Securitizations. DBRS Rating Criteria for U.S. Residential Mortgage-Backed Securities: Default. Dominion Bond Rating Service DECEMBER 2004

Transcription

1 Securitizations Dominion Bond Rating Service DBRS Rating Criteria for U.S. Residential Mortgage-Backed Securities: Default DECEMBER 2004 SUSAN KULAKOWSKI MICHAEL NELSON KEN HIGGINS QUINCY TANG

2 Table of Contents Executive Summary 1 Primary Frequency Drivers: Credit Score and LTV 1 Base Frequencies for Various LTVs 2 Other Characteristics affecting Frequency 2 Mortgage Product 3 Amortization & Term to Maturity 3 Interest Resets 4 Interest-Only Features 5 Loan Purpose 5 Documentation 6 Grade 7 Occupancy 7 Property Type & Ownership Interest 8 Conclusion 8 Appendix 9 Payment Shock Comparison Table: Hybrids and IOs

3 EXECUTIVE SUMMARY In this document, Dominion Bond Rating Service ( DBRS ) analyzes mortgage default frequency as part of its rating methodology for securitizations of U.S. residential mortgages. This methodology discusses how the characteristics a borrower, a mortgage, and a property serve to increase or decrease the likelihood of mortgagor default as devised and employed by DBRS in its RMBS model. PRIMARY FREQUENCY DRIVERS: CREDIT SCORE AND LTV The combination of LTV and credit score is fundamental to the analysis of risk in residential mortgage-backed securities. This pair impacts both the frequency of default and the severity of loss after default. Both are strongly correlated with mortgage default rates. LTV is positively correlated - the higher the LTV, the greater the default rate. The credit score itself, however, is negatively correlated - the lower the credit score, the greater the default rate. The higher the LTV, the greater the default risk. The converse may provide a more satisfactory illustration of why this is true. The lower the LTV, the greater the borrower s investment in the property and the greater the variety of refinance/resale opportunities available. Both serve to lower the default rate. Essentially a larger down payment is a larger financial (and emotional) commitment; second, it serves to lower the monthly payment; and, finally, it affords the borrower a greater opportunity to refinance or sell the property, should the borrower run into financial difficulties. The lower the credit score, the greater the default risk. Again, the converse may provide a more satisfactory insight into the dynamics of this relationship. The higher the credit score, the better the borrower s financial management skills. Credit score and loan-to-value ratio (LTV), as a pair, are the primary drivers of mortgage default frequency. A mortgage product is identified by its defining components: term to maturity, amortization term, interest-only features, and the nature of interest paid. Loan purpose and documentation standards are handled as continuous variables based on credit score. Borrower grade, occupancy, and property type are discrete variables that influence default frequency. Better financial management skills suggest that the borrower is not only financially savvy but also likely to have more substantial savings on hand. Consequently, the borrower will be able to make a larger down payment and maintain a financial cushion of at least several months to fall back upon should the borrower run into financial difficulties. In addition to having strong correlations with mortgage default rates, LTV and credit score tend to move together towards greater or lesser default risk. That is, a borrower with a higher LTV, indicating a greater risk of default, is more likely to have a lower credit score, also indicating a greater risk of default. Similarly, a borrower with a lower LTV, indicating a lesser risk of default, is more likely to have a higher credit score, also indicating a lesser risk of default. The LTV ratio has historically been and remains an important variable in estimating default risk. Credit score, although brought into widespread use in the mortgage lending industry only within the past eight years, has become an equally important variable. These two variables are used in tandem within the DBRS RMBS model: the credit score provides the exponential shape of the default curve while the LTV sets the level of the default curve for each rating category. Residential Mortgages DOMINION BOND RATING SERVICE Information comes from sources believed to be reliable, but we cannot guarantee that it, or opinions in this Study, are complete or accurate. This Study is not to be construed as an offering of any securities, and it may not be reproduced without our consent.

