Fixed-Income Research

The ABCs of HELs
December 8, 2004
Primary Authors

David Heike Akhil Mago 212-526-8312

INTRODUCTION The Home Equity Loan (HEL) sector has grown exponentially since 2002 to form the largest component of the ABS market. These bonds have increasingly become a core holding for ABS investors due to their high liquidity and attractive spread pickup over the benchmark auto and credit card sectors. However, HEL bonds demand careful analysis because of their inherent mix of credit, prepayment, and structural risks. This article provides a broad overview of the HEL market to help ABS investors get acquainted with the opportunities and risks in the sector. We begin with a historical overview of the market evolution over the past decade to provide some perspective on the lending industry. We examine typical loan characteristics, discuss underwriting trends and highlight the drivers of collateral performance. From a bond perspective, we discuss typical structural features of HEL ABS transactions and outline the key risk factors for ABS bondholders.

Strategy

David Heike dheike@lehman.com Akhil Mago akmago@lehman.com Sihan Shu sshu@lehman.com
Quantitative Research

Dick Kazarian dick.kazarian@lehman.com Stefano Risa srisa@lehman.com Namit Sinha nsinha@lehman.com

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

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

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We define HELs as subprime first-lien mortgages

INTRODUCTION In this report, we define a home equity loan (HEL) as a subprime first-lien mortgage and use these terms interchangeably. This is the most common convention among ABS investors, who equate HELs with first-lien mortgages made to borrowers with imperfect or limited credit history. This somewhat peculiar terminology grew from the original usage of the term in the ABS market, when it generally referred to second-lien mortgages taken out by lower credit borrowers for debt consolidation purposes. This classification is not universally accepted. Some market participants, including many mortgage lenders, apply the rubric of HELs to a broader universe of loans (Figure 1). Borrower characteristics, underwriting and performance vary widely among these related loan types. Most of these related sectors are relatively small; subprime first-lien mortgages still comprise over 95% of loan originations in this broader set. While we do not discuss these 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 in the early-1990s. Simultaneous closed-end second-liens issued at the time of purchase (piggyback seconds) have recently gained in popularity. • Home equity lines of credit (HELOCs): Revolving lines of credit backed by borrower equity typically made to a prime quality borrower. These could either be first- or second-liens. • High loan-to-value loans (HLTV): Mortgages with LTVs in excess of 100%, often up 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/firstpay defaults or delinquencies. Scratch and dent loans do not qualify the guidelines originally established for the pool (guideline exceptions).

Other smaller loan types are sometimes included in this definition

Figure 1.
600 500 400 300 200 100 0 1995

Historical Loan Originations, ($bn)
Subprime First Lien HELOC Specialty Second Lien HLTV

1996

1997

1998

1999

2000

2001

2002

2003

2004E

Source: Lehman Brothers, Inside B&C Lending

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Figure 2.

Comparison versus Other Mortgage Products, 2H04
Gross WAC (%) 5.75 5.95 6.20 Average Loan Average Average Size ($) LTV FICO 200,000 450,000 200,000 70 71 82 740 740 700 DTI Cutoff < 36 < 38 < 45 Full Doc (%) 95 90 35 Fixed (%) 70 20 70

Loan Type Prime Conforming Prime Jumbo Alt-A Conforming

Underwriting Comments Most marketable properties, agency underwriting Similar to Prime Conforming loans except for loan size. Higher LTV than prime conforming, less docs, less primary occupied, more multi-family, more cash out Government insured, low and moderate income borrowers Similar to Alt-A Conforming except for loan size Moderate income borrowers, limited credit history or credit issues Low income borrowers, usually located on private property Same borrower leverage as HEL, superior borrower credit, higher documentation, more purchase Low income borrowers, typically located in MH parks

FHA/VA Alt-A Jumbo Home Equity Loans (Subprime Mortgages) Manufactured Housing (Land-home) Second-Lien

6.25 6.45 7.25 7.50 9.60

125,000 450,000 170,000 90,000 40,000

100 76 82 80 95

640 700 630 600-720 685

< 42 < 42 < 50 <50 <55

95 35 65 90 70

90 35 30 95 95

Manufactured Housing (Chattel)
Source: Lehman Brothers

9.75-12.00 45,000

90

600-720

<50

95

95

We compare HEL characteristics to other mortgage products

Subprime mortgage characteristics fall on a credit continuum between prime/Alt-A mortgages and manufactured housing loans (Figure 2). An average subprime borrower pays a mortgage rate 150-200bp higher than the conventional prime mortgage rate due to poorer credit characteristics. The average borrower has a Fair Issac & Co. (FICO) credit score of 630, having either limited credit history or experienced credit problems in fulfilling previous consumer or mortgage debt obligations. The average loan size is around $170,000 with typical LTVs ranging between 80-85%. EVOLUTION OF THE HEL MARKET The HEL sector has changed dramatically since its early days. The market participants have changed over time. Borrower, loan and structural characteristics seem to change on an annual basis. We describe the evolution of the HEL market by dividing it into four broad phases (Figure 3): • Pre-1996 – Nascent • 1996-1998 – Initial growth • 1999-2001 – Consolidation • 2002 to 2004 – Expansion
Pre-1996 – Nascent

The market participants, borrower, loan and structural characteristics have changed dramatically over time

In the early 1990s, HELs consisted mostly of second liens ...

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

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... with conservative loan guidelines

The absence of a proven credit grading system led to conservative loan programs that focused 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 short amortization terms (less than 15 years). Lending was concentrated in the lower-tier subprime market (referred to as “hard money” lending), with a high proportion of loans made to seriously credit-impaired borrowers (foreclosure, bankruptcy bailouts, etc.).
1996-1998 – Initial Growth

The market expanded rapidly between 1996 and 1998 ...

The 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 rate backup. In addition, the subprime market offered attractive margins over conventional mortgages due to low competition among the limited number of existing players.

Figure 3.
600

HEL Loan Originations, ($bn)

Early Days 500 400 300 200 100 0
1990 1991 1992 1993 1994 1995

Initial Growth

Consolidation

Expansion

1996

1997

1998

1999

2000

2001

2002

2003 2004E

Source: Lehman Brothers, Inside B&C Lending

Figure 4.

Major HEL Lenders across Various Market Phases
Pre-1996 1996-1998 1999-2001 2002 to 2004

Money Store Associates First Capital Household Ameriquest Beneficial Household CitiFinancial New Century Household ContiMortgage Bank of America CitiFinancial Guardian Savings and Loan IMC Washington Mutual Household LongBeach Savings Money Store Option One Option One Green Tree GMAC-RFC First Franklin Advanta Countrywide Washington Mutual GMAC-RFC First Franklin Countrywide New Century GMAC-RFC Ameriquest Wells Fargo

Source: Lehman Brothers, Inside Mortgage Finance

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The ABCs of HELs

• •

The increasing use of securitization provided non-bank lenders an alternate source of funding, enabling them to enter the subprime sector. The evolution of credit scores helped lenders to better understand and price borrower credit risk. This common benchmark provided lenders and investors with the ability to analyze and compare credit performance across borrowers, which increased liquidity and facilitated the introduction of new loan types.

