Criteria for Rating German Residential Mortgage ... - Standard & Poor's

Criteria | Structured Finance | RMBS:
Criteria for Rating German
Residential Mortgage-Backed
Securities
Primary Credit Analysts:
Torsten Althaus, Frankfurt (49) 69-33-999-300; torsten_althaus@standardandpoors.com
Tilmann Kuhfuss, Frankfurt (49) 69-138709-7372
Andre Vollmann, London (44) 20-7826-3855
Karen Naylor, London (44) 20-7826-3533
Victoria Johnstone, London (44) 20-7826-3864
Stephen McCabe, London (44) 20-826-3594
Table Of Contents
Traditional True Sale Structures
Synthetic Structures
The General Rating Process
Credit Analysis
Foreclosure Frequency Assumptions
Loss Severity Assumptions
Cash Flow Analysis for Funded Synthetic Transactions
Cash Flow Analysis for True Sale Transactions
Substitution of Assets
Documentation Aspects of Synthetic RMBS Transactions
Surveillance
August 31, 2001
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Criteria | Structured Finance | RMBS:
Criteria for Rating German Residential
Mortgage-Backed Securities
(Editor's Note: This criteria article originally was published on Aug. 31, 2001. We're republishing this article
following our periodic review completed on March 31, 2011.
These criteria have been updated and clarified by "Methodology And Assumptions: Update To The Criteria For
Rating German Residential Mortgage-Backed Securities," published on Jan. 6, 2009. Also, part of these criteria have
been superseded by "Cash Flow Criteria for European RMBS Transactions," published on Nov. 20, 2003, and
"Methodology And Assumptions: Update To The Cash Flow Criteria For European RMBS Transactions,"
published on Jan. 6, 2009.)
This article details Standard & Poor's rating approach to German residential mortgage-backed securities (RMBS).
This approach is based on a detailed analysis of German mortgage originators' underwriting and servicing
procedures and the performance of residential mortgages in the German market, and on the surveillance of rated
German RMBS transactions since 1998.
German mortgage transactions rated by Standard & Poor's to date have included mortgage assets originated by the
following banks:
• Landesbanks;
• Commercial banks;
• Private banks;
• Mortgage banks;
• Cooperative banks; and
• Savings banks.
For the purposes of this article, residential mortgage loans refer to loans taken out by individuals, or in certain
circumstances, companies, to finance the purchase of residential properties located in Germany. Typically, German
lenders look to the use of the property, rather than the status of the borrower, in determining whether a loan is
classified as residential.
German RMBS transactions to date have employed both "true sale" and "synthetic" structures, outlined below and
in table 1. This article addresses both types of transactions, and highlights the differences in the approach where
necessary. A comparison with the German Hypotheken Pfandbriefe is also included in table 1. This article does not
outline Standard & Poor's approach to rating Hypotheken Pfandbriefe (see "Criteria for Rating German
Pfandbriefe", published on RatingsDirect on July 7, 1997 for further details of this approach). Hypotheken
Pfandbriefe has been included for comparison, as it bears certain similarities to RMBS, and is an important
instrument for funding mortgage lending in the German market.
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Traditional True Sale Structures
Few German RMBS transactions to date are structured as traditional true sale transactions. This involves the sale of
a pool of residential mortgage loans to a bankruptcy-remote special-purpose entity (SPE), which then issues a
number of tranches of rated notes. The key drivers for these types of structures are fundraising, balance-sheet
management, and risk management.
Synthetic Structures
Synthetic structures for German RMBS transactions can be divided into unfunded, partially funded, or fully funded
structures. The key driver for this type of structure is capital and risk relief.
Unfunded Structures
Unfunded structures normally take the form of credit default swaps or guarantees. A number of these have been
executed in the German market. In this type of structure, the mortgage lender enters into a swap with a
counterparty, typically an OECD bank. This counterparty makes payments to the lender to the extent certain losses
occur on a defined pool of mortgage loans, commonly known as the reference pool.
Partially Funded Structures
As the name suggests, these structures combine an unfunded element, in the form of a credit default swap, with a
funded element, in the form of notes. These notes are issued either by the bank directly, or via an SPE. In both cases,
the notes are backed by appropriately rated collateral or are guaranteed by an appropriately rated counterparty.
Fully Funded Structures
These structures are fully funded, with the notes issued either by the bank directly, or via an SPE. In both cases, the
notes are backed by appropriately rated collateral or are guaranteed by an appropriately rated counterparty.