4 DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page 2 BASE FREQUENCIES FOR VARIOUS LTVS The following four charts present the base default frequency risk for various combinations of LTVs and credit scores. They assume that the mortgage is an otherwise vanilla mortgage, i.e., a 30-year fixed-rate, purchase money mortgage on an owner-occupied single family house, underwritten to a full doc standard. Historically, LTV has been a popular and quite useful measure of default risk because its inverse, home-owner s equity, represents the borrower s initial financial commitment to the property. During the past five to eight years, FICO has become widely used in predicting default rates. It is also quite useful in predicting defaults as it is a good indicator of a borrower s general propensity to meet the obligations on a timely basis. The combination of LTV and FICO is more powerful than either individually. Base Default Frequency for Various LTVs Assuming FICO of 820 Base Default Frequency for Various LTVs Assuming FICO of % 2.5% 14.0% 12.0% Base Default Frequency 2.0% 1.5% 1.0% AAA AA A BBB Base Default Frequency 10.0% 8.0% 6.0% 4.0% AAA AA A BBB 0.5% 0.0% 100% LTV 90% LTV 80% LTV 70% LTV 60% LTV BB B 2.0% 0.0% 100% LTV 90% LTV 80% LTV 70% LTV 60% LTV BB B Base Default Frequency for Various LTVs Assuming FICO of 720 Base Default Frequency for Various LTVs Assuming FICO of % 30.0% 9.0% 8.0% 25.0% Base Default Frequency 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 100% LTV 90% LTV 80% LTV 70% LTV 60% LTV AAA AA A BBB BB B Base Default Frequency 20.0% 15.0% 10.0% 5.0% 0.0% 100% LTV 90% LTV 80% LTV 70% LTV 60% LTV AAA AA A BBB BB B OTHER CHARACTERISTICS AFFECTING FREQUENCY In addition to LTV and credit score, several additional characteristics are important to assess default risk. These include the mortgage product itself, loan purpose, documentation standard, borrower grade, occupancy, and property type. The discussion that follows begins with mortgage product, the most crucial characteristic after LTV and credit score.

5 DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page 3 MORTGAGE PRODUCT To comprehensively estimate the default risk of any particular loan, the DBRS RMBS model estimates a default risk for each component of a mortgage. These components include amortization, interest resets, and interest-only periods. Once the default risk for each component is estimated, the RMBS model multiplies these together to estimate the default risk for the entire mortgage. Historically, mortgage lenders offered two basic types of mortgage products - fixed rate mortgages (FRMs) and adjustable rate mortgages (ARMs). FRMs are fully amortizing loans, offered with either a 15-year maturity or a 30-year maturity. Of these, 15-year FRMs have historically performed exceptionally well, with base default expectations of 1.25% or less for two reasons. Fifteen-year FRM borrowers tend to be the most creditworthy borrowers and 15-year FRMs tend to have lower LTVs. Alternatively, a base default expectation of about 2.25% is reasonable for 30-year FRMs, which was the most commonly offered mortgage product until recently. In contrast, traditional ARMs with annual (or more frequent) resets have not performed nearly as well, with base default expectations about two times as high. In recent years, mortgage lenders have expanded the available options for adjustable rate mortgages to include longer initial fixed periods of two to ten years (hybrid ARMs) and interest-only periods, which may or may not coincide with the longer initial fixed period (IO hybrids). Balloon loans, either partially amortizing or interest only, and negatively amortizing ARMs are less common today. Amortization & Term to Maturity Frequency Factor Frequency Benefit for Fully Amortizing Mortgage Loans Amortization Term in years Whether a mortgage loan fully or partially amortizes is key to understanding default risk. A fully amortizing loan pays both principal and interest with a monthly mortgage payment calculated so that the loan amortizes completely over its life (i.e., the amortization term is equal to the term to maturity). It may pay either a fixed or an adjustable coupon. Fully amortizing loans with terms to maturity of less than 30-years have historically performed better than 30-year mortgage loans. The DBRS RMBS model provides a benefit for shorter amortization periods. Regardless of credit sector, a 15-year fully amortizing loan has about 80% of the default risk of a 30-year fully amortizing mortgage loan. While short amortization terms (12 years or less) are likely to perform well within securitized mortgage pools because they amortize so quickly, DBRS s estimates of default frequency do not provide for any reduction in default expectation for these loans. Three other amortization schedules are possible. Increasingly popular is an IO-type amortization. These mortgages marry a short-lived interest-only mortgage to a fully amortizing mortgage with a substantially longer life. Most often, the initial interest-only period will be two to ten years, while the subsequent fully amortizing period will range from 28 to 20 years. For mortgage loans that include an initial IO period, the DBRS model does not extend any amortization benefit for subsequent, faster amortization. The two other amortization schedules - balloons and negative amortizing ARMs - are less common. Balloon mortgages are one possibility with two variations: partially amortizing or interest-only. The partially amortizing balloon is a mortgage loan that pays principal and interest like a long-term fully amortizing mortgage, but matures before the amortization schedule would bring the outstanding principal balance to zero. The most common partially amortizing balloon is a 15/30 balloon, which pays monthly principal & interest (P&I) like a 30-year fully amortizing loan but which requires a final payment of all principal due at the end of 15 years. For the purposes of mortgage-backed securities, any