... leading to new loan types and underwriting standards

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 proportion of purchase borrowers increased and the market shifted from second-liens towards subprime first-liens. The proportion of seriously credit-impaired borrowers declined, as more mainstream subprime borrowers were extended credit. • Strong competitive pressures led to the loosening of underwriting standards and the introduction of higher LTV programs by new lenders to capture market share.
1999-2001 – Consolidation

A majority of lenders faced financial difficulties from 1999 to 2001 ...

There was a major shakeup among subprime lenders between 1999 and 2001. Threefourths of the active lenders either exited due to financial problems or merged with larger players. Some of the notable issuers to exit during this period were ContiMortgage, First Plus, 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 underwriting standards, aggressive gain-on-sale income accounting, and unfavorable market conditions after the liquidity crisis in 1998. Most of the new non-bank lenders that entered the market after 1996 were thinly capitalized. These lenders used gain-on-sale accounting with aggressive assumptions around residual valuations to gain favorable access to funding. However, poor collateral performance due to lax underwriting caused them to take large non-cash writedowns against their residual asset valuations. These financial problems were magnified during the 1998 liquidity crisis, when market execution became unfavorable due to a widening in spreads. This led lenders to turn to whole loan sales (to bank portfolios), which in turn lowered whole loan prices. HEL issuance growth stalled during this period (Figure 3). Most lenders used mortgage warehousing lines of credit for inventory financing. Financing was reduced following the liquidity crisis as these warehouse facilities were either curtailed or eliminated.
2002 to 2004 – Expansion

... driven by lax underwriting and aggressive accounting

Issuance has grown exponentially since 2002 ...

The HEL market has grown exponentially from 2002 to 2004. This surge in issuance is based 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 homeownership trends (Figure 5a). However, homeownership trends understate purchase demand in subprime, where overall market penetration has increased markedly more than the overall mortgage market. • Refinancing volume remains high even in a environment of rising interest rates, due to tighter margins. The increase in competition among a number of large lenders

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The ABCs of HELs

has compressed subprime margins over the last year (Figure 5b). Subprime loan rates have been declining while conventional mortgage rates have risen modestly. Strong home price appreciation (HPA) has supported cash-out refinancing volumes (Figure 5c). Please refer to the section on collateral performance for the link between HPA and prepayments. The use of securitization as a funding mechanism has increased; approximately 80% of new loan originations are being securitized (Figure 5d). This has reduced capital constraints and enabled the entry of smaller lenders. The subprime market has expanded to include borrowers that were traditionally covered by Alt-A lenders. This is evidenced by collateral trends in the 2002-2004 vintages (Figure 10). Average loan size has increased by around 30%, while limited documentation loans have increased from 27% to 38% from 2001 to 2004.

... driving servicing portfolio growth

Servicing portfolio growth has mirrored the recent increase in issuance. Servicing portfolios have grown sharply for large originators that typically retain servicing of their originations (Ameriquest, Countrywide etc.). Figure 6 lists the top issuers and servicers of subprime mortgages for 1H04. The securitized market got a major technological boost in 2001 when issuers began to monetize 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

The growth of NIMs prompted dealer conduits to enter after 2001

Figure 5.

Issuance Growth Drivers
a. U.S. Homeownership Rate (%) b. Spread of Subprime Mortgage Rates to Conventional Prime (%)
4 3 Fixed Hybrid

70 68 66

2
64 62 60 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004

1 0
1998 1/98 2000 1/00 2002 1/02 2004 1/04

c. U.S. Annual HPA (%)
% 16 % 12 % 8

d. HEL Securitized Issuance vs. Loan Originations, ($bn)
600 500 400 300 200 100 40% 20% 0% 1996 1997 1998 1999 2000 2001 2002 2003 2004E
Unsecuritzed Securitized Securitized % (RHS)

100% 80% 60%

4 % 0 %
1998 2000 2002 2004

0

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

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Figure 6.
1H04 Rank

Top Lenders and Servicers in 1H04
Market Share 1H04 15.1% 8.2% 6.5% 6.5% 5.7% 5.5% 4.7% 4.5% 4.4% 4.3% 4.3% 2.9% 2.3% 2.2% 2.0% Origination Volume ($bn) 2003 1H04 39.0 27.4 19.8 20.3 20.1 19.9 20.1 16.5 21.4 13.0 14.0 8.2 8.0 8.2 7.0 38.2 20.7 16.4 16.3 14.4 13.9 11.9 11.4 11.1 11.0 10.9 7.3 5.7 5.6 5.0 Primary Servicers Ameriquest CountryWide Household Citifinancial Option One Homecomings Chase Ocwen HomeEq Wells Fargo Washington Mutual National City Select Portfolio New Century Litton Loan Market Share 1H04 8.7% 7.1% 6.8% 6.6% 5.9% 5.9% 4.4% 4.2% 4.1% 3.2% 2.9% 2.7% 2.6% 2.5% 2.2% Servicing Portfolio ($bn) 2003 1H04 49.0 39.3 51.4 50.4 41.4 44.2 27.9 37.5 24.0 12.7 19.3 18.4 28.6 11.6 12.3 71.8 58.0 56.2 54.0 48.3 48.2 36.4 34.8 33.9 26.1 23.7 22.2 21.0 20.9 17.9

Subprime Lenders

1 Ameriquest 2 New Century 3 CountryWide 4 Household 5 First Franklin 6 Washington Mutual 7 Option One 8 Wells Fargo 9 CitiFinancial 10 Fremont 11 GMAC RFC 12 WMC 13 Accredited 14 Aegis 15 BNC
Source: Inside B&C Lending

their residual risk position. The rapid growth of NIM securitizations prompted a number 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 in 2004. These dealer shelves aggregate collateral from originators through secondary market whole loan purchases. This improved liquidity and efficiency in the secondary whole loan market has led to product standardization across issuers and greater thirdparty due diligence. The REIT structure has been gaining popularity among lenders A growing number of mortgage originators have recently organized themselves as Mortgage REITs. There are two key factors that have recently emerged to make REIT conversion 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 effectively convert one-time gain-on-sale income to spread income that is recognized over 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 more attractive. • The reception of the equity market to REIT IPOs has been extremely positive, as REIT stocks offer dividend yields of around 10-12%. LOAN CHARACTERISTICS HEL borrowers can choose between different combinations of interest payment options, amortization types and loan terms. We describe these in detail below.
Interest Payment Types

Borrowers can choose between fixed and hybrid interest rates ...

Borrowers 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.

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Hybrid adjustable rate mortgages (Hybrid ARMs, 70% by issuance): These mortgages have a fixed coupon for an initial period and a floating-rate coupon after a specified 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-rate period and a 28-year floating-rate period. There are less popular variants where the length of the initial fixed rate period is zero (pure ARM), three (3/27 hybrid), and five years (5/25 hybrid). Hybrids are the dominant loan type for subprime mortgages. Borrowers typically have a short time horizon, hoping to refinance into a lower-rate prime mortgage due to improvement in their credit file. Fixed-rate (30% by issuance): These are fixed coupon, level pay mortgages with typical loan terms of 30 years. These formed a large proportion of the market of the market before 1996 (Figure 7).

