US Residential Subprime Mortgage Criteria.pdf by yan198555

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									Structured Finance



U.S. Residential
Subprime Mortgage
Criteria
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U.S. Residential Subprime
Mortgage Criteria
The Rating Process for
Subprime Mortgage Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Review of the Originator’s and Servicer’s Operations.                      .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   5
Collateral, Legal, and Structural Analysis . . . . . . . . .               .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   6
Rating Committees . . . . . . . . . . . . . . . . . . . . . . . . .        .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   7
Rating Surveillance . . . . . . . . . . . . . . . . . . . . . . . . .      .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   7

Loan Quality Guidelines for
Subprime Mortgage Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Underwriting and Loan Quality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Home Equity or Subprime? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Standardizing Quality Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Credit Scores and Ratings Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Mortgage Scores and Surveillance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Issuer Reviews for
Subprime Mortgage Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . 17
New Issuers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Operational Benchmarks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Annual Audit Reviews . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

Credit Analysis for
Subprime Loan Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
The Ratings Model . . . . . . . . . . . . . . . . . . . . . . . . . . . .              .   .   .   .   . . . . . . . . . . . . . . 29
Foreclosure Frequency Assumptions for Subprime Loans .                                 .   .   .   .   . . . . . . . . . . . . . . 29
Loss Severity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        .   .   .   .   . . . . . . . . . . . . . . 44
Seasoned Loan Analysis . . . . . . . . . . . . . . . . . . . . . . . . .               .   .   .   .   . . . . . . . . . . . . . . 54
Additional Credit Enhancement Requirements. . . . . . . . .                            .   .   .   .   . . . . . . . . . . . . . . 56
Default and Loss Curves. . . . . . . . . . . . . . . . . . . . . . . . .               .   .   .   .   . . . . . . . . . . . . . . 58




   Standard & Poor’s Structured Finance            I   U.S. Residential Subprime Mortgage Criteria                                                                 1
    Structural Considerations for
    Subprime Mortgage Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . 59
    Senior/Subordinate Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
    Bond Insured Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
    Excess Interest, Overcollateralization, and Subordination Structures. . . . . . . . . . . 67
    Senior/Subordinate Structures with Excess
    Interest, Overcollateralization, and Bond Insurance . . . . . . . . . . . . . . . . . . . . . . . 71

    Analyzing Excess Interest in
    Subprime Mortgage Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . 73
    Defaults. . . . . . . . . . . . . . . . . . . . . . . . .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   74
    Advancing . . . . . . . . . . . . . . . . . . . . . . .     .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   75
    Prepayments . . . . . . . . . . . . . . . . . . . . .       .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   76
    Weighted Average Coupon Deterioration                       .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   77
    Basis Risk . . . . . . . . . . . . . . . . . . . . . . .    .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   78

    Legal Criteria for Subprime
    Mortgage Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
    General Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
    Securitizations by Code Transferors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
    Securitizations by SPE Transferors and Non-Code Transferors . . . . . . . . . . . . . . . 91
    Special-Purpose Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
    Collateral-Specific Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
    Criteria Relating to Various Forms of Credit Enhancement . . . . . . . . . . . . . . . . 112
    Criteria Related to Retention of
    Subordinated Interests by Transferor in a True Sale . . . . . . . . . . . . . . . . . . . . . . 113
    Swap Opinion Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
    Interim Criteria for the Tenth Circuit Court of Appeals Eliminated . . . . . . . . . . 116
    Criteria: Trustee, Servicer, Custodian,
    Eligible Accounts, and Eligible Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
    Select Specific Opinion Criteria/Language . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
    Representations and Warranties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128

    Servicer Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
    Role of the Servicer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135




2
                                                                                                  U.S. Residential Subprime Mortgage Criteria




Servicing Fee . . . . . . . . . .             .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   137
Accounting Reports . . . . .                  .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   138
Resignation of a Servicer .                   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   138
Servicer Removal Triggers                     .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   138

Servicer Evaluation Criteria . . . . . . . . . .                                                                          .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   141
The Evaluation Process. . . . . . . . . . . . . . . . . . . . . .                                                         .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   142
Subprime Servicer Differences From Other Servicers                                                                        .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   143
Approved Servicer Requirements. . . . . . . . . . . . . . .                                                               .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   143

Surveillance Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
General Overview . .          .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   145
Methodology . . . . . .       .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   145
Building the Analysis         .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   147
Stress Tests. . . . . . . .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   .   150

Appendix A
Standard & Poor’s Ratings File Format . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

Appendix B
Glossary for Standard & Poor’s Ratings File Format . . . . . . . . . . . . . . . . . . . . . 159

Appendix C
Information Required for On-Site Review of Company . . . . . . . . . . . . . . . . . . . 171

Appendix D
Income Calculations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183

Appendix E
Liabilities and Other Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189

Appendix F
Criteria for FICO Scores. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191




  Standard & Poor’s Structured Finance                                    I       U.S. Residential Subprime Mortgage Criteria                                                                                   3
The Rating Process for
Subprime Mortgage
Transactions

T
         he rating process for subprime mortgage securitizations, as for any securitiza-
         tion, begins when a banker or issuer contacts Standard & Poor’s to discuss a
         proposal. For new issuers, initial conversations take place six to eight weeks
prior to the scheduled pricing of a transaction. Issuers with existing subprime mortgage
securitizations typically begin discussions three to four weeks before a planned issuance.
This beginning phase usually takes place through a conference call or brief meeting,
where an overview of the transaction is presented. The purpose of this first stage is
to identify any unusual or complicated structural, credit, or legal issues that may
need to be ironed out before a formal rating process can begin. If no such complication
exists, the rating process proceeds according to an agreed-upon time schedule.


Review of the Originator’s and Servicer’s Operations
When the issuer decides to proceed, a complete analysis of the transaction begins.
Rating analysts meet on-site with management of the originator or seller of the
receivables. This exercise enables analysts to expand their understanding of the
issuer’s strategic and operational objectives. It also provides a more defined level
of familiarity with underwriting policies, contractual breach procedures, and
operational controls. Generally, the review includes:
I A financial and corporate overview of the originator and servicer as presented

   by senior management;
I A discussion of the originator’s and servicer’s history in the subprime

   mortgage business and strategic plan; and
I A meeting with senior management and key personnel from pertinent areas,

   such as underwriting, loan disposition, computer systems utilized by the
   company, internal audit, finance, and sales and marketing.




  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   5
       In addition, a detailed discussion of the characteristics of the originator’s collateral,
    the repayment pattern of the obligors, and the performance history of the assets, as
    well as an examination of prior transactions, is typically undertaken. These discussions
    are often complemented by walk-through tours of the originator and servicer.
       Analysts perform a review of all new issuers. For frequent issuers, analysts usually
    perform these reviews annually, or more frequently if circumstances have changed,
    for example, due to significant procedural or technological enhancements.
       It is important to note that the review does not include an audit. Instead, the rating
    is based on the representations of the various parties to the transaction, including
    the issuer and its counsel, the investment banker and its counsel, and the issuer’s
    accountants. More details on Standard and Poor’s underwriting and servicer evaluation
    criteria can be found in the “Issuer Reviews” and “Servicer Evaluation Criteria”
    sections.


    Collateral, Legal, and Structural Analysis
    The analysis focuses primarily on the legal, collateral, and structural characteristics
    of the transaction. The legal criteria for structured finance ratings was developed in
    the early 1980s for mortgage-backed securities (MBS), and the fundamental tenet of
    these criteria is to isolate the assets from the credit risk of the seller.
      The collateral analysis involves an in-depth review of historical asset performance.
    Analysts collect and examine years of data on the performance variables that affect
    transaction credit risk.
      The structural review involves an examination of the disclosure and contractually
    binding documents for the transaction. The criteria cover many aspects of the structure,
    from the method of conveyance of mortgage loans to the trust, to the method of
    security payment and termination. The analysis also considers the payment allocation
    and what is being promised to securityholders.
      The prospectus for publicly rated transactions is prepared by the issuer’s counsel
    before a transaction is priced. However, the underlying documentation determines
    whether the structure will afford interest as promised and ultimate principal payments.
    The most important of these documents is the pooling and servicing agreement. All
    new issuers generally submit the first draft of the pooling and servicing agreement
    which should be in substantially complete form, as significant subsequent changes
    to the agreement may cause a delay in the rating of the transaction.




6
                                   The Rating Process for Subprime Mortgage Transactions




Rating Committees
A team of analysts is assigned to each transaction. After the team performs its
review of the issuer’s operations and analyzes the collateral, a committee of appro-
priately trained and experienced analysts is assembled to determine whether the
transaction has sufficient credit enhancement for the desired rating. Analysts ordinari-
ly present the credit and structural aspects of a transaction to a rating committee
before a transaction is priced.
  The transaction team is responsible for ensuring that all pertinent information is
presented to the rating committee. The committee presentation includes information
gathered from the review of the originator and servicer, collateral, cash flows, enhance-
ment recommendations, and information on the legal and structural characteristics
of the transaction. This information will be compiled into a confidential presentation.
Once the rating committee meets and makes its decision, the results will be conveyed
to the banker. A rating letter is issued at closing, and for public ratings, a credit
analysis is normally disseminated.


Rating Surveillance
After a rating is assigned, it is monitored and maintained by the surveillance process.
The purpose of surveillance is to ensure that the rating continues to reflect the per-
formance and structure of the transaction as it was analyzed at transaction closing.
Performance information is disclosed in a report prepared monthly by the servicer of
the transaction. Before a transaction’s closing date, analysts review the data itemized
in the servicing report to ensure that all necessary information is included.
   The surveillance process encompasses monitoring issue performance and identifying
those issues that should be considered for either an upgrade or a downgrade. The
surveillance function also encompasses tracking the credit quality of all entities that
may be supporting parties to the transaction, such as liquidity enhancers. Analysts
review performance data periodically during the course of the transaction and contact
the issuer and trustee if ratings change. For changes to public ratings, a press release
is normally disseminated.
   Standard & Poor’s must be informed of any changes concerning the original structure
of the transaction, including management, credit policy, system changes, or any
change in the status of the original parties involved in the transaction. All information
will be used as part of normal surveillance maintenance for the transaction.




 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   7
Loan Quality Guidelines
for Subprime Mortgage
Transactions

T
          he analytical approach to classifying loans included in pools submitted for
          ratings is based on borrower quality rather than the current industry practice
          of mortgage versus home equity loans. This differentiation initially referred
to lien status, with “mortgages” referring to first lien prime loans and “home equities”
referring to second lien positions of predominately impaired or subprime borrowers.
The securities created from these loans were, and in many investment banking houses
still are, underwritten and traded in separate areas.


Underwriting and Loan Quality
Since the advent of the home equity market there has been a dramatic shift in the
make-up of home equity pools from predominately second lien loans to pools which
now include 90% to 100% first lien mortgage loans provided to subprime borrowers.
The mortgage loan rating criteria described here consider borrower quality the primary
distinguishing characteristic in establishing pool type. The analysis of all mortgage
loans considers the effect of lien position, loan to value (LTV) ratio or in the case of
second liens combined loan to value (CLTV), mortgage size, type of property, note
characteristics, and a myriad of other variables. It is Standard & Poor’s practice to
refer to pools as “prime” and “subprime” and to further distinguish pools by first
lien, second lien, high LTV, and home equity lines of credit.
   Standard & Poor’s focuses the analysis on determining the risk of loss associated
with a specific mortgage loan. This distinguishes it from the originator who under-
wrote the same loan. Underwriting describes the process of how a lender determines
which loan will be approved and which will not. Some institutions only lend to the
most creditworthy borrowers. Others are willing to take increased risks for higher
potential returns.




  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   9
        Underwriting does not describe the entire process of attracting borrowers, select-
     ing documentation, or the extent of quality control. Rather, underwriting is the
     determination of an individual’s ability and willingness to repay a loan on a particular
     property, based on the lenders particular guidelines and products. The result of
     underwriting is an accept (yes) or reject (no) decision. The ratings process, however,
     is not a yes or no process, but rather the quantification of the risk associated with
     each mortgage loan in order to establish appropriate credit enhancement requirements
     for the rated securities.


     Home Equity or Subprime?
     The concept of “prime” versus “subprime” has been altered dramatically by the
     development and implementation of automated underwriting systems (AUS) by
     Freddie Mac and Fannie Mae. The designations of prime and subprime evolved for
     the published agency underwriting guidelines. A loan which met the guidelines was
     considered prime (commonly referred to as “A” loans) while everything else was
     subprime (referred to as “A-”, “B”, “C”, or “D” as the borrower credit deteriorated).
     A variation of the “A”, “Alternative-A” was created to designate loans that otherwise
     met the guidelines but were covered by agency product lines; that is, second homes,
     investor properties, and limited documentation loans.
        With the implementation of AUS, however, the guidelines no longer strictly define
     what is agency eligible. Their respective AUS accept a loan based on the overall
     mortgage score even though there is an aspect of the loan which was unacceptable
     only a short time ago. Thus the distinction between prime and subprime has become
     less clear.
        The home equity loan-backed securities (HELBS) market has also evolved over the
     past several years. It is now vastly different than it was in 1988, when the first rated
     transaction was issued. Currently, the HELBS market is dominated by issuers engaged
     in first-lien subprime lending, with traditional home equity second-lien loans making
     up a declining share of the market. Today, many issuers—including mortgage com-
     panies, banks, and finance companies—target subprime obligors who, just a few
     years ago, had limited alternatives for borrowing outside of the traditional home
     equity market.
        This lending climate continues to generate new products targeted at specific borrower
     characteristics, which has further blurred the traditional meaning of a home equity
     loan. As a result, Standard & Poor’s analysis distinguishes between collateral types
     based on borrower credit (prime or subprime) and loan type (first lien, second lien,
     or high LTV/debt consolidation). With the preponderance of issues using subprime
     first-lien collateral, the more appropriate reference is subprime rather than traditional
     home equity.



10
                                                Loan Quality Guidelines for Subprime Mortgage Transactions




Standardizing Quality Definitions
The proliferation of non-conforming products and definitions created a confusing
array of A-, B, C and D loans sharing common names but displaying quite diverse
performance expectations (see table 1). To alleviate the impact of these anomalies
on the ratings process, Standard & Poor’s introduced its standard definitions
(see table 2).

Mortgage Scores and Standardized Risk Grades
The developments in automated underwriting systems, credit scoring, and the evolution
of mortgage scoring have provided a wealth of new data to support the analysis of
risk. The sophistication of mortgage scoring now allows underwriters the ability to
statistically determine the risk associated with the combination of a specific borrower,

                                                                  Table 1
                        Comparison of Three Originator’s Subprime Guidelines

                                               A-                    B                C                D
 Company A         Consumer credit             Minor derogs.         <35% of trade    <50% of trade    Total disregard
                                               in past 24 mos.       lines reported   lines reported   for credit
                   Debt/income                 45                    50               55               55
                   NOD*/                       None in               None in          None in          Recent bankruptcy/
                   bankruptcy                  past 3 yrs.           past 2 yrs.      past 1.5 yrs     foreclosure
 Company B         Mortgage                    2x30                  2x30             4x30 or          5x30 or
                   credit                                                             3x30 and         2x60 or 1x90
                                                                                      1x60
                   Consumer                    3x30 rev.             4x30 or          8x30 or          12x30 or
                   credit                      3x30 inst             2x60             2x60 and         6x60 or
                                                                                      1x90             4x90
                   Loan to value               LTV† <75+/45          LTV <80+/45      LTV <80+45       LTV 75+55
                                               LTV <75/55            LTV <75/50       <75/50           LTV <75/60
                   NOD/                        None in               None in          None in          None in
                   bankruptcy                  past 2 yrs.           past 2 yrs.      past 1.5 yrs.    past yr.
 Company C         Mortgage                    2x30                  4x30             6x30             12x30
                   credit                                                             1x60 *           6x60*
                                                                                      1x90*            2x90*
                   Consumer                    Not stated            Not stated       Not stated       Not stated
                   credit Loan
                   to value                    LTV=85/80             LTV<=85/80       LTV<=70/70       LTV<=70/65
                   Debt/                       42                    Not stated       Not stated       55
                   income
                   NOD/                        Not                   Not              Not              None in
                   bankruptcy                  stated                stated           stated           past yr.
 *NOD-Notice of Default; †LTV- Loan to Value




 Standard & Poor’s Structured Finance                        I   U.S. Residential Subprime Mortgage Criteria             11
     mortgage note, and property. Mortgage scoring allows this risk to be measured with
     a heightened degree of consistency and objectivity.
       Through a mortgage score, an automated underwriting system communicates the
     foreclosure or loss risk on either a relative or an absolute basis. Mortgage scores are
     different from credit scores. Credit scores are assessments of a borrower’s credit history,
     which is just one of many factors included in a mortgage score. Mortgage scoring
     can best be described as the quantification of the intuitive process embedded in
     manual underwriting.
       The mortgage score employed in Standard & Poor’s ratings process allows the
     rank ordering of loans by their unique default probability. As a result of its analyses
     of the major automated underwriting systems, risk grades have been introduced
     to stratify the relative foreclosure risk among varying mortgage, property, and
     borrower characteristics.
       Most of the major automated underwriting systems and the associated scoring models
     have been analyzed and their relative predictive underwriting systems are being used.
     Standard & Poor’s risk grades will equate one system’s mortgage’s risk with another,
     even if they are underwritten under different automated underwriting systems.


     Credit Scores and Ratings Criteria
     Standard & Poor’s has reviewed consumer credit scores designed by Fair, Isaac and
     provided as FICO scores by Experian, BEACON scores by Equifax, and EMPIRICA
     scores by Trans Union. These scores are used as a surrogate for the credit reputation
     of individual borrowers. As the automated underwriting technology evolved, these
     scores or similar customized scores became a key factor in the development of the
     mortgage or application scores that are integral to the systems reviewed so far. As a
     result of this research, a mortgage scoring algorithm was incorporated into the ratings

                                                    Table 2
                            Standard & Poor’s Subprime Underwriting Guidelines

      Characteristic                          A-                  B             C             D
      Mortgage credit                      2x30               3x30          4x30           5x30
                                                                            1x60           2x60
                                                                                           1x90
      Consumer credit                      2x30               3x30          4x30           4x30
                                           1x60               2x60          3x60           3x60
                                                                            1x90           2x90
      Debt/income ration (%)                  45                 50            55            60
      *NOD/Bankruptcy                   None in            None in       None in        None in
                                      past 5 yrs.        past 3 yrs.   past 2 yrs.      past yr.
      *Notice of default.