Table 1
Basic Features of True Sale and Synthetic RMBS vs. Pfandbriefe Transactions
True sale Synthetic
Assets Assets transferred to an SPE Defined pool of reference assets and
a defined notion of losses
Nature of the
assets
RMBS Hypotheken Pfandbriefe
Assets within a cover register
(Deckungsstock)
Residential mortgage loans Residential mortgage loans Principally residential and commercial
mortgage loans up to 60% lendable value
(Beleihungswert), as defined by the
Mortgage Banking Act (Hypothekenbank
Gesetz) and associated rulings
Issuer SPE SPE or a sufficiently rated bank or
any bank with certain collateral
arrangements
Funding Fully funded to match the pool of assets Unfunded, partially funded, or fully
funded based on the obligation of the
rated bank or collateral
arrangements
Balance-sheet
treatment
Principal and
interest payments
Criteria Structured Finance RMBS: Criteria for Rating German Residential Mortgage-Backed Securities
Generally designed for off-balance-sheet
treatment
Generally designed for
off-balance-sheet treatment
From the pool of segregated assets From the issuing bank or the
collateral securing the funded
elements
Mortgage bank or Landesbank
Fully funded and supported by assets in the
cover register
On-balance-sheet design
Assets of the cover register
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Table 1
Basic Features of True Sale and Synthetic RMBS vs. Pfandbriefe Transactions (cont.)
Cash flow analysis Detailed cash flow analysis to ensure the
payments from pool of assets are sufficient
to maintain payments of interest and
principal on the rated debt in a recessionary
environment
Maturity of the
transaction
Criteria Structured Finance RMBS: Criteria for Rating German Residential Mortgage-Backed Securities
Dependent on the maturity of the
underlying assets
The General Rating Process
Rated collateral usually tailored to
provide cash flows as required.
Interest subparticipation might
require separate cash flow modeling
Potentially part of the transaction
definitions
Detailed cash flow analysis addressing the
dynamic nature of the asset pool
Usually shorter than the underlying assets,
but still dependent on the asset
characteristics
Standard & Poor's assesses the interaction of structural, legal, and credit quality features in a transaction, and tests
the robustness of these qualities using various assumptions appropriate for the rating sought. The conservatism of
the assumptions reflects the level of the rating. In most cases, the rating process includes the following steps:
• An initial meeting is held to discuss the asset characteristics, structure, data requirements, and the time schedule.
With respect to data requirements, Standard & Poor's asks the originators to supply specific information on each
loan in a standardized data template (available on request). The data requested includes items such as loan
balance, property value, etc.
• A one-day visit (corporate overview) is conducted to review the underwriting, servicing, and collection policies
and procedures of the originator (and a servicer if a different entity is employed) of the mortgage loans. A sample
agenda can be found in Appendix 1. Typically, managers (Abteilungsleiter) give presentations on the topics
outlined in the agenda. These topics are crucial to the rating analysis of the mortgage loans to be securitized.
Standard & Poor's will endeavor to allocate native German-speaking primary analysts to German transactions.
Therefore, these presentations can be conducted in German.
• The credit quality of the underlying loan is determined, thereby yielding the credit enhancement levels before any
cash flow analysis. This risk analysis takes into account the results of the servicer review and the credit analysis of
the underlying mortgage loan portfolio (see Foreclosure Frequency Assumptions below). In true sale transactions
and some funded synthetic transactions, final credit enhancement levels are determined after a cash flow analysis
(see Loss Severity Assumptions).
• There is a review of and comments are made on the draft transaction documents and legal opinions. Arranging
banks typically print and distribute the preliminary offering circular at this stage and Standard & Poor's typically
issues a presale report and assigns preliminary ratings to the transaction. Shortly before the close of the
transaction a final credit committee will examine whether the prerequisites for a final rating are fulfilled, and
whether any outstanding issues have been satisfactorily resolved.
• Following the release of the final rating letter, the transaction will be transferred to the surveillance department.
This department is responsible for the ongoing monitoring of the transaction.
Credit Analysis
The credit quality of German mortgage pools is assessed by estimating the credit risk associated with each loan in
the pool. The aggregate of this risk is then calculated to assess the overall credit quality of the pool. The credit risk
associated with each loan in the pool is quantified by estimating each loan's probability of default leading to
foreclosure and its loss severity (the loss that would be realized as a result of foreclosure).