Amortization Type

... level pay and IO mortgages

Borrowers can choose between two amortization schedules: • Level Pay: These are fully-amortizing mortgages where the length of the amortization 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 the remaining 20-28 years of the mortgage. For example, for a 5-year IO loan, the borrower only makes interest payments for the first five years with no principal amortization. At the end of five years, the borrower faces an increase in monthly payments since principal begins to amortize based on a 25-year schedule. Since almost all recent IO loans are also hybrids, the borrower faces two payment resets over the life of the loan – the rate reset (interest payments) and the amortization reset (principal payments). IO products were traditionally used in the prime market as a means of tax-advantage to borrowers and have gained popularity in the subprime market since 2004 (15-20% of issuance). Please refer to the section on IO loans for more details.

Figure 7.
600 500 400 300 200 100 0 1995

Historical Loan Originations by Interest Payment Type, ($bn)
Pure ARM 5/25 3/27 2/28 FRM

1996

1997

1998

1999

2000

2001

2002

2003

2004

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

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The ABCs of HELs

Figure 8.
100% 80% 60% 40% 20% 0%

Overall Prepayment Penalty Distribution

1998

1999

2000
12 Mo. 24 Mo.

2001
36 Mo.

2002
60 Mo.

2003

2004

Source: Lehman Brothers, Loan Performance

Prepayment Penalties

Most loans are originated with prepayment penalties

Most subprime mortgages (80% of Hybrids, 65% of FRMs) are originated with prepayment penalties during the first few years, which limit borrower prepayments and protect the lender’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 the first three years (around 65% of FRM penalty loans) while the length of the hybrid penalty period usually coincides with the initial fixed-rate period (Figure 8). The amount of the penalty is usually 6 months of interest payments on 80% of the prepaid balance (2.5 to 3 points).
Interest Rate Caps/Floor

Hybrid borrowers are protected from large rate increases due to embedded caps

To protect hybrid borrowers from large increases in interest-rates during the floatingrate period, hybrid loans are embedded with various interest rate caps. Hybrid loans typically 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 fixedrate (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 the minimum mortgage rate to the initial fixed rate.
Property Type and Loan Purpose

HEL collateral can be further segmented by loan purpose and property type (Figure 9). The composition of single-family and rate-refinance mortgages has remained largely constant across time. COLLATERAL TRENDS The subprime market has shifted to higher credit quality loans as evidenced by recent trends in collateral characteristics (Figure 10). Since credit bottomed out in 2000-2001,

Currently, the average subprime homeowner has superior credit quality...

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Figure 9.

2004 Issuance by Property Type and Loan Purpose
Property Type
5% 1%
14%

Loan Purpose
1%

8% 9%

30%

55%

77% Single-Family 2-4 Unit Other
Source: Lehman Brothers, Loan Performance

Planned Unit Development Condo

Rate Refi

Purchase

Cash-Out Refi

Other

Figure 10.

Average Historical FICO Scores and Loan Size
FICO Loan Size ($K)
200 160 120 80 40
ARM FRM

660

ARM FRM

620

580

540 1998 1999 2000 2001 2002 2003 2004

0 1998 1999 2000 2001 2002 2003 2004

Source: Lehman Brothers, Loan Performance

FICO scores especially for fixed-rate product have risen by around 30 points1. Over the past three years, overall loan sizes have increased from $120K to $150K. This shift away from the lower-tier subprime borrowers has been prompted by two factors. First, due to the fixed cost of liquidation (legal fees, refurbishing etc.), low-balance loans are associated with higher loss severities. Second, lenders have avoided the lower-tier subprime market due to growing predatory lending concerns around high-cost loans to weak credit quality borrowers. ... but higher borrower leverage The recent improvement in borrower quality has been accompanied by an increase in borrower leverage (Figure 11). This is evidenced by higher LTVs, falling loandocumentation levels and largely constant DTIs (even in a declining interest rate environment). Thus, subprime homeowner characteristics have evolved towards a stronger credit quality, but a more levered borrower.

1

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

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Figure 11.

Historical LTV and Documentation Trends
LTV (%) Full Doc Loan (%)
90 80 70
ARM FRM

84 82 80 78 76 74 1998

ARM FRM

60 50 1999 2000 2001 2002 2003 2004 1998 1999 2000 2001 2002 2003 2004

Source: Lehman Brothers, Loan Performance

We examine historical performance of HEL collateral and highlight the key performance drivers

COLLATERAL PERFORMANCE The blend of prepayment and credit characteristics positions HEL as a unique cross-over sector between mortgage and asset backed securities. In this section we examine historical performance of HEL collateral and highlight the key performance drivers. The analysis of HEL securities is dependent on assumptions around four key performance variables - voluntary prepayments, involuntary prepayments (defaults), delinquencies and severity rates.
Voluntary Prepayments

Voluntary prepayments are driven by rate and cashout refinancing, curing and turnover ...

Voluntary prepayments can result from rate refinancing, cashout refinancing, credit curing 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 to 25-35CPR before stabilizing at those levels. Hybrid prepayments follow a typical pattern which is closely related to the length of the initial fixed-rate and the prepayment penalty period (Figure 12). Hybrid voluntary prepayments are faster than fixed-rate due to a self-selection bias; many borrowers with a shorter time horizon choose a hybrid over a 30-year fixed-rate product.

... and are greatly dependent on loan type

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Figure 12.

Voluntary Prepayments by Deal Age
FRM ARM
2000 2003

60% 45% 30% 15% 0%
01

1998 2001 2004

1999 2002

80% 60% 40% 20% 0%

1998 2002

1999 2003

2000 2004

2001

13 12

25 24

37 36

49 48

61 60

73 72

0 1

12 13

24 25

36 37

48 49

60 61

72 73

Source: Lehman Brothers, Loan Performance

Voluntary prepayments are driven by the following factors: Better credit borrowers have higher rate-refinancing sensitivity Borrower Characteristics: Rate-refinancing sensitivity is smaller for lower-credit borrowers than it is for better-credit borrowers due to fewer financing alternatives and lower sophistication. The different dimensions of borrower credit quality (FICO, LTV, DTI etc.) can be largely captured by a single variable: the spread at origination (SATO). SATO measures the difference in the mortgage rate between the specified loan and a constant quality subprime mortgage rate. Assuming that lenders price borrower risk efficiently, a higher SATO implies a worse credit borrower2. The refinancing sensitivity across a high and 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 analysis can be performed through borrower FICO, LTV, DTI data.