12
                                Loan Quality Guidelines for Subprime Mortgage Transactions




model, which is the engine for risk ranking and analyzing loans and pools of loans
in the ratings process.
  As an added refinement to the scoring concept, risk grades were developed and
introduced in September 1996. The risk grades, based on research conducted with
Freddie Mac, reflect a mapping of the basic mortgage score into a system that rank
orders individual mortgage loans from a high credit quality, low default expectation
at RG1 to a low credit quality, high default risk probability at RG7. The model
incorporating the mortgage score algorithm and the risk grade assessment was intro-
duced in February 1997. Since then, a significant number of issuers have begun to
provide either mortgage scores from approved automated underwriting systems or
FICO scores with loan pools submitted for ratings. With this increase in FICO score
submissions, there is a need for guidelines and criteria for selecting the appropriate
FICO score.
  Standard & Poor’s risk grades are used to adjust loss coverage on mortgage pools,
giving credit or assessing additional loss coverage depending on relative risk of fore-
closure on a loan (see table 3). The highest quality grade loans will be credited by
20% (1.0 minus 0.8). For example, if a pool of RG3 loans required 10% loss coverage
for an ‘AAA’ rating, the lowest quality grade, highest risk loans will be adjusted up
300% (4.0 minus 1.0) . In other words, a pool of RG3 loans that would have required
10% loss coverage for the ‘AAA’, if graded RG7 (and there were no changes in the
other loan characteristics) the pool would require 40% loss coverage for the same
‘AAA’ rating.

Consumer Credit Score Criteria
Research has shown that the use of credit and mortgage scores is not limited to the
origination process. Portfolios of seasoned loans can be periodically marked to market
for both credit and collateral using tools that are currently available and embedded
in the ratings model. As a result, criteria has been developed for defining consumer

                                             Table 3
                            Loss Coverage-Levels Adjustment

 Standard & Poor’s Risk Grade                                   Credit enhancement factor (x)
 RG1                                                                                       0.8
 RG2                                                                                       0.9
 RG3                                                                                        1
 RG4                                                                                      1.25
 RG5                                                                                        2
 RG6                                                                                        3
 RG7                                                                                        4




 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria      13
     credit score criteria for loans submitted at the time of origination or post origination
     that are to be included in rated mortgage-backed securities. Criteria are under devel-
     opment for seasoned loans, which are defined as loans held in portfolio for more
     than six months after origination. Finally, criteria also have been developed for
     continuous pool review and ongoing surveillance.

     New Originations
     Standard & Poor’s has reviewed the guidelines established by Fannie Mae and
     Freddie Mac and has endorsed similar guidelines for selecting FICO scores included
     with new loans submitted for ratings. These guidelines follow.
        A newly originated loan requires a representative consumer credit score that will
     be used in the Standard & Poor’s ratings model. To select a representative score,
     each borrower’s score is collected from each of the three credit repositories. Then
     the middle score is selected for both the primary and secondary borrower. The lower
     of the two middle scores is the representative score used in the automated underwriting
     or mortgage score algorithm.
        If one borrower has only two scores and the other has three, then the middle score
     of the three would be selected, the lower of the two would be selected, and the lowest
     score of the remaining pair would be the representative score that is used. Likewise,
     if one of the borrowers has only one score available from the three repositories, that
     score would be used. For the other borrower the rules above would apply.

     Seasoned Loans
     Seasoned loans are currently defined as loans that have been in a portfolio for more
     than nine months from the origination date. Consumer credit scores reflect the impact
     of changes in the pattern of consumer payments and credit usage. Entries to individual
     credit files are posted daily. As a consumer’s credit deteriorates, the number and
     durations of derogatories increase. These tend to reduce the credit score and likewise
     increase the risk of the mortgages as reflected in the mortgage score.
        Loans that have been on an originator’s or issuer’s books for longer than 90 days
     could show significant deterioration or improvement in credit based on the circum-
     stances affecting the borrower. For periods of time shorter than 90 days, particularly
     the first 30-60 days after origination, loans submitted for ratings typically could not
     yet reflect significant deterioration. At the same time, loans with 90 days or more of
     seasoning are distanced from the origination point. This justifies a re-scoring of both
     the borrower’s credit and a recalculation of the equity position in the property as
     reflected by an adjusted LTV.
        One of the significant issues associated with requiring scores on seasoned loans
     is that it is difficult to acquire three scores on each significant borrower in the




14
                              Loan Quality Guidelines for Subprime Mortgage Transactions




property as is required at origination. As an alternative, several alternatives
are being investigated, including:
I Using look-up tables that would provide the selection of the appropriate repository

  based on the location or zip code of the borrower;
I Using the origination representative score selected according to the criteria above;

  or
I Using one repository consistently for scoring all seasoned loans submitted for ratings.

  In this case, consistency would be sampled during the periodic underwriting
  review process.


Mortgage Scores and Surveillance
The evolution in automated underwriting technology, specifically mortgage scoring,
has been extended to measuring the changing complexion of risk in seasoned portfolios.
A number of large servicers are using periodic scoring to identify trends and shifts in
the risk of the servicing portfolio. This information allows the servicers to flag loans
for specific management action. These actions would more accurately reflect the
implied risk of the borrower.
   The credit of a borrower and the risk of an associated mortgage can and will
change. This occurs over time as the circumstances of the borrower are affected by
life’s events. and/or the value of the property is affected by general economic and
specific regional market conditions. As a result, servicers are collecting consumer
credit scores on their portfolio borrowers on a monthly or quarterly basis and are
tracking the trends displayed by both individual borrowers and aggregate mortgage
portfolios. The results of this heightened level of scrutiny are improving their
day-to-day operations, particularly in mitigating losses.




 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   15
Issuer Reviews for
Subprime Mortgage
Transactions
New Issuers
The quality of the underwriting of the mortgages securitizing the pass-through
certificates is integral to credit quality and performance. Therefore, a review of all
elements of an originator’s business is conducted before determining whether that
entity is eligible to participate in the rated transaction. The review takes place
regardless of whether or not the originator, as a company, is rated.
   This section will outline the aspects of Standard & Poor’s comprehensive review
of the company. The review is summarized it into four functional areas: management
and organization, loan production, underwriting and quality control, and secondary
marketing. Finally, the company’s portfolio performance is reviewed and compared
to internal data sources. After completion of the review the primary analyst will present
to a committee all pertinent information related to each area. Should there be concerns
regarding operational policies or performance, additional credit enhancement may
be required. The specific percentage increase is determinant upon Standard & Poor’s
evaluation of the level of risk the company adds to the transaction. Prior to the on-
site review, a questionnaire is sent to the company for completion. The questionnaire
should be completed and returned prior to the on-site review date (see appendix C).

Management and Organization
The review begins by meeting with management to become familiar with the originator’s
organizational structure, the experience of key managers, and the company’s overall
plan for growth, new products, new markets, and employee training. Management
should have a well defined business strategy which has been successfully executed.
The company is evaluated in part on its orientation to operating and financial risk,
and its reaction to market variables. Procedures for all areas should be well docu-
mented, with the necessary controls in place as well as all licensing and insurance



  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   17
     coverages. Analysts will examine the company’s data processing capabilities such as
     total capacity, and the current level of capacity, disaster recovery plans, contingency
     plans, system security, and back-up facilities. The company’s past three years of
     audited financial statements are evaluated to determine their financial condition.

     Loan Production
     In analyzing an originator’s production capabilities, analysts will review the volume
     of loans originated and acquired for the past five years. In addition to examining
     total volume, it is necessary to evaluate production segregated by property type,
     permanent versus construction loans, first versus seconds, prime versus subprime,
     high loan to value, and home equity lines of credit. Production also should be
     reported by loan type (ARMs, FRMs, GEMs, etc.) as well as government versus
     conventional loans. This information gives further insight into the company’s
     experience with various loan types. It also may illustrate the extent to which it
     has operated prudently in the past.
       The sources of production are also reviewed, including loans originated versus
     loans purchased, the percent from wholesale correspondents and brokers, as well
     as the geographical distribution of the production. The volume of retail versus
     wholesale production is reviewed due to the performance differential between the
     production sources. Reviewing the source of production is necessary for several
     reasons. A geographic distribution indicates the company’s familiarity with the
     laws of various states. Also, geographic dispersion aids in diversification of the
     company’s production risk.
       Similarly, if a large portion of its production has been acquired, the company’s
     approval process for each correspondent is carefully reviewed. In addition, it is
     important to determine whose underwriting guidelines are used to originate the
     loans. The company must also track the performance of loans purchased from
     various correspondents. All third party originators should be included in a quality
     control review at least annually. Also, an annual re-certification should be performed
     where the originators financial position, insurance coverages, and performance is
     reviewed. If loans from a particular correspondent default frequently, then the originator
     would do a closer screening of its loans, possibly modify its commitment with the
     correspondent, or stop buying loans from that correspondent entirely. In addition,
     the company’s production of Section 32 loans is reviewed, including audit procedures
     and system edits and checks.




18
                                              Issuer Reviews for Subprime Mortgage Transactions




Underwriting and Quality Control
The company’s underwriting guidelines and quality control procedures are carefully
reviewed. Due to the inherent risks associated with subprime originations an emphasis
is placed upon the appraisal and appraiser review processes, the underwriting guidelines
and adherence to them, and the quality control process and findings.
   A company generally needs a tenure of at least 3 years to be eligible to participate
in a transaction. For subprime originators, exceptions may be made to that requirement
if there are compensating factors. These might include the company’s history of suc-
cessfully operating as a lender for other products; a well thought out, prudent product
line and market approach exists; and knowledgeable management and staff having
experience in this field have been hired.
   Traditionally, subprime loans were equity based lending decisions. However, with
increased competition and the maturation of the market, more credit-based products
having higher LTV’s have been introduced into the market. Given these developments,
an increased focus is placed on the underwriting function. Underwriters should have
experience with subprime underwriting or may have a consumer finance background.
If traditional prime credit underwriters are to underwrite the subprime product, special
training should be provided to them. Those who underwrite the subprime product
preferably will be segregated from the prime underwriters and will only underwrite
subprime product.
   Given the current mortgage market, many lenders are stretching their guidelines
for the sake of increased production. Standard & Poor’s monitors underwriting
guideline changes and adjusts its loss coverage requirements if the quality of the


                                                Table 1
                       Standard & Poor’s Rules Based Credit Classifications

 Characteristic                    A           A-                   B              C           D
 Mortgage Credit                0x30          2x30               3x30           4x30        5x30
                                                                                1x60        2x60
                                                                                            1x90
 Consumer Credit                              2x30               3x30           4x30        4x30
                                              1x60               2x60           3x60        3x60
                                                                                1x90        2x90
 Revolving                      2x30
 Installment                    1x30
 Debt/Income                      36            45                 50             55          60
 NOD*/                   none in past     none in              none in        none in     none in
 bankruptcy                  7 years      5 years         past 3 years   past 2 years   past year
 *Notice of default.




 Standard & Poor’s Structured Finance     I   U.S. Residential Subprime Mortgage Criteria       19
     loans is found to be deteriorating. Underwriters’ track records should be monitored
     the same way as correspondents’ loan quality. Exception approval policies are reviewed
     as well. The frequency and type of exception should be tracked by the company.
     Likewise, the suspension and declination rates per underwriter and originator
     should be closely monitored. Lending authority limits should be in place based
     on the experience and capability of the underwriters.
        Underwriting guidelines are reviewed to determine how the company’s credit classes
     align with the rating criteria guidelines for loans which a credit score or approved
     mortgage score is not provided (see table 1). For example, does the company’s ‘B’
     program match our definition of a ‘B’ quality loan? If not, adjustments to the credit
     classifications are made. It is imperative that the underwriters be consistent when
     assigning credit classes to the loans so that the risk of default and loss to the transaction
     may be evaluated correctly. This consistency is analyzed through the company’s
     exception rate, quality control procedures, practices, and findings.
        Due to the overwhelming utilization of credit scores, it has become a factor in our
     current credit risk analysis. As a result, we request originators to provide credit
     scores. By extension, credit scores have become an integral factor in our underwriting
     review process. In the absence of a credit score, the greatest weight is placed on the
     mortgage credit when determining the most appropriate credit class for subprime
     loan programs (see appendix F). This is because mortgage credit is considered the
     most predictive factor of future mortgage payment performance.
        Standard & Poor’s subprime credit classifications are categorized as rolling delin-
     quencies. This means the consecutive delinquency is counted as one delinquency. For
     example, if a mortgagor is 30 days delinquent for four consecutive months the delin-
     quency history would be classified as 1 X 30. If the lender’s underwriting guidelines
     categorize the delinquencies on an instance basis, the same 30 day delinquency for
     four months would count as 4 X 30. Due to the difference between rolling delinquency
     and instance basis delinquency, there is a potentially dramatic difference between the
     risk profile of a borrower depending on how the past delinquency performance is
     reported. It is therefore extremely important when reviewing underwriting guidelines
     of a lender to determine the reporting method. This determination will allow for an
     accurate risk assessment of the loan program and an accurate comparison with the
     rules-based credit classifications.
        Loans approved which have an exception to the guidelines should be kept to a
     minimum since this could lead to inconsistency. A large number of exceptions may
     also indicate that the underwriting guidelines are present but the focus of the company’s
     lending decisions are more production driven than credit driven.
        Like credit classifications, lenders’ income documentation programs will be
     reviewed and must be mapped to Standard & Poor’s documentation codes. The
     documentation type codes are as follows:


20
                                               Issuer Reviews for Subprime Mortgage Transactions




I   C No Employment/Income Verification
I   E No Asset Verification and No Employment/Income Verification
I   V Verbal Verification of Employment (VVOE)
I   W One Paystub Obtained
I   X One Paystub Obtained and VVOE
I   Y One Paystub and One W-2 and VVOE or One Year 1040 (self employed)
I   S Streamline Refinance (a description is found below)
I   Z Full Documentation (Two years employment and income verification)
   Streamline refinance programs have been designed for portfolio retention whereby
the current servicer may refinance a borrower’s loan. The characteristics of loans eligible
for this program include: single family residence, owner occupied, and a no cash-out
mortgage loan. The new mortgage loan should be a fixed-rate level payment first
mortgage. The loan being refinanced may be at least 12 months seasoned.
   The acceptable documentation for streamline refinance loans are the following:
I A new 1003 (Residential Loan Application);

I A mortgage payment history for the past 12 months exhibits no 30 days past due;

I A new “in file” credit report; and

I A warranty by the lender in the pooling and servicing agreement that the value of

   the property has not declined if the original appraisal report is used. If the lender
   is concerned about its ability to make this warranty because there has been a
   decline in market values in a particular area, the lender should then obtain a
   new appraisal.
   The other acceptable documentation is a salaried borrower’s current pay stub or
a self-employed borrower’s tax returns for the last year. The lender must determine
that the borrower is qualified for the new mortgage using the new monthly payment
to calculate debt to income ratios. However, the borrower will not have to be re-
qualified if all of the following conditions are met:
I The refinance mortgage is being originated by the current servicer and it has the

   original underwriting file;
I The borrower’s income has not declined;

I The original mortgage being refinanced is a conventional mortgage that was

   originally underwritten as a full documentation loan;
I The borrower has a satisfactory payment history for at least 12 months; and

I The new monthly fixed installment is no more than 15% greater than the original

   fixed installment for which the borrower previously qualified.
   However, if the new mortgage is being originated by someone other than the current
mortgage servicer who has the original underwriting file, a new appraisal report
is required.
   Standard & Poor’s has standard calculations for other underwriting factors
such as the calculation of income and debts. These standards are compared to the


    Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria    21
     originators guidelines and assessed for conservative, liberal, or industry norm factors
     (see appendices D and E).
        Since many lenders use equity level as a compensating factor for derogatory credit
     or high debt ratios, it is imperative that the appraisal be accurate. The company’s
     appraiser approval, appraisal review, and appraiser monitoring processes should be
     thorough and all encompassing. Many companies will employ a chief appraiser who
     will be responsible for reviewing a third party appraiser’s qualifications for approval.
        Once approved, the quality of the third party appraisers work should be monitored
     on an ongoing basis either as part of the quality control review or by staff appraisers.
     Appraisal variance between the quality control findings and originations should not
     allow for a difference of greater than 10%. If the value differential is greater than
     10% further investigation should be done to determine the cause of the differential.
     If the value stated on the appraisal is found to be lower without just cause, the value
     used in the approval process and subsequent LTV should be lowered.
        All appraisers should be reviewed at least annually. An approved list is normally
     maintained which contains those appraisers in good standing with the company.
     Often staff appraisers will utilize other data sources to aid in the collateral valuation.
     For first lien products a Uniform Residential Appraisal Report Form 1004 or Form
     2055 with an interior and exterior inspection is required. For second lien loans a
     Drive-by Form 704 or Form 2065 is required. Standard & Poor’s appraisal codes
     are listed in the accompanying table (see table 2).
        To ensure that underwriting guidelines are being adhered to, an independent audit
     team of the originator should perform a post-closing review. The sample is usually
     derived from a combination of random and adverse selections. The files should be
     fully re-underwritten and re-verified at least 10% of production monthly or a statistical
     sample having a 95% confidence level. At least 10% of the sample should receive
     new credit reports and field review appraisal. Exceptions cited are normally tracked


                                               Table 2
                               Standard & Poor’s Appraisal Codes

      Appraisal type codes                         Appraisal type obtained
      01                                           Tax assessment
      02                                           Broker price opinion (BPO)
      03                                           Drive-By 704 Form/ Form 2055 (exterior only)
      04                                           Full 1004
      05                                           Form 2075
      06                                           Form 2065
      07                                           Form 2055 (interior and exterior)
      08                                           Automated Appraisal System




22
                                            Issuer Reviews for Subprime Mortgage Transactions




by underwriter, branch, broker, or appraiser as applicable. Delinquency performance
should be also be tracked for each of these entities. This process aids the company
in ensuring that its policies are adhered to and that the products it approves are
consistently underwritten.
  Credit scoring models and artificial intelligence systems are becoming widely utilized
in the mortgage industry. Historically, the consumer lending industry has used credit
scoring to determine the creditworthiness of a borrower for such products as credit
cards. Now many mortgage lending institutions, mortgage insurers, and government
sponsored agencies have incorporated this technology into the mortgage lending
decision. Lenders are choosing to use automated underwriting systems because they
provide consistency to the underwriting process, potentially aid lenders in complying
with fair lending objectives, and increase efficiency.
  In addition, as a predictive tool automated underwriting systems allow lenders to
make better lending decisions with regard to the likelihood of an applicant repaying
the loan. Standard & Poor’s has reviewed various systems utilized today. An auto-
mated underwriting system must be evaluated and approved by Standard & Poor’s
prior to their acceptance in a transaction.
  Some lenders have also begun straying from the traditional collateral valuation
methods that has traditionally been used in the industry. The alternative forms of
collateral valuation are usually less comprehensive and may or may not require an
on-site inspection, depending on other characteristics of the loan application. The
credit quality of the borrower and loan to value restrictions are generally used as
offsetting factors for the increased risk of using an alternative valuation method of
the subject property.
  If a lender intends to use a valuation method other than what is required by
Standard & Poor’s, the loan must be approved through the Documentation and
Automated Collateral Scoring System (DACSS). DACSS will evaluate the attributes
of a loan application and the credit quality of a borrower. If eligible, DACSS will
then assign alternative documentation and collateral requirements in accordance
with rating criteria, without assigning a corresponding increase in foreclosure fre-
quency expectation. If a loan is not DACSS approved and contains a valuation
method other than that required by Standard & Poor’s, the loan cannot be included
in a transaction to be rated.




