, there is typically enough excess spread to cover most AFC

issues since losses are low and the AFC cap is out of the money (carryforward featureis valuable for subordinates).

• Excess spread compression and AFC issues are more prominent later in the life of thedeal due to three factors. First, the fixed rate collateral percentage increases over timesince hybrid loans typically prepay much faster than fixed-rate loans over the life ofthe deal. Second, losses typically start ramping-up after the first year and reach 3-5CLRaround month 36. Third, most interest rate hedges are typically not outstanding afterthe first 24 months and do not offset basis risk late in the life of the deal.

Housing Market SlowdownHEL collateral performance is highly levered to the strength of the housing market(please refer to the section on collateral performance). Strong home price appreciationsince 2003 has had a strong impact on prepayments and credit performance (defaults,delinquencies and severities). Prepayments have been fast on the 2003 and 2004 vintagespartly due to strong cashout refinancings driven by robust HPA. Credit performance hasimproved since borrowers have been bailed out by the built up equity in the home in theevent of credit problems.

In an event of a slowdown in the housing market, prepayments are expected to slowdown and losses/delinquencies will likely increase. We estimate that the effect of a 3%slowdown in the appreciation rate would increase defaults by 30% and slowdownprepayments by 5% on 2004 vintages. The combined effect would be an increase in totalcumulative losses by 35-40% in a HPA slowdown scenario. However, bonds are partlyprotected since the excess spread available to offset losses increases due to slowerprepayments.

Predatory Lending/ServicingThe subprime business has been put under increasing scrutiny for issues around variouspredatory practices. The common predatory lending practices that have been questionedare charging high interest or fees, including excessive prepayment penalties, extendingloans beyond the borrower’s financial ability to repay, refinancing a loan despite the lackof benefit to the borrower (flipping) etc. In addition, predatory servicing issues have ledto probes into the practices at major subprime servicers such as Fairbanks and Ocwen.The second largest servicer, Fairbanks, was downgraded three full grades to “BelowAverage” and paid $40 million in settlement claims to its regulator (OTS) relating toquestionable servicing practices.

HEL transactions are at risk due to assignee liability provisions attached to certainpredatory lending statutes. Assignee liability permits a borrower to hold the purchaseror assignee liable for the same penalty as the original lender. The magnitude of theproblem has been increasing since certain state laws contain unlimited assignee liabilityprovisions (uncapped penalties). Lenders have been adjusting to a patchwork ofevolving local, state and federal regulations enacted to address the issue. The problem hasbeen compounded by the lack of clarity around statutory violations in several jurisdictions.Certain jurisdictions have subjective standards to determine whether a loan is predatory(for example, net tangible benefit or repayment ability tests) while others are vaguearound the categories of loans covered by the statute.

Excess spread compression and AFCissues are more prominent late in

the life of the deal

The strength of the housing market willimpact HEL performance ...

... both on the prepayment and credit front

The subprime market has been put underincreasing scrutiny for predatory practices

The risk for HEL transactionshas been increasing due to assignee

liability provisions

December 8, 2004 30


Rating agencies have also been amending their criteria to protect transactions againstpredatory lending liabilities. Transactions containing loans with assignee liability requireadditional credit enhancement due to the risk of potential liabilities (Figure 29). Loansfrom jurisdictions that carry unlimited potential liability or with vague statutoryviolation clauses are typically not included in transactions. Agencies also rate the abilityof lenders to implement compliance procedures to minimize violations. Lenders areusually required to make representations regarding the compliance of the securitizedloans and warranty repurchasing loans that violate statutory provisions.

As an aside, the increasing focus on predatory lending has impacted the availability ofcredit in different jurisdictions. Lenders might reduce or completely eliminate lendingin states to protect themselves against vague statutory lending statutes or if the marketfor the sale of loans originated in that state is curtailed. Lending practices have adjustedbased on changing market appetite for loan types. For example, the Federal Home LoanBanks and GSEs have ceased purchasing securities backed by loans with prepaymentpenalty terms in excess of three years.

IO Credit PerformanceThe HEL market has witnessed limited credit performance in an environment of risingrates. With consumer leverage being high and consolidation of traditional forms ofconsumer debt (credit cards, auto loans) into mostly floating-rate mortgages, investorsare concerned around credit performance as rates adjust higher. This risk has beenfurther accentuated in the HEL market due to the shift towards credit levered productssuch as interest-only (IO) loans and piggyback seconds.