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The potential loss associated with a loan can therefore be calculated by multiplying the foreclosure frequency with
the loss severity. In order to quantify the potential losses associated with the entire pool, each loan's foreclosure
frequency and loss severity is weighted by its percentage of the total pool balance. A weighted-average foreclosure
frequency (WAFF) and a weighted-average loss severity (WALS) are then calculated at each rating level. The product
of these two variables estimates the required loss protection, in the absence of additional mitigating factors (e.g.,
excess spread, whether in cash or synthetic) in the transaction.
Standard & Poor's assumes that as the economic environment declines, the credit risk associated with a particular
pool will increase; that is, more borrowers will default on their loans, and the loss realized as the result of
foreclosure will be more extreme. Standard & Poor's, therefore, requires higher loss protection or credit cover for
the higher rated notes in a mortgage transaction.
The details of Standard & Poor's assumptions in the calculation of the foreclosure frequency and loss severity
measures for a German mortgage pool are given below.
Foreclosure Frequency Assumptions
Base Foreclosure Frequency
A base foreclosure frequency is assumed at each rating level (see table 2). The base foreclosure frequency is the
probability of foreclosure for each loan under each rating scenario. The higher base foreclosure frequencies at the
higher rating levels capture the increase in foreclosure risk in more stressful economic conditions.
Table 2
Base Foreclosure Frequency Assumptions
Rating Base foreclosure frequency (%)
AAA 12
AA 8
A 6
BBB 4
It is assumed that a loan will have an increased (or sometimes decreased) foreclosure risk compared with the base,
depending on its unique underwriting characteristics. Therefore, the base foreclosure frequency is modified for each
loan to address any increase or decrease in risk due to these characteristics. The characteristics that lead to base
foreclosure modifications are given in table 3, and discussed in detail in the text thereafter. Loans without any of the
characteristics that attract changes to the foreclosure frequency are considered to be benchmark.
There is a recognized need for market participants to construct models that replicate these base foreclosure
frequency modifications. Table 3 therefore outlines the loan characteristics that are considered to have an effect on
foreclosure frequency, and provides the associated adjustments that Standard & Poor's typically advise. It is strongly
emphasized that these are guidelines only, and foreclosure adjustments will be increased or decreased after an
analysis of originator-specific underwriting and servicing characteristics, and/or performance data. In addition,
Standard & Poor's will continue to monitor and assess German mortgage credit risk, and will refine and add criteria
accordingly.
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Table 3
Criteria Structured Finance RMBS: Criteria for Rating German Residential Mortgage-Backed Securities
Characteristics Affecting Base Foreclosure Frequency and Related Adjustment Guidelines
Description of characteristic Foreclosure frequency adjustment guidelines
Loan-to-value (LTV) < 55% Base multiplied by 0.8
LTV 55% to 80% Base multiplied by 1.0 (no change)
LTV > 80% Base multiplied by 1.1 to 3.0 according to a continuous function.
Indicative multiples at discrete LTV levels are given as follows:
85% LTV = base multiplied by 1.2
90% LTV = base multiplied by 1.6
95% LTV = base multiplied by 2.4
100% LTV = base multiplied by 3.0
Interest-only loans (endfaellige Darlehen) without satisfactory
additional collateral (term < 20 years)
Base multiplied by 1.67
Letting loans (fremdvermietete Objekte) Base multiplied by 1.5 to 1.8 and then added to base (e.g., for a base of 12%: base
multiplied by 1.67 = 20%; base plus 20% = 32%
Loan size > €400,000 or equivalent Increases by 1% to 20% of base (increases as loan size increases and caps when
loan size reaches €1,000,000)
Unacceptable geographic concentration Case-by-case consideration
Affordability not adequately assessed Case-by-case consideration
Completion date >18 months (with no arrears) Subtract 10% to 25% of base (increases as seasoning increases and caps when
seasoning reaches about 60 months)
Arrears Case-by-case consideration, based on arrears management and performance data
Loan-to-Value (LTV)
LTV is defined as the ratio of aggregate mortgage debt divided by the value of the property. This ratio has
historically been a key foreclosure predictor, with low LTV ratios associated with lesser probabilities of loan default.
A low LTV ratio indicates that a borrower has a high equity investment in a property, but can also indicate some
prior financial management.