 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria    23
     Secondary Marketing
     Imprudent marketing policies can quickly destroy a company’s financial strength.
     Therefore a review will be conducted of the five main areas within secondary marketing:
     pricing, pipeline management, trading and hedging, securitization, and document
     delivery. Analysts will review the procedures for deriving and setting prices, and,
     once decided upon, disseminating prices to branches and third party originators.
     Within pipeline management, rate-lock offerings are reviewed, as are the tracking
     capabilities of the rate-lock commitments that are outstanding. The process for
     tracking loans in the pipeline, the average closure rate, and sample position and
     inventory reports are likewise reviewed.
       Trading and hedging functions are emphasized in the review due to the potential
     exposure these practices and policies may place on the company. The review will
     encompass where the trading authority lays, how trading activity is monitored and
     accounted for, the types of hedging vehicles utilized, and the overall hedging strategy.
     The company’s experience with issuing securities in the secondary market, its funding
     facilities, the type of investor commitments utilized, and its mark to market forward
     valuation practicesare carefully analyzed. Good tracking procedures for documents
     outstanding from county recorders, title companies, and production offices, as well
     as documents sent to the custodian or investor, are essential controls within the
     document delivery area.


     Operational Benchmarks
     When determining originator eligibility, general operational benchmarks are used
     to evaluate the company. It must be kept in mind that these are benchmarks, and
     individual circumstances are always considered.

     Management and Organization
     The benchmarks for management and organization are the following:
     I Corporate operations have a history of at least three years with the product being

       securitized and show adequate financial performance. With companies originating
       new product types, extensive experience with other products will be considered as
       a compensating factor. Compensating factors may be management’s experience in
       the industry that may have been acquired at another institution. Operating experience
       is determined from a combined experience approach between management experience
       and company history;
     I Long- and short-term goals are reviewed relative to performance;

     I Management personnel have an average of 15 years of industry experience and at

       least three years of product-specific experience;
     I Policies and procedures manuals exist for all operational areas;




24
                                               Issuer Reviews for Subprime Mortgage Transactions




I Systems capabilities are adequate for the institution’s volume and expected
  near-term volume;
I Training is provided to the institution’s employees;

I No material lawsuits are outstanding against the institution;

I A disaster recovery plan is in place covering systems and site; and

  Fidelity Bond and Errors and Omissions coverages are in force and conform
to industry standards.

Loan Originations
The benchmarks for loan originations are as follows:
I Production should be geographically diverse;

I No one seller should provide over 10% of the institution’s total volume;

I Internal controls must be present for approving and monitoring broker/

  correspondent sellers;
I Underwriting guidelines should be well documented;

I Underwriters should have experience with the product being originated;

I Lending authority limits should be in place and varied based on

  underwriter experience;
I Second-look decline processes should be in place for those loans denied

  by underwriting;
I Formal exception-approval processes must be present. Total exceptions of loan

  approvals should not exceed 10% of total production;
I Risk upgrades should be available to only one credit class for subprime

  credit classifications;
I Appraiser approval processes should be in place and the quality of appraisals

  should be monitored by either in-house appraisers or by outsourced quality
  control appraisers;
I Appraisal variance between the quality control findings and originations should

  not allow for a difference of greater than 10%;
I Quality control must be conducted monthly and contain a random sample of at

  least 10% or a statistical sample having a confidence level of at least 95%; and
I Ten percent of the 10% quality control audit should be subject to field reviews.




Portfolio Performance
A company’s portfolio performance is a primary focus of the ratings evaluation.
The company’s delinquency, loss, and loss severity statistics are analyzed on a static-pool
basis. These statistics should be reported in the standard 30-, 60-, and 90+-day cate-
gories, including the percent in foreclosure, real estate owned (REO), and bankruptcy
according to the Office of Thrift Supervision (OTS) Delinquency Calculation




    Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria    25
     Method. The delinquencies are compared to regional averages and other industry
     statistics, along with Standard & Poor’s own internal sources and statistics.
       The portfolio is analyzed in part by loan type, property type, average loan size,
     average servicing fee, credit class, documentation type, geographic concentrations,
     weighted average maturity, and the weighted average coupon. The performance of
     prior transactions will be compared to the expected performance at transaction closing.
     An important issue addressed when reviewing performance is the company’s policy
     toward repurchasing defaulted loans out of a transaction. This practice masks
     actual performance of the underlying collateral and may not be relied upon for
     future transactions.


     Annual Audit Reviews
     On-site reviews will be performed periodically and findings will be presented to a
     committee. Changes to underwriting guidelines, as well as any extensive operational
     changes, should be reported on an ongoing basis to Standard & Poor’s. The changes
     will be evaluated for materiality. If it is determined that credit classifications or doc-
     umentation code changes are warranted, the loan programs will be re-mapped.




26
Credit Analysis for
Subprime Loan Transactions

Q
          uantifying the amount of loss that a mortgage pool will experience in all
          economic scenarios is the key to modeling credit risk. To achieve this, analysts
          use varying stress assumptions to gauge mortgage pool performance in all
          types of economic environments. The basis for the stress scenario applied
to each rating category can be found in the historical loss experience of the
mortgage market.
  The great depression of the 1930s provided what many consider the most catastrophic
environment for mortgages in this century. While we do not expect a repeat of a
1930s Depression, it is an excellent case study of how unemployment and falling
property values can impact mortgage losses. The Oil Belt of the 1980s (Texas,
Louisiana, and Alaska) provides another example of a severe loss environment. The
more recent experience in New England and Southern California provides additional
information on how various risk characteristics affect loss experience. Loss data on
individual loan characteristics vary from one to another, depending on the actual
make up of the mortgages experiencing these declines. A combination of historical
evidence along with strong analytical judgment is used in determining loss criteria.
  This section will focus on how the risk of loss is determined as a result of economic
and credit factors. Loss coverage assumptions for subprime loans were developed
using standard A quality, first-lien criteria as a benchmark. Accordingly, standard
criteria will apply for loan type, dwelling type, LTV ratio, the size and term of the
loan, geographic concentration, and the documentation requested during the under-
writing process. These individual risk characteristics usually have an affect on one of
the two factors which determine the overall risk of loss on a loan (although some
characteristics affect both factors). These factors are:
I Foreclosure frequency, which is the probability that a loan will default,

  is discussed in the “Foreclosure Frequency Assumptions” section below, and
I Loss severity, which is the amount of loss that will be realized on a defaulted loan,

  is discussed in the “Loss Severity” and “Seasoned Loan Analysis” sections.




  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   27
                                                        Chart 1
                      How Standard & Poor's Ratings Model Works

           Identify                                                                 Applications
             Loan                                                              I Risk Grading
        Characteristics                                                        I Loan Loss Reserves
                                                                               I Risk-Based Pricing
                                                                               I Best Execution Analysis
                                                                               I Portfolio Management
                                                                               I Servicing Management
     Import Database File




            Quality
                                      Verfication
            control




                                                                                             Return
                                                                                             Reports
                                           S&P
                                        Economic
                                          Index



                              LTV                        S&P
                           Adjustment                    Risk
                          (Seasoned Loans)              Grades




         Loan-by-                      Probability of
       Loan Analysis                   Loan Default
                                                                      Loss
                                                                                        Output
                                                                    Coverage


                                         Expected
                                        Loss Upon
                                          Default




                                S&P                    LTV
                             Economic               Adjustment
                               Index             (Seasoned Loans)




28
                                                  Credit Analysis for Subprime Loan Transactions




  The adjustments made to Standard & Poor’s base foreclosure frequency assumptions
for subprime loans are likewise discussed in that section. Finally, this review will end
with a discussion on default and loss curves.


The Ratings Model
Standard & Poor’s ratings model is an econometric model which determines the
risk associated with a mortgage loan or portfolio of mortgage loans. The ratings
model utilizes standard mortgage and credit file data to compute credit enhancement
requirements for residential mortgage loans based upon the rating criteria
(see appendix A). These individual loan analyses can then be aggregated to
provide ratings requirements on a portfolio of mortgage loans (see chart 1).


Foreclosure Frequency Assumptions for Subprime Loans
The level of foreclosures on subprime loans directly correlates with the mortgagor’s
ability and willingness to pay. Most of today’s lenders are relying on a combination
of credit scoring and traditional, matrix-driven underwriting practices (see table 1).
Currently, if a consumer score is not provided to Standard & Poor’s, a loan pool’s
specific composition within these categories of credit classifications will be used in
determining the foreclosure frequency assumptions. Analysts will adjust the standard
prime foreclosure frequency assumptions according to predetermined multiples for
the increased risk associated with subprime mortgage loans (see table 2).
  During 1996, the use of Fair, Isaac and Co.’s (FICO) credit scoring method
became commonplace in the residential mortgage industry. Used for many years in
unsecured consumer lending, the FICO credit score is a statistical method of assessing


                                              Table 1
                               Subprime Credit Classifications

 Characteristic                             A-                   B               C            D
 Mortgage credit                         2x30                3x30            4x30          5x30
                                                                             1x60          2x60
                                                                                           1x90
 Consumer credit                         2x30                3x30            4x30          4x30
                                         1x60                2x60            3x60          3x60
                                                                             1x90          2x90
 Debt/income                                45                  50              55           60
 NOD*/bankruptcy                      None in             None in         None in       None in
                                    past 5 yrs.         past 3 yrs.     past 2 yrs.     past yr.
 *NOD—Notice of delinquency.




 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria       29
     repayment risk based on a borrower’s credit history, as reported to the three major
     credit repositories: Experian, Trans Union, and Equifax. A credit score is a numeri-
     cal summary of the relative likelihood that an individual will pay back a loan. As an
     index, the score reflects the relative risk of serious delinquency, foreclosure, or bank-
     ruptcy associated with a borrower.
        Based on analysis Standard & Poor’s has conducted, it has been determined that
     the availability of consumer credit scores enhances the ratings process. Therefore,
     when loan level information regarding the mortgage loans is sent in for analysis, the
     consumer credit score should be included (see appendix F). Credit scores, in addition
     to other loan characteristics, are used to derive Standard & Poor’s Mortgage Scores,
     which are then mapped to Standard & Poor’s Risk Grades. The current A, A-, B, C,
     and D guideline-based ranking scale will be replaced with a default-based system of
     risk grades 1 to 7, (RG1 to RG7), with RG1 being the highest quality and RG7
     being the most risky.
        There has been much debate surrounding the use of credit scores in subprime lending.
     Many traditional subprime lenders believe that granting credit based upon a “score”
     deprives the borrower the ability to tell his/her story to a human underwriter. One
     significant difference between the use of scores in the ratings process and their use
     by underwriters is the simple and somewhat obvious fact that underwriters are
     granting or rejecting credit, and the ratings process is focused on the analysis of
     closed loans.
        The developments in automated underwriting systems, credit scoring, and the
     evolution of mortgage scoring have provided the subprime industry with a wealth
     of new data to support the analysis of risk. The sophistication of mortgage scoring
     now allows underwriters the ability to statistically determine the risk associated with
     the combination of a specific borrower, mortgage note, and property. Mortgage
     scoring allows this risk to be measured with a heightened degree of consistency and
     objectivity. While Standard & Poor’s certainly does not advocate lending based upon
     a FICO score alone, its use as an independent, unbiased, statistical method of assessing
     repayment risk is useful in the ratings process (see “Loan Quality Guidelines” section).




                                              Table 2
                         Subprime Foreclosure Frequency Adjustments

      Credit Grade                            LTV<= 75%                             LTV> 75%
      A-                                                1.25                             1.50
      B                                                 2.00                             2.40
      C                                                 3.00                             3.60
      D                                                 4.00                             4.80



30
                                              Credit Analysis for Subprime Loan Transactions




  This section outlines many of the key risk factors that are considered in the rating
analysis. For clarity in the examples shown, individual risk factors are compared
against a benchmark mortgage that Standard & Poor’s defines as “prime.” The
reader should be aware that many of these factors are interactive. That is, as more
and more risk factors combine for a single mortgage loan, the risk of loss changes.
A mortgage loan on a condominium in an amount of 80% of the condominium’s
value has a certain level of risk. A 90% loan-to-value (LTV) loan on a single-family
home has a different risk characteristic. Combining the two, a 90% LTV on a con-
dominium may have a unique risk of loss that is different from the product of each
individual factor.
  The standard foreclosure frequency assumptions are expressed in relation to a
prime pool of mortgage loans. A prime pool is defined as fixed-rate, fully-amortizing,
owner-occupied, level payment, first lien mortgages on single-family detached homes.
The underlying properties should be well dispersed geographically, in areas with
strong economic bases. Loan balances should not exceed $400,000 and represent no
more than 80% of the value of the home. Underwriting guidelines should require
that the borrower have no history of delinquent payments and a minimum FICO
score of 660. At least 300 loans should make up the pool to provide the desired
level of statistical confidence. Table 3 details the foreclosure frequency assumptions
for a prime pool at each rating level. Standard & Poor’s uses multiples to arrive at
each of the rating categories in order to reflect varying stress assumptions to gauge
mortgage pool performance in all types of economic environments.
  The base foreclosure frequency of a prime pool for each rating category is affected
by changes in loan characteristics such as:
I Borrower credit quality (see table 2),

I Loan to value (LTV) ratios,

I Type of secured property,

I Loan purpose,

I Occupancy status,




                                             Table 3
           Base Foreclosure Frequency Assumptions for a Prime Quality Pool

 Rating level                                                       Foreclosure frequency (%)
 AAA                                                                                      15
 AA                                                                                       10
 A                                                                                         8
 BBB                                                                                       6
 BB                                                                                        3
 B                                                                                        1.5



 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria     31
     I   Mortgage seasoning (see “Seasoned Loan Analysis”),
     I   Pool size,
     I   Loan size,
     I   Loan maturity,
     I   Loan documentation,
     I   Adjustable-rate mortgages (ARMs),
     I   Balloon mortgages, and
     I   Lien status.

     Loan to Value (LTV) Ratios
     LTVs historically have proven to be key predictors of foreclosure rates. The LTV of
     a loan is defined as the mortgage loan balance divided by the lower of the home’s
     purchase price or appraised value, expressed as a percentage. Standard & Poor’s
     bases its analysis of the relationship between LTV ratio and credit risk on empirical
     data from the mortgage insurance industry.
        Higher LTV loans gained popularity in the inflationary environment of the 1960s
     and 1970s as it became more difficult for first-time homebuyers to accumulate 20%
     for a down payment. Consequently, 90% loans (defined as anything between
     80.01% and 90%) and 95% loans (anything between 90.01% and 95%) became
     popular, although 95% LTV loans have become less popular in recent years as a
     result of their poor performance in the 1980s.
        The higher the LTV ratio, the greater the risk of mortgage foreclosure. It is estimated
     that loans with LTVs of 90% have a 1.5 times (x) greater risk of being foreclosed
     than loans with a ratio of 80%. Loans with an LTV of 95% are assumed to be 3.0x
     riskier than loans with an LTV of 80%. Loans with an LTV of 100% are assumed
     to be 4.5x riskier than loans with an LTV of 80%. These assumptions are also
     assuming that the borrower has a FICO score less than or equal to 699. Table 4
     shows Standard & Poor’s foreclosure frequency multiples based upon LTV and
     FICO score.

     Type of Secured Property
     The type of property pledged to secure a mortgage loan also affects its default prob-
     ability. Standard & Poor’s categorizes all properties into three segments: single-family
     detached, low-rise condominium, and high-rise condominium. Each segment contains
     additional property types with similar risk. Table 5 shows the different groupings of
     the various property types by segment and the foreclosure frequency adjustments or
     multiples applied to the prime foreclosure frequency assumptions for each.
       Standard & Poor’s views the single-family detached unit as the safest type of property,
     and it is the only loan type included in a prime pool. This type of home represents
     the largest share of the residential housing market and still remains the preferred


32
                                                      Credit Analysis for Subprime Loan Transactions




property type for most homebuyers. Because of the high level of demand for this
property type, single-family detached homes should experience the least market
value decline in an economic downturn.
  Single-family attached, low-rise condominiums, and two-family properties are all
viewed as somewhat riskier than single-family detached properties. Although these
properties are of very high quality, demand is somewhat less than for single-family
detached units. Single-family attached properties include row houses, townhouses,
and semidetached dwellings. Low-rise condominiums include all properties of four
stories or less. An additional source of risk is contained in two-unit properties since
rental income may be necessary to support the mortgage. This risk is somewhat
decreased when the owner occupies one of the units.
  High-rise condominiums, co-ops, and three- to four-family homes are viewed as
the riskiest property types and probably have the narrowest appeal. In high-rise
condominiums and co-ops, whole buildings can be subject to large market value
declines and foreclosures if the property is not well managed or maintained. There


                                                     Table 4
              Foreclosure Frequency Multiples Based Upon Loan to Value (LTV)
                                  and FICO Score <= 699

 Loan to value (%)                                                       Foreclosure frequency multiple
 <=80                                                                                               1.0
 80.01<=90                                                                                          1.5
 90.01<=95                                                                                          3.0
 95.01<=100                                                                                         4.5


                                                     Table 5
                 Foreclosure Frequency Multiples Based Upon Property Type

 Property type                                                                                Multiple
 Single-Family Detached                                                                             1.0
 Low-rise condominium, single family attached, two family detached                                  1.2
 High-rise condominium, three-four family detached                                                  2.0



                                                     Table 6
                 Foreclosure Frequency Multiples Based Upon Loan Purpose

 LTV                              >70<=75                      >75<=80         >80<=85             >85
 Purchase                               1.0                        1.0              1.0             1.0
 Refinance rate/term                    1.0                        1.0              1.0             1.0
 Cash-out                               1.1                        1.2              1.5             2.0



 Standard & Poor’s Structured Finance         I   U.S. Residential Subprime Mortgage Criteria         33
     also is concern that there is less pride of home ownership in high-rise condominiums
     and co-ops. Included in this category with the highest level of loss coverage are
     three- to four-family detached homes. These homes are viewed as riskier because
     they tend to be dependent on high levels of rental income.

     Loan Purpose
     The purpose of any loan falls into one of two categories: purchases or refinancings.
     Within the refinancing category, Standard & Poor’s distinguishes between rate/term
     refinancings and equity take-out refinancings. Table 6 illustrates the corresponding
     foreclosure frequency adjustments or multiples applied to the prime foreclosure
     frequency assumptions. The adjustments are the same for each rating category.
     There is no additional adjustment to the prime foreclosure frequency assumptions
     for purchase or rate/term refinance loans. A purchase mortgage is the term used to
     describe the typical mortgage transaction where a buyer is funding a portion of the
     acquisition price for a new home. The collateral value pledge to the mortgagee is
     strongly supported by both the purchase price and an appraisal.
       In a rate/term refinancing, the mortgagor replaces an existing loan with a new,
     shorter maturity or lower interest rate loan, thereby decreasing the term or lowering
     the monthly payments. Closing costs may be funded in a rate/term refinancing, with
     a maximum of $1,000 additional cash released to the borrower.
       Cash-out refinancings have a higher risk profile. This is because of the difficulty in
     measuring actual market value because there is no sale price. For this reason, in the
     rating analysis the LTV ratio will be adjusted upward by 5%. Loans with LTVs
     above 70% are adjusted to compensate for additional risk. However, cash-out refinances
     that have seasoned at least five years will be treated the same as rate/term refinances
     for determining loss coverage.