partially amortizing balloon mortgage with an amortization schedule of 30 years and a term to maturity of ten years or longer will behave like its fully amortizing cousin. Balloons with quick amortization schedules will benefit from the rapid amortization, although the amortization benefit will be smaller than it would be otherwise for a fully amortizing mortgage loan. Balloons that mature quickly increase default risk, especially if the final payment comes due during the peak default years (three to five). In general, the longer the maturity and the longer the maturity in relationship to the amortization, the less risky the mortgage. The other type of balloon mortgage that is only rarely offered as a first lien mortgage is the interest-only balloon. These mortgages pay only interest and require repayment of the full principal balance at maturity. To the extent that lenders offer interest-only mortgages, they direct these mortgages to the most creditworthy, who use these mortgages as financing tools. The final possibility for amortization is negative amortization, which adds unpaid accrued interest to the principal balance, causing the outstanding loan balance to grow. Negatively amortizing mortgage loans performed very badly during the 1990s and are infrequently offered today. Within the RMBS model, the frequency factor for loans that permit negative amortization is 1.2 times.

6 DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page 4 A variation occasionally seen is the mortgage that offers the borrower a choice of up to three different monthly payments. These are: (1) a fully amortizing payment; (2) an interest-only payment that covers interest, but excludes any principal payment; or (3) a minimum payment that is less than the interest-only payment, adding accrued interest to the unpaid principal balance and negatively amortizing the mortgage balance. Most lenders that offer such choices to borrowers report that the vast majority of borrowers opt for the fully amortizing or interest-only payment and not the negatively amortizing minimum payment. In practice, these mortgages have to date performed better than the negative amortizing ARMs of the 1990s, but some default risk remains. To the extent that financially troubled borrowers opt for the minimum payment and do negatively amortize a mortgage, negative amortization can be disastrous if property values fall below the outstanding principal balance. Interest Resets Frequency Factor. Frequency Factor Frequency Penalty for Adjustable Rate and Hybrid Mortgage Loans Time to First Reset in months Frequency Penalty for Various Interest-Only Periods Interest-Only Period in years The nature of the mortgage coupon also reflects default propensity. The standard American mortgage that was securitized into the secondary market was, until the early- to mid-1990s, a 30-year fully amortizing mortgage, either fixed rate or adjustable rate, with either a 20% down payment or a smaller down payment and mortgage insurance offering coverage down to 80% or less LTV. During the 1990s, adjustable-rate mortgages (ARMs) were increasingly offered into the secondary market (although ARMs were available well before the 1990s, as indicated by Freddie Mac s decision to add the one-year ARM to its Primary Mortgage Market Survey in 1984). The willingness of lenders to make ARMs available to borrowers increased the base of mortgages because: (1) lenders were often willing to qualify borrowers at exceptionally low teaser rates, which are good until the first interest rate reset, and (2) by generally lowering initial interest costs. Because the interest costs for ARMs were (and remain) lower than the 30-year fixed rate mortgages (at least at the time of origination and ignoring the possibility of interest rate increases), the borrowers taking these mortgages were generally those less able to qualify for 30-year fixed rate mortgages, i.e., generally less creditworthy borrowers. ARM borrowers, therefore, remain more likely to default than their fixed rate borrower counterparts. This occurs for three reasons. First, ARMs are initially cheaper than FRMs so less financially stable borrowers are more likely to qualify for an ARM. Second, although the past 15 years have witnessed exceptional declines in interest rates, interest rates on ARMs sometimes do index upwards to higher rates. Third, lenders in the past were particularly generous in qualifying borrowers for ARMs, often offering exceptionally low teaser rates through the first interest rate reset and qualifying borrowers at the teaser rate rather than the more costly fully-indexed rate. These first two reasons combine to explain payment shock, the rude awakening experienced by borrowers (and lenders alike) when the borrower s monthly payment resets beyond the borrower s ability to pay it. The third, qualifying borrowers at even lower teaser rates, also explains poor historical performance. Hybrid ARMs, which combine fixed and adjustable interest characteristics, have become common in securitizations during the past five years. These adjustable rate mortgages combine an initial fixed rate period of two years or more (differing from the traditional ARM that generally resets every one, six, or 12 months) with usually annual rate and payment resets thereafter. Borrowers who assume hybrid ARMs tend to self-select much the way fixed rate and adjustable rate borrowers self-select. Financially stronger borrowers tend toward hybrids with longer initial fixed periods, say five to seven or more years. Financially weaker borrowers tend toward hybrids that reset at the two- or three-year mark. Overall, hybrid ARMs represent increasing segmentation within the mortgage market. With hybrid ARMs, lenders can offer relatively cheaper rates to borrowers who prefer longer periods of payment stability. At the same time, with hybrid ARMs, lenders can offer relatively longer periods of fixed interest costs to borrowers who would otherwise prefer traditional ARMs.