Standard & Poor's ability to rely on LTV ratios is crucial, given that the LTV ratio is important in the estimation of
foreclosure frequency (and loss severity, see below). In general, securitized loans in Germany have benefited from
full property valuations. German mortgage lending banks typically have in-house valuation experts, with extensive
experience in the building and construction industry.
German banks normally use a material value method (Sachwertverfahren) or a return value method
(Ertragswertverfahren) to determine the value of a property. The resulting market valuation is then deducted by a
certain percentage to give a "lendable" value or Beleihungswert. Lenders use this reduction as potential coverage in
a forced sale situation. Typically, the less liquid the property is considered to be, the higher the deducted percentage
(or haircut) is from the property value. This approach stems from Mortgage Banking Act requirements for those
banks regulated by this act, but has also been adopted by nonmortgage banks.
In order to give benefit to this conservative valuation haircut, Standard & Poor's adjusts the lendable values in its
calculation of LTV ratios. Subsequent references to LTV in this article refer to this adjusted LTV. The degree of
uplift to the valuation depends on the transaction structure. In synthetic structures, where a minimum level of
haircut is stated in the eligibility criteria, and where all losses are audited prior to being allocated, Standard &
Poor's will typically re-engineer the valuation, giving full benefit to the haircut. The timing and comprehensiveness
of the audit will affect this analysis. In the case of true sale transactions, partial benefit is given, resulting in a
valuation that is below market value but in excess of the Beleihungswert.
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Note that in the case of multiple loans secured on one property, the aggregate of this mortgage debt is used to
calculate a single LTV per property.
Loan Repayment Type
Most German residential mortgage loans have fixed interest rates and fixed repayment characteristics for a period of
time. The length of this fixing period varies from one to 15 years, but is most commonly set at five to 10 years.
Upon maturity of the fixing period, the lending bank is obliged to provide a new offer for the next fixing period.
The offer typically relates to a new interest rate, but some lenders allow the principal amortization features to
change as well. Mortgage payments are usually direct debited monthly, but quarterly, semiannual, and annual
payments can also be arranged.
Borrowers repay their loan using either a full repayment or an interest-only scheme (endfaelliges Darlehen). With a
full repayment loan, the principal amortizes over the life of the loan; that is, the borrower repays principal and pays
interest at each mortgage payment date. Standard & Poor's does not consider repayment loans to have any increased
or decreased risk of foreclosure, but these loan types can affect the structural analysis (see Extension Risk below).
With an interest-only loan, the borrower makes monthly interest payments, with the total principal due at final
maturity. German borrowers typically accrue this principal payment elsewhere (e.g., in a life insurance investment
vehicle, Kapitallebensversicherung, or in a building society savings plan, Bausparvertrag). These schemes are
normally assigned to the lender and used to redeem the loan at maturity.
Standard & Poor's will discuss with the originator to what degree any additional security has been taken for
interest-only loans, and will examine the potential mismatch between the collateral arrangements and the mortgage
loan amount due at maturity to assess any refinancing risk. After these assessments, interest-only loans with original
terms of less than 20 years may be considered to carry greater credit risk.
Letting Loans
In general, there is relatively low home ownership in Germany compared with other European countries.
Letting-loan properties are exposed to different risks than owner-occupied properties. Such risks include the
borrower's level of reliance on the rental receipts to meet mortgage payments, and the borrower's prior experience
in managing rental properties.
The German environment for letting properties exposes the borrower to a number of additional risks. Primarily,
there are tax incentives associated with rental properties, so high degrees of leverage are often used to maximize
these benefits. The tax benefits can also result in inflated prices for rental properties.
Secondly, there are strong legal tenant protections. These protections fix the maximum increase in rent amount,
allow for increases in the tenant resignation period over time, and restrict the landlord's ability to terminate the
renting contract.
Lastly, the yield associated with rental properties is generally low. Without incorporating the tax benefit,
occasionally the yield is lower than the interest owed on the mortgage loan. Thus, any delays in the implementation
of the tax deductions after the purchase of a letting property can place financial stress on a highly leveraged
borrower.
Criteria Structured Finance RMBS: Criteria for Rating German Residential Mortgage-Backed Securities
In order to account for these additional risks, the foreclosure frequencies assigned to German rental properties are
generally much higher than owner-occupied properties.
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Criteria Structured Finance RMBS: Criteria for Rating German Residential Mortgage-Backed Securities
Note that Standard & Poor's considers family homes with an attached rental flat to be owner-occupied and as such
do not attract the additional foreclosure risk of a letting-only property.