                                                                            Table 7
                           Adjustment Factor Applied to Prime Foreclosure Frequency
                                       Assumptions for Seasoned Loans

                                                                               —Months seasoned—
      Loan type                        <60          60<72           =72<84            =84<96   =96<108   =108<120    120
      ARM, hybrid arms                  1.0          0.875                  0.85       0.825       0.8      0.775    0.75
      Fixed-rate Loan                   1.0            0.75                 0.70        0.65       0.6       0.55    0.50
      15 year balloon                   1.0          0.875             0.875           0.875     0.875      0.875   0.875
      All other loan types              1.0             1.0                  1.0         1.0       1.0        1.0     1.0
      For further description regarding loan types refer to the glossary.




34
                                              Credit Analysis for Subprime Loan Transactions




Occupancy Status
Mortgages for non-owner-occupied homes are considered riskier than loans on primary
residences. A homeowner is more likely to forfeit a second home or an investment
property than their primary residence. An additional risk with investment properties
is that the rental income is needed to make the mortgage payments, and rental
income may not always be there. Accordingly, the prime foreclosure frequency
assumptions are increased by a factor of 3.0x on second homes and investment
properties to account for the increased risk of default.

Mortgage Seasoning
There are two types of seasoning credits that Standard and Poor’s applies to its prime
foreclosure frequency assumptions. Table 7 illustrates the foreclosure frequency
multiples according to loan type if a loan is seasoned. The other type is described
in the next paragraph titled “LTV adjustments.”
   LTV adjustments. A repeat sales index is used to reflect property value changes
affected by the price movements of homes. The index for a loan at the time it was
originated is compared to the most recent index for that property’s geographic location
to compute the level of appreciation or depreciation. The use of repeat sales indexes
provide additional information in assessing current collateral values. However, an
index cannot replace an actual sale or full appraisal. The main shortcoming to any
index is that it is using values of neighboring properties that may or may not be relevant
to a specific property. Analysts will take a measured approach in their application of
the repeat sales index.
   Indexes can be found at the metropolitan statistical area, county, or zip code level.
A property’s value is adjusted when an index is available. The adjusted property
value is then used in the determination of the current loan to value ratio. The
important thing to note is that the foreclosure frequency is based on the adjusted
LTV using the adjusted property value and the current balance of the loan. If there
is no index available, the adjusted loan to value only takes into affect amortization.
   Under certain conditions, the loan to value ratio of a seasoned loan may not be
adjusted using a repeat sales index. In these cases, a recent property-specific valuation
has been obtained through a new appraisal or a broker’s price opinion.

Pool Size
As in any statistical sample, loan pool size is important in determining risk.
Standard & Poor’s considers 300 loans a population of sufficient size to ensure
diversity and the accuracy of loss assumptions. Pools with less than 300 loans, but
no fewer than 100 loans, are ratable on an actuarial basis. However, an adjustment




 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   35
     is made in pool credit quality analysis. Pools with less than 100 loans are reviewed
     on a case-by-case basis.
        Analysts will assess a small pool penalty for mortgage pools containing less than
     300 loans. The purpose of the small pool penalty is to capture the uncertainty in the
     assumed foreclosure frequencies. Approaching the subject from the standpoint of
     sampling theory, a formula has been developed for adjusting the average foreclosure
     frequency for each pool based on the average foreclosure frequency for the pool and
     the number of loans in the pool (the sample size) for a 99% confidence level. This
     equation, which measures the standard error of the sample mean, is:

       FF + 2.58(    FF(1-FF)     )
                        N
       where,

       FF = average foreclosure frequency, and
       N = number of loans.
       The problem with using this equation is that the adjusted foreclosure frequency
     will always be greater than the base. Put another way, the factor is always greater
     than one even at 300 loans (which is necessary to remain consistent with other MBS
     rated to date) except in the limiting cases when N, or FF, is very large or very small
     (0.9999 or 0.0001). Unless an issuer has a pool of an infinite number of loans, there
     will always be a small pool penalty (P). Clearly, this is impractical.
       Therefore, to make the method practical and consistent with the 300-loan benchmark,
     the equation is normalized at N equals 300, resulting in the following equation:

       FF + 2.58(    FF(1-FF)     )
                        N

       P(FF,N) =
                     FF(1-FF)

       FF + 2.58(    FF(1-FF)     )
                       300

       This represents the first equation divided by the same equation evaluated at 300
     loans. The small pool penalties calculated this way will be less severe for a given
     number of loans than in the past. This actuarial model will not be used, however, to
     estimate losses on pools with less than 100 loans. In those rare cases, a separate
     arrangement may be made to review each loan file in order to arrive at an appropriate
     credit enhancement level.




36
                                              Credit Analysis for Subprime Loan Transactions




Loan Size
Loan size is another credit quality factor. Jumbo loans, defined as loans with a balance
of more than $400,000, are considered higher risks. In an economic downturn, jumbos
are more likely to suffer greater market value decline as a result of a limited market
for the underlying properties. This would increase the loss severity on the mortgage.
The larger the market value decline, the more likely the mortgagor will default. In a
declining market, there is less willingness (not necessarily less ability) to repay.
   Mortgage loan default rates are influenced by a number of variables, including the
principal balance of the loan. Default criteria for jumbo mortgages are based on a
study of the relationship between loan size and default rates, resulting in foreclosure
frequency adjustment factors. This approach makes adjustments to the assumed
foreclosure frequency for a given loan based on its unpaid principal balance. The
resulting foreclosure frequency multiples are applied to the prime foreclosure frequency
assumptions for jumbo loans for the following loan balances. The accompanying
chart illustrates various adjustments along the loan balance continuum (see chart 2).
   Analysts have also studied the relative default rates based on LTV ratios to determine
if the impact of varying LTV ratios on jumbo loan defaults is greater than the standard
adjustments. The data indicate that the standard adjustments adequately cover any
additional default risk associated with higher LTV ratios.


                                             Chart 2
                                Loan Balance Continuum

     Fixed Rate Loans

                 <$400,000<             <$600,000<            <$1,000,000<

         1.0x                 1.2x                     1.6x                  3.0x




     Adjustable Rate Loans

                 <$400,000<             <$600,000<            <$1,000,000<

         1.0x                 1.1x                     1.4x                  2.5x




 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   37
     Loan Maturity
     By their very nature, mortgages with 15-year terms are less risky than comparable
     30-year mortgages. The shorter term means that the 15-year mortgage amortizes
     faster (see Loss Severity section). In addition, industry data indicate that 15-year
     mortgages default less frequently than 30-year mortgages.
       According to data analyzed, 30-year mortgages have historically performed two to
     three times worse than 15-year loans. The lower default risk as indicated by this
     data implies that a lower foreclosure frequency should apply to 15-year mortgages.
     Another point that highlights the lower risk in 15-year loans is the relative monthly
     payments. For example, for a $300,000 mortgage at 12%, the monthly payment on
     a 15-year loan is about 30% higher than for a 30-year loan. Qualifying at a 28%
     debt-to-income ratio, the 30-year borrower’s income would be $94,340 versus
     $122,869 for the 15-year borrower. This represents a much higher income bracket.
     The 15-year borrower could easily refinance into a 30-year loan to increase net
     cash flow or could suffer a $28,000 cut in pay and still afford the same size mort-
     gage at a 30-year term. As a result, Standard & Poor’s will give 10% credit to the
     foreclosure frequency.
       While no data are available to compare the default experience of 20-year mortgages
     versus 30-year mortgages, it is believed that because of the shorter term, the accelerated
     amortization, and the borrower profile, 20-year loans are less risky than comparable
     30-year loans. Therefore, the foreclosure frequency for 20-year loans is reduced
     by 5%.
       Table 8 illustrates the differences in the foreclose frequency adjustments or multiples
     applied to the prime foreclosure frequency assumptions for a loan with a 15, 20 and
     30 year maturity. For loans with a term of greater than 360 months there is a multiple
     of 1.05 applied to the prime foreclosure assumptions.

     Documentation
     While reduced documentation introduces an additional risk factor, an assessment
     must be made whether total credit risk has increased. Many accelerated underwriting
     programs aim to offset potentially higher credit risk by increasing the required size


                                               Table 8
                     Foreclosure Frequency Multiples Based Upon Loan Term

      Term                                                                            Multiple
      >30 years                                                                           1.05
      30 years                                                                            1.00
      20 years                                                                            0.95
      15 years                                                                            0.90



38
                                                   Credit Analysis for Subprime Loan Transactions




of the mortgagor’s down payment. Intuitively, there is a point at which a certain
level of risk is offset by an increased down payment. Standard & Poor’s ratings
model encompasses LTV as a separate risk factor from documentation type. Therefore,
a loan having a low LTV with limited documentation may have the same loss coverage
requirement as a higher LTV loan with full documentation. An increased level of


                                                 Table 9
                                        Documentation Types

                                                                Original first/         Foreclosure
                                                               combined LTV       frequency multiple
 No employment/income verification                                         >90                     2
                                                                           >80                   1.5
                                                                           >70                   1.2
                                                                           >60                   1.1
                                                                          <=60                  1.05
 No Asset Verification and No Employment/Income Verification               >90                     4
                                                                           >80                  2.25
                                                                           >70                  1.44
                                                                           >60                  1.21
                                                                          <=60                   1.1
 Verbal verification of employment (VVOE)                                  >90                     2
                                                                           >80                   1.5
                                                                           >70                   1.2
                                                                           >60                   1.1
                                                                          <=60                  1.05
 One paystub obtained                                                      >90                     2
                                                                           >80                   1.5
                                                                           >70                   1.2
                                                                           >60                   1.1
                                                                          <=60                  1.05
 One paystub and VVOE or one year 1040 (self employed)                     >90                     2
                                                                           >80                   1.5
                                                                           >70                   1.2
                                                                           >60                   1.1
                                                                          <=60                  1.05
 One paystub and one W-2 and VVOE                                          >90                   1.5
                                                                           >80                  1.25
                                                                           >70                   1.1
                                                                           >60                  1.05
                                                                          <=60                  1.03
 Full documentation                                                        >90                    1
                                                                           >80                    1
                                                                           >70                    1
                                                                           >60                    1
                                                                          <=60                    1



 Standard & Poor’s Structured Finance       I   U.S. Residential Subprime Mortgage Criteria        39
     protection will be looked for to cover the relative risk present as a result of under-
     writing with reduced documentation.
       The adjustment factors act as multipliers to the existing foreclosure frequency
     numbers. There will be no adjustment to the corresponding loss severity factors. The
     reason for adjusting the foreclosure frequency is that there is a higher probability
     that unqualified mortgagors may be approved in certain limited documentation

                                             Table 10
                                   ARM Adjustment Matrix*

      Life Cap = 0
      Adjustment frequency           0<RC†<=3             RC>3,=0
      0 to 6 months                        1.9                  5
      >> 6 to 24 months                    1.9                1.9
      >> 24 to 36 months                   1.7                1.9
      >> 36 to 60 months                   1.6                1.7
      >> 60 to 84 months                   1.5                1.6
      >> 84 to 120 months                  1.2                1.2
      >> 120 months                          1                  1
      0 << Life Cap <= 4
      Adjustment frequency            0<RC<=1             1<RC=2      2<RC<=3     RC>3,=0
      0 to 6 months                        1.5                1.6          1.7         1.7
      >>6 to 24 months                     1.5                1.5          1.6         1.6
      >> 24 to 36 months                   1.2                1.2          1.2         1.3
      >> 36 to 60 months                   1.1                1.1          1.1         1.2
      >> 60 to 84 months                     1                  1            1         1.1
      >> 84 to 120 months                    1                  1            1           1
      >> 120 months                          1                  1            1           1
      4 << Life Cap <= 7
      Adjustment frequency            0<RC<=1             1<RC=2      2<RC<=3     RC>3,=0
      0 to 6 months                        1.5                1.6          1.7       1.70x
      >> 6 to 24 months                    1.5                1.5          1.6       1.60x
      >> 24 to 36 months                   1.3                1.3          1.3       1.40x
      >> 36 to 60 months                   1.2                1.2          1.2       1.30x
      >> 60 to 84 months                   1.1                1.1          1.1       1.20x
      >> 84 to 120 months                    1                  1            1       1.05x
      >> 120 months                          1                  1            1       1.00x
      7 << Life Cap <= 10
      Adjustment frequency            0<RC<=1             1<RC=2      2<RC<=3     RC>3,=0
      0 to 6 months                        1.6                1.7          1.8           5
      >>6 to 24 months                     1.6                1.6          1.7         1.9
      >>24 to 36 months                    1.5                1.5          1.5         1.9
      >>36 to 60 months                    1.4                1.4          1.4         1.7
      >>60 to 84 months                    1.3                1.3          1.3         1.6
      >>84 to 120 months                   1.2                1.2          1.2         1.2
      120 months                             1                  1            1           1




40
                                                                     Credit Analysis for Subprime Loan Transactions




programs. In formulating the adjustment factors, it should be kept in mind that
while most programs developed thus far are similar in concept, they also contain
subtle differences (see table 9).
  Reduced or limited documentation loans vary in documentation requirements, but
the focus of the products is to reduce the amount of paperwork the mortgagor is
required to submit at loan application. For example, a stated income from the borrower
may be used in the debt-to-income calculations. However, it is also possible that
only current pay stubs are obtained.
  Recognizing that the credit worthiness of a borrower and certain loan characteristics
may be used as compensating factors for various forms of alternative documentation,
a scoring system has been developed that evaluates these characteristics. The new
Documentation and Automated Collateral Scoring System (DACSS) evaluates the
attributes of a loan application and the credit quality of a borrower). It then assigns,


                                                              Table 10 (cont’d)
                                                ARM Adjustment Matrix*

 Life Cap >> 10
 Adjustment frequency                                0<RC<=1                          1<RC=2             2<RC<=3              RC>3,=0
 0 to 6 months                                                 1.9                           1.9                 1.9                5
 >> 6 to 24 months                                             1.9                           1.9                 1.9               1.9
 >> 24 to 36 months                                            1.7                           1.7                 1.7               1.9
 >> 36 to 60 months                                            1.6                           1.6                 1.6               1.7
 >> 60 to 84 months                                            1.5                           1.5                 1.5               1.6
 >> 84 to 120 months                                           1.2                           1.2                 1.2               1.2
 >> 120 months                                                   1                             1                   1                1
 Pay Cap                                         Adjustment
 PC =0                                                        5.00
 0<PC<=5                                                      1.25
 5<PC<=8                                                      1.40
 8<PC<=17                                                     1.75
 PC>17                                                        2.00
 Life cap adjustment                             Adjustment
 d< 0                                                         5.00
 d=0                                                          1.00
 0d=1                                                         1.20
 1d=3                                                         1.75
 3¶
                                                              5.00
 *The final ARM loan adjustment is the lesser of the ARM matrix adjustment, the pay cap adjustment, and the life cap adjustment.
 †RC—Rate cap.¶—Life cap minus current rate.




 Standard & Poor’s Structured Finance                     I     U.S. Residential Subprime Mortgage Criteria                          41
     if eligible, alternative documentation and collateral requirements in accordance with
     the rating criteria. This occurs without assigning a corresponding increase in foreclosure
     frequency expectation.
        Alternative collateral valuations are property valuations derived from traditional
     industry forms but used in a nontraditional manner. Prior to DACSS, Standard &
     Poor’s required a full Uniform Residential Appraisal Report (URAR) (Fannie Mae
     form 1004) for all first-lien mortgages, regardless of perceived default risk. Currently,
     the perceived default risk is used to evaluate alternative collateral documentation
     levels so that a first-lien mortgage may only require a drive-by appraisal.

     Adjustable-Rate Mortgages
     In analyzing adjustable-rate mortgage (ARM) credit risk, the rating analysis focuses
     on the following factors to determine loss protection:
     I Frequency of rate increases;

     I Amount of potential rate increase per period;

     I Incremental life-cap, or the amount of potential rate increase over the life

        of the mortgage;
     I Negative amortization; and

     I Volatility of the index.

        Table 10 lists the adjustments or multiples for various types of ARMs. The
     assumed foreclosure frequency for each loan will be adjusted by the applicable
     amount. For example, the multiple for an ARM that adjusts annually with a rate
     cap of 2% and an incremental life cap of 6% would be 1.5 times (x) that of a com-
     parable fixed-rate loan. The multiple for a loan that adjusts every two years with a
     5% rate cap and a 8% incremental life cap is 1.9x its fixed-rate counterpart.
        The payment cap and life cap adjustments included in table 10 are determined for
     each loan along with the ARM matrix adjustment, and the lesser of the three is
     applied to the loan. For instance, regardless of the adjustment frequency or the periodic
     pay cap, if a loan has a life cap adjustment of two—that is, the current interest rate
     can never increase more than 2%—the penalty is not greater than 1.75x.
        ARMs without rate caps have substantially more credit risk. Here, all interest rate
     risk is shifted from the lender to the mortgagor. During an economic downturn,
     housing values and borrowers’ income could remain constant (or decline) as mortgage
     interest rates rise sharply.
        For ARMs that do not fit into the table, the specific ARM program will be analyzed
     to determine the appropriate adjustment factor. For instance, certain adjustable loan




42
                                                     Credit Analysis for Subprime Loan Transactions




programs provide for a fixed-rate period before the loan becomes fully adjustable.
These ARMs are commonly referred to as 2/1, 3/1, 5/1, 7/1, or 10/1 Hybrid ARMs.
If the rate on these loans have the ability to go to their life caps at the first adjustment,
the respective foreclosure frequency multiples are 1.6x, 1.5x, 1.3x, 1.2x, and 1.0x. If
these loans cannot go to their life caps at the first adjustment date (in other words,
they have periodic caps), the respective foreclosure frequency multiples are 1.4x,
1.3x, 1.2x, 1.05x and 1.0x.

Balloon Mortgages
A balloon mortgage is a loan with principal payments that do not fully amortize the
loan balance before maturity. One common form of balloon mortgage offered in
the residential market is a fixed-rate loan with level principal and interest payments
calculated on the basis of a 30-year amortization schedule. After a specified term
(usually five, seven, ten or fifteen years), the remaining unpaid principal balance is
due in one large payment. Some loans provide the borrower with an option to
refinance for an additional 23 years if all of the following conditions are met:
I The borrower remains the owner-occupant of the home securing the loan,

I Monthly payments are current and have not been 30 days late even once during

  the 12 months preceding the maturity date,
I The interest rate for the new mortgage note is no more than five percentage points

  above the original note rate,
I There are no other liens on the property (except liens for taxes and special assessments

  not yet due and payable), and
I The borrower makes a written request to the servicer.

