U.S. RMBS Market Prepares for New Challenges in 2000

[By Doug French, with Frank Raiter, Susan Barnes, Gail McDermott, Terry Osterweil, Michael Stock, and Thomas Warrack, analysts, residential mortgages group, structured finance ratings, Standard & Poor's Ratings Services]

The U.S. residential mortgage-backed securities (RMBS) market is expected to remain healthy throughout 2000, but it is unlikely to revisit the record loan origination levels achieved in 1998. The prospect of more interest rate hikes by the Federal Reserve in 2000 will continue to pressure these originations, which will probably not reach the US$1 trillion mark for the first time since 1997.

On the agency front, the two major government-sponsored enterprises (GSEs) are expected to increase their subprime and "alternate A" origination volumes, assisted by the continued deployment of their automated underwriting systems and their push for partnering with major originators. Higher conforming balances will also spur on more activity for the GSEs, especially in the prime arena.

The chief culprit for this falloff in originations was the gradual rise in interest rates, which climbed steadily throughout 1999. The 30-year fixed mortgage rate, for example, began 1999 at 6.83% and finished the year at 8.05%. Higher rates have caused refinancing demand to dwindle; as recently as 1998, refinancings accounted for over 60% of all mortgage volume, but as of January 2000, that level hovered at approximately 25%.

A Word About Y2K

The RMBS market typically witnesses frenzied activity during the last month of the year. As expected, though, the fourth quarter of 1999 was one of the slowest quarters ever, and much of this can be attributed to computer-related concerns and the year 2000 turnover. The fourth-quarter inertia was offset, however, by increased activity in October and November. In addition, January 2000 securitization volume was normal, indicating that issuers did not wait until after the new year to securitize.

The market was seized by a hibernation factor. Issuers seemed to display an urgency to get their product to market by Thanksgiving and then laid low until the effects of Y2K played themselves out.

Prime Securitization Market Braces

For Encroachment By GSEs

Because the refinancing boom is over, prime RMBS volume will taper off in 2000. Securitizations will also shrink, in the wake of the federal government's announcement that the GSE ceiling for 2000 has been increased by 5.29%, to $252,700. This latest jump is the third consecutive increase of 5% or more. Published reports estimate that approximately 82,000 loans, worth in the neighborhood of $21 billion, will fall below this new mark. Most of this activity will probably be absorbed by Fannie Mae and Freddie Mac.

As the loan limit for the GSEs continues to increase, the percentage of loans securitized in the private-label market will keep eroding. Though $92 billion is a healthy number, the decline is a point of concern.

The demand for refinancing is projected to remain low throughout 2000. The prime market would probably withstand an increase in the prime lending rate of 25 or 50 basis points, but a steeper rate hike could send origination levels down dramatically and greatly reduce profitability.

As rates ratchet higher and origination volume continues its moderate descent, Standard & Poor's will pay special attention in 2000 to underwriting guidelines, which may become more lenient as banks seek to attract business.

Prime mortgage securitizations began 1999 in robust fashion, on the heels of 1998's records. But volume dropped dramatically in the third quarter, and the fourth quarter proved to be one of the quietest ever - again, mostly related to Y2K concerns.

In total, securitization volume fell to $92 billion, down from its record level of $134 billion in 1998. Much of this year-over-year shortfall was due to aggressive purchasing by FNMA and FHLMC, for which the maximum conforming balance was raised in 1999 to $240,000, a 5.66% increase over 1998's level of $227,150.

Most of the critical data involved in prime transactions remained virtually unchanged in 1999. The weighted average loan-to-value (LTV) ratio for 30-year, fixed-rate transactions crept up to 73.73% from the previous year's level of 73.56%, and the weighted average FICO score in 1999 was only fractionally higher at 718.08. Despite these consistent numbers, however, Standard & Poor's AAA' credit enhancement levels surged from 4.29% in 1998 to 4.52% last year. This increase came about because of rising rates, which translated into greater loss severity. In addition, higher house prices enhanced risk by increasing the likelihood of cash-out refinancing, and the number of loans with less-than-full documentation continued to rise.

Subprime Volumes Expected to Hold Course

Credit will become a bigger issue in the subprime market in 2000. As many of the subprime deals issued during the high-volume period of 1996-98 begin to season, each issuer's tier ranking will depend as much on the performance of its outstanding transactions as on the capitalization it holds. Standard & Poor's will continue to hone its subprime ratings model by tracking the pool characteristics and performance of these transactions.