Loan Size
Large loans are considered to have more inherent risk than smaller loans owing to the increased sensitivity of these
borrowers to changes in their financial situation in times of recession. Jumbo loans are defined as loans with a
balance of more than €400,000. This limit will be adjusted on an ongoing basis to reflect regional price differences.
Geographic Concentration
If a pool is not suitably diversified by region, a local economic downturn can adversely affect the losses in the
mortgage pool. Standard & Poor's generally considers the effect of regional concentrations on foreclosure
frequencies on a case-by-case basis. In this analysis, the proportion of the pool in each geographic area is compared
with the population distribution of Germany as a whole. If they correspond approximately, typically no additional
foreclosure risk will be assumed.
Affordability
Standard & Poor's will assess how the servicer calculates the borrower's long-term income available for loan
repayment (frei verfügbares Einkommen, Kapitaldienstfähigkeit), and the frequency with which it updates averaged
expense predictions based on borrower characteristics (Ausgabenpauschalen). Standard & Poor's may conclude that
a borrower's financial ability to repay the loan may be compromised if these procedures are not deemed to be
adequate, and will increase the foreclosure frequency accordingly.
Seasoning
Historical data indicates that the most likely period in which a borrower will default is the first five years following
completion. A mortgage that has been outstanding for a significant period of time (and is not currently in arrears) is,
therefore, considered to have a lower likelihood of foreclosure.
Arrears
Loans in arrears clearly have a greater propensity to go into foreclosure given their status. Standard & Poor's
recognizes that collection efforts made by the lender will reduce the probability of foreclosure for loans in arrears.
Standard & Poor's will also analyze the types of performing arrangements and arrears management procedures
utilized by an originator, and consider originator-specific performance data and roll rates when sizing the
foreclosure risks associated with loans in arrears.
Second-Charge Mortgages
Unlike in some other European jurisdictions (e.g., the U.K.), in Germany Standard & Poor's assumes no increase in
the assumed foreclosure frequency for second mortgages. Multiple loans secured off one property is the norm in
Germany and generally reflects market lending practices rather than additional borrowing to finance, for example,
home improvements.
Loss Severity Assumptions
Loss severity is the estimated loss that will be realized on a defaulted loan. A loss is realized on a loan if the sale of
the repossessed property does not cover the costs associated with enforcing the mortgage, the accrued interest on the
loan during the foreclosure period, and the remaining loan balance. The loss severity is calculated by dividing this
realized loss by the loan balance, expressed as a percentage.
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Market Value Decline
The rating analysis assumes that the sale proceeds received from a property are less than the original valuation of the
property, owing to a recessionary market value decline. Standard & Poor's market value decline assumptions for
German residential properties are shown in table 4. These market value declines are both rating and loan dependent.
The tax incentives associated with rental properties can result in overly inflated prices for these types of properties.
Standard & Poor's therefore assumes that a rental property will show a greater market value decline than an
owner-occupied property.
Table 4
Market Value Decline Assumptions
Rating Standard market value declines (%) Letting loans market value declines (%)
AAA 35 45
AA 30 40
A 26 36
BBB 22 32
Jumbo Valuations
Properties with high valuations are assumed to experience higher loss severities owing to the smaller and less liquid
market for these types of properties. A property with a valuation greater than €500,000 attracts a 1% to 20%
increase in loss severity, which increases as the property valuation increases and caps at about €1,000,000. As with
jumbo loan limits, this limit will be adjusted on a continuing basis to reflect regional price differences.
Foreclosure Costs, Foreclosure Period, and Accrued Interest
The fixed costs associated with foreclosure are assumed to be, on average, 6% of the loan balance for each defaulted
loan. This figure includes all costs and fees resulting from the pursuit of arrears, litigation, administration,
maintenance, and sale of the property. Where loss protection needs to be sized for the interest accrued during the
foreclosure period (e.g., in some synthetic structures, and in true sale structures without a cash flow simulation), a
24-month foreclosure period and a stressed interest rate of 8% to 12% are assumed.
Second Charge Mortgages
Standard & Poor's loss severity calculations also account for prior-ranking mortgages not included in the
securitization. The proceeds from the sale of the property are used to fulfill the prior-ranking obligation (including
the loan balance, costs of foreclosure, and interest accrued during the foreclosure period) before they are used to
cover the second charge securitized loan.
Loss Severity Calculation Example
An example of Standard & Poor's loss severity calculation for an individual loan is shown in table 5.