  With or without such an option, the ability to refinance is never a certainty. The
original lender is not under a contractual obligation to offer a new loan to the balloon
borrower. Repayment of balloon mortgages, unlike their fully amortizing counterparts,
depends not only on the borrower’s earning capacity, but also on his or her ability
to refinance five, seven, ten, or fifteen years after origination. As a result, both the
borrower and the lender are subject to forces, such as the movements of interest



                                                 Table 11
                 Foreclosure Frequency Multiples Based Upon Balloon Loans

 Balloon term      LTV <= 60   60.01 < LTV <= 70      70.01 < LTV <= 80   80.01 <LTV <90   90.01 <LTV
 Five years              1.7                    2                   2.4              2.7           3
 Seven years             1.5                   1.7                   2              2.25          2.5
 Ten years               1.2                   1.5                  1.7             1.85           2
 Fifteen years            1                     1                    1                1            1




  Standard & Poor’s Structured Finance     I    U.S. Residential Subprime Mortgage Criteria         43
     rates and property values at the time of refinancing, that are beyond their control.
     Borrowers who are unable to refinance may default on their balloon loans.
       In light of this added credit risk, Standard & Poor’s looks for higher levels of loss
     protection for rated subprime transactions involving balloons. Table 11 shows, for
     different LTV ranges, the multiples applied to the prime foreclosure frequency
     assumptions for balloon loans of various types and maturities.

     Lien Status
     For second mortgage pools, the combined loan to value (CLTV) ratio is used to
     identify the applicable foreclosure frequency and market value decline. However, for
     nearly all second mortgage loans the borrower is taking equity out of the property,
     so the foreclosure frequency and market value decline are adjusted to address the
     additional credit risk that is incurred when the property value is determined by an
     appraisal rather than a purchase price. Table 12 illustrates the foreclosure frequency
     multiples applied to the prime foreclosure frequency assumptions based upon lien
     status and CLTV.


     Loss Severity
     The loss severity assumptions for first-lien subprime mortgages should be no different
     than what would be expected for first-lien A quality mortgages. Therefore, the credit
     quality of a borrower should not play a role in the severity of loss experienced on a
     given loan. The loss severity assumptions detailed in this section are expressed in
     relation to a prime pool of mortgage loans. Loss severity is a combination of the
     assumed market value decline of the related property and the costs associated with
     foreclosing on such property. The accompanying box details exactly how these
     two factors combine to determine the total amount of loss severity a loan may
     experience (see “Calculation of Loss Severity” box).
       Table 13 details the loss severity assumptions for a prime pool at each rating level.
     Analysts use multiples to arrive at the loss severities for the different rated categories
     in order to reflect varying stress assumptions in all types of economic environments.
       The base loss severity assumptions for each rating category are affected by factors
     such as the following:
     I Loan to value (LTV) ratios,

     I Mortgage insurance,

     I Lien status,

     I Loan balance,

     I Loan maturity,

     I Loan type,

     I Loan purpose,




44
                                                                       Credit Analysis for Subprime Loan Transactions




I    Property type and occupancy,
I    Geographic dispersion,
I    Standard & Poor’s Economic Index, and
I    Mortgage seasoning (see section below).




                                                                    Table 12
                  Foreclosure Frequency Multiples Based Upon Lien Status and CLTV

    Combined LTV                                                                                        Foreclosure frequency (%)
    <=70                                                                                                                                  1
    <=80                                                                                                                              1.2
    <=90                                                                                                                                  3



                                                                    Table 13
                               Loss Severity Assumptions for a Prime Quality Pool

    Rating level               Loss severity (%)                  Market value decline (%)                   Foreclosure costs (%)*
    AAA                                             43                                         34.5                                   25
    AA                                              40                                           32                                   25
    A                                               35                                           28                                   25
    BBB                                             34                                         27.2                                   25
    BB                                              33                                         26.4                                   25
    B                                               33                                         26.4                                   25
    *Foreclosure costs include an interest carry component which assumes a 12% mortgage rate, brokerage fees (5%), legal fees (3%),
    taxes (3%) and other costs (2%).




        Calculation of Loss Severity

        “AAA” Rating Level*
        Purchase price of home                                                                                               $100,000
        Loan balance (80% of purchase price)                                                                  $80,000
        Market value decline (34.5% of purchase price)                                                                         (34,500)
        Market value at foreclosure sale                                                     (65,500)                            65,500
        Market loss                                                                           14,500
        Foreclosure costs¶(25% of loan balance)                                               20,000
        Total loss                                                                                            $34,500
          Total loss/loan balance = loss severity $34,500/$80,000 = 43%
        * Assumes first-lien mortgage loan, owner-occupied, single-family detached property, with an LTV of 80%
        The ‘AAA’ category assumes a 34.5% market value decline in an economic depression.
        ¶ Foreclosure costs include an interest carry component which assumes a 12% mortgage rate, brokerage fees (5%),
        legal fees (3%), taxes (3%) and other costs (2%).




    Standard & Poor’s Structured Finance                      I    U.S. Residential Subprime Mortgage Criteria                            45
     Loan to Value (LTV) Ratios
     LTV is defined as the ratio of mortgage debt divided by the lower of the home’s
     purchase price or appraised value, expressed as a percentage. Generally, the higher
     the LTV, the higher the loss severity (see table 14). However, mortgages with LTVs
     of greater than 80% may show lower loss severities because these loans may have
     primary mortgage insurance (see box).

     Mortgage Insurance
     Primary mortgage insurance (MI) may be present for loans with LTVs above 80%.
     This insurance generally covers the top 6%-30% of the loan’s balance, depending on
     the type of mortgage loan and the LTV of loan. (These percentages represent standard
     Fannie Mae/Freddie Mac coverage). If the claims-paying ability of a primary mortgage
     insurer is rated ‘AA’ or better, Standard and Poor’s will give full credit to the standard
     insurance coverage provided. This assumes that the insurance being provided is for
     the amount stated above and is diversified across a number of insurers. Lower claims-
     paying ability ratings will either receive partial credit or no credit, depending on the
     individual rating. An example of how loss severity is calculated with standard MI
     present is shown in the accompanying box. The previous example above showed
     this calculation without the benefit of MI.

                                                                       Table 14
                              Effect of Loan to Value on Loss Severity Assumptions*

      ‘AAA’ rating level
      LTV                                                                                      Loss severity (%)
      <=50                                                                                                    0
      <=60                                                                                                   20
      <=70                                                                                                   35
      <=80                                                                                                   43
      <=90                                                                                                   53
      <=95                                                                                                   55


      ‘AA’ rating level
      LTV                                                                                      Loss severity (%)
      <=50                                                                                                    0
      <=60                                                                                                   12
      <=70                                                                                                   28
      <=80                                                                                                   40
      <=90                                                                                                   49
      <=95                                                                                                   52
      *Assumes all prime loans; that is, owner-occupied, single-family, detached properties.




46
                                                                 Credit Analysis for Subprime Loan Transactions




  Mortgage insurers are now looking to insure a greater percentage of a loan’s balance,
possibly as much as 50% of the balance of the loan, or down to a 50% LTV. This
coverage can occur as loan-level deep MI coverage, or possibly as part of a modified
pool policy. In a modified pool policy, the balance of each loan is also covered to a
certain level. However, there typically is an overall stop loss coverage applied to the
entire pool.
  Because of the increased reliance on the coverage provided by the insurer, the
insurer’s rating becomes a more significant factor. To this end, analysts will apply a
discount to the supplemental insurance coverage provided (any coverage above the
standard insurance coverage levels) based on the insurer’s rating. The discount is
applied by giving credit to the provided supplemental insurance in an amount equal
to 100% minus the discounted percentage, as shown in table 15.
  Minimum credit enhancement levels will be required if the ratings model determines
that by applying the supplemental coverage as shown above, little or no additional
credit enhancement is warranted. These minimum requirements will be determined
on a case by case basis, depending on the model’s output and the specific insurer’s
claims denial or adjustment history.

Lien Status
Standard & Poor’s loss severity assumptions are higher for second lien mortgage
loans than for first lien mortgage loans because of the inherent risk. Second mortgages
are more sensitive to a decline in the value of the mortgaged property than are first
mortgages. The first mortgage lender has first claim to foreclosure proceeds, before
any proceeds are available to pay the second mortgage lender. As a result, the second
mortgage loan is first to absorb any loss resulting from a decline in the
property value.


  Calculation of Loss Severity with Mortgage Insurance
  “AAA” Rating Level*
  Purchase price of home                                                                                                 $100,000
  Uninsured loan balance (75% of $90,000)                                                                                 $67,500
  Market value decline (34.5% of purchase price)                                                                          (34,500)
  Market value at foreclosure                                                                          (65,500)             65,500
  Market loss                                                                                                                2,000
  Foreclosure costs¶(25% of uninsured loan balance)                                                                        16,875
  Total loss                                                                                                              $18,875
     Total loss/loan balance = loss severity $18,875/$90,000 = 20.97%
   * Assumes first-lien mortgage loan, owner-occupied, single-family detached property, with an LTV of 90% and primary mortgage
   insurance coverage to 75.0% of the loan balance. The ‘AAA’ category assumes a 34.5% market value decline in an economic
   depression. ¶ Foreclosure costs include an interest carry component which assumes a 12% mortgage rate, brokerage fees (5%),
   legal fees (3%), taxes (3%) and other costs (2%).




 Standard & Poor’s Structured Finance                    I   U.S. Residential Subprime Mortgage Criteria                             47
       Because of this sensitivity to market value declines, the appraisal process is important
     in determining the potential loss severity for second mortgage loans. Similar to the
     process used on first-lien equity take-out mortgage loans, the property value is
     determined solely by an appraisal rather than by the lesser of a sales price and an
     appraisal. As a result, the property values are adjusted to address this additional
     credit risk by dividing the LTV ratio by 95%. This will increase the loss severity on
     the loan because of the increase in the LTV.
       The accompanying box, “Effect of Lien Status on Loss Severity”, shows how loss
     severities change with the size of a second mortgage loan relative to the first mortgage
     loan. The potential loss severity of a second mortgage loan increases as its LTV
     decreases relative to that of the first mortgage loan.

     Loan Balance
     Data indicate that mortgage loans of $370,000 or more take longer to foreclose and
     resell the property. The current criteria assume that for loans up to $370,000 there
     is a 12 month timeframe to liquidate the property and therefore 12 months of
     carrying costs.
        Starting at $370,000, the foreclosure period increases 1 month for every $10,000
     in loan balance, up to a maximum of 24 months to liquidate. For example mortgage
     loans with balances ranging from $370,000-$379,999 and from $380,000-$389,999,
     the foreclosure period would be 13 and 14 months, respectively.
        An additional six months is added to the foreclosure period if the loan is a junior
     lien mortgage loan. This increase in the liquidation period increases the carrying
     costs and significantly increases the loss severity and loss coverage of such loan.

     Loan Maturity
     By their very nature, mortgage loans that have 15-year terms are less risky than
     comparable 30-year mortgages. The shorter term means that the 15-year mortgage
     amortizes faster. The faster amortization impacts the loss severity when a loan
     defaults. Typically, a pool of mortgage loans will have experienced from 50%-60%


                                                Table 15
                          Discount Applied to Supplemental Insurance Coverage

      Rating of insurer                                                           Discount (%)
      AAA                                                                                    0
      AA+                                                                                   25
      AA                                                                                    50
      AA-                                                                                   75
      A+ or lower                                                                          100




48
                                                                     Credit Analysis for Subprime Loan Transactions




of its defaults by the fifth year, with the greatest risk in years three and four. Less
than 20% of the total defaults generally occur in the first two years. The later a loan
defaults, the lower the severity, as a result of the ongoing additional amortization.
The average amortization differences between 15- or 20-year mortgages and 30-year
mortgages are illustrated in table 16.
  The amortization differentials for the first five years average 3.3% for 20-year
loans and 7.8% for 15-year loans. The actual differences are in the columns headed
“percentage difference” and range from 0.9%-6.1% for 20-year loans and 2.1%-
14.3% for 15-year loans. Since the actual time of default cannot be predicted,



  Effect of Lien Status on Loss Severity

  “AAA” rating*
  Appraised value of property                                                                                                    $100,000
  Assumed value of property¶                                                                                                       95,000
  Combined loan balance of first
  and second mortgages                                                                          $80,000
  Market value decline
  (34.5% of assumed value)                                                                                                          32,775
  Market value at foreclosure                                                                    (62,225)                           62,225
  Market loss                                                                                     17,775
  Foreclosure costs§                                                                              20,000
  Total loss                                                                                    $37,775
  Net foreclosure proceeds
  = $80,000 - $37,775 = $42,225
                                                                                         Scenario 1                         Scenario 2
  First mortgage loan:                                                                           45,000                             25,000
  Second mortgage loan:                                                                          35,000                             55,000
  Total loan balance:                                                                            80,000                             80,000
  Application of foreclosure proceeds
  First mortgage loan                                                                            42,225                             25,000
  Second mortgage loan                                                                                  000                        17,225
                                                                                                 42,225                             42,225
  Loss severity by lien position:
                                                                          Scenario 1                                     Scenario 2
  First mortgage loan                                           45,000 - 42,225 = 6%                            25,000 - 25,000 = 0%
                                                                     45,000                                         25,000
  Second mortgage loan                                             35,000 - 0 = 100%                           55,000 - 17,225 = 69%
                                                                    35,000                                         55,000
   Note: The greater the second-lien mortgage loan is relative to the first, the lower the loss severity assigned to the second-lien loss.
   *Assumes a single-family detached, owner-occupied property, 12% fixed-rate fully amortizing, equity takeout loan, and average
   underwriting standards. ¶ $95,000 rather than $100,000 is used for second-mortgage equity takeout criteria because of potential
   inaccuracies in appraisal valuations. §Foreclosure costs consist of accrued interest (12% of the combined loan balances, assuming
   time horizon of a year), brokerage fees (5%), legal fees (3%), taxes (3%), and other costs (2%). If the interest rate on the first and
   second mortgage loan is above 12%, the foreclosure costs will increase.




 Standard & Poor’s Structured Finance                       I    U.S. Residential Subprime Mortgage Criteria                                 49
     Standard & Poor’s assumes 7% for 15-year loans and 3.6% for 20-year loans for
     its model based on default in month 30.
        Amortization differentials can be used to determine relative loss severities, which
     are shown in table 17. This table compares the ‘AAA’ and ‘AA’ loss severities for a
     30-year mortgage loan having an original balance of $80,000, an 80% LTV ratio,
     and a 12% coupon, to the corresponding 15- and 20-year loss severities. Given the
     relative amortization differences as shown above, a 20% and 8% loss severity credit
     is given for 15-and 20 year mortgages, respectively.
        The following shows the differences in loss severity (LS) due to the loan maturity:
     I For a 30-year loan with a 12% coupon in the ‘AAA’ category, LS is equal to 43.0.

     I In the ‘AA’ category, LS is equal to 40%.




                                                            Table 16
                                          Comparative Amortization Rates

      Age (yrs.)          30-yr. loan       20-yr. loan          Difference (%)      15-yr. loan          Difference (%)
      1                         0.996             0.987                      0.9             0.975                   2.1
      2                         0.992             0.973                      1.9             0.946                   4.6
      3                         0.988             0.956                      3.2             0.914                   7.5
      4                         0.982             0.938                      4.5             0.877                  10.7
      5                         0.977             0.917                      6.1             0.837                  14.3
      Average                    N.A.             N.A.                       3.3             N.A.                    7.8
      N.A.—Not applicable.




                                                            Table 17
                                             Comparative Loss Severities

                                        30-year                        20-year                       15-year
                                          ‘AAA’           ‘AA’           ‘AAA’        ‘AA’             ‘AAA’        ‘AA’
      Home price ($)                    100,000      100,000           100,000     100,000           100,000     100,000
      Mortgage ($)                       80,000       80,000            77,360      77,360            73,600      73,600
      Market value decline ($)           34,500       32,000            34,500      32,000            34,500      32,000
      Foreclosure recovery ($)           65,500       68,000            65,500      68,000            65,500      68,000
      Market loss ($)                    14,500       12,000            11,860       9,360             8,100       5,600
      Foreclosure costs ($)              20,000       20,000            20,000      20,000            20,000      20,000
      Total loss ($)                     34,500       32,000            31,860      29,360            28,100      25,600
      Loss severity (%)                     43             40             39.8        36.7              35.1         32
      Relative to 30-year (%)              100            100              93          92                82          80




50
                                                 Credit Analysis for Subprime Loan Transactions




I   For a 20-year loan with a 12% coupon in the ‘AAA’ category,
    LS is equal to 39.8%.
I   In the ‘AA’ category, the LS is equal to 36.7%.
I   For a 15-year loan with a 12% coupon in the ‘AAA’ category,
    LS is equal to 35.1%.
I   In the ‘AA’ category, the LS is equal to 36.7%.

Loan Type
In order to more accurately calculate the potential carrying costs for an adjustable
rate loan, the loan will be assumed to have an interest rate which is 2/3 of the way
between the initial interest rate and the lifetime rate cap. The higher the interest
rate, the greater the carrying costs associated with the default of such loan, and the
higher the loss severity of the loan. The LTV of a negatively amortizing loan is
assumed to be the original LTV, plus 2/3 of the difference between the LTV limit set
by the mortgage note and the original LTV.

Loan Purpose
The purpose of the loan can indicate the borrower’s willingness to pay, and thus
future loss potential. A loan purpose can be viewed as the reason the mortgage loan
is being made. There are two major categories of loan purpose, a loan made for the
purchase of a home or a loan made to refinance an existing loan. Within the refinance
category, there are two types, a rate/term refinance and an equity take-out refinancing.
   When a loan is being made to refinance another loan, the property value is
determined solely by an appraisal rather than by the lesser of a sales price and an
appraisal. Nonetheless, Standard & Poor’s sees no additional risk in a rate/term refi-
nancing. This is due to the borrower merely taking out a new loan with a lower rate
than the original loan. In this case, the appraisal process should not put the borrower
in any worse economic position than before. Thus, a rate/term refinancing loan
needs no greater credit enhancement than a similar loan originated for the purchase
of a home.
   However, refinancings that remove equity are considered riskier. This is due to
the difficulty in measuring property valuation, since there is no sales price to quantify
actual value. If a refinanced home is over-appraised when the equity take-out is
originated, above-average market value declines are expected under adverse market
conditions. The larger the market value decline, the higher the probability that the
mortgagor will default. Because of this, the property values are adjusted to address
this additional risk by dividing the LTV ratio by 95%. This will result in an increase
in the loss severity of the loan due to an increase in the LTV.




    Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   51
     Property Type and Occupancy
     The type of property pledged to secure a mortgage also effects pool credit quality.
     Standard & Poor’s breaks down property types into the following categories: single
     family detached, low rise condominium, single family attached, two family, high rise
     condo, and three-to-four family.
        Standard & Poor’s views the single family detached unit as the safest property and
     it is the only loan type included in the prime pool. This type of home represents the
     largest share of the residential housing market and remains the preferred property
     type for most home buyers. Because of high levels of demand for this property type,
     single family detached homes should experience the least market value decline in an
     economic downturn. Market value declines for other property types are adjusted to
     reflect the decreased liquidity experienced with these properties.
        Single family attached, low rise condominiums, and two family properties are
     viewed as somewhat riskier. Although these properties are very high quality, demand
     is somewhat less than for single family detached properties. Single family attached
     properties include rowhouses, townhouses, and semi-attached dwellings. Low rise
     condominiums consist of properties with four stories or less. An additional risk is
     contained in two unit properties since rental income may be necessary to support
     the mortgage. This risk is somewhat decreased when the owner occupies one of
     the units.
        High rise condominiums and three-to-four family homes are viewed as the riskiest
     property types and probably have the narrowest appeal. In high rise condominiums,
     whole buildings can be subject to large market value declines and foreclosures if the
     property is not well managed or maintained. There is also the concern of less pride
     of ownership in high rise condominiums. Included in this category with the highest



                                             Table 18
        Market Value Decline Assumptions Based Upon Property Types and Occupancy

      Occupancy            Rating   Single family             SFA, 2 family             3-4 family,
      type                  level   detached (%)        low rise condo (%)    high rise condo (%)
      Owner occupied         AAA              34                        36                      38
                              AA              32                        34                      36
                               A              28                        30                      32
                             BBB              23                        25                      27
      Non-owner occupied     AAA              38                        40                      42
                              AA              36                        38                      40
                               A              32                        34                      36
                             BBB              27                        29                      31




52
                                              Credit Analysis for Subprime Loan Transactions




level of risk are three-to four family detached homes. These homes are viewed as
riskier because they tend to be dependent on high levels of rental income.
   Mortgages on second homes are considered riskier than loans on primary residences.
A homeowner is more likely to forfeit a second home before giving up a primary
home. Second homes include vacation homes and investor properties.
   Market value declines by property type and ownership type appear in table 18.
These estimates are based on analysis of how an economic downturn would effect
demand for these properties and how much the market value decline would be.

Geographic Dispersion
The requirements for loss coverage will be adjusted for any pool of loans that is more
vulnerable to economic strength or weakness based upon its geographic dispersion.
The analysis for this type of risk is performed in two ways.
   First, a regional analysis is performed through the use of a proprietary index that
measures an area’s residential home price stability and vulnerability to future residential
property price declines (see the “Standard & Poor’s Economic Index” section).
   Second, a determination is made as to whether there is any excessive geographic
concentration in any one zip code represented within the pool. Standard Poor’s
looks for no more than 5% of the pool to come from any one zip code. The following
is the zip code adjustment calculation for concentrations in excess of 5%.
  Zip Code Adjustment Calculation:
  Rating Level                       Adjustment Factor
  AAA                                (Highest zip code - 5%) x WALS* x 1.0
  AA                                 (Highest zip code - 5%) x WALS x 0.8
  *Weighted Average Loss Severity.


Standard & Poor’s Economic Index
A logistic regression model has been developed to examine annual house price
changes in approximately 178 metropolitan statistical areas (MSAs) between 1983
and 1998. Based on the regression model, the Standard & Poor’s Research Group
constructed the Economic Index to identify the MSAs that have a relatively high
probability of experiencing a house price decline within the next year.
  During the strong economic growth of the 1990s, house price declines moderated
significantly. One important implication of this moderation is the reduction in the
credit risk in residential mortgages. To the extent that a mortgagor defaults, the
resilience in the property value can markedly curtail the loss on the mortgage. In
terms of credit risk on a pool of mortgages, the loss magnitude is further curtailed
by the geographic distribution of the underlying properties. In that sense, geographic




 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   53
     dispersion can be an additional significant advantage for limiting the credit risk of a
     mortgage pool.
        For prudence, however, analysts may adjust the risk evaluation of mortgage pools
     based on the projection of the economic index. Given the recent modest price
     declines in the majority of MSAs and the projection of the index, the adjustment
     may attach a 2% or a 4% price decline to MSAs identified by the index as having
     relatively high probability of experiencing house price depreciation.
        The projections of the economic index will be updated annually because the
     regression equation is constructed using annual observations with a one-year lag. In
     addition, it has limitations in projecting long-term house price changes. Because of
     its built-in time lag of the response probability, it can project house price changes
     over the coming year. Beyond one year, however, the projection is subject to
     enlarged statistical errors. (For further information, see “Assessing House Price
     Changes of MSAs With Regional Economic and Demographic Indicators,”
     Structured Finance Monthly, October 1998.)


     Seasoned Loan Analysis
     Seasoning Credit
     Standard & Poor’s will give credit to loss coverage for seasoned loans. The basis for
     giving this credit is:
     I The borrower’s ability to pay generally improves over time;

     I The loan amortizes and builds equity; and

     I As the borrower’s equity builds, his willingness to pay increases.

       For fixed-rate loans, the level of loss coverage will be reduced by between 25%
     and 45% for a pool of loans seasoned five to 10 years, and by 50% for a pool seasoned
     over 10 years. ARM pools with five to 10 years’ seasoning will receive between
     12.5% and 22.5% credit, and pools with over 10 years’ seasoning will receive 25%
     credit, half of what comparable fixed-rate pools receive.
       A borrower’s ability to make mortgage payments is measured by the relationship
     between income and the mortgage payments over time. To calculate that measurement,
     assume a $100,000 unpaid principal balance on a 30-year fixed-rate mortgage with
     an 8% rate of interest and an 80% LTV ratio. Monthly taxes and insurance escrows
     are 25% of the monthly principal and interest payment, and the borrower has a
     28% debt-to-income ratio.
       Based on the above assumption, the principal and interest constant is $734 per
     month and taxes and insurance equals $183 per month for a total monthly payment
     of $917. The 28% debt ratio means the borrower has an annual gross income
     of $39,300.



54
                                              Credit Analysis for Subprime Loan Transactions




   Consider the situation where both income growth and the inflation rate are 4%
per year. After five years, the new payment is only 24% of gross monthly income, or
a reduction of 14.3% from the original 28% ratio. After 10 years, the new payment
is only 20.7% of gross monthly income, or a reduction of 26.1% from the original
28% ratio. These results demonstrate that for fixed-rate loans the borrower’s ability
to pay improves by 14%-18% after five years and 26%-33% after 10 years.
   The analysis for ARMs takes a slightly different twist. Inflation will not only
cause the taxes and insurance component to rise but should also impact the rate. For
this analysis, the mortgage rate was increased at the inflation rate, rounded to the
nearest eighth. To recompute the principal and interest constant, the unpaid balance
at each period must be determined. This was done using the remaining balance for
the prior period and the adjusted rate for the current period to determine the
amount of amortization. The 4% inflation and income growth scenario results in a
payment-to-income ratio decrease of 6%-11%.
   The portion of the credits attributable to the borrower’s ability to repay are:
I For fixed loans seasoned five to 10 years, 15%;

I For fixed loans seasoned more than 10 years, 30%;

I For ARMs seasoned five to 10 years, 7.5% and

I For ARMs seasoned more than 10 years, 15%.

   Standard & Poor’s seasoning credits are based on the above plus an additional
10% and 20% to the five- to 10-year credit and the over 10-year credit, respectively,
for amortization and willingness to pay. Half these amounts are added to the ARM
credits above, resulting in total seasoning credits for ARMs of 12.5% to 22.5%,
and 25%, respectively.

Housing Price Adjustments
A repeat sales index is used to reflect property value changes affected by the price
movements of homes. Analysts will compare the index for a loan at the time it was
originated against the most recent index for that property’s geographic location in
order to compute the level of appreciation or depreciation. The repeat sales indexes
provide additional information in assessing current collateral values. However, an
index cannot replace an actual sale or full appraisal. The main shortcoming to any
index is that it is using values of neighboring properties that may or may not be
relevant to a specific property. In its application of the repeat sales index, Standard
& Poor’s takes a measured approach. Indexes can be found at the MSA, county, or
zip code level. Analysts will adjust a property’s value when an index is available.
The adjusted property value is then used in the determination of the current loan
to value ratio.




 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   55
        The important thing to note is that the loss severity is based on the adjusted LTV
     ratio using the adjusted property value and the current balance of the loan. If there
     is no index available, the adjusted loan to value only takes into account amortization.
        Under certain conditions, analysts may not adjust the value of a seasoned loan
     using a repeat sales index. In these cases, a recent property-specific valuation has
     been obtained through a new appraisal or a broker’s price opinion. Property-specific
     valuations are generally a better indicator of value than an index-adjusted value.


     Additional Credit Enhancement Requirements
     Mortgagor Bankruptcy Protection
     Under certain personal bankruptcy filings, a judge could order a modification of a
     mortgage loan’s interest rate or a reduction in its principal amount. The amount of
     coverage that is required to address bankruptcy risk is an amount equal to the
     greater of $100,000 or 0.06% of the total aggregate principal balance of the loans
     with LTV ratios greater than 75%.

     Special Hazard Coverage
     Special hazard coverage is necessary for a pool when certain damage to a property is
     caused by an earthquake or by some other means which is not covered by standard
     hazard insurance. The amount of special hazard coverage required is an amount
     equal to the greatest of:
     I One percent of the current mortgage pool principal balance,

     I twice the principal balance of the largest balance loan, and

     I the aggregate principal balance of the loans representing the largest zip code

       balance in California.



                                             Table 19
                             Loss Coverage Needed for Fraud Risk (%)

                                                          —“AAA” Credit Enhancement Level—
      Life of pool (years)                              0%<=5%         >5%<=10%          <10%
      1                                                       1                2            3
      2                                                       1                1            2
      3                                                     0.5                1            1
      4                                                     0.5                1            1
      5                                                     0.5                1            1
      6+                                                      0                0            0




56
                                                 Credit Analysis for Subprime Loan Transactions




Fraud Coverage
Another cause for loan loss that must be covered separately is fraud or misrepresen-
tation in preparation of the loan application. Pool insurers have stated explicitly that
they will not cover losses stemming from suspected fraud. Standard & Poor’s
assumes fraud risk is highest at the time of loan origination and then diminishes,
reaching zero after five years. Table 19 shows the amount of fraud coverage required
for years one through five of the pool’s life, depending on what level of coverage
is provided.
   The coverage requirements for bankruptcy, special hazard, and fraud are specifically
needed in transactions in which the credit coverage provider will not provide coverage
for losses resulting from these causes. Pool policies and primary mortgage insurance
policies typically deny reimbursement for these losses. In these instances, coverage
for these types of losses must be provided by different means to the required levels
as stated above. Alternative means include reserve funds, loss specific insurance
policies, or subordinate classes.
   In a senior/subordinate transaction, the protection provided by the subordinate
classes for these types of losses may be limited, or “carved-out” of the total subordinate
balance, to the levels described above. Any additional losses of a specific type above
the carve-out limit may be allocated pro rata to all classes of certificates.




                                            Chart 3
                             Subprime New Pool Default Curve
        % of
    total defaults
          25


         20

         15


         10


          5


          0
                     2   7        12        24         36      48       60       72
                                             Month




 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria      57
     Default and Loss Curves
     Historic default curves are created from the aggregate observed default experience of
     mortgage loans. The default history of a pool of mortgage loans with similar charac-
     teristics is segmented by time and calculated (typically) on an annual and cumulative
     basis from the year of origination to the present.
       Default curves vary by book of business; that is, the year of origination of a specific
     pool, as well as by product type. Product types are segmented according to Standard
     & Poor’s definitions, such as prime, subprime, or high CLTV, and further subdivided
     by LTV, lien position, property type, etc. The default curve for new subprime mortgage
     pools is presented in chart 3. The default curve for seasoned (older than 12 months)
     subprime mortgage pools is presented in chart 4.
       Default experience is then adjusted for normal delays that occur between initial
     payment default and the occurrence of the loss on the sale of real estate owned.
     While the actual time for property liquidation from payment default varies from
     loan to loan, on average a 12-month delay has been assumed.




                                              Chart 4
                              Subprime Seasoned Pool Default Curve
             % of
         total defaults
               25


              20


              15


              10


               5


               0
                          2   7      12      24         36     48       60      72
                                               Month




58
Structural Considerations
for Subprime Mortgage
Transactions

S
      ince the late 1980’s, the most commonly used credit enhancement structures
      in the subprime/home-equity loan sector have become bond insured, senior/
      subordinate, and hybrid structures. All of these structures utilize excess interest
and the build-up of overcollateralization as the first loss credit support.
  The issuer’s decision as to which type of credit enhancement structure to use takes
into consideration many factors but is primarily investor driven, based upon which
structure yields the best economic value. When new products enter the MBS or ABS
market, or during volatile and uncertain times, bond insured transactions are typically
the credit enhancement of choice. Effectively, the investor is relying on the rating of
the bond insurer rather than the credit risk of the underlying collateral. As investors
have become more educated about the credit and performance of the product, senior/
subordinate, and hybrid structures have become popular and, in many cases, more
economical for the issuers. Also, many investors who have become saturated with
bond insured paper are willing to buy senior bonds which are credit enhanced
by subordination.
  A growing number of lenders are therefore seeking to take advantage of the lower
costs and financial flexibility associated with the senior/subordinate structure. In
particular, one cost saving is that the issuer no longer has to pay an insurance premium
to the bond insurer. Additionally, the net proceeds from executing a senior/subordinate
credit enhancement structure can in many cases be superior to that of a bond insured
structure depending upon investor spread or coupon demands. When subordinate
bond spreads are tight, to the applicable treasury bond market, often a senior/
subordinate structure yields superior economics to the issuer. Alternatively, when
subordinate bond spreads are “wide” over treasuries the bond insured structure may
be more economical. Investor interest, and therefore subordinate bond spreads, are
made on a case by case basis depending upon the issuer or servicer’s reputation for
quality product and, most importantly, their financial position. In addition, the



  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   59
     choice of credit enhancement used in a structure will greatly impact the bond sizes
     across the credit rating scale (see table 1).
       The credit analysis for these structures is the same, regardless of type. Most
     importantly, is the use of the shifting interest structure, which allows credit support
     to grow over time, at least until the transaction is through the majority of our default
     curve. This occurs through criteria that mandates that the majority of principal
     cashflow be allocated to the most senior classes, or by requiring that the overcol-
     lateralization target be pegged to the initial pool balance during the early stages of
     a transaction’s life.
       Only after determining that the mortgage pool is performing well will credit support
     be allowed to step down. The delinquency and loss levels experienced by the mortgage
     pool is critical to the determination of how much credit support will be needed over
     the life of the deal. Adequate credit support or loss coverage will enable all rated
     classes to receive their promised monthly interest payment and to ultimately receive
     back all their principal. Accordingly, if the pool is performing well (relative to the
     initial expectation of delinquency, loss, and the level of credit support), the release
     or stepping down of credit support is warranted.
       This section provides a detailed explanation of the following structures, with
     particular attention being paid to the allocation of cashflow and its role in the
     preservation of credit support:
     I Senior/subordinate;

     I Bond insurance;

     I Excess interest, overcollateralization, and subordination; and

     I Excess Interest, overcollateralization, subordination, and bond insurance.




                                                                        Table 1
                                                                  Bond Sizes*

                     Standard & Poor’s                               Straight            Excess Interest,                Excess Interest,
                        Loss Coverage                 Bond           Senior/          Overcollaterlization             Subordination, and
      Rating             Requirements               Insured              Sub.          and Subordination                 Bond Insurance
      AAA                               16.75         100.00             83.25                             87.50                    96.00
      AA                                11.00             0.00             5.75                              4.25                    0.00
      A                                  7.75             0.00             3.25                              4.25                    0.00
      BBB                                5.50             0.00             2.25                              4.00                    4.00
      BB                                 3.00             0.00             2.50                              0.00                    0.00
      B                                  2.00             0.00             1.00                              0.00                    0.00
      NR                                   —              0.00             2.00                              0.00                    0.00
      Totals                                          100.00            100.00                            100.00                   100.00
      *Sizes will vary based upon the amount of excess spread, overcollateralization, target, CPR speeds, fees, etc.




60
                              Structural Considerations for Subprime Mortgage Transactions




Senior/Subordinate Structures
Similar to the senior/subordinate credit enhancement structures in the traditional
residential jumbo MBS market, a senior/subordinate structure for subprime loan
securitizations is characterized by the subordination of junior classes that serve as
credit support for the more senior certificates. All interest shortfalls and principal
losses will be allocated to the most junior bond first, resulting in a write-down of its
principal balance. Although not commonly used in the subprime/home-equity sector,
a discussion of this type of securitization will serve as a useful foundation before
delving into to the more complex, hybrid structures to follow.
   In contrast to a structure that utilizes excess interest, in this structure credit support
is solely provided by the subordinate bonds. This results in larger subordinate bonds
than would have been needed if excess interest was also used to cover losses. Since
the subordinate market for subprime bonds has not yet matured to the level that the
traditional residential subordinate MBS market has, issuers are especially incented to
sell as few subordinate bonds as possible.

Allocation of Cashflow
Most residential MBS or ABS are structured as pass-through transactions. All principal
and interest (including liquidation and insurance proceeds, seller repurchase and
substitution proceeds, servicer advances, and other unscheduled collections), generated
by the underlying mortgage pool are allocated in a priority order to bondholders. In
the subprime, home-equity sector interest is generally paid to all outstanding bonds,
beginning with the most senior, and then in priority order to the remaining junior
bonds. After all classes have received in full their promised interest payment, principal
will be allocated based upon the terms of the governing documents. According to
the rating criteria, since the subordinate bonds provide the only source of credit
support in this type of structure, their receipt of principal must be delayed until
a majority of borrower defaults have occurred (see “Stepping Down of Loss
Protection” section). Amongst the senior classes, principal will be allocated sequentially
or pro rata, based upon the average life preferences of investors.
  Defaulted loan cashflow: liquidation proceeds or the full principal balance. When
a loss is realized on a defaulted loan, issuers have two options in allocating cashflow.
The most senior bonds can be promised the full, unpaid principal balance of the
defaulted loan, or more simply the proceeds generated from the loan’s final disposition.
  If the full, unpaid principal balance of the defaulted loan is paid to senior classes,
the structure must utilize an interest, interest, principal, principal cashflow allocation.
That is, all rated classes must receive interest before any payments of principal are
made. This is imperative because the payment to senior classes of more cashflow
than the defaulted loan is actually generating will result in the temporary shortfall of



  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   61
     interest to subordinate bondholders. This violates Standard & Poor’s timely receipt
     of interest criteria.
        In the traditional residential MBS sector, interest and principal are generally promised
     first to the senior classes, before cashflow is allocated to the subordinate bonds. How-
     ever, the principal payment is limited to a percentage of liquidation proceeds. In the
     subprime home-equity sector, most issuers have promised to pay to senior classes the
     liquidation proceeds, and will also pay interest to all rated classes in the transaction
     before allocating principal.
        Preserving subordinate bonds. There is the possibility that the credit composition
     of a mortgage pool will diminish over time as the level of defaults increases. This
     can occur as a result of stronger borrowers refinancing out of the pool as time goes
     on. This shift in pool makeup is commonly known as “adverse selection.” Accordingly,
     the rating criteria will require that all principal collections be paid first to the most
     senior class, lowering its percentage interest in the pool and therefore increasing the
     percentage interest represented by the subordinate classes. The resulting “shifting
     interest” increases the level of credit protection to the most senior bondholders
     over time.
        Typically, the senior bondholders will receive all principal payments for at least
     three years and until the level of credit support has increased to two times its initial
     level. After that time, and provided that additional performance based tests are met,
     holders of the subordinate bonds may receive a portion of principal collections.