7 DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page 5 The crucial feature in identifying the additional default risk represented by the mortgage coupon is the length of the initial fixed period. A fixed rate mortgage, the least risky option, never resets. Because this borrower will never face payment shock, the default frequency factor for fixed rate mortgages is 1.0 times. An ARM, on the other hand, may experience its first reset anytime between one month after origination and ten years out. Within the RMBS model, this risk is represented by an equation that starts at a factor of 1.5 times for any mortgage that resets within the first 12 months, decreases as the initial fixed period lengthens, and, by six years, falls to a factor of 1.0 times, representing a risk equivalent to the risk of a fixed rate mortgage. Interest-Only Features During the past five years, mortgage lenders have offered 30-year mortgages that begin with an interest-only period (typically two to ten years), followed by a fully amortizing loan for the remainder of the 30 years (i.e., the remaining 28 to 20 years). The interest-only period brings an additional level of risk to the mortgage. Although the amount of foregone principal amortization is minimal, the IO borrower faces twice as many payment shocks as faced by a fully amortizing ARM borrower. In addition to the risk of payment shock caused by increases in interest rate - which the fully amortizing ARM borrower must face - the IO borrower will face a large payment shock when principal first comes due. The payment shock will be large even if interest rates remain unchanged because the principal payment required will be relatively large, given that the amortization term is shorter than 30 years. Despite the fact that amortization will be quick during the subsequent fully amortizing period, the RMBS model provides no amortization benefit to any loan that includes an initial interest-only period. (For more information, see Appendix). Within the RBMS model, interest-only mortgages have different penalties depending on the term to maturity. IOs with a shorter 15-year maturity carry a larger frequency factor than do loans with a 30-year maturity. This occurs because the short term to maturity requires a relatively much larger principal payment, increasing the likelihood of payment shock when principal first comes due. Whether the term to maturity is 15 or 30 years, the risk of payment shock is greatest for interest-only loans with short initial fixed rate periods (less than five years). Not only may interest rates reset upwards, increasing default risk, but for short IO periods, the first principal payments also come due during the period of greatest default risk (years three to five). For intermediate term interest-only loans, the default risk lessens simply because the borrower has more opportunities during the intervening years to sell or refinance. In addition, although housing prices may fall after loan origination and remain depressed for extended time frames, it is unlikely that a property ten years after it was originated would be worth less than it was at origination. For the longest term interest-only loans, information on historical performance is limited and increasing default frequency factors reflect a conservative bias. LOAN PURPOSE Borrowers historically assumed mortgages to purchase homes. However, the past 12 years have witnessed great cycles of refinancings as mortgage interest rates fell from highs of more than 10% on 30-year FRMs in 1990 through the 40-year lows of mid These cycles of falling rates (coupled with improved automated underwriting engines and low/no cost refinance opportunities) fostered large increases in the numbers of both rate/term refinances and cash-out refinances. The base loan purpose is purchase, with a default frequency factor of 1.0 times. Purchases are the least risky of all loan purposes, including rate/term refinances, for a variety of reasons. The primary reasons are solid property valuation, borrower equity, and motivation. One of the risks in originating mortgages is that a property may be overvalued, i.e., in the event of liquidation, the servicer may not be able to sell the property in order to satisfy the outstanding mortgage obligation. Mortgage Interest Rate Environment Frequency Penalty for Loan Purpose 10.0% 9.0% Interest Rate. 8.0% 7.0% 6.0% 5.0% 4.0% Frequency Factor % Sep-93 Sep-94 Sep-95 Sep-96 Sep-97 Sep-98 Sep-99 Sep-00 Sep-01 Sep-02 Sep-03 Sep Credit Score 30PMMS 10yrCMT Rate/Term Refinance Cash-out Refinance Purchase

