BkyCramDownArticle_01_30_09 by girlbanks

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									                                                                                                             January 30, 2009



The Potential Effect Of Proposed
Bankruptcy "Cram-Down"
Legislation On U.S. RMBS
Primary Credit Analysts:
Sharif Mahdavian, New York (1) 212-438-2412; sharif_mahdavian@standardandpoors.com
Matthew Maciaszek, New York (1) 212-438-2884; matthew_maciaszek@standardandpoors.com


Table Of Contents
Modification Efforts And Bankruptcy Law
Potential Judicial Modification Terms And Effects
Bankruptcy Carve-Outs
Going Forward
Notes




www.standardandpoors.com/ratingsdirect                                                                                           1
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The Potential Effect Of Proposed Bankruptcy
"Cram-Down" Legislation On U.S. RMBS
Standard & Poor's Ratings Services is monitoring proposed Congressional legislation that would permit
modification in bankruptcy proceedings of residential mortgage loans secured by principal residences. Such
proposed legislation, also called "cram-down" legislation, may affect the allocation of losses in U.S. residential
mortgage-backed securities (RMBS) transactions that securitize mortgage loans that the potential change in law
would address.

Standard & Poor's Ratings Services believes, based on our review to date, that these effects could include:

• Bankruptcy losses in RMBS transactions may become larger than the bankruptcy "carve-outs" (see box) that
  issuers typically structure into certain types of RMBS transactions. This could result in pro rata principal losses to
  all securities in such transactions. Because these carve-outs are not sized to accommodate the change in law that
  the proposed legislation contemplates, there could be a disproportionate effect on the cash flow to some senior
  securities, which may experience pro rata bankruptcy losses even though they are otherwise able to withstand
  traditional credit losses at the 'AAA' stress level.
• To the extent that such legislation permits the terms of residential mortgages on primary residences to extend
  beyond the legal final maturity date of the rated securities, we believe that some securities may fail to fully pay
  down before the transaction's legal final maturity. This may negatively affect the senior securities of transactions
  that experience severe subordinate security write-downs.
• If the modification of mortgage terms through bankruptcy proceedings becomes more prevalent, there may be
  similar write-down, rating, and "moral hazard" effects as those that our recent loan modification study describe,
  regardless of whether a transaction uses bankruptcy carve-outs (see "Scenario Analysis: The Potential Impact Of
  Loan Modifications On U.S. Residential Mortgage-Backed Securities," published Nov. 25, 2008, on
  RatingsDirect).



Modification Efforts And Bankruptcy Law
Chapter 13 of the U.S. Bankruptcy Code currently prohibits a debtor from modifying the terms of a mortgage loan
secured solely by his or her primary residence. Since 1993, the U.S. Supreme Court has interpreted this section of the
Bankruptcy Code to preclude modification of a mortgage loan secured, in whole or in part, solely by the debtor's
primary residence, including any modification of the rate, principal, or term of the mortgage loan, or any bifurcation
of the loan into a secured and unsecured portion with adjustment to either portion.

As a result of the current prohibition against the modification of mortgage loan terms for a debtor's primary
residence, bankruptcy losses in U.S. RMBS transactions have, in our view, historically been modest relative to
traditional credit losses given the substantial volume of such mortgage loans backing U.S. RMBS transactions that
could not be modified in bankruptcy. Standard & Poor's has historically based its bankruptcy loss estimates on
actual losses market participants have typically experienced, with what we believed to be due consideration to
existing law and legal precedents.

However, in an attempt to reduce foreclosures of residential property that distressed borrowers own, legislation has
been proposed in both the House and the Senate that would permit a debtor who files for bankruptcy under



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                                             The Potential Effect Of Proposed Bankruptcy "Cram-Down" Legislation On U.S. RMBS


Chapter 13 to propose a plan that includes any or all of the above types of modifications.



Potential Judicial Modification Terms And Effects
The currently proposed cram-down legislation would generally permit a Chapter 13 debtor to propose a plan that
includes the following regarding a mortgage loan on a debtor's primary residence (see note 1):

• Reducing the principal mortgage loan amount by bifurcating the loan into secured and unsecured portions, with
  the new principal amount of the mortgage loan equal to the market value of the property and the unpaid
  unsecured portion forgiven if the debtor satisfies the plan by making all payments for the bankruptcy plan period
  of three to five years;
• Changing the mortgage loan's interest rate by delaying or reducing interest on adjustable-rate loans, converting
  an adjustable-rate mortgage to a fixed annual percentage based on the most recent yields on conforming
  mortgages that the Federal Reserve has published (plus a "reasonable premium for risk"), or reducing the rate of
  a fixed-rate mortgage loan; or
• Extending the amortization term of the mortgage loan up to the longer of 40 years or the remaining term of the
  original loan.