     Allocation of Losses
     In the case of the senior/subordinate structure, the junior class of certificateholders’
     right to receive a share of the cash flow are subordinated to the rights of the senior
     certificateholders. In addition, losses cause the certificate balance of lower-rated
     certificates to be written down prior to the more senior bonds. Whenever the mortgage
     pool suffers a loss that threatens the amount due to the senior certificateholders,
     cash flow which would otherwise be due to the subordinated certificateholders must
     be diverted to cover the shortfall. Therefore all interest shortfalls and principal loss
     will be allocated to the most junior class outstanding. Shortfalls which result from
     delinquencies are generally covered by servicer advances that must ultimately be
     backed by a highly rated party, usually the trustee.

     Stepping Down of Loss Protection
     As stated earlier, all rated transactions must preserve credit support until the mortgage
     pool has experienced a majority of its defaults and the remaining borrowers have
     proven their ability to perform well, as judged by delinquency and loss tests. How-
     ever, after that point the decline of credit enhancement over time has traditionally
     been a feature of Standard & Poor’s-rated mortgage-backed securities. This stepping


62
                                     Structural Considerations for Subprime Mortgage Transactions




down of credit enhancement is contingent upon collateral performance, measured by
loss and delinquency numbers as well as the time elapsed since securitization.
   In the senior/subordinate structure, the stepping down of loss protection occurs
when principal is allocated to the subordinate bonds. Historical data show that 70%-
80% of all defaults occur in the first five years after the origination of a fixed-rate,
subprime home-equity mortgage pool. Accordingly, to protect against severe losses
during this stressful time period, a five-year lockout period was developed. During
this time period, no reduction in credit enhancement is to take place. This lockout
is also intended to protect certificateholders against deterioration in the collateral
pool’s credit profile due to adverse selection.
   The stepping down of loss protection was initially designed for traditional residential
MBS. In these transactions subordinate bonds were locked-out from receiving principal
prepayments for the first five years.
   The senior prepayment percentages are subject to meeting the delinquency and
loss triggers (see box). If at any time the triggers are not met, the senior prepayment
percentage will return to 100%.
   Variation for Subprime Home-Equity Deals. The subprime home-equity sector
typically utilizes a variation of this criteria. This allows subordinate bonds to begin
to receive principal cashflow after the third year, if credit support has grown to
twice its initial percentage of the current outstanding pool balance. Therefore all
principal collections will be directed to the senior classes until a “step-down date”
has occurred, typically defined as the later to occur of three years, when the mortgage
pool has been paid down by 50%, and the payment date when the senior note’s
credit support has doubled. In addition to the lock-out period, delinquency and loss
tests must be passed, proving the mortgage pool is performing at least as well as
initially expected (see “Performance Triggers” and “Loss Tolerances” boxes).



  Senior Prepayment Percentages
       he senior prepayment percentage is the portion of the prepayments received in a given period that is
  T    allocated to the senior class. The criteria for the senior prepayment percentage is as follows:

  I   One hundred percent for the first five years of     I   The senior percentage plus 40% of the junior
      the transaction,                                        percentage in the eighth year,
  I   The senior percentage plus 70% of the junior        I   The senior percentage plus 20% of the junior
      percentage in the sixth year,                           percentage in the ninth year, and
  I   The senior percentage plus 60% of the junior        I   The senior percentage in the tenth year
      percentage in the seventh year,                         and thereafter.




 Standard & Poor’s Structured Finance           I   U.S. Residential Subprime Mortgage Criteria               63
       If either the delinquency or the loss test was failed, the subordinate bonds would
     again be lock-out, and all principal would be reallocated to the most senior class.

     Maintenance Test
     Once the determination has been made that principal may be allocated to the
     subordinate bonds, principal may be allocated to each subordinate bond that has
     maintained at least two times its original credit support as a percentage of the
     current outstanding pool balance. Delinquency and loss tests should also continue
     to be met.

     Senior Mezzanine Pro Rata Allocation
     The allocation of principal between the senior and junior classes may be allowed. To
     attain pro rata allocation between the senior and the mezzanine classes before the end
     of the standard lock-out period, the mezzanine class must be oversized to compensate
     for the early receipt of principal. Additional cashflow analysis proving that extremely


       Performance Triggers

            rincipal payments will be made to the subor-       initial level of credit support. The tolerance is
       P    dinate bonds only after the initial subordi-
       nate principal lock-out period, and when the
                                                               generally 40%-50%.
                                                                  Additionally, as mentioned above, this delin-
       aggregate balance of 60-plus day delinquencies          quency test must be accompanied by a loss test
       (including loans in bankruptcy, foreclosure or REO      that, if failed, will again shut-off the payment
       status) is less than 40%-50% of the then-out-           of principal to the subordinate bonds. The loss
       standing credit support.                                tolerance will be determined on a case by case
          The 60-plus day delinquency tolerance level          basis depending upon the expected-case loss
       will be determined on a deal by deal basis,             expectation for that particular pool. This tolerance
       depending upon the pool composition, the historical     level will be set in increments starting low and
       delinquency experience of the issuer, and the           stepping up over time.




       Loss Tolerances
           or a typical fixed-rate, subprime, home-equity loan pool the cumulative loss tolerance might
       F   be as follows:

       I   24-36 months: 1.0%
       I   37-48 months: 1.75%
       I   49-60 months: 2.50%
       I   61 months and thereafter: 3.50%




64
                             Structural Considerations for Subprime Mortgage Transactions




fast prepayments with losses experienced late in the deal, with no disruption of
cashflow to rated classes, will also be conducted. Delinquency and loss test should
continue to be met.


Bond Insured Structures
When new products enter the MBS or ABS market, or during volatile and uncertain
times, investors typically demand the comfort associated with bond-insured transactions.
Effectively, the investor is relying on the corporate credit of the bond insurer and not
the underlying collateral. As investors and issuers gain experience with the product,
the senior/subordinated structure may, in many cases, prove to be more economical
for issuers.
  In this structure, the monoline surety bond provider ultimately guarantees credit
support. Excess interest is typically used as the first loss credit support, as well as to
build to a targeted level of overcollateralization. By using excess interest to accelerate
the principal payment to the senior certificates, overcollateralization will result as
the balance of the mortgage loans in the pool exceeds the principal balance of the
certificates. Excess interest is used to pay down the senior certificate balance, thereby
increasing the level of overcollateralization until a specified amount is reached.
  Once this specified amount is reached, excess interest will be released to the residual
class owner, which in most cases is the issuer of the security. The establishment of
overcollateralization protects the bond insurer from losses in the later years of the
transaction when the amount of currently generated excess interest is diminished or
has already been released to the residual class. The specified level of overcollateral-
ization may increase or decrease over time, subject to certain caps and triggers.
  After excess interest and any associated overcollateralization are exhausted, the
surety bond provider’s policy is obligated to pay all claims resulting from inadequate
cash flow. The bond insurer will make an insured payment in order to keep interest
payments current and ultimately repay all principal due.
  Excess interest equals the amount that the net coupon on the underlying mortgage
pool exceeds the coupon rate to the bondholders. In subprime home-equity transactions,
the amount of excess interest available to cover losses is generally sufficient to cover
at least an investment-grade rating (‘BBB-’) level of loss. Most often, bond insurers
will not insure transactions that cannot be considered investment grade or better by
Standard & Poor’s.

Allocation of Cashflow
When the entire mortgage pool is “wrapped” by a bond insurer, all classes of certificates
can be rated based upon Standard & Poor’s rating of the bond insurer’s financial
strength. A ‘AAA’ rated insurer is most commonly engaged. As a result, interest is



 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   65
     generally paid to all classes of certificates concurrently based upon their pro rata
     percentage interest in the mortgage pool. Excess interest, which is the amount of
     interest that does not need to be paid to bondholders or pay fees, is generally used
     as first-loss credit support, prior to the obligation of the bond insurer to cover
     any shortfalls.
       In this credit enhancement structure, since there are no subordinate bonds providing
     credit support, principal collections may be allocated to all classes of certificates issued,
     solely at the discretion of the issuer. Generally principal is allocated sequentially
     amongst the senior classes in order to accommodate investor’s varying average-life
     requirements.

     Allocation of Losses
     In this structure, the monoline surety bond provider ultimately guarantees credit
     support. Losses will be covered initially by excess interest and then by overcol-
     laterlization. After the excess spread and overcollateralization have been reduced
     to zero, the bond insurer will cover any shortfalls in current interest or principal
     payments. Shortfalls which may result from delinquencies are generally covered
     by advances made by the servicer, which must be backed by a highly rated party,
     usually the trustee.

     Stepping Down Loss Protection
     The obligation of the bond insurer to cover all losses or shortfalls in cashflow allocated
     to the insured classes remains in place for the life of the transaction. There is no
     ability for the bond insurer to limit or step down the amount of coverage provided
     to the bondholders. However, the amount of credit support in front of their obligation
     may, in most cases, be stepped down based upon pool performance.
       The first loss credit protection typically comes in the form of either excess interest
     and overcollateralization. Separately or in combination, this credit support usually is
     enough for Standard & Poor’s to internally rate the transaction investment grade
     without the bond insurer. Since the bond insurer ultimately guarantees the certificates
     against losses, they generally design performance tests and triggers for the release or
     step down of the excess spread, overcollateralization, or subordinate bonds, based
     upon the issuer’s past performance and depending upon the insurer’s own risk analysis.
     They should be conservative enough to protect the insurer against an investment
     grade level of losses, or if rated subordinate bonds are issued, that they are
     adequately protected.
       In the most commonly used bond-insured structure, excess interest is used to cover
     losses and make accelerated principal payments to certificateholders, thereby creating
     overcollateralization to a targeted amount. The overcollateralization target is a fixed
     percentage of the initial pool balance and will generally remain unchanged until the


66
                             Structural Considerations for Subprime Mortgage Transactions




later of three years or when the mortgage pool pays down by 50%. At that time, if
performance based tests are met, the overcollateralization target generally steps-down
to two times the initial percentage of the current pool balance. Therefore, as the pool
pays down over time, the amount of credit support or overcollateralization will step
down as well.

Obligation and Timing of Guarantee Payment
The obligation of the bond insurer to cover shortfalls in cashflow is unconditional
and irrevocable. They will guarantee to make an insured payment to cover any defi-
ciency in the available funds—principal and interest collections from the underlying
borrowers as well as any servicer advances or other payments—in order to pay the
timely or current monthly interest amount and to ultimately guarantee all principal
payments. Generally the bond insurer will make payments of principal based upon
their obligation to cover any subordination deficit, which is the amount, if any, that
causes the aggregate certificate balance to exceed the balance of the mortgage pool
due to losses.
  The trustee will notify the bond insurer that an insured payment is to be made no
later than the business day prior to the distribution date. The bond insurer will then
be required to make an insured payment by the distribution date.

Capital Charge Methodology
In order for Standard & Poor’s to maintain its rating of the financial strength of the
bond insurer, a deal by deal assessment is made of the risk or exposure they are taking
on. This allows for the tracking of insurer liabilities on a transaction or policy basis.
For this tracking purpose only, the residential mortgage group will assign an internal
rating to the transaction, based upon the level of credit support provided in the deal,
without consideration to the insurance policy.
   Effectively, this is the rating that could be assigned based upon the internal credit
support only. A capital charge or reserve amount is then calculated based upon the
assessment of risk covered by the insurer’s policy. Bond insurers will typically only
issue policies on transactions considered to be rated investment grade (“BBB-”
or better).


Excess Interest, Overcollateralization,
and Subordination Structures
The senior/subordinate with overcollateralization structure is a hybrid structure which
combines the use of excess interest to cover losses and create overcollateralization,
from ABS and bond insured structures, with the credit tranching found in the
traditional residential MBS sector.



 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   67
        Since its inception in the late 1980s, most subprime home-equity loan transactions
     have had to rely on the third party credit support provided by bond insurers. The
     collateral type and issuers did not have enough history, and investors preferred the
     additional comfort of the bond insured structure. This changed in mid-1997. By
     then, a sufficient subprime subordinate bond market had developed and many
     investors began to be over-exposed to the most commonly used bond insurers.
     Subordinate bond yields were tight to treasuries and it became more economic to
     issue senior/subordinate transactions. Issuers also needed alternatives and had become
     uneasy on their reliance of the bond insurers. Since then, the market has embraced
     both. Top tier issuers now have the ability to use either structure. Smaller, less financially
     secure issuers still often require bond insurers to attract investor interest.
        Excess Interest Valuation / Cashflow Analysis. Excess interest is created based upon
     the excess of the net mortgage rates paid by borrowers in the underlying mortgage
     pool and upon the interest rate paid to bondholders. Cashflow analysis is necessary
     to determine how much excess interest will be available to cover losses over the life
     of the transaction. The analysis must consider the following variables:
     I Mortgage interest rate,

     I Weighted average coupon deterioration,

     I Fees,

     I Rate and timing of default and prepayment speeds,

     I Length of time for loss realization,

     I Bond pass-through rates, and

     I Structural features such as the prioritization of principal cashflow.

        An analysis of cashflows is done to determine the amount of overcollateralization
     and the size of the subordinate bonds necessary at each rating category. Cashflows
     should demonstrate that each rated class receives timely interest and ultimate repay-
     ment of principal. Default and loss severity projections will be made at each rating
     category regardless of structure or type of credit support.
        In order to stress the cashflow in structures that utilize excess interest, conservative
     assumptions will be made for the unknown variables. In addition to default and
     loss, of particular importance is the rate of voluntary prepayments. The faster the
     mortgage pool pays down, the less excess interest will be generated and available
     to cover losses.
        Although prepayment speeds will vary from issuer to issuer, (and based upon
     economic factors, such as the interest rate environment, the strength of the economy,
     and the housing market), empirical studies have shown that fixed-rate subprime
     loans prepay in a range of 20%-30% constant prepayment rate (CPR). Prepayment
     speeds will also vary depending upon the competition amongst lenders
     (see “Analyzing Excess Interest” section).




68
                                     Structural Considerations for Subprime Mortgage Transactions




Allocation of Cashflow
Interest is generally paid to all senior classes of certificates concurrently based upon
their pro rata percentage interest in the mortgage pool. Interest will then be allocated
sequentially, in priority order, to the subordinate bonds. Excess interest will then
be used to cover current losses, paid to the most senior bonds to build towards
the overcollateralization target, and lastly will be “released” from the deal through
payments to a residual certificate holder.
  The targeted level of overcollateralization is usually set as a percentage of the original
pool balance. It may be reduced after the third anniversary of the closing date, subject
to the satisfaction of certain loss and delinquency triggers (see “Stepping Down of
Loss Protection”). These triggers ensure that overcollateralization continues to
accumulate in the event the pool performance begins to deteriorate.
  Principal is then allocated sequentially, pro rata, or in some combination among
the senior classes, in order to accommodate investor’s varying average-life requirements.
Remaining principal will then be paid sequentially, in priority order, to the subordinate
bonds (see “Principal allocation to the subordinate bonds”).

Allocation of Losses
In this hybrid structure, the credit enhancement to each rated class is provided first
by the monthly generated excess interest, second through the decrease in any over-
collateralization, and third will be allocated to the subordinate bonds. After all
excess interest and overcollateralization has been depleted, subordinate bonds, on
a priority basis, are shorted interest or written down for principal loss.

Stepping Down of Loss Protection
  Defaults are expected to peak around the end of years three to four for subprime
home-equity product. As a result, if the loan pool is performing well a step down, or
decrease in credit support, after that time is in most cases warranted. The two forms



  Delinquency Trigger

       he most commonly used delinquency trigger             The 60+ day delinquency tolerance level will
  T    tests the level of seriously delinquent loans
  against the outstanding aggregate credit support
                                                          be determined on a deal by deal basis, depending
                                                          upon the pool composition, the historical delin-
  as follows: 100% of the principal balance of 60-plus    quency experience of the issuer, and the initial
  day delinquent loans (including loans in bankruptcy,    level of credit support. The tolerance is generally
  foreclosure, or REO) may not exceed 40%-50% of          40%-50%.
  the then currently-available credit support.




  Standard & Poor’s Structured Finance          I   U.S. Residential Subprime Mortgage Criteria                 69
     of credit support that must be maintained are excess interest/overcollateralization
     and the subordination of lower-rated bonds.
       Because delinquency is a leading indicator of default, Standard & Poor’s will
     incorporate a delinquency-based performance trigger into the overcollateralization
     target level and tie that to the step-down condition (see box).
       Overcollateralization. The stepdown of the overcollateralization target after the
     third year may occur if the mortgage pool has been paid down by 50%, credit
     enhancement has doubled, and the pool can withstand delinquency and loss-based
     performance tests. Conversely, should cumulative losses to date exceed certain pre-
     determined amounts, the overcollateralization target will be required to step-up, or
     increase back to the original amount required. The available credit support will
     equal the current overcollateralization amount plus the sum of the principal balance
     of the subordinate bonds.
       Additionally, this delinquency test must be accompanied by a loss test that, if
     failed, will again stop the release of excess interest from the transaction and shut-off
     the payment of principal to the subordinate bonds (see “Loss Tolerances” box). The
     loss tolerance will be determined on a case by case basis depending upon the expected-
     case loss for that particular pool. The tolerance level will be set in increments starting
     low and stepping up over time.
       If these tests are passed after a step-down date—defined as the later of three years
     or the payment date when the mortgage pool has been paid down by 50%—the
     overcollateralization target may step down to two times its initial percentage of the
     current pool balance.
       If the delinquency test is failed, the overcollateralization target will be permitted
     to step-down no further. It will remain at the target percentage of the current pool
     balance as of the payment date when the test was last passed. If the loss test is
     failed, the overcollateralization target must step back up to the original target,
     as a percentage of the initial pool balance.
       Principal allocation to the subordinate bonds. Principal may also be allocated to
     the subordinate bonds if, after the step-down date (the later of three years or a pool
     pay-down of 50%), the level of credit support for the most senior bonds outstanding
     (as a percentage of the current balance of the mortgage pool) has doubled. Additionally,
     the loss and delinquency tests must be passed.
       This is commonly referred to as the senior enhancement percentage and is calculated
     as two times the initial overcollateralization percentage plus two times the initial
     subordination percentage. If either the loss or delinquency test is failed, the subordi-
     nate bonds will again be locked out from receiving principal and all principal will
     be allocated to the most senior class until the tests are passed.
       Maintenance Test. Once it is determined that principal cashflow can be distributed
     to the subordinate bonds, each class is eligible to receive its pro rata share if it has


70
                                              Structural Considerations for Subprime Mortgage Transactions




maintained at least two times its initial credit support as a percentage of the current
pool balance. Therefore only the subordinate bonds whose credit support has doubled
will receive principal payments. The classes that pass the doubling test may receive
their pro rata share assuming delinquency and loss tests are passed. Table 2 depicts
the optimal credit support percentages that need to be reached before principal can
be paid to subordinate bonds.