8 DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page 6 First, with an arm s length transaction between an independent buyer and seller, there is little uncertainty as to the value of the property, which should be very close to true market value, minimizing the risk of overvaluation. Second, while the down payment made by the borrower may be large or small, at the time of origination, an active cash investment is being made in the property by the borrower. If the borrower either makes no down payment (100 LTV at origination) or borrows more than the value of the property through a high LTV program, this advantage for purchase money mortgages disappears. Refinance mortgages are riskier than purchase money mortgages, whether the refinance is a rate/term refinance or a cash-out refinance. That is because refinance mortgages share none of the advantages of purchase money mortgages. First, because there is no sale, there is no true property value, i.e., no value that satisfies buyer, seller, and appraiser. Second, no down payment is required (and, in fact, with a cash-out mortgage, the property provides cash to the borrower), making the refinance process more of a financial transaction and less of an active commitment to the property, essentially turning the home into a financing vehicle. Although refinancings are in general riskier than purchase money mortgages, the risk varies by credit sector. In the prime sector, purchase money mortgages and rate/term refinances are the two most common loan purposes and perform similarly. In contrast, sub-prime borrowers are more likely to assume cash-out refinances, which do not perform as well as purchase money mortgages. The DBRS model uses continuous equations based on borrower credit score to calculate default factors for both rate/term and cash-out refinances. The frequency factors for rate/term refinances range from 1.2 times for borrowers with high credit scores to 1.5 times for borrowers with weak credit scores. Intuitively, this is DOCUMENTATION A lender may require four types of verifications: verification of mortgage (or rental) payment (VOM), employment (VOE), income (VOI), and deposits and/or assets (VOD/VOA). Twenty years ago, a lender collected these using standard government-sponsored enterprise (GSE) forms from mortgagee, employer, and depository. Today lenders accept alternate forms provided by the borrower or other sources. Existing mortgage obligations generally appear on the borrower s credit report. The lender phones the employer near closing to verify employment while the borrower submits pay stubs, W2s, and tax returns to verify current and annual income. Borrowers can submit two bank statements to verify deposits. Verifications vary across the credit spectrum. While prime borrowers generally obtain full doc mortgages - especially for purchase money mortgages - lenders offer prescreened programs, with very minimal requirements, to borrowers with strong credit on low risk transactions. Except for these lender-offered programs, less-than-full-doc appealing because the penalty is modest for strong credits and more substantial for weaker credits, although rate/term refinances may be slightly riskier overall. In direct contrast, the frequency factors for cash-out refinances range from more than two times for borrowers with high credit scores, to 1.6 times for borrowers with weak credit scores. That is, the stronger the borrower, the larger the penalty for a cash-out refinance. Two points of the analysis warrant discussion: the similarity between the two refinance purposes for sub-prime borrowers and the dissimilarity between the two for prime borrowers. Firstly, for the weakest borrowers, the difference between a rate/term refinance (1.5 times factor) and a cash-out refinance (1.6 times factor) is slim. This occurs because, given the fundamentally high credit risk in sub-prime, there is little additional deterioration in performance for cashouts. Even when a mortgage loan made to a sub-prime borrower is labeled rate/term refinance, it is more likely to be a refinance of an existing cash-out mortgage than of a purchase money mortgage. In addition, because property valuations are more likely to be pushed for sub-prime mortgages, and especially for higher LTV sub-prime mortgages, substantial uncertainty about the actual homeowner s equity remains, whether the mortgage is a rate/term or cash-out refinance. Secondly, the substantially higher cash-out penalty for the strongest credit borrowers applies not only for discussion of loan purpose, but also for documentation standards. Prime borrowers have the ability to cost effectively borrow without having to assume a larger, long-term mortgage burden, so prime cash-out refinances are relatively rare. To the extent that prime borrowers re-mortgage into cash-out refinances, it seems that these prime borrowers are adversely self-selecting, extracting equity from their homes. The default performance of these mortgages is worse than for any other purpose, indicating a larger penalty is warranted. prime mortgages are relatively rare. The Alt-A channel includes prime borrowers unwilling or unable to meet full doc requirements ( less-than-full is a distinguishing characteristic of Alt-A ). A sub-prime borrower has a wide range of programs to choose from, some of which require very minimal documentation (although at a higher price to compensate the lender for the increased risk). If a verification is completed in a manner that meets the GSE full doc standard, that verification is met. A full doc or an alt doc, then, would have all four verifications (VOM, VOE, VOI, and VOA/VOD) completed in a way that meets the full standard of the GSEs for manually underwritten mortgage loans. For programs with less stringent requirements, DBRS evaluates the verifications separately. For example, a stated income, stated assets program, while not authenticating income or assets, will still require VOM and VOE.

