LO 36.6: Describe the relationship between the credit ratings cycle and the

LO 36.6: Describe the relationship between the credit ratings cycle and the housing cycle.
The goal of the rating system is to rate through-the-cycle, meaning that there should not be excessive upgrades (downgrades) if the housing market heats up (slows down). A problem may arise if the agency assigns, say, an AAA rating during a boom period. As the housing market slows down, the probability of default increases and the security has migrated to AA even though the agency has not made a public pronouncement. The problem is further exacerbated if new deals are based on the credit enhancements from the AAA rating in the boom period.
As economic conditions change, it is expected to see some upgrades or downgrades in mortgage-backed securities. However, the effect may amplify up and down markets. For example, in a downward trending market, additional enhancements are needed to maintain the highest ratings. This crowds out the credit available for lower rated borrowers increasing the required loan rate or raising qualification standards. The opposite is true for housing upturns freeing up credit for lower rated borrowers.
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Topic 36 Cross Reference to GARP Assigned Reading – Ashcroft & Schuermann
Cash Flow Analysis o f Excess Spread
In the ratings process it is necessary to simulate the cash flows of the structure to forecast the degree of excess spread used for credit enhancement. As you can imagine, the forecasts are complex and depend on several interrelated factors including credit enhancement, timing of losses, prepayment rates, interest rates, trigger events, weighted average loan rate decrease, prepayment penalties, pre-funding accounts, and hedging instruments. The more important factors are discussed as follows.
First, the credit enhancement identifies the amount of collateral that can be impaired before the tranche suffers an economic loss. The timing of losses is also important because as losses accumulate, less excess spread will be available. A more conservative approach would front-load the losses. Prepayments will directly impact the excess spread. Prepayments may be voluntary (refinance, sales) or involuntary (default) so the prepayment assumption directly impacts the cash flow analysis. Prepayments typically follow the CPR (conditional prepayment rate) convention. However, it is important to note that hybrids will have higher than predicted defaults on or about the reset date due to the sudden change in rates and financial condition of the subprime borrower. A more conservative view would accelerate prepayments reducing further interest collections. Finally, the path of interest rates introduces uncertainty into the projected cash flow stream. Interest rates determine the adjustments (i.e., cash inflows), and influence refinancing.

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