Senior/Subordinate Structures with Excess Interest,
Overcollateralization, and Bond Insurance
Another structural alternative becoming increasingly popular in the subprime home-
equity sector combines the use of excess interest, overcollateralization, subordinate
bonds, and bond insurance. It typically groups the issuance of a ‘BBB’ or ‘BBB-’
rated subordinate bond with the overcollateralization feature. Credit enhancement
to the senior classes is thus provided through a combination of the following:
I Subordination;

I Excess interest, which is used to pay down certificates and create

  over-collateralization; and
I Bond insurance policy which guarantees current payment of interest and ultimate

  payment of principal to the senior certificates.
  Credit enhancement for the subordinate classes is provided solely through credit
to excess interest and overcollateralization. In a typical transaction utilizing this
structure, excess interest and the targeted level of overcollateralization allows the
subordinate bond to be rated at least investment grade. A bond insurer then wraps
the remaining pool to ‘AAA’. The addition of the subordinate bond in this structure


                                                                  Table 2
                                               Credit Support Percentages

                    Loss coverage                                                                                   Optimal credit
 Rating              requirements                    Bond sizes                 Subordination                support percentages*
 AAA                              16.75                        87.50                         12.50                           29.00
 AA                               11.00                         4.25                          8.25                           20.50
 A                                 7.75                         4.25                          4.00                           12.00
 BBB                               5.50                         4.00                          0.00                            4.00
 BB                                3.00                         0.00                            —
 B                                 2.00                         0.00                            —
 NR                                  —                          0.00                            —
                                                            100.00
 *In the following example the senior enhancement percentage will equal 29.00%, calculated as: (12.50 * 2) + (2.00 * 2).
 The overcollateralization target is 2.0%.




 Standard & Poor’s Structured Finance                      I     U.S. Residential Subprime Mortgage Criteria                     71
     gives additional credit support to the insurer and therefore works to reduce its overall
     exposure and capital charge. Cashflow analysis to value the excess spread available
     to cover losses over the life of the deal is again required to size the overcollateralization
     target and to determine the size of the subordinate bond.
        Since ultimate credit support to the senior bonds is provided by a bond insurer,
     they will most often determine the mortgage pool performance tests with the issuer.
     Standard & Poor’s will insure that the triggers work to protect the insurer, and that
     the subordinate bond (which the bond insurer is not covering) is adequately protected.
        The obligation of the bond insurer to cover all losses or shortfalls in cashflow
     allocated to the insured classes remains in place for the life of the transaction. There
     is no ability for the bond insurer to limit or reduce the amount of coverage provided
     to the bondholders.




72
Analyzing Excess Interest
in Subprime Mortgage
Transactions

W
              hile the section on structural considerations explores the various trans-
              action types that are prevalent in the securitization of subprime mortgage
              loans, most of these structures utilize excess interest, or excess spread,
as a form of credit enhancement to cover losses. Excess interest is defined as any
interest funds available after payment of interest to all certificateholders, and payment
of all fees and expenses of the trust. In each of these structures, the excess interest is
used first to cover any current monthly losses. Any remaining excess interest is then
used to accelerate the payment of the certificates and thereby create overcollateralization
(due to the balance of certificates outstanding being less than the principal balance
of the outstanding mortgage loans). Once currently available excess interest is ex-
hausted, additional losses will reduce the level of overcollateralization. After all of
the overcollateralization is used up, additional credit enhancement can come in the
form of a bond insurance wrap, subordination, or a combination of both.
  The amount of excess interest available in a given transaction can and will vary
based on numerous variables. This section will outline the assumptions for valuing
excess interest.
  In addition to the known variables, such as the WAC on the collateral, fees, and
pass-through rates, analysts must make assumptions for the variables that will
impact the level of excess interest available, which include the following:
I Level and timing of defaults,

I Delinquency advancing,

I Prepayments,

I WAC deterioration, and

I Basis risk.

  To accurately determine the value of the excess interest, cash flows are run at each
rating category. The assumptions used are intended to stress each of the above factors.




  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   73
     Defaults
     Defaults play a major role in the amount of excess interest available in a given
     transaction. The frequency of defaults and the timing of those defaults will influence
     the amount of excess interest that may be on hand to cover potential losses.
       The section on foreclosure frequency assumptions discusses how any mortgage
     loan is dependent on the characteristics of the loan, the credit history of the borrower,
     and the economic conditions and stress to which the borrower is subject. By factoring
     each of these into the equation, a foreclosure frequency estimation is established for
     each loan, and for each rating category. The foreclosure frequency of each loan is
     then aggregated to determine the weighted average foreclosure frequency of the
     pool, again at each rating category.
       Because these foreclosure frequencies are loan- and product-specific, subprime
     mortgage loans tend to have higher foreclosure frequencies than prime loans due to
     higher LTVs and poorer credit history of the borrowers. The greater the amount of
     foreclosures, the lesser the amount of mortgage loans that are in the pool and therefore
     less excess spread available to cover any future losses.
       The timing of defaults are product specific as well. For the subprime product, history
     has shown that defaults begin gradually in month seven (or earlier for pools that are
     seasoned greater than twelve months), peak between months 24 and 48, and then
     taper off by month 72. In an effort to put as much stress on the cash flows as possible,
     the defaults are assumed to occur in bullets. Realistically the defaults will actually
     be occurring over a period of time, by bulleting the defaults the analysis depletes
     the excess interest in a stressed manner, and will also stress the availability of cash
     to pay current interest.
       If the cash flows show that payment of current interest can be maintained and the
     losses adequately absorbed while ultimately paying the rated class, the transaction


                                              Table 1
                                   Bullet Default Assumptions

     Month        % FF when WA seasoning < 12 months      % FF when WA seasoning > 12 months
     2                                              0                                      5
     7                                              5                                     10
     12                                           10                                      20
     24                                           20                                      25
     36                                           25                                      20
     48                                           20                                      15
     60                                           15                                       5
     72                                             5                                      0




74
                              Analyzing Excess Interest in Subprime Mortgage Transactions




will meet the stress test. In addition, the balance of the loan at the time of default is
calculated by assuming only scheduled principal payments have occurred on the
loan, and that no prepayments on that loan have taken place.
   To summarize, the level of defaults at any point in time will equal the product of
(x), the foreclosure frequency for the rating scenario being analyzed, (y), the 0%
CPR (constant prepayment rate) principal balance of the mortgage pool during the
month in which the default occurs, and (z) the bulleted default percentage, as shown
in table 1.
   Typically, a 12-month lag is assumed from the time a loan defaults until the loan
is liquidated. In other words, 12 months after the defaults occur, a percentage of the
balance (equal to the loss severity at the rating level being analyzed) will be lost, and
the remainder of the balance will be recovered as net proceeds.
   For example, assume a loss coverage amount of 10% which is comprised of a
foreclosure frequency of 30.5% and a loss severity of 33%. Standard and Poor’s loss
coverage amount equals the foreclosure frequency times the loss severity. At the
peak of the default curve in month 36, 25% of the total defaults will take place that
month, or 25% of 30.5%, equaling 7.625% of the amortized principal balance of
the mortgage pool. Twelve months later, in month 48, 7.625% of the pool balance
will suffer a loss severity of 33%, equating to 2.5% of the pool balance being written
down. The entire amount of the loss will be taken in month 48.


Advancing
The availability of excess interest is also impacted by whether or not advances are
being made on delinquent and defaulted loans. Most subprime transactions require
the servicer to make such advances until the time that the loan is liquidated. However,
the servicer does not have to make an advance on a specific loan if it determines
that the amount advanced will not be recoverable from liquidation proceeds. If
advances are required, then the excess interest from these loans may be available
to offset potential losses.
   This premise is also dependent on the rate at which the interest portion of the
advance is being made. If the advance is made at the gross or net loan rate, excess
interest would be available until the loan is liquidated. However, if the advance is
made at a rate sufficient only to cover interest to certificateholders, then there would
be no additional advanced interest available to be used for credit support.
   Likewise, transactions without an advancing mechanism will not have any interest
flowing into the transaction from delinquent or defaulted loans. Therefore, this should
be assumed in the cashflows. In this case, an added stress is placed on the cash flows.
Because no advancing is occurring, analysts will assume that a certain percentage of
loans are delinquent at any point in time, in addition to the amount of loans in default



 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   75
     at that time. Six months prior to each bullet default, beginning with the default balance
     in month 12, a like percentage of loans will be delinquent in interest as is in default.
     Recovery of this delinquent interest occurs six months later; that is, the first delinquent
     period begins in month 6 with recovery in month 12. This delinquency stress continues
     for all bullets throughout the default curve.


     Prepayments
     The rate of prepayments significantly impacts the amount of excess interest which
     flows into a transaction. The greater the amount of loans prepaying, the less excess
     interest will be available. The rate of prepayments that is assumed will occur is based
     on the historical experience of the industry or the specific issuer. The pricing speed
     may be used as a proxy for this speed and is typically reported as a CPR. This indicates
     the “all in” speed at which loans are removed from the pool. That is, the speed at
     which loans voluntarily prepay combined with the rate at which defaults occur.
        However, Standard & Poor’s uses this pricing speed to indicate voluntary prepayments
     only. The rating analysis assumes that poorer credit quality borrowers will not be
     able to prepay, and that therefore prepayments will include only the voluntary type.
     An added stress to the cash flows is then done by layering defaults (as described in
     the default section and in table 1 above) on top of the voluntary prepayment assump-
     tions. In this regard, it is believed that voluntary prepayments are inversely related
     to the economic scenario as you go up the rating scale to a more stressful economic
     scenario. However, because defaults increase at a greater pace as the more severe
     economic downturn occurs, the overall speed at which loans are removed from the

                                                Table 2
                                   Voluntary Prepayment Speed

     Rating                                                               Voluntary
     scenario                                                             prepayment speed
     AAA                                                                  pricing speed—6.00%
     AA+                                                                  pricing speed—5.00%
     AA                                                                   pricing speed—4.00%
     AA-                                                                  pricing speed—3.00%
     A+                                                                   pricing speed—1.50%
     A                                                                    pricing speed—1.00%
     A-                                                                   pricing speed—0.50%
     BBB+                                                                 pricing speed
     BBB                                                                  pricing speed
     BB                                                                   pricing speed
     B                                                                    pricing speed




76
                                             Analyzing Excess Interest in Subprime Mortgage Transactions




pool will increase. Table 2 shows the voluntary prepayment speed assumptions at
the various rating levels. In addition, if the issuer’s historical prepayment experience
warrants a ramp up or down for prepayments, the cash flows will be run accordingly.
   It should be again noted that Standard & Poor’s will analyze the speed at which
the deal is priced versus the issuer’s historical experience, and if it is determined that
the pricing speed does not adequately reflect the actual prepayment history for the
issuer and the collateral type, the prepayment assumptions will be adjusted accordingly.


Weighted Average Coupon Deterioration
Mortgage prepayment history has shown that the WAC of a pool, and therefore the
available excess spread, decreases over time in mortgage transactions. That is, loans
having higher interest rates and greater margins are removed from a pool at a faster
rate than comparable loans with lower rates and margins. This is due to borrowers
with higher rate loans having a greater incentive to refinance their loans if their credit
improves. As riskier credits, these borrowers also have a higher probability of default.
In either case, these higher rate loans are removed from the pool. This again will
cause the total amount of excess interest available in the transaction to decline as
the age of the deal increases.
  Therefore, the ratings analysis stresses the cash flows in order to replicate this feature.
To accomplish this, beginning in month seven, analysts will assume an annual reduction
of the gross WAC for the pool of mortgage loans by the amount as shown in table

                                                               Table 3
                                    Weighted Average Coupon Reduction*

                                  WAC of pool                       10.00<=WAC of pool <          WAC of pool
 Rating level                      < 10.00 (%)                                 12.00 (%)          => 12.00 (%)
 AAA                                           .14                                   .45                    .60
 AA+                                           .13                                   .40                    .55
 AA                                            .12                                   .37                    .50
 AA-                                           .11                                   .35                    .47
 A+                                            .09                                   .30                    .44
 A                                             .08                                   .25                    .40
 A-                                            .07                                   .22                    .35
 BBB+                                          .06                                   .18                    .30
 BBB                                           .06                                   .18                    .30
 BBB-                                          .06                                   .18                    .28
 BB                                            .06                                   .18                    .28
 B                                             .06                                   .18                    .28
 *These figures represent an annual amount of WAC decrease.




  Standard & Poor’s Structured Finance                  I     U.S. Residential Subprime Mortgage Criteria    77
     3. When the coupons of the mortgage loans are greater, the assumption will be made
     that the WAC deterioration will be greater. Therefore, as the table depicts, the greater
     the WAC on the pool, the greater the WAC decline assumed in the cash flows. Analysts
     will also assume that a more stressful environment will cause more, and higher rate,
     loans to be removed from the pool. Therefore the WAC deterioration assumed will
     increase as the rating level increases (see table 3).
       This reduction in the weighted average coupon is accomplished by charging the
     applicable amount as an additional fee, which is then deducted at the beginning of
     the waterfall. It should be noted that the WAC for an adjustable-rate pool is determined
     by adding the fully-indexed margin to the applicable index on the day on which the
     transaction is priced.


     Basis Risk
     When a transaction contains mortgage loans with an interest rate which is different
     from that which the certificates accrue, basis risk occurs. The changing spread between
     the two rates may cause shortfalls in the cash flow needed to pay the bonds. To
     date, this risk has been addressed by generally assuming a fixed spread between the
     two rates for the term of the deal. This approach by definition is less precise, as
     spreads will move over time.
        Standard & Poor’s has adopted a new approach which provides for and estimates
     the future volatility in spreads using Markov Chain Monte Carlo (MCMC) simulations,
     overlaid onto an autoregressive (AR) time series model that is fitted to a stationary
     time series. By definition, a stationary time series has a constant mean over time,
     finite second moment, and an auto-covariance function that is independent of time
     (Brockwell and Davis, 1991).
        This last point means the covariance for any given lag is constant. Interest rate
     data are not stationary but can be made stationary by differencing; then, the AR
     model is fit to the differenced series. The fitted AR model has a constant variance,
     which represents the interest rate volatility. The Markov Chain approach allows
     the volatility to vary based on a likelihood of transitioning among different levels
     of volatility. Therefore, interest rate data over a long historical period can be included
     in the modeling without overstating the volatility by appropriately weighting
     the scenarios.
        As an example, an appropriate government rate within a country can be used as a
     benchmark against which all other rates for that country are modeled. The 91-day
     Treasury bill rate is the benchmark for U.S. rates. Benchmarking ensures that the
     results are consistent across the spectrum of rates and avoids unrealistic inversions.
     For each rating category, two paths from the simulations are used which represent a




78
                                            Analyzing Excess Interest in Subprime Mortgage Transactions




low-rate and a high-rate scenario. For higher ratings, simulated paths closer to the
extremes are used.
  In an attempt to cover all possible rate scenarios, data from 1973 through the
present are included in the modeling. However, the oil crisis of 1973-1974 and the
deregulation of the U.S. banking industry in the early 1980s resulted in two highly
volatile periods that are not likely to be repeated in the future. Therefore, without
some form of weighting, the high volatility of these periods would make its way into
the AR model and increase the estimated variance to levels that are unlikely to recur,
resulting in overly stressful interest rate assumptions in the cash flow analysis. In
order to more reasonably weight the volatility experience, an MCMC model is overlaid
onto the AR model.
  Based on the data, a probability-transition matrix is developed for three volatility
states. Associated with each state is a different value of the standard deviation for
the AR model. As the rates are simulated, there is a small likelihood of being in a
state of relatively high volatility. Similarly, a probability-transition matrix for different
levels of rates is developed. This checks the simulation at each step in the process. If
the move from the current rate to the next is unlikely, then there is a small chance
that the new value will be accepted.
  In this way, the combined MCMC and AR model (MCMC/AR) method allows
the volatility to vary from time to time and tests the reasonableness of a resulting
jump. The simulation results are ordered, and select percentiles are used for different
rating scenarios. For example, the extremes are used for ‘AAA’, while the 2.5 and
97.5 percentiles are used for noninvestment-grade scenarios.


                                                              Table 4
                                                     Average Spreads

 Six Month LIBOR (US) to One Month LIBOR (US)
                             AAA                       AA                 A          BBB      Non-investment
 Month range            spread (%)              spread (%)       spread (%)     spread (%)   grade spread (%)
  1 - 36                         0.26                 0.27              0.28          0.29                 0.30
  37 - 72                        0.23                 0.25              0.26          0.27                 0.29
  73 - 108                       0.18                 0.24              0.25          0.26                 0.28
  109 - 144                     -0.15                 0.21              0.22          0.24                 0.26
  145 - 180                     -0.22                 0.08              0.15          0.17                 0.21
  181 - 216                     -0.70                -0.37              -0.01         0.22                 0.27
  217 - 252                     -0.85                -0.46              -0.05         0.18                 0.30
  253 - 288                     -0.75                -0.54              -0.21         0.09                 0.22
  289 - 324                     -0.71                -0.55              -0.28         0.01                 0.21
  325 - 360                     -0.93                -0.76              -0.50        -0.12                 0.27
 Fixed Spread                    0.14                 0.21              0.24          0.26                 0.29



  Standard & Poor’s Structured Finance                 I     U.S. Residential Subprime Mortgage Criteria      79
     Estimation of Rates Relative to the Benchmark
     To determine the levels for other interest rates, linear regression models are fit to
     these data. A regression of another rate on the benchmark rate provides a model to
     estimate the other rate given a specific value for the benchmark. This modeling is
     independent of the benchmark simulations. Once the linear regression models are
     fit, specific rate scenarios can be estimated using the low- and high-rate scenarios
     from the simulations as inputs to the linear regression models.
        In order to ensure that the rated securities will be paid in accordance with their
     terms even in an adverse interest rate environment, the cash flow tests are used to
     determine whether each transaction can withstand basis risk in combination with
     losses. Table 4 illustrates some of the assumptions made in our model.




80
Legal Criteria for
Subprime Mortgage
Transactions
General Overview



S
        ubprime residential first lien mortgage and subprime closed-end home equity
        loans are originated or transferred into a securitization structure by banks or
        other financial institutions, insurance companies, or nonbank corporations.
Some of the legal issues raised by these transactions differ depending on whether the
entity transferring the loans is a nonbank corporation that is eligible to become a
debtor under the U.S. Bankruptcy Code (a “code transferor”), a bank, other financial
institution. Also relevant is whether the entity is an insurance company that is not
eligible to become a debtor under the Bankruptcy Code (a “non-code transferor”),
or an entity subject to the Bankruptcy Code (such as a municipality or public-purpose
entity), but which is deemed by Standard & Poor’s to be bankruptcy-remote in that
the bankruptcy or dissolution of such entity for reasons unrelated to the transaction
structure is deemed unlikely to occur (an “SPE transferor”). Unless otherwise indicated,
an entity either selling, contributing, depositing, or pledging assets for purposes of
securitization, including the originator of the assets and any intermediary entity
participating at any level in a structure transaction as a transferor of assets, is
referred to as a transferor.
   This section discusses the critical legal issues raised by structured subprime residential
first lien mortgage and subprime closed end home equity loan transactions (and
Standard & Poor’s criteria related thereto). Also set forth are the major legal concerns
found in most structured financings, as well as the legal issues (