9 DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page 7 A lender s documentation code is open to interpretation. It condenses a complex set of rules into a single statistic used outside of the lending institution by users without first-hand knowledge of the rules by which it was evaluated and the credit culture under which it was determined. The following table presents three common doc programs and DBRS codes. Informed judgment will at times be required to map an originator s doc codes into a standardized form, as is also true for borrower grades. A preponderance of exceptions across the verifications will lead to a code that is lower, even if each verification is marginally satisfied. increasing doc penalty occurs because the less documentation completed as part of the mortgage application process, the greater the uncertainty about the borrower s financial stability and the propensity to pay. Although documentation mainly serves to establish the borrower s current financial and employment circumstances and does not necessarily predict the borrower s future circumstances, a borrower with a generally stable income stream historically, employment record, and ability to save is likely to continue to demonstrate these characteristics in the future. Program "Stated Income" "No Ratio" "No Income, No Assets" DBRS Code 3 2 or 3 2 Mortgage GSE GSE GSE Employment GSE GSE GSE Income Not Verified Not Verified Not Verified Assets/ 1 or 2 bank Not GSE Deposits statements Verified Frequency Factor Frequency Penalty for Various Documentation Standards As with loan purpose, the frequency penalty for documentation programs is continuous based on borrower credit score. Importantly, the frequency penalties for reduced documentation increase as the borrower credit score improves, as does the penalty for cash-out refinances. The Credit Score Full Doc 3 Complete Verifications 2 Complete Verifications 1 Verification or None GRADE DBRS s analysts generally use the following guidelines to standardize borrower grades. An A borrower has been not more than 1 x 30 days delinquent within the past year and has no bankruptcy or foreclosure within the past seven years. An A- borrower has been perhaps as much as 2 x 30 days delinquent, but not 60 days delinquent and has no bankruptcy or foreclosure within five years. A B-grade borrower may have been 1 x 60 days delinquent and has no bankruptcy or foreclosure within two years. A C-grade borrower is a borrower who may have been 1 x 90 days delinquent (or worse) or who may have declared bankruptcy or suffered a foreclosure within the past year. A grade of A is the base borrower grade. Its factor is 1.0 times. The DBRS frequency factor for a grade of A- increases to 1.2 times, 1.35 times for a B-grade, and 1.5 times for a C-grade. To the extent that guidelines offer different mixes of allowable delinquencies, recency of bankruptcy, or other features, an analyst must review available performance data or, if there is no reliable data, make a thoughtful judgment based on known performance. OCCUPANCY Owner-occupancy is the base occupancy status. Its default factor, like the factors for all other base statuses, is 1.0 times. An owner who lives in the mortgaged property is more likely to be financially committed to the property and more likely to be attentive to the maintenance needs of the property. Both investor-owned properties and second homes are, all else equal, more likely to experience a default. In practice, however, because investor properties and second homes are subject to more stringent lending guidelines and additional underwriting scrutiny during the application process, their historical performance has been good for carefully underwritten programs. For an individual who buys a property as an investment, the financial commitment to the property may be as strong as an owner-occupier s commitment. However, the property itself does not fulfil the investor s/borrower s immediate, basic need for housing and the investor may be dependent on rental income to cover the mortgage and other payments. In addition, to the extent that renters are not as financially or emotionally committed to the property and given the investor s more distant contact with the property s maintenance needs, an investor-owned property is more likely to be poorly maintained. As it is by nature an investment, subject to investment return goals and reflecting a certain appetite for risk, vacancy and/or rental market risk may alter the likely investment outcome, property value, and the borrower s interest. The frequency factor for investor-owned properties is 1.7 times. Similarly, a second home represents a secondary commitment on the part of a mortgagor. Although the