In addition, there are other features of the currently proposed legislation that do not relate to the loan modification
process, but that we believe may increase the probability that a defaulted or likely-to-default mortgage will be
altered in a bankruptcy proceeding. These include:

• The exclusion of mortgage debt secured by a debtor's principal residence when a bankruptcy court determines
  whether the debtor's secured and unsecured debt burden exceeds the maximum allowable for a debtor seeking
  Chapter 13 protection, increasing the likelihood that more borrowers will qualify;
• The ability of the bankruptcy court to disallow a claim by a creditor that is subject to any remedy for damages or
  rescission by the debtor due to failure to comply with any Truth in Lending Act or state or federal consumer
  protection law; and
• Restrictions on the debtor's liability for any fees, costs, or charges arising from a debt secured by the debtor's
  principal residence and incurred while the bankruptcy case is pending.

Cram-down legislation currently being considered by Congress would apply only to loans outstanding before
enactment of the legislation.

The losses that occur from principal and mortgage interest rate reductions during a bankruptcy proceeding may be
comparable with losses from the loan modification process. The type of modifications and the success rate of
modified loans in bankruptcy typically determine what impact, if any, the RMBS security holders will realize.
Standard & Poor's previously analyzed the effect of various modification strategies and the potential effect on
ratings for sample transactions from the major mortgage product categories (prime, subprime, alternative-A (Alt-A),
and payment option adjustable-rate mortgage (ARM)). (See "Scenario Analysis: The Potential Impact Of Loan
Modifications On U.S. Residential Mortgage-Backed Securities," published Nov. 25, 2008, for the potential
implications on investors of various loan modification scenarios.)




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                                             The Potential Effect Of Proposed Bankruptcy "Cram-Down" Legislation On U.S. RMBS




Bankruptcy Carve-Outs
While losses resulting from loan modifications outside of bankruptcy are allocated according to the rules governing
traditional credit losses, losses from bankruptcy principal write-downs and other judicial modifications to the
secured lien may be allocated in certain transactions to all of the securities pro rata after the transaction reaches a
minimum threshold of bankruptcy losses. A number of securitized transactions that rely on subordination as the sole
means of credit enhancement have implemented these so-called bankruptcy "carve-outs" in the past. Typically, it
has been the prime RMBS (and some Alt-A RMBS) transactions that use the senior/subordinate structure. Few, if
any, subprime RMBS transactions included bankruptcy carve-outs.




While Standard & Poor's does not request the inclusion of bankruptcy carve-out limits in our rated transactions,
when such carve-outs have been included, Standard & Poor's typically has looked for minimum bankruptcy
carve-out amounts to allow allocation of losses to 'AAA' rated securities only in a 'AAA' stress environment. To
date, we have based these amounts on the current Bankruptcy Code and our view of bankruptcy loss experience.
Typically, we have sized these amounts at the larger of $100,000 or a percentage of the loans whose loan-to-value
ratio exceeded 75%. (See notes 2 and 3 for typical definitions related to bankruptcy carve-outs in transactions.)

Since mortgage loans secured solely by primary residences may not be altered in bankruptcy under current
bankruptcy law, there is a relatively small universe of loans that can be discharged or modified in such proceedings,
and historical experience reflects modest bankruptcy losses. However, the current bankruptcy carve-out sizes do not
account for the possible loan modifications that the proposed cram-down legislation may permit, which could, in
our view, expose typical U.S. RMBS collateral (generally backed by principal residences) to not only principal losses,
but also reductions in monthly payments (see notes 2 and 3 regarding Deficient Valuations and Debt Service
Reductions). We believe that, given typical bankruptcy carve-out sizes, such increases in bankruptcy losses could, in
short order, result in principal losses being allocated to the senior-most certificates.

For example, assuming a typical 2006 prime jumbo transaction that exhibits average collateral characteristics and
has a bankruptcy loss limit of $122,000, or 4 basis points (bps) of the outstanding current mortgage loan balance,
table 1 shows our expected principal bankruptcy losses across varying home price decline and bankruptcy scenarios.
In this example, we assume that the loans that exhibited the highest combined LTV (CLTV) ratios at the time of
origination are the most likely to default, and that all bankruptcy losses stem from a decline in the property's price



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                                             The Potential Effect Of Proposed Bankruptcy "Cram-Down" Legislation On U.S. RMBS


relative to the current mortgagor's equity in the property. The results suggest that the bankruptcy loss threshold may
not prevent the allocation of losses to senior securities under most scenarios. In this example, only under a home
price decline assumption of 25% and lifetime 0.25% bankruptcy rate does the bankruptcy loss threshold prove
sufficient to prevent pro rata loss allocation to the senior certificates.