Table 5
Criteria Structured Finance RMBS: Criteria for Rating German Residential Mortgage-Backed Securities
'AAA' Loss Severity Calculation for a First Ranking Loan, Assuming an LTV of 80%
Original property value 100,000
Loan balance 80,000
Foreclosure proceeds 100,000 minus 'AAA' market value decline of 35% = 65,000
Gross loss 15,000
Realization costs
24 months accrued interest at 12% 19,200
Selling, legal and other costs at 6% 4,800
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Table 5
'AAA' Loss Severity Calculation for a First Ranking Loan, Assuming an LTV of 80% (cont.)
Total costs and interest 24,000
Net loss
39,000
Loss severity = net loss divided by loan balance 39,000 divided by 80,000 = 48.75%
Large Exposure Risk
Given the relatively low risk nature of German mortgages, and the exclusion of certain risks through synthetic
transactions, the credit enhancement levels at the lower rating levels are sometimes sensitive to large exposures. In
order to examine this sensitivity, Standard & Poor's compares the enhancement levels required when the whole pool
is included in the credit analysis, with those obtained from subpools of the largest exposures. If necessary, Standard
& Poor's will increase the required credit enhancement after this analysis.
Cash Flow Analysis for Funded Synthetic Transactions
Standard & Poor's ratings address the likelihood of full and timely payment of interest and principal in accordance
with the terms of the obligation. This is true for both funded synthetic and true sale transactions.
In funded synthetic structures, it is the collateral (such as Pfandbriefe or government bonds) that generates the
interest and principal that is used to pay interest and repay principal on the rated notes. This collateral backs the
obligations of the issuing bank to make principal and interest payments, and allows the issuing bank to obtain
ratings on the notes that are higher than its own. Often, the collateral has the same interest rate and maturities as
the rated notes.
To the extent the bank issuing the notes fails to make a payment, the trustee will liquidate the collateral and pass on
the proceeds to noteholders. If the proceeds from liquidation are insufficient to redeem the notes in full, the trustee
will deliver a proportional amount of the collateral to the noteholders as payment in kind.
If the collateral is not grossed up for withholding tax deductions, Standard & Poor's will request a legal opinion
confirming that there is no current or pending withholding tax payable.
Cash Flow Analysis for True Sale Transactions
True sale mortgage securitizations involve the issuance of rated bonds, which are split into tranches of differing
seniority (so-called "senior-subordinated" structures). Seniority may be related to payment of interest, principal, or
both.
Beneath the rated bonds there usually exists a first-loss fund provided by the originator of the assets, often called the
"reserve fund". The reserve fund is used to cover both interest shortfalls and principal losses arising in the
transaction.
Criteria Structured Finance RMBS: Criteria for Rating German Residential Mortgage-Backed Securities
The transaction might also incorporate specific structural features designed to minimize the issuer's exposure to
external economic factors (e.g., interest rate hedges). A cash flow model will usually be created to replicate the asset
and liability structure over the life of the transaction.
The transaction cash flows are stressed in order to test both the credit and liquidity support provided by the assets,
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subordinated tranches, cash reserve, and any external sources (such as a liquidity facility). Stresses to the cash flows
are implemented at all relevant rating levels.
Defaults
Defaults are assumed to occur over a three-year recession. The effect of the timing of this recession on the ability of
the assets to repay the liabilities is assessed, and the recession start period will be chosen on the basis of this
assessment.
Although the recession normally starts in the first month of the transaction, the 'AAA' recession is usually delayed
by a further 12 months. As described above, the cumulative level of defaults within a mortgage pool is given by the
WAFF. The WAFF is applied to the principal balance outstanding at the start of the recession. Defaults are assumed
to occur periodically in amounts calculated as a percentage of the WAFF.
The timing of defaults generally follows two paths, referred to here as "fast" and "slow" defaults. These timings are
shown in table 6. In most cases, the fast default curve is applied, unless the transaction is more sensitive to the slow
default curve.
Table 6
Criteria Structured Finance RMBS: Criteria for Rating German Residential Mortgage-Backed Securities
Default Bullets for Fast and Slow Default Curves
Recession month Fast default (% of WAFF) Slow default (% of WAFF)
1 30 0
6 30 5
12 20 5
18 10 10
24 5 20
30 5 30
36 0 30
Recoveries
Standard & Poor's assumes that the recovery of proceeds from foreclosure and sale of repossessed properties will
occur 24 months following a payment default. The value of recoveries will be equal to the defaulted amount less the
WALS. The WALS used in a cash flow model will usually be based on principal alone, including costs. During the
foreclosure period, unpaid interest on defaulted mortgages will accrue in the cash flow model depending on the
current interest rate, which itself is varied according to certain criteria (see below).