Figure 13.
50

Rate Sensitivity by Borrower Credit Quality
Low SATO

40

High SATO

30

20

10

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

Rate Incentive (%) FRM: 3-year penalty penalty, 15-30 WALA Source: Lehman Brothers, Loan Performance

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Prepayment penalties provide a significant disincentive to prepay

Prepayment Penalty: Loans with prepayment penalties prepay more slowly since the 2.5-3.0 point penalty provides a significant disincentive during the penalty period. Moreover, borrowers with a low propensity to prepay self-select themselves into these loans. Borrowers with penalty loans who postpone their prepayments typically prepay immediately after the end of the penalty period, thereby causing a transitory spike in prepayments. Hybrid prepayments display a sharp spike after the prepayment penalty period (which usually coincides with the initial fixed-rate period) and CPRs typically reach as high as 70-80 CPR for a few months. Fixed rate prepayments also demonstrate a 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).

Figure 14.
50

Prepayment Sensitivity by Loan Size
Small Size Large Size

40

30

20

10

0 -1.5 -1 -0.5 0
Rate Incentive (%) FRM: 3-year penalty penalty, 15-30 WALA Source: Lehman Brothers, Loan Performance

0.5

1

1.5

Voluntary prepayments increase with loan age ...

Loan Age/Seasoning: Voluntary prepayments increase with loan age for the following three reasons. First, cash out refinancing activity increases over time as borrowers build up equity due to accumulated home price appreciation. Second, credit curing becomes viable 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 few years of taking a new mortgage. Interest Rates: Prepayments of premium mortgages are a function of the amount of rate incentive, defined as the difference between the origination and the current market rate. Subprime prepayments are less sensitive to a change in interest rates than conventional prime mortgages. This is largely explained by the lower loan balances (limits dollar incentive to refinance), higher fixed cost of refinancing (cost of origination) and lower sophistication of these borrowers. The typical relationship between voluntary prepayments and rate incentive is as shown below (Figure 15).

... falling interest rates ...

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Figure 15.
50

Total Prepayments (CPR) by Rate Incentive (%)
FRM

40

ARM

30

20

10

0 -2.25 -1.50 -0.75 0.00
Rate Incentive (%) FRM: 15-30 month weighted average loan age (WALA), ARM: 15-20 WALA, prepayment penalty loans Source: Lehman Brothers, Loan Performance

0.75

1.50

... and home price appreciation

Home Price Appreciation: Cashout refinancings increase during periods of strong home price appreciation, as borrowers tap the built up equity in the house to retire more expensive debt or meet big ticket expenses. In addition, strong home price appreciation allows borrowers to reduce their mortgage rate even with unchanged market rates by lowering the LTV (Figure 16a). The impact of HPA varies with the interest rate environment since borrowers are more likely to be able to afford a larger mortgage and cash out if rates have declined. Thus, the impact of HPA on prepayments is more pronounced for in-themoney mortgages and relatively muted out-of-the-money (Figure 16b). Other Economic Variables: Other economic variables such as unemployment and income growth also impact voluntary prepayments. An improving credit environment with low unemployment and strong income growth would boost turnover due to higher economic activity and the increased ability to trade up to bigger houses.

Figure 16.

Total Prepayments (CPR) by HPA
a. CPR by Deal Age b. CPR by Rate Incentive (%)*
50 40 30 20
5% HPA 8% HPA

50% 40% 30% 20% 10% 0% 0 12 24 36
Deal Age * FRM 3-year prepayment penalty, 15-30 WALA Source: Lehman Brothers, Loan Performance

Normal HPA Fast HPA

10 0

48

60

72

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

Rate Incentive (%)

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The ABCs of HELs

Defaults and Delinquencies

Defaults and delinquencies are important variables for credit analysis

Forecasting involuntary prepayments (defaults) is critical for the credit analysis of subordinate and mezzanine HEL securities. Delinquency levels are particularly important in 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 default and delinquency performance by vintage is displayed below (Figure 17 and 18).
Defining Defaults

We define defaults as loan terminations from the 60+ delinquency bucket ...

The two most commonly-used definitions of defaults are (i) loan terminations with losses, or (ii) loans terminating from the 60+ delinquency bucket. The definition of defaults is not standardized across issuers/servicers and varies by trust. In addition, a number of trusts do not report defaults and severities individually, but instead state final loss rates. It is important to specify a standard definition for defaults to compare performance across different trusts and loan characteristics. Since accurate loss information is often not available at the loan level, we define defaults as loan terminations from the 60+ delinquency bucket. This definition includes loan terminations which get resolved with no losses (due to adequate home equity or mortgage insurance), and thus results in smaller effective severities.

Figure 17.

Defaults (CDR) by Deal Age
FRM ARM
2000 2004 20% 15% 2001 25% 1998 2002 1999 2003 2000 2004 2001

18% 15% 12% 9% 6% 3% 0% 0 12

1998 2002

1999 2003

10% 5% 0% 24 36
Deal Age

48

60

72

0

12

24

36
Deal Age

48

60

72

Source: Lehman Brothers, Loan Performance

Figure 18.

60+ Delinquencies (% Cur Bal) by Deal Age, Incl. BK, FCL and REO
FRM ARM
2000 2004 30% 2001 40% 1998 2002 1999 2003 2000 2004 2001

30%

1998 2002

1999 2003

20% 20% 10% 10% 0% 0 12 24 36
Deal Age Source: Lehman Brothers, Loan Performance

0% 48 60 72 0 12 24 36
Deal Age

48

60

72

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Defaults and delinquencies are driven by the following factors: ... and use SATO as a summary variable for borrower quality Borrower Characteristics: Indicators of borrower credit quality such as length of employment, credit history, debt-to-income ratio etc. provide an indication of expected default rates. Borrowers who have previously experienced major derogatories on 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 a residence. These dimensions of borrower credit quality can also be largely captured by SATO. Defaults and delinquencies for a high and low quality borrower pool (distinguished by SATO) are shown in Figure 19. The assumption that lenders price borrower risk efficiently is reasonable, since SATO adequately differentiates the credit quality between loans.

Figure 19.

Defaults and Delinquencies by Borrower Credit Quality
Defaults 60+ Delinquency (% Current Balance)
25 20 15 10 5 0
Low SATO High SATO

15 12 9 6 3 0 0

Low SATO High SATO

12

24

36
Deal Age

48

60

0

12

24
Deal Age

36

48

60

FRM, 2000 vintage, no prepayment penalty Source: Lehman Brothers, Loan Performance

Defaults and delinquencies rise with deal age

Loan Age/Seasoning: Defaults are relatively rare during the first year of a loan due to the recency of underwriting and long liquidation timelines. Total delinquencies rise over time and 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 shift in the pool towards terminally delinquent borrowers. The borrowers who remain in the pool are typically of average credit quality, since the good quality borrowers usually prepay and the bad quality borrowers typically default as the deal seasons. Home Price Appreciation: Home price appreciation is an important driver of defaults and delinquencies 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. On average, using a cross-sectional MSA study, a decrease in HPA by 3% (difference of around 10% 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 significant impact on credit performance. A 2% decrease in local employment growth is estimated to increase defaults and delinquencies by 3-4% (Figure 20).

Higher HPA lowers the borrower incentive to default

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Figure 20.