Table 1
 Cumulative Bankruptcy Losses
 (As a % of the current balance for a typical prime jumbo transaction)
 Bankruptcy rate (%)                       Home price decline (original to current) (%)

                                       25.00            27.50            30.00            32.50            35.00
 0.25                                   0.04             0.05             0.05             0.06             0.06
 1.00                                    0.23             0.25             0.28             0.31            0.34
 1.75                                    0.34             0.38             0.43             0.48            0.53
 2.50                                    0.48             0.55             0.62             0.69            0.76
 3.25                                    0.59             0.68             0.77             0.86            0.95

Furthermore, current bankruptcy rates for the 2005-2007 prime jumbo vintages are approaching or have exceeded
0.25% (see chart 1). Any change in law encouraging bankruptcy filings will most likely raise these percentages
substantially. And, since the Bankruptcy Code does not currently allow for modifications of first liens on principal
residences, the percentage of borrowers in bankruptcy does not necessarily reflect what losses RMBS transactions
will ultimately realize as "bankruptcy losses" per se as opposed to losses from foreclosure or other processes such as
short sales. So with the prospect of growing bankruptcy modifications, including interest rate adjustments, for loans
on primary residences, we would expect the actual bankruptcy losses a transaction has incurred, as a percentage of
loans actually in bankruptcy, to increase significantly.




www.standardandpoors.com/ratingsdirect                                                                                                                        5
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                                             The Potential Effect Of Proposed Bankruptcy "Cram-Down" Legislation On U.S. RMBS


 Chart 1




For the Alt-A transactions, we would expect higher bankruptcy rates considering the poorer credit quality of the
typical Alt-A borrower (see chart 2). For Alt-A transactions that used senior/subordinate structures with carve-outs,
the overall bankruptcy rates for the Alt-A sector suggest that bankruptcy loss rates will substantially exceed those in
comparable prime transactions. Additionally, we believe that a larger proportion of Alt-A borrowers will actually
qualify for bankruptcy under Chapter 13, while a greater percentage of prime borrowers may not qualify if the court
determines they can afford to pay according to the original mortgage terms.




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                                             The Potential Effect Of Proposed Bankruptcy "Cram-Down" Legislation On U.S. RMBS


 Chart 2




For an Alt-A transaction that does not include negative amortization loans and has a bankruptcy loss limit of
$150,000, or 6 bps of the outstanding current mortgage loan balance, table 2 shows our expected principal
bankruptcy losses using the same home price decline assumptions as in our prime jumbo example. We increased the
bankruptcy loss percentages to reflect both the higher level of actual bankruptcy rates observed to date for Alt-A
borrowers and our expectation of increased bankruptcy rates in the Alt-A sector. Once again, we assume that the
loans that exhibited the highest CLTV values at the time of origination are the most likely to default and that all
bankruptcy losses stem from a decline in the property's price relative to the current mortgagor's equity in the
property. Even with current bankruptcy rates, the results suggest that Alt-A carve-outs will be exhausted more
quickly and actual bankruptcy losses that transactions incur will be more significant than those in the prime jumbo
example.

We recognize that within the Alt-A sector, transactions that use overcollateralization may contain more loans from
less creditworthy borrowers. Since those transactions typically do not contain carve-outs, chart 2 may somewhat
overstate the overall bankruptcy percentage. However, we still believe that the bankruptcy percentage of affected
Alt-A loans will substantially exceed that of the affected prime jumbo collateral.




www.standardandpoors.com/ratingsdirect                                                                                                                        7
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                                             The Potential Effect Of Proposed Bankruptcy "Cram-Down" Legislation On U.S. RMBS


Table 2
 Cumulative Bankruptcy Losses
 (As a % of the current balance for a non-negative-amortization Alt-A transaction)
 Bankruptcy rate (%)                               Home price decline (original to current) (%)

                                           25.00               27.50               30.00              32.50               35.00
 1.25                                       0.26                0.30                0.33               0.37                0.41
 3.00                                       0.48                0.56                0.65                0.74                 0.83
 4.75                                       0.58                0.72                0.86                1.00                 1.14
 6.50                                       0.70                0.89                1.09                1.29                 1.48
 8.25                                       0.81                1.06                1.31                1.56                 1.81

Finally, we performed the same exercise for a negative amortization, senior/subordinate transaction that has a
bankruptcy loss limit of approximately $500,000, or 4 bps of the outstanding current mortgage loan balance. Table
3 shows our expected principal bankruptcy losses across similar home price decline assumptions to those in our
previous examples. As in the non-negative-amortization Alt-A example, we increased the bankruptcy loss
percentages to reflect both the higher level of bankruptcy rates observed to date for Alt-A borrowers and our
expectation of increased bankruptcy rates in the Alt-A sector. In addition, we assumed that each borrower entering
bankruptcy had negatively amortized 10% of their original loan balance. All other assumptions remained the same.
As we expected, the degree of loss that the negative-amortization pool exhibited is the most pronounced of the three
examples.