Delinquencies
The liquidity stress that results from short-term delinquencies, i.e., those mortgages that cease to pay for a period of
time but then recover and become current with respect to both interest and principal, is also modeled. To simulate
the effect of delinquencies, interest receipts equal to one-third of the WAFF are assumed to be delayed.
This assumption applies for the first 18 months of the recession, and full recovery of delinquent interest is assumed
to occur after a period of 18 months. Thus, if in month five of the recession the total collateral interest is €1 million
and the WAFF is 30%, €100,000 of interest (one-third of the WAFF) will be delayed until month 29.
Interest and Prepayment Rates
Three different interest rate scenarios—rising, falling, and stable—are modeled using both high and low prepayment
assumptions. This gives rise to six different stress scenarios at each rating level. Interest rates always start from
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EURIBOR at the time of modeling. For rising interest rates, EURIBOR rises by 2% per month to a ceiling of 12%,
where it remains for the rest of the transaction's life. For falling interest rates, EURIBOR falls by 2% per month to a
floor of 2%, where it remains for the rest of the transaction's life. For stable interest rates, EURIBOR is held at the
current level throughout the life of the transaction. In the 'AAA' scenario the interest rate increase will not begin
until month 13.
Criteria Structured Finance RMBS: Criteria for Rating German Residential Mortgage-Backed Securities
High and low prepayments are set at 30.0% and 0.5% per annum and applied on a monthly basis to the decreasing
mortgage balance. In 'AAA' scenarios where the recession starts in month 13, the prepayment rate in the first year is
set to an intermediate rate of 15% per annum. Standard & Poor's reserves the right to increase the high prepayment
assumption in the event that historical prepayment rates are at high levels, or the transaction is particularly sensitive
to high prepayments (e.g., in the case of a transaction that relies heavily on excess spread).
Interest rate and prepayment rate scenarios are revised if there is sufficient evidence to warrant such adjustments.
Reinvestment Rates
Unless the transaction has the benefit of a guaranteed investment contract (GIC) with an appropriately rated entity,
it is assumed that the transaction will suffer from a lower margin on reinvested redemption proceeds and other cash
held in the SPE than the margin received on the underlying assets.
If proceeds are received and reinvested throughout the quarter, and the long-term rating of the GIC provider is
lower than that of the rated notes being subjected to the stress, then the reinvestment rate is assumed to be
EURIBOR less a rating-dependent margin, with a floor of 2%.
The rating-dependent margin is a multiple of the contractual margin. The multiple used for this calculation varies
from three at the 'AA' level to five at the 'AAA' level. For example, if the contractual reinvestment rate is EURIBOR
minus 50 basis points (bps), the assumed reinvestment rate would be EURIBOR minus 150 bps for the 'AA' level,
and EURIBOR minus 250 bps for 'AAA'. If the GIC provider has an 'A-1+' short-term rating (but not a 'AAA'
long-term rating) the actual GIC rate can be relied upon for the first year of the transaction in a 'AAA' scenario, but
must revert to the stressed rate thereafter.
Originator Insolvency
Mortgage payments from borrowers are typically paid by direct debit into a collection account, transferred to a
transaction account in the name of the issuer, and finally credited to the GIC account. The collection account is
often not in the name of the issuer, as most originators do not want to ask borrowers to change their direct debit
instructions as a result of a securitization.
The degree to which insolvency of the originator will affect the cash flow from the assets depends, therefore, on the
collection account characteristics. The amount at risk depends on the timing of payments from borrowers and the
frequency with which these funds are transferred to the transaction account. If all borrowers pay on the same day of
the month, then even with daily sweeping of the collection account, up to one month's cash flow from the assets is
potentially at risk. This risk must be modeled appropriately for each transaction, but could result in a loss of one
month's cash flow, depending on the legal analysis.
Expenses
All the issuer's foreseeable expenses should be modeled. Standard & Poor's normally requires a schedule of these
expenses to be provided. In addition to foreseeable expenses, the model should contain amounts sized for contingent
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expenses. This amount depends on the size of the transaction, and can be modeled either as a separate contingency
reserve or a haircut to the reserve fund, or can be addressed through an appropriate guarantee.