Defaults and Deliquencies by Employment Growth Buckets (%), HPA Adjusted
Defaults 60+ Delinquency (% Current Balance)
25 20 15 10 0% 2%

18 15 12 9 6 3 0 0

0% 2%

5 0 12 24
Deal Age

36

48

60

0

12

24
Deal Age

36

48

60

Source: Lehman Brothers, Loan Performance

Severity Rates

Loss severities are determined by liquidation expenses, P&I advancing and market value declines

Loss severity rates, which measure the percentage loss on liquidations are driven by three key components (i) Liquidation expenses (legal fees, foreclosure fees etc.) (ii) Delinquent principal and interest (P&I) advanced by the servicer, and (iii) Property market value decline (if any). The length of the foreclosure process affects liquidation expenses and the P&I advanced, while accumulated home price appreciation determines the equity cushion available to cover market value declines. The historical severity rates by loan type are shown below (Figure 21).

Figure 21.

Severity (Pre-MI ) by Deal Age
FRM ARM
2000 2004 45% 30% 2001 60% 1998 2002 1999 2003 2000 2004 2001

75%

1998 2002

1999 2003

50%

25% 15% 0% 0 12 24 36
Deal Age Source: Lehman Brothers, Loan Performance

0% 48 60 72 0 12 24 36
Deal Age

48

60

72

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.

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Amortization Type: Loans with an initial IO period have a higher average principal outstanding at the time of default. This amortization gap can result in severities being higher by 2-3% for IO loans. Mortgage Insurance: Certain HEL deals utilize mortgage insurance policies to protect the 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 to insurance reimbursements by the mortgage insurer (please refer to the section on structural features of HEL securities for more details). Loan Age/Seasoning: Severity rates tend to increase with loan age and stabilize around 30% by 30 months. This is explained by a higher proportion of long foreclosure timeline loans among defaulting loans later in the life of the deal. Longer liquidation timelines entail higher P&I advancing, liquidation fees, and a possible lack of upkeep by the defaulting borrower. Accumulated HPA: Accumulated HPA reduces severity rates by providing an equity cushion to cover liquidation expenses and P&I advancing. In addition, loans with strong HPA typically have shorter liquidation timelines, since short sales are often used as the liquidation mechanism. This further reduces the liquidation cost.
Originator/Servicer Effects

Collateral performance is strongly influenced by originator practices ...

The variation in underwriting and verification practices across originators is an important determinant of collateral performance which is often not evident from a loan tape. Subprime lenders use a variety of business practices to determine the accuracy and completeness of information while making a loan. The two key processes during underwriting are property appraisal and income verification. These are gaining increasing importance due to the prevalence of limited/stated documentation and high LTV loans (Figure 10). The effectiveness of underwriting exceptions for fringe borrowers is another key determinant of credit performance. The relatively high delinquencies and defaults of subprime loans underscores the importance 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 value of the loan’s future cash flows to the trust. This is typically achieved through two parallel strategies. On the one hand, the servicer tries to get the borrower back on track. This could 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 the necessary legal steps to liquidate the collateral to satisfy the borrower’s obligations. A balanced execution of both these strategies is critical to maximize trust cashflow. These originator/servicer effects can lead to significant differences in performance across loans that appear similar on paper based on stated characteristics.

... and servicing capablities

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The ABCs of HELs

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 servicer is also responsible for submitting monthly remittance reports and advancing principal and interest to the trust. Most transactions have more than one primary servicer. • Special servicer: Performs the specialized function of handling seriously delinquent loans. Thus, the special servicer focuses on loss mitigation, managing defaults and REO (real estate owned) properties. • Master servicer: Responsible for overseeing the different sub-servicers (primary and special) present on the transaction. Thus, the master servicer monitors the monthly remittance reporting and aggregation, tracks the movement of funds between the different accounts. In addition, the master servicer handles the event of a sub-servicer bankruptcy/inability to service by handling servicing for an interim period before assigning a new sub-servicer.

STRUCTURAL FEATURES OF HEL SECURITIES HEL securities are the most structurally complex of the core ABS sectors. The interaction of prepayments, defaults and delinquencies with the structure creates unique paydown mechanics for HEL securities. We discuss the major elements of deal structures below. HEL transactions are shifting towards senior/subordinate structures ... Prior to 1997, most HEL ABS transactions used bond insurance from AAA-rated monoline insurers as a form of credit enhancement. The growing liquidity in the ABS market after 1997 led to a gradual shift towards senior/subordinate structures. The 1998 liquidity crisis temporarily halted this shift, but senior-subordinated structures grew in popularity following the restructuring among lenders from 1999-2001. This recent shift towards senior-subordinate structures has been fuelled in part by strong demand from GSEs, foreign investors and structured finance CDOs. The securitized market has also graduated from the use of mostly passthrough tranches at AAA level, to time-tranching the senior AAA-rated sequential securities. The typical capital structure of a new issue HEL deal is shown in Figure 23. Most current home equity deals (around 90%) issue floating-rate securities (indexed to 1MoLIB) backed by a combination of fixed and hybrid collateral. Deals use senior/ subordinate structures, over-collateralization, excess spread, performance triggers,

... utilizing different forms of credit enhancement

Figure 23.

Capital Structure by Issue Year, (%)
1998 1999 93.8 0.0 2.3 0.0 0.0 1.7 0.1 0.0 1.0 0.9 0.0 0.1 0.0 2000 91.8 0.0 3.1 0.1 0.0 2.5 0.0 0.1 1.4 0.7 0.0 0.2 0.0 2001 91.2 0.1 3.2 0.2 0.1 2.5 0.1 0.1 1.6 0.7 0.0 0.2 0.0 2002 89.0 0.0 4.0 0.1 0.0 3.1 0.1 0.3 2.5 0.8 0.0 0.1 0.0 2003 85.5 0.1 5.2 0.1 0.1 4.0 0.8 1.0 2.2 1.0 0.0 0.1 0.0 2004 83.5 1.3 4.2 0.8 0.7 2.8 1.7 1.5 1.9 1.2 0.2 0.1 0.0

AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BB-

92.3 0.0 3.0 0.0 0.0 2.4 0.1 0.0 1.0 1.1 0.0 0.0 0.0

Source: Lehman Brothers, Intex

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The ABCs of HELs

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

Figure 24.

Deal Waterfall Payment Mechanics

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 INTEREST WATERFALL Bonds are paid interest to stated coupon (1MoLIB+DM up to net WAC) AAA Bond Coupon Payments AA A BBB Excess interest flows into excess cashflow waterfall

PRINCIPAL WATERFALL Bonds are paid principal in order of credit priority

EXCESS CASHFLOW WATERFALL Excess cashflow is used to cover losses, meet basis risk shortfalls and recoup bond losses

Turbo principal to attain target OC Cover basis risk shortfalls Cover Bond Losses Hedge cashflow not used for basis risk shortfalls and bond losses flows to the residual holder/NIM Embedded Hedges (Interest rate corridors/swaps)
Hedge cashflow is available for basis risk shortfalls and bond losses not covered by excess interest

Residual cashflow Residual Holder/NIM

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Interest Waterfall

Senior fees and premiums are deducted from gross interest ...