Table 3
 Cumulative Bankruptcy Losses
 (As a % of the current balance for a negative-amortization Alt-A transaction)
 Bankruptcy rate (%)                            Home price decline (original to current) (%)

                                         25.00              27.50              30.00              32.50              35.00
 1.25                                     0.43               0.46               0.50               0.54               0.57
 3.00                                      0.93               1.02               1.10              1.18               1.27
 4.75                                      1.40               1.53               1.67              1.80               1.93
 6.50                                      1.87               2.05               2.23              2.41               2.59
 8.25                                      2.33               2.56               2.79              3.02               3.25

The scope of exposure to transactions with bankruptcy carve-outs is obviously a primary concern for market
participants. We would expect almost all exposure to occur in shifting-interest transaction structures that use
subordination as the sole means of credit enhancement.

Carve-outs appear to be more prevalent in pre-2005-2006 vintages. Some issuers (and relevant shelves) such as RFC
(RFMSI-SA and RALI-QA, QO, QH), Washington Mutual (WaMu), IndyMac (INDA), and Bear Stearns (Prime),
eliminated carve-outs that appeared in earlier transactions. Other issuers that maintained carve-outs in more recent
vintages include RFC (RFMSI-S and RALI-QS), Lehman Brothers (SARM and LMT), and IndyMac (INDX). But
market participants have indicated that investor preference may have played a large part in determining whether
carve-outs ultimately were utilized in any particular transaction.




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                                             The Potential Effect Of Proposed Bankruptcy "Cram-Down" Legislation On U.S. RMBS




Going Forward
Since the proposed changes to the current bankruptcy law have not been finalized, it is difficult to gauge the impact
of the pending legislation on outstanding rated U.S. RMBS. However, Standard & Poor's expects to monitor the
impact of any bankruptcy losses to each rated RMBS if and when the legislation passes. For bankruptcy carve-outs,
because these carve-outs were not initially sized for the change in law the proposed legislation contemplates, there
could be a disproportionate effect on the cash flow to some senior securities. Senior tranches with 'AAA' ratings
may experience some pro rata bankruptcy losses in spite of otherwise being able to withstand traditional credit
losses at the 'AAA' stress level.



Notes
(1) Cram-down legislation does not give a bankruptcy judge the power to modify the value of a debtor's primary
residence. Rather, it is the Chapter 13 bankrupt debtor who proposes a bankruptcy plan, including modification of
his/her mortgage loan, to the court, which the bankruptcy judge is generally required to approve, provided that the
judge determines that the plan complies with the Bankruptcy Code.

(2) Bankruptcy Loss: With respect to any mortgage loan, a Deficient Valuation or Debt Service Reduction; provided,
however, that a Bankruptcy Loss shall not be deemed a Bankruptcy Loss under this agreement so long as the servicer
has notified the trustee in writing that the servicer is diligently pursuing any remedies that may exist in connection
with the related mortgage loan and either the related mortgage loan is not in default on payments due under the
mortgage loan or delinquent payments of principal and interest under the related mortgage loan and any related
escrow payments for such mortgage loan are being advanced on a current basis by the servicer, in either case
without giving effect to any Debt Service Reduction or Deficient Valuation.

Bankruptcy Loss Coverage Amount: As of any date of determination, the Bankruptcy Loss Coverage Amount shall
equal $100,000 as reduced by the aggregate amount of Bankruptcy Losses allocated to the certificates since the
cutoff date and any permissible reductions in the Bankruptcy Loss Coverage Amount as evidenced by a letter of each
rating agency to the trustee to the effect that any such reduction will not result in a downgrading, qualification, or
withdrawal of the then-current ratings it has assigned to the classes of certificates.

(3) Deficient Valuation: A bankruptcy proceeding whereby the bankruptcy court may establish the value of the
mortgaged property at an amount less than the then-outstanding principal balance of the mortgage loan secured by
the mortgaged property or may reduce the outstanding principal balance of a mortgage loan. In the case of a
reduction in that value of the related mortgaged property, the amount of the secured debt could be reduced to that
value, and the holder of the mortgage loan thus would become an unsecured creditor to the extent the outstanding
principal balance of the mortgage loan exceeds the value so assigned to the mortgaged property by the bankruptcy
court. In addition, other modifications of the terms of a mortgage loan can result from a bankruptcy proceeding,
including the reduction (a Debt Service Reduction) of the amount of the monthly payment on the related mortgage
loan. However, none of these shall be considered a Debt Service Reduction or Deficient Valuation so long as the
servicer is pursuing any other remedies that may be available with respect to the related mortgage loan and either
the mortgage loan has not incurred payment default or scheduled monthly payments of principal and interest are
being advanced by the servicer without giving effect to any Debt Service Reduction or Deficient Valuation.




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