I’ve just read a good paper by Engel & McCoy, Turning a Blind Eye: Wall Street Finance of Predatory Lending, which, while certainly having an axe to grind (they want more regulation), does give a good overview of the problems. Their central point is:

As this excerpt from one prospectus illustrates,securitization turns a blind eye to the underwriting of subprime loans:

With the exception of approximately 20.82% of the mortgage loans in the statistical mortgage pool that were underwritten in accordance with the underwriting criteria of The Winter Group, underwriting criteria are generally not available with respect to the mortgage loans. In many instances the mortgage loans in the statistical mortgage pool were acquired by Terwin Advisors LLC from sources, including mortgage brokers and other non-originators, that could not provide detailed information regarding the underwriting guidelines of the originators.

As this suggests, Wall Street firms securitize subprime home loans without determining if loan pools contain predatory loans. In the worst situations, secondary market actors have actively facilitated abusive lending.

The big problem (to me) is loan re-negotiation, which has been the subject of some political chatter in recent weeks:

Securitization complicates and often blocks work-outs with borrowers who are harmed by predatory loans. This is because the underlying securitization contracts tie the trustee’s and servicer’s hands if they attempt to negotiate a repayment plan in lieu of foreclosure. The value of the securities and the amount of their returns are based on cash flows that are determined, in part, by the loan terms. To protect these cash flows, securitization contracts typically prohibit changes to the terms of the underlying loans. In addition, securitization contracts often prohibit servicers from waiving prepayment penalties and other loan provisions.

There is a very good table in the Engel & McCoy paper (on page 2056 of the Fordham Law Review), showing S&P Upgrades and Downgrades of Public Subprime RMBS, 2003-2006. It’s not a proper transition matrix, but it’s a start. 

Anyway, what brought on this surge of interest in the mechanics of sub-prime was the recent announce by Fitch:

Fitch has affirmed three classes and downgraded one class of notes issued by Northwall Funding CDO I, Ltd., (Northwall). The following rating actions are effective immediately:

–$165,326,758 class A-1 notes affirmed at ‘AAA’;
–$46,500,000 class A-2 notes affirmed at ‘AAA’;
–$40,500,000 class B notes affirmed at ‘AA’;
–$18,000,000 class C notes downgraded to ‘BB’ from ‘BBB’ and remain on Rating Watch Negative (RWN).

Northwall is a collateralized debt obligation (CDO) that closed May 17, 2005 and is managed by Terwin Money Management, LLC (Terwin). Northwall has a substitution period that grants Terwin limited trading ability until September 2007. The portfolio is composed of approximately 89% subprime residential mortgage-backed securities (RMBS), 8% Prime RMBS, and 3% CDOs.

The downgrade of the class C notes reflects the deterioration in credit quality of the portfolio.
Approximately 11% of the portfolio has been downgraded since last review and as of the most recent trustee report the WARF has increased to 5.07 (‘BBB/BBB-‘) from 4.35 (‘BBB/BBB-‘) at last review. In Fitch’s view approximately 13.5% of the portfolio is below investment grade quality, including approximately 5.9% ‘CCC’ or lower quality. There is one defaulted asset comprising $994,341 of the portfolio. In addition, approximately 7% of bonds in the portfolio are on Rating Watch Negative (RWN).

As far as I can make out from a google-cached report by Credit Suisse, the original issue came in the tranches indicated above, with an additional “equity tranche” representing 5% of the issue.

There was another announcement by Moody’s:

Moody’s Investors Service today announced downgrades on 120 securities originated in the second half of 2005 and backed by subprime, first-lien mortgage loans. The actions follow a review of the securities rated in the second half of 2005 and affect securities with an original face value of over $1.5 billion, representing 0.7% of the dollar volume and 4.1% of the securities rated by Moody’s in the second-half of 2005 that were backed by subprime, first-lien loans.


The actions reflect the higher than anticipated delinquency rates of first-lien subprime mortgage loans securitized in the second half of 2005. These loans were originated in an environment of aggressive underwriting, although not to the same degree as the subprime loans originated in 2006. Aggressive underwriting combined with the prolonged slowdown in the housing market has caused significant loan performance deterioration and is the primary factor in these rating actions. Moody’s has noted a persistent negative trend in severe delinquencies for first-lien subprime mortgage loans securitized in late 2005 and 2006.


The vast majority of these downgrades impacted securities originally rated Baa or lower. In total 54 securities originally rated Baa and 60 securities previously rated Ba were downgraded. Additionally, 6 tranches originally rated A were downgraded. No action was taken on securities rated Aaa or Aa.


In addition to the high rates of early delinquency predicating today’s actions, Moody’s notes that subprime mortgages originated in late 2005 and 2006 that are subject to interest rate reset present an additional cause for credit concern. Subprime borrowers from previous vintages of such collateral avoided “payment shock” and potential default by refinancing. However, with the recent pressure in home price appreciation and tightening of mortgage lending standards, such refinancing opportunities may be more limited. Moody’s has noted that transactions issued in the second half of 2005 have begun to exhibit slower prepayment speeds as they near the two-year interest reset than did prior vintages. Moody’s is actively surveying loan servicers to evaluate the impact of potential increases in loan modification due to these upcoming resets.

Why do I bring this up? Well … no real reason. I just wanted to point out that the highest rated tranche of the issue reviewed by Fitch was the best-protected $165-million of a $300-million issue … asset coverage of 1.8:1, in fact, to put it in terms familiar to those who invest in Split-Share preferreds.

Also, I’m really annoyed at all the weeping and wailing over sub-prime. There have been significant losses, but so far they have been borne by

i) those who bought the lower-rated or equity tranches, and it serves ’em right!

ii) those who have panicked and sold stuff into a panicked market because it has the word “sub-prime” in it somewhere. To say something is a sub-prime derivative is about as meaningful as saying something else is an equity. It comes in many flavours.

There’s more perspective over at Tom Graff’s Accrued Interest.

2 Responses to “Sub-Prime!”

  1. […] but does not substantiate the charge that they’re doing a poor job. But that’s another post … and doubtless many more, as actual data start to come in to replace all this guessing. […]

  2. […] Gee, the last one was so much fun I think I’ll do another! Let’s look at “Bear Stearns Asset Backed Securities Trust 2005-1″. […]

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