10 DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page 8 borrower may make a strong commitment to a second home, it again does not satisfy an immediate, basic need for housing. Given the choice between making the mortgage payments on a primary residence and a second home, almost all borrowers would choose to maintain their primary residences. The frequency factor for second homes is 1.2 times. PROPERTY TYPE & OWNERSHIP INTEREST The final characteristic evaluated for default frequency is property type and ownership. Detached single-family homes, the most common property type in the U.S. housing market, form the base property type. Its default factor is 1.0 times. The default factor increases to the extent that the property houses more than one family (multi-family properties) or that ownership is somehow shared and an individual mortgagor is financially tied to neighboring properties (condominiums, co-operatives). Increased frequency factors also apply to manufactured housing units. Within the DBRS model, all property types that house a single family and are fee simple ownership have a default factor of 1.0 times. Property types that qualify include planned unit developments (PUDs), diminimus planned unit developments (dpuds), and townhouses. A condo or co-op, although intended as single-family housing, differs in that a mortgagor buying a condominium or co-operative is tied to the neighboring units for the financial and physical maintenance of the larger building in which the unit resides. This co-dependency creates additional default risk, which is especially apparent in circumstances where the larger building association is financially troubled even though the individual unit owners are not. To account for this increased risk, the DBRS factor for both condominiums and co-operatives is 1.5 times. Small multi-family buildings of four or fewer housing units represent somewhat greater default risk. These buildings are frequently purchased by individuals who occupy one unit as a primary residence and rent the remaining units. As the number of units increases, the mortgage burden rises, increasing the owner-occupier s dependence on rental income to cover mortgage and other building payments. The DBRS default factor for two-family buildings is 1.15 times, for three-family buildings is times, and for fourfamily buildings is 1.5 times. Finally, of all property types, manufactured housing (MH) carries the greatest default risk. The DBRS model distinguishes between single-wide MH, with a default factor of 2 times, and double-wide MH, with a default factor of 1.8 times. CONCLUSION The default risk of a 30-year fixed-rate purchase money mortgage, underwritten to a full doc standard, assumed by an A mortgagor who will occupy the single-family detached house as the primary residence may be simply estimated by evaluating the borrower s credit score in combination with the original LTV of the mortgage. As the characteristics of the mortgage move away from that base mortgage, default risk changes. Where possible, the DBRS model estimates the default risk for a continuous variable as a continuous function. To estimate the default risk of the various components of mortgage product, for example, the DBRS model uses equations to gauge the reduction in default risk as amortization term decreases, initial fixed hybrid period lengthens, or interest-only period extends. Similarly, variables with default risk that changes by credit score are evaluated by credit score. The primary driver of default frequency - the combination of credit score and original LTV - is built in this way. In addition, the default penalties for loan purpose and documentation also vary by credit score. Discrete characteristics, such as borrower grade, occupancy, and property/ownership type, are evaluated independently. This model is a tool used to evaluate the overall risk of a pool of mortgages destined for the secondary market based on the historical performance of similar pools. As such, it does not seek to capture qualitative differences in origination or servicing practices, nuances of the structural features of an MBS, or legal issues such as predatory lending requirements. For thoughtful analysis of issues like these and judgments regarding future performance, the rating process additionally includes the judgment and experience of the rating analysts and the rating committee.