Interest only (IO) mortgages have exploded in popularity over the past couple of yearsand account for around 15-20% of 2004 originations. There has been concern aroundIO performance due to the potential for a double payment shock (rate reset andamortization reset). This is accentuated for loans where the IO period coincides with theinitial fixed-rate period, leading to a simultaneous double shock for the borrower. Thetrends in IO issuance characteristics also point to an increase in risk:

Figure 29. Factors to Assess Potential Liability from Predatory Statutes

• Scope of the statute: The loans covered by the statute should be identified. Thestatute should clearly distinguish between those loans that are covered and thosethat are not.

• Assignee liability test: For any type of loan under its scope, the statute should beexamined to see if it imposes assignee liability. If the statute does not carry assigneeliability, then the cashflow of the trust is not available to meet any potential liabilitiesdue to predatory abuses.

• Maximum penalty assessment: For loans carrying assignee liability (exposed loans)that are covered by the statute, the maximum amount of penalties should beestablished. It should be determined if monetary damages are limited to a dollar amountor if they are uncapped (unlimited assignee liability). Rating agencies only allow loansto be included in transactions when they carry either no assignee liability or the riskassociated with violating an anti-predatory lending law is quantifiable (limited liability).

• Safe harbors: The availability of certain provisions (for example, due diligenceprocedures) that a purchaser or assignee can implement to avoid liability (“safeharbors”) or limit the number of violations should be examined.

These concerns have impacted ratingagency criteria ...

... and lending practices

Leverage has been increasing in theHEL market ...

... with the proliferation of IO loans


December 8, 2004 31

• IO terms have been shortening, and increasing percentages have the IO periodcoinciding with the initial fixed-rate period.

• Initial IO originations had significantly superior credit characteristics (higherFICO, loan documentation, loan size) than hybrids However, these differences inborrower quality have been reducing in recent originations.

• While the IO product in prime jumbos has been used mostly for tax motivations,there is evidence to suggest that affordability constraints drive subprime borrowerstoward IOs.

The additional risk of IO loans has been partly factored in by the rating agencies, withMoodys demanding additional 15-20% credit enhancement for IO loans. We believethat the risk is more pronounced when the IO period coincides with the initial fixed-rateperiod leading to a double payment shock for borrowers. The risk is mostly from higherforeclosure frequencies and limited on the severity front.

SUMMARYThe HEL market has grown rapidly over the last three years to form the largest segmentof the ABS market. The analysis of HEL securities involves a careful analysis of theinteraction between collateral performance (credit and prepayment) and structuralfeatures. The wider spreads in the sector are explained by this combination of prepaymentand credit features which positions it as a unique cross-over sector between the mortgageand asset backed sectors. The next few years will test the maturity and depth of the HELmarket due to potential structural and credit risks from rising interest rates, leverage tothe housing market and an evolving regulatory environment.

The risk is mostly from higherforeclosure frequencies and limited

on the severity front

December 8, 2004 32


ADDITIONAL READING

ABS Weekly Outlook

Impact of Slower Home Prices (10/6/03)

HEL Model Prepayments (3/22/04)

Comparing Rating Agency Criteria in HEL (5/10/04)

Projected HEL Issuance (7/26/04)

Revised S&P Interest Rate Vectors (8/16/04)

Fitch Revision to Interest Rate Stresses (8/23/04)

HEL Liquidation Timelines (09/13/04)

Structural Features of HEL Subordinates (10/18/04)

Shelf Publications

Subprime IO Mortgages: Characteristics, Mechanics, and Performance

A First Look at Second Liens

Net Interest Margin Securitizations in the HEL Market

Home Equity Lines of Credit: Stable Performance and Solid Structure

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December 8, 2004 33

GLOSSARYAssignee Liability: A liability that attaches to a purchaser or assignee of a loan (includinga securitization trust) by virtue of holding a predatory loan. Typically, statutes withassignee liability permit a borrower to hold the purchaser or assignee liable for the samepenalty as the original lender. The potential assignee liability may sometimes exceed theoriginal principal balance of the loan.

Buy-Down Points: Feature by which borrowers can reduce their interest rates as well astheir monthly payments by paying an additional amount upfront. From the lender’spoint of view, it gives them cash up-front during securitization.

Cleanup Call: Most deals have a provision of providing the residual holder with anoptional clean-up provision to call the bonds when the bond principal balance reachesa certain percentage of the initial collateral balance (typically 10%).

Closed-end Loan: The loan type where the borrowed amount is fixed and determinedat origination. This is contrasted with revolving lines of credit which enable theborrower to vary the amount borrowed over time upto a maximum limit.

Excess Spread: The cash flow that remains after deducting the monthly bond interest,servicing fees and any credit enhancement premiums (e.g., lender paid mortgageinsurance, LOC or surety bond fees) from the monthly collateral coupon.

Lien: The lien position determines the priority of the lender’s claim to the home in theevent of default by the borrower. A second-lien receives any residual proceeds from thesale of the house after the first-lien holder is paid in full.

Loan extension/Loan modification: Renegotiating the contract terms to enable borrowersto make regular payments. In extensions, the loan period is extended by adding themissed payments to the end of the loan period. Loan modifications involve changing thecoupon in an interim period etc to enable the borrower to come back to schedule.

Loss Mitigation: Used by servicers to reduce/delay the losses on a portfolio throughtechniques such as loan extensions, modifications, loan assumptions etc. This enablesa delinquent loan to renew payments and return to current status.

Monoline Gaurantee: A financial guarantee issued by a AAA-rated corporation coveringthe timely payment of principal and interest on a security.

Over-collateralization: The difference between the collateral balance backing the dealand the total principal balance of bonds outstanding. This serves as a form of creditenhancement as it provides a first cushion to absorb collateral losses.

Short sale: The servicer agrees to settle the debt with the proceeds of the property saleby the delinquent borrower, even if it implies a small loss for the trust. The servicerchoice is based on a NPV analysis comparing the cost of the foreclosure, REO dispositionand future missed payments against the immediate loss. The trust is usually better offwith this exit strategy as the liquidation of the delinquent loan is fast and cheap.

December 8, 2004 34


Triggers: Conditional tests that determine the priority and order of payments to thevarious tranches in the event of deterioration of collateral performance. These triggerevents are typically based on credit performance parameters such as rolling three-month60-day delinquencies and cumulative losses. A deal is said to be failing triggers if any ofthe specified triggers fail due to poor credit performance.

The views expressed in this report accurately reflect the personal views of David Heike the primary analyst(s) responsible for this report,about the subject securities or issuers referred to herein, and no part of such analyst(s)’ compensation was, is or will be directly orindirectly related to the specific recommendations or views expressed herein.

Any reports referenced herein published after 14 April 2003 have been certified in accordance with Regulation AC. To obtain copiesof these reports and their certifications, please contact Larry Pindyck ([email protected]; 212-526-6268) or Valerie Monchi([email protected]; 44-(0)207-102-8035).

Lehman Brothers Inc. and any affiliate may have a position in the instruments or the companies discussed in this report. The firm’sinterests may conflict with the interests of an investor in those instruments.

The research analysts responsible for preparing this report receive compensation based upon various factors, including, among otherthings, the quality of their work, firm revenues, including trading, competitive factors and client feedback.

Lehman Brothers usually makes a market in the securities mentioned in this report. These companies are current investment bankingclients of Lehman Brothers or companies for which Lehman Brothers would like to perform investment banking services.

Publications-L. Pindyck, B. Davenport, W. Lee, D. Kramer, R. Madison, A. Acevedo, T. Wan, M. Graham, V. Monchi, K. Banham, G. Garnham, Z. Talbot

This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates (“Lehman Brothers”) and has been approvedby Lehman Brothers International (Europe), authorised and regulated by the Financial Services Authority, in connection with its distribution in the EuropeanEconomic Area. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. This material isdistributed in Australia by Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch. This material is distributedin Korea by Lehman Brothers International (Europe) Seoul Branch. This document is for information purposes only and it should not be regarded as an offerto sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any mannerwithout the written permission of Lehman Brothers. We do not represent that this information, including any third party information, is accurate or completeand it should not be relied upon as such. It is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressedherein reflect the opinion of Lehman Brothers and are subject to change without notice. The products mentioned in this document may not be eligible for salein some states or countries, and they may not be suitable for all types of investors. If an investor has any doubts about product suitability, he should consulthis Lehman Brothers representative. The value of and the income produced by products may fluctuate, so that an investor may get back less than he invested.Value and income may be adversely affected by exchange rates, interest rates, or other factors. Past performance is not necessarily indicative of future results.If a product is income producing, part of the capital invested may be used to pay that income. Lehman Brothers may, from time to time, perform investmentbanking or other services for, or solicit investment banking or other business from any company mentioned in this document. © 2004 Lehman Brothers. Allrights reserved. Additional information is available on request. Please contact a Lehman Brothers’ entity in your home jurisdiction.

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