Available 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, MI insurance premiums (if any) and other fees (bond insurer etc.) are paid at the top of the waterfall. The servicing fee is typically set at 50bp/year. Most servicers provide liquidity to the trust by advancing principal and interest (P&I) for delinquent loans as long as the advanced amount is considered recoverable. The servicer recovers this P&I advancing either through the monthly collections account when a loan becomes current, or from the liquidation proceeds following a default. The amount remaining after meeting these payments (net WAC), flows into the interest waterfall. Interest is typically paid to the bonds sequentially in order of priority up to the stated 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 steps up after the cleanup call distribution date if the option holder does not call the deal. The limit of the bond coupon to the net WAC of the collateral is also called the available funds cap (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 the bonds early in the life of the deal. For example, if the collateral net WAC is 6.5% and the weighted 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 WAC and the interest paid to the bonds (excess spread) flows into the excess spread waterfall.
Principal Waterfall

... to pay bond coupon ...

... any excess spread flows into the excess spread waterfall

Principal payment mechanism varies across the life of the deal

The scheduled principal, prepaid principal and principal recovery from liquidations flows into the principal waterfall. The principal payment mechanism varies across the life of the deal. During the first 36 months of the deal (lockout period), senior bonds are paid principal sequentially in the order of credit priority with the mezzanine and subordinate bonds being locked out. After the stepdown date, conditional on the deal passing performance triggers (explained below), principal is allocated to maintain a target current credit enhancement for the senior and subordinate bonds (typically twice the initial credit enhancement). If the deal fails triggers in any month, the deal switches back to paying sequentially. Bonds start to take losses from the bottom of the capital structure upwards in reverse credit priority when the collateral balance is reduced below the total outstanding bond balance. The collateral balance backing the deal is typically higher than the total principal balance of bonds outstanding. This over-collateralization (OC) serves as a form of credit enhancement as it provides a first cushion to absorb collateral losses. The OC might either be funded initially, or it may build up over time by applying excess spread to the payment of bond principal (referred to as the “turbo” feature). Any collateral principal remaining 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-collateralization target percentage. The OC target is typically specified as a percentage of the original collateral balance before the stepdown date. After the stepdown date, conditional on triggers passing, the OC target is specified as a percentage of the current collateral

Over-collateralization serves as a form of credit enhancement ...

... and is maintained at a target level

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The ABCs of HELs

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

Figure 25.
OC builds to target

OC Buildup Mechanics
OC at target (% of original balance) OC steps down at the stepdown date to new OC target (% of current balance) OC at floor and growing as a percentage of current balance.

}

Principal released to residual holder/NIM

0

12

24

36

48 Deal Age

60

72

84

96

Excess Cashflow Waterfall

Excess spread is available to cover collateral losses ...

The net collateral interest (net WAC) in excess of the amount required to pay bond interest flows into the excess spread waterfall. This excess spread is available to build overcollateralization, cover basis risk shortfalls and bond losses before paying the residual holder. In the event of the current OC being lower than the OC target (due to collateral losses or initial OC ramp-up), any excess cashflow goes to pay principal to the bonds to attain the target OC (turbo principal). Thus, excess spread is available to meet any collateral losses before the deal experiences an erosion in OC. There is some limited crosscollateralization among groups since the excess cashflow from one group can offset losses of 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 WAC of 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 previous payment months. Excess spread is also available to pay back any bond principal losses experienced in previous months. The excess spread remaining after meeting these payments goes to pay the residual/NIM holder.
Trigger Mechanics

... basis risk shortfalls and bond losses

Deals contain performance triggers ...

HEL deals contain provisions to release principal to the subordinate tranches after an initial lockout period if the pool meets certain performance tests or “triggers”. Triggers provide additional credit protection to the senior bonds by directing a larger proportion of the available cash flow to senior bonds if performance deteriorates. This enhances senior credit support as the subordinate classes increase as a percentage of the total collateral.

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... based on cumulative losses and current delinquencies

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 follows a schedule typically stepping up from month 36 to month 72-84. The threshold of the cumulative 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 current senior enhancement of the deal. For example, the delinquency trigger might be specifed to fail if the 60+ delinquencies are greater than 50% of the current senior credit enhancement. Thus, the 60+ delinquency trigger threshold changes dynamically based on the current senior enhancement. The dynamic nature of the delinquency threshold causes this trigger to typically toggle intermittently between passing and failing over the life of the deal. This can be explained by looking at the following example. In a payment month when the 60+ delinquency trigger fails, 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 the senior enhancement). This delinquency threshold rises over the next few distribution dates to a level where the trigger passes. The reverse mechanism then takes effect as passing triggers causes the senior credit enhancement to fall. The threshold falls to a level where the trigger fails for a subsequent payment date. At this point the cycle repeats again.
NIMs

The delinquency trigger typically toggles between passing and failing

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

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

Figure 26.

NIM Securitization Structure

AAA Collateral Balance

AAA

AA A BBB OC

AA A BBB OC NIM Residual

Residual

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... and recieves cashflow from excess spread, hedges, OC release and prepayment penalties

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 basis risk shortfalls and bond losses have been covered. • Interest rate hedges: HEL transactions contain hedge instruments to partly offset interest rate risk (please refer to section on risk factors for more details). Payments under these interest rate cap/swap hedge agreements (after application to cover basis risk shortfalls and bond losses) are applied to NIMs. • Over-collateralization release: This OC stepdown releases principal cash flow to the residual holder (Figure 25). • Prepayment penalties: The residual holder sometime holds the Class P security, which consists of prepayment penalty cash flow. While this security is completely separate from the 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 due to faster prepayments, higher losses, and increase in LIBOR. Higher prepayment speeds decrease NIM cashflow due to a lower dollar amount of excess spread. However, this risk is partly mitigated by the offsetting impact of prepayment penalty cash flow which flows to the NIM. The NIMs are also partly protected from losses since the principal payment windows on the NIMs are typically structured to end by month 24. Losses in HEL deals do not become prominent early in the life of the deal (refer to section on collateral performance drivers). Thus, the NIM is only exposed to the front end of the loss curve. The risk from rising interest rates is also mitigated by additional cashflow from the hedge instrument.
Mortgage Insurance

The risk of excess spread compression is mitigated by several features

MI provides credit enhancement by lowering trust severities

Some HEL deals utilize mortgage insurance (MI) as an additional form of credit enhancement. Mortgage insurance policies protect the trust against a limited amount of loss (specified by the policy) in an event of default by the homeowner (Figure 27). MI policies lower effective trust severities and thus reduce the level of subordination and overcollateralization required. However, this is compensated by the lower excess interest available in the structure due to payment of the insurance premium from the interest cashflow (senior in the interest waterfall). Recent HEL transactions include mortgage insurance on high LTV loans (usually >80 LTV) which are associated with higher 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 this case, the borrower is not aware of the existence of a mortgage insurance policy on the loan. Since these are purchased by the trust, the mortgage insurance premium is 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 insurance premiums 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 a mortgage insurance policy before extending credit to the homeowner. While origination level policies are commonly used by prime mortgage originators, they are not very common among subprime lenders. These are typically referred to as “borrower-paid” MI policies since the borrower explicitly agrees to pay the insurance premium to the insurance provider.