11 DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page 9 APPENDIX Payment Shock Comparison Table: Hybrids and IOs The table below sets out four mortgage loans for comparison purposes. These are a 30-year fixed-rate mortgage, the base loan; plus a 5/1 IO hybrid, which carries an initial fixed rate for the first five years and pays interest only during that time; a 5/1 hybrid, which also carries an initial fixed rate for the first five years, but which is fully amortizing; and a 3/1 IO hybrid, which carries an initial fixed rate for the first three years and pays interest only during that time. The mortgage rates used were current at the end of September The end-of-september forward curve for six-month LIBOR was used to adjust the interest rates for the hybrid adjustable mortgages. For the purposes of this comparison, all hybrids were assumed to reset annually to the lesser of the prior rate plus 2% (i.e., a 2% annual interest rate cap) or the projected LIBOR rate plus a gross margin of 2.75%. While the overall cost of these mortgages after ten years of payments are not significantly different, at the reset dates, borrowers with adjustable rate mortgages can face significant payment shock in a rising interest rate environment. In addition, unless interest rates have fallen enough to offset the new principal payment, the IO borrower can experience payment shock when the first principal payments come due. All mortgage loans carry a term to maturity of 30 years and an original loan amount of $350,000. In addition, after the first reset, all hybrids reset annually. 30-yr FRM 5/1 IO Hybrid 5/1 Hybrid 3/1 IO Hybrid IO Period (months) none 60 none 36 1st Reset (months) fixed rate Amortization Term (months) Initial Interest Rate 5.28% 4.44% 4.30% 4.00% 30-yr FRM 5/1 IO Hybrid 5/1 Hybrid 3/1 IO Hybrid Interest Rate 5.28% 4.44% 4.30% 4.00% First Payment 2.17% 6-mos. New Monthly Payment $1,939 $1,295 $1,732 $1,167 LIBOR forward Increase over 30-yr FRM Payment curve $0 ($644) ($207) ($773) As % 30-yr FRM Payment 100% 67% 89% 60% Interest Rate 5.28% 4.44% 4.30% reset to 6.00% Starting 4th year 4.21% LIBOR Monthly Payment $1,939 $1,295 $1,732 $2,184 Increase over 30-yr FRM Payment $0 ($644) ($207) $245 As % 30-yr FRM Payment 100% 67% 89% 113% As % Original Payment 100% 100% 100% 187% Interest Rate 5.28% 4.44% 4.30% reset to 7.35% Starting 5th year 4.60% LIBOR Monthly Payment $1,939 $1,295 $1,732 $2,480 Increase over 30-yr FRM Payment $0 ($644) ($207) $541 As % 30-yr FRM Payment 100% 67% 89% 128% As % Original Payment 100% 100% 100% 213% Interest Rate 5.28% reset to 6.44% reset to 6.30% reset to 7.63% Starting 6th year 4.88% LIBOR Monthly Payment $1,939 $2,350 $2,108 $2,541 Increase over 30-yr FRM Payment $0 $411 $169 $602 As % 30-yr FRM Payment 100% 121% 109% 131% As % Original Payment 100% 181% 122% 218%

12 DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page yr FRM 5/1 IO Hybrid 5/1 Hybrid 3/1 IO Hybrid Interest Rate 5.28% reset to 7.92% reset to 7.92% reset to 7.92% Starting 7th year 5.17% LIBOR Monthly Payment $1,939 $2,674 $2,429 $2,606 Increase over 30-yr FRM Payment $0 $735 $490 $667 As % 30-yr FRM Payment 100% 138% 125% 134% As % Original Payment 100% 207% 140% 223% Interest Rate 5.28% reset to 8.09% reset to 8.09% reset to 8.09% Starting 8th year 5.34% LIBOR Monthly Payment $1,939 $2,710 $2,462 $2,640 Increase over 30-yr FRM Payment $0 $771 $523 $701 As % 30-yr FRM Payment 100% 140% 127% 136% As % Original Payment 100% 209% 142% 226% Interest Rate 5.28% reset to 8.30% reset to 8.30% reset to 8.30% Starting 9th year 5.55% LIBOR Monthly Payment $1,939 $2,756 $2,503 $2,685 Increase over 30-yr FRM Payment $0 $817 $564 $746 As % 30-yr FRM Payment 100% 142% 129% 138% As % Original Payment 100% 213% 145% 230% Interest Rate 5.28% reset to 8.34% reset to 8.34% reset to 8.34% Monthly Payment $1,939 $2,765 $2,512 $2,694 Starting 10th year Increase over 30-yr FRM Payment $0 $826 $573 $ % LIBOR As % 30-yr FRM Payment 100% 143% 130% 139% As % Original Payment 100% 214% 145% 231% Cum. Principal Payments $62,930 $27,707 $57,211 $35,969 At the end of ten years Cum. Interest Payments $169,777 $209,055 $190,890 $219,997 Inc. over 30-yr FRM Cum. Payment $0 $4,055 $15,394 $23,259 As % 30-yr FRM Cum. Payment 100% 102% 107% 110%