Substitution of Assets
Some transactions allow for the substitution of mortgage loans as the original mortgage loans repay. In order to
ensure that the credit quality of the portfolio does not deteriorate, a substitution model has been developed for use
by originators. This model should be run for each substitution to ensure that the level of credit enhancement remains
sufficient.
Criteria Structured Finance RMBS: Criteria for Rating German Residential Mortgage-Backed Securities
Additional requirements include a limitation on how many loans may be substituted in any one quarter (10% of
principal outstanding), a cap on the proportion of delinquencies on the existing pool (cannot exceed 2% of principal
outstanding), and a restriction on the proportion of the first loss tranche used to cover losses (no more than 25%).
Documentation Aspects of Synthetic RMBS Transactions
Given that a high proportion of German RMBS transactions are synthetic transactions, a number of important
documentation issues are highlighted below.
Definition of Losses
In synthetic transactions, losses can be divided into principal losses, interest losses, and losses associated with
foreclosure costs. It is also possible to differentiate between losses occurring on the balances of the loans to be
securitized, and the same losses occurring on prior-ranking loans that are not included in the securitization.
It is important that the documentation clearly specify which risks are being transferred. The originator sets the
definition of losses arising from the reference pool for which it is seeking credit protection. Therefore, the loss
definitions can differ from one transaction to another. While the definition of losses can be tailored for the reference
pool, it is not possible to do this for prior-ranking loans that are not in this pool.
Accordingly, Standard & Poor's needs to know the prior-ranking balances, held with third party banks or the
originator (or both), to be able to calculate losses which will occur on these prior-ranking balances. In addition, the
allocation of recoveries in the synthetic waterfall needs to reflect the degree to which accrued interest and
foreclosure costs have been excluded from the loss definition. If these items have been excluded, then they must rank
junior in the waterfall.
Conditions for Loss Allocations
The conditions under which losses are allocated are key in synthetic transactions. The trustee's plausibility check of
transaction reports, its audits of loans that lead to losses (eligibility criteria, credit and collections procedures, and
servicing practices, as determined in the offering circular), and the timing of loss allocations are regarded as crucial.
In addition, the scope of the audits with respect to the eligibility criteria, credit collection policies, and other
servicing requirements is considered to have a crucial effect on the transaction.
Extension Risk
German repayment mortgage loans allow certain terms of the mortgage, namely the interest rate and the
amortization rate, to be renegotiated at the refix (renewal) date. If the borrower renegotiates amortization rates at
the refix date, this can extend the final maturity of the mortgage loan.
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In order to ensure that that all principal from the underlying assets is received prior to the maturity of the rated
notes, one of the following mechanisms has been employed to date:
• The servicer agrees to not allow a borrower to reduce the amortization rate.
• The transaction is structured with a final maturity date after the expected maturity of the underlying mortgage
loans.
• In the case of a synthetic transaction, a credit event with regards to the loans in the reference pool should be
allowed to occur only up until the expected final maturity.
Surveillance
Criteria Structured Finance RMBS: Criteria for Rating German Residential Mortgage-Backed Securities
Continuous surveillance is carried out throughout the life of the transaction to ensure that it is performing in
accordance with the initial rating assumptions, and to monitor changes in the underlying performance of the assets.
The purpose of surveillance is to ensure that the ratings assigned continue to reflect the structure and performance of
the transaction, and the likelihood that interest and principal will continue to be paid on time and in full in
circumstances reflective of the assigned rating.
If the performance of the underlying assets or of the transaction itself deteriorates or improves to the extent that the
rating originally assigned is no longer a true reflection of the risk of nonpayment, Standard & Poor's reserves the
right to change its rating accordingly.
The rating of a transaction may also be changed to reflect revisions in the rating of a supporting party to the
transaction or as a result of regulatory or other issues that have an effect on the transaction.
It is a requirement of a Standard & Poor's rating that performance data is received on a regular basis throughout the
transaction's life. This is typically provided monthly or quarterly, and is provided by the issuer, or servicer on its
behalf, with all relevant information on the assets and the liabilities needed to maintain comprehensive surveillance.
There is a standard set of surveillance data requirements for all German RMBS transactions. These are discussed
with the originator at the corporate overview, and any variations to reflect, for example, particular products, are
incorporated at this stage. A copy of these surveillance data requirements is available on request.
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