HEL deals typically use lender-paid MI policies

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Figure 27.

MI Claim Calculation

To calculate the payment against the MI claim, loans are specified to the covered down to a target LTV. For example, for a loan with an initial LTV of 90%, the target LTV might be specified as 60%. The MI coverage percentage is calculated as the (Original LTV-Target LTV)/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. The claim amount is sum of the unpaid principal balance, P&I advanced and expenses (legal fees, real estate taxes, property maintenance expense etc.). The MI provider has the following 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, based on the expected sale price of the property. This can be demonstrated by the following example. Original Loan Term Original Property Appraisal Original Loan Value Original LTV MI Policy Target LTV Coverage % MI Claim Calculation Unpaid principal balance on default P&I advanced Other expenses (legal, property tax etc.) Total Claim Amount

100,000 90,000 90% 60% 33.3% 80,000 10,000 20,000 110,000

Property sale value (current) 85,000 MI Provider Options Option1: Pay total claim and obtain title to property Amount Paid 110,000 Amount recovered through property sale 85,000 Net Cost 25,000 Option2: Pay coverage% of the claim amount Net Cost (110,000 * 33.3%) 36,667 Breakeven 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 claim amount. The trust thus incurs no loss on the default as long as the property sale price is higher than this amount. If the property value falls lower than this value, the MI provider will 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 provider is minimal

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

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Rating agencies size subordination by estimating collateral losses and excess spread credit

RATING AGENCY METHODOLOGY Rating agencies estimate two key variables before rating a transaction. First, they review loan level data to calculate base case losses for a pool. Losses will depend primarily on collateral characteristics, but other factors, such as an originator’s past performance, will also affect base case loss estimates. The expected cumulative net loss estimate serves as the foundation for the amount of credit support needed for a given rating category. The rating level assigned represents a multiple of cumulative credit losses expected over the life of the deal. Second, rating agencies determine the amount of excess spread available to build credit enhancement or cover losses. In addition to losses, the other important assumptions when calculating excess spread credit are interest rates, loss timing, prepayments, collateral WAC deterioration, and triggers.
Interest Rates

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

LIBOR stresses are used to assess the basis risk present in HEL transactions (please refer to section 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 have less excess spread if it does not have adequate hedge protection. Therefore, steeper LIBOR curves will impose a higher level of stress. In response to growing concerns around the basis risk, all three rating agencies introduced more stressful interest rate vectors in 2004, which are significantly steeper than the forward curve3 (Figure 28). This has resulted in an increase in OC levels and subordination for transactions rated using the new methodology.

Figure 28.
10%

AAA Interest Rate Stresses, 1 MoLIB
New Moodys New Fitch New S&P Forward S&P Equivalent

8%

6%

4%

2%

0% 0 20 40 60
Deal Age

80

100

120

Timing of Losses

The timing of losses can have a dramatic effect on the credit protection of a subordinate bond. Since excess spread is highest in the first few years of a transaction, a flat CDR or front-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 loss curve assumptions may vary to maintain realistic default rates depending on the total level of prepayments.
3

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

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Prepayments

The key for more conservative prepayment assumptions is to create basis risk by using a faster prepayment curve for ARMs and slower speeds for FRMs. Fitch and Moody’s are more conservative and achieve a greater basis risk stress by assuming faster hybrid prepayments. S&P’s base case voluntary prepayment curve (CRR) is based on the specific deal prospectus pricing curve and the involuntary component (CDR) of prepayments is dependent on total cumulative losses.
WAC Deterioration

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

There 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 flows and credit enhancement levels. In some transactions, overcollateralization levels are allowed to step down when triggers pass after the lockout period ends. While some subordinate securities may receive principal at this time, enhancement levels drop and subsequent losses may actually be more stressful for the remaining tranches. RISK FACTORS HEL securities carry risks arising from structural features, macroeconomic conditions, regulatory provisions and credit performance. The degree of these risks varies across different vintages and transactions.
Interest Rate Risk

HEL investors are exposed to rising interest rates due to basis risk ...

HEL investors are exposed to rising interest rates due to the basis risk between floatingrate bonds and a combination of fixed-rate and hybrid collateral. HEL transactions are at risk on two fronts. First, the floating-rate bond coupon is capped at the net weighted average coupon (net WAC) on the collateral. Thus, HEL floaters contain embedded short interest rate caps with the strike dependent on the net WAC of the collateral. This is also known as available funds cap (AFC) risk. Second, the excess spread available to cover losses/basis risk shortfalls falls as the collateral coupon rises less than the coupon on 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 be paid from any excess spread available in the deal in the current month or any later month. This raises the effective AFC strike of the short caps embedded in these floaters, since bonds can still receive full coupon (1MoLIB + DM) if excess spread exists 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 the trust as LIBOR increases. The hedge cashflow is available to cover basis risk shortfalls (if any).

... which is partly offset by structural features

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Lehman Brothers | MBS & ABS Strategies

The ABCs of HELs

Excess spread compression and AFC issues are more prominent late in the life of the deal

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 feature is valuable for subordinates). • Excess spread compression and AFC issues are more prominent later in the life of the deal due to three factors. First, the fixed rate collateral percentage increases over time since hybrid loans typically prepay much faster than fixed-rate loans over the life of the deal. Second, losses typically start ramping-up after the first year and reach 3-5CLR around month 36. Third, most interest rate hedges are typically not outstanding after the first 24 months and do not offset basis risk late in the life of the deal.
Housing Market Slowdown

The strength of the housing market will impact HEL performance ...

HEL collateral performance is highly levered to the strength of the housing market (please refer to the section on collateral performance). Strong home price appreciation since 2003 has had a strong impact on prepayments and credit performance (defaults, delinquencies and severities). Prepayments have been fast on the 2003 and 2004 vintages partly due to strong cashout refinancings driven by robust HPA. Credit performance has improved since borrowers have been bailed out by the built up equity in the home in the event of credit problems. In an event of a slowdown in the housing market, prepayments are expected to slow down 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 slowdown prepayments by 5% on 2004 vintages. The combined effect would be an increase in total cumulative losses by 35-40% in a HPA slowdown scenario. However, bonds are partly protected since the excess spread available to offset losses increases due to slower prepayments.
Predatory Lending/Servicing

... both on the prepayment and credit front

The subprime market has been put under increasing scrutiny for predatory practices

The subprime business has been put under increasing scrutiny for issues around various predatory practices. The common predatory lending practices that have been questioned are charging high interest or fees, including excessive prepayment penalties, extending loans beyond the borrower’s financial ability to repay, refinancing a loan despite the lack of benefit to the borrower (flipping) etc. In addition, predatory servicing issues have led to probes into the practices at major subprime servicers such as Fairbanks and Ocwen. The second largest servicer, Fairbanks, was downgraded three full grades to “Below Average” and paid $40 million in settlement claims to its regulator (OTS) relating to questionable servicing practices. HEL transactions are at risk due to assignee liability provisions attached to certain predatory lending statutes. Assignee liability permits a borrower to hold the purchaser or assignee liable for the same penalty as the original lender. The magnitude of the problem has been increasing since certain state laws contain unlimited assignee liability provisions (uncapped penalties). Lenders have been adjusting to a patchwork of evolving local, state and federal regulations enacted to address the issue. The problem has been 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 vague around the categories of loans covered by the statute.

The risk for HEL transactions has been increasing due to assignee liability provisions

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Lehman Brothers | MBS & ABS Strategies

The ABCs of HELs

These concerns have impacted rating agency criteria ...

Rating agencies have also been amending their criteria to protect transactions against predatory lending liabilities. Transactions containing loans with assignee liability require additional credit enhancement due to the risk of potential liabilities (Figure 29). Loans from jurisdictions that carry unlimited potential liability or with vague statutory violation clauses are typically not included in transactions. Agencies also rate the ability of lenders to implement compliance procedures to minimize violations. Lenders are usually required to make representations regarding the compliance of the securitized loans and warranty repurchasing loans that violate statutory provisions.

Figure 29.

Factors to Assess Potential Liability from Predatory Statutes

Scope of the statute: The loans covered by the statute should be identified. The statute should clearly distinguish between those loans that are covered and those that are not. Assignee liability test: For any type of loan under its scope, the statute should be examined to see if it imposes assignee liability. If the statute does not carry assignee liability, then the cashflow of the trust is not available to meet any potential liabilities due 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 be established. It should be determined if monetary damages are limited to a dollar amount or if they are uncapped (unlimited assignee liability). Rating agencies only allow loans to be included in transactions when they carry either no assignee liability or the risk associated with violating an anti-predatory lending law is quantifiable (limited liability). Safe harbors: The availability of certain provisions (for example, due diligence procedures) that a purchaser or assignee can implement to avoid liability (“safe harbors”) or limit the number of violations should be examined.

... and lending practices

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

Leverage has been increasing in the HEL market ...

The HEL market has witnessed limited credit performance in an environment of rising rates. With consumer leverage being high and consolidation of traditional forms of consumer debt (credit cards, auto loans) into mostly floating-rate mortgages, investors are concerned around credit performance as rates adjust higher. This risk has been further accentuated in the HEL market due to the shift towards credit levered products such as interest-only (IO) loans and piggyback seconds. Interest only (IO) mortgages have exploded in popularity over the past couple of years and account for around 15-20% of 2004 originations. There has been concern around IO performance due to the potential for a double payment shock (rate reset and amortization reset). This is accentuated for loans where the IO period coincides with the initial fixed-rate period, leading to a simultaneous double shock for the borrower. The trends in IO issuance characteristics also point to an increase in risk:

... with the proliferation of IO loans

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Lehman Brothers | MBS & ABS Strategies

The ABCs of HELs

• •

IO terms have been shortening, and increasing percentages have the IO period coinciding with the initial fixed-rate period. Initial IO originations had significantly superior credit characteristics (higher FICO, loan documentation, loan size) than hybrids However, these differences in borrower 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 borrowers toward IOs.

The risk is mostly from higher foreclosure frequencies and limited on the severity front

The additional risk of IO loans has been partly factored in by the rating agencies, with Moodys demanding additional 15-20% credit enhancement for IO loans. We believe that the risk is more pronounced when the IO period coincides with the initial fixed-rate period leading to a double payment shock for borrowers. The risk is mostly from higher foreclosure frequencies and limited on the severity front. SUMMARY The HEL market has grown rapidly over the last three years to form the largest segment of the ABS market. The analysis of HEL securities involves a careful analysis of the interaction between collateral performance (credit and prepayment) and structural features. The wider spreads in the sector are explained by this combination of prepayment and credit features which positions it as a unique cross-over sector between the mortgage and asset backed sectors. The next few years will test the maturity and depth of the HEL market due to potential structural and credit risks from rising interest rates, leverage to the housing market and an evolving regulatory environment.

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Lehman Brothers | MBS & ABS Strategies

The ABCs of HELs

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
Surveillance

New Surveillance Tools on LehmanLive SAIL/ARC Tracker

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Lehman Brothers | MBS & ABS Strategies

The ABCs of HELs

GLOSSARY Assignee Liability: A liability that attaches to a purchaser or assignee of a loan (including a securitization trust) by virtue of holding a predatory loan. Typically, statutes with assignee liability permit a borrower to hold the purchaser or assignee liable for the same penalty as the original lender. The potential assignee liability may sometimes exceed the original principal balance of the loan. Buy-Down Points: Feature by which borrowers can reduce their interest rates as well as their monthly payments by paying an additional amount upfront. From the lender’s point of view, it gives them cash up-front during securitization. Cleanup Call: Most deals have a provision of providing the residual holder with an optional clean-up provision to call the bonds when the bond principal balance reaches a certain percentage of the initial collateral balance (typically 10%). Closed-end Loan: The loan type where the borrowed amount is fixed and determined at origination. This is contrasted with revolving lines of credit which enable the borrower 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 mortgage insurance, 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 the event of default by the borrower. A second-lien receives any residual proceeds from the sale of the house after the first-lien holder is paid in full. Loan extension/Loan modification: Renegotiating the contract terms to enable borrowers to make regular payments. In extensions, the loan period is extended by adding the missed payments to the end of the loan period. Loan modifications involve changing the coupon 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 through techniques such as loan extensions, modifications, loan assumptions etc. This enables a delinquent loan to renew payments and return to current status. Monoline Gaurantee: A financial guarantee issued by a AAA-rated corporation covering the timely payment of principal and interest on a security. Over-collateralization: The difference between the collateral balance backing the deal and the total principal balance of bonds outstanding. This serves as a form of credit enhancement 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 sale by the delinquent borrower, even if it implies a small loss for the trust. The servicer choice is based on a NPV analysis comparing the cost of the foreclosure, REO disposition and future missed payments against the immediate loss. The trust is usually better off with this exit strategy as the liquidation of the delinquent loan is fast and cheap.

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Lehman Brothers | MBS & ABS Strategies

The ABCs of HELs

Triggers: Conditional tests that determine the priority and order of payments to the various tranches in the event of deterioration of collateral performance. These trigger events are typically based on credit performance parameters such as rolling three-month 60-day delinquencies and cumulative losses. A deal is said to be failing triggers if any of the specified triggers fail due to poor credit performance.

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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 or indirectly 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 copies of these reports and their certifications, please contact Larry Pindyck (lpindyck@lehman.com; 212-526-6268) or Valerie Monchi (vmonchi@lehman.com; 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’s interests 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 other things, 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 banking clients of Lehman Brothers or companies for which Lehman Brothers would like to perform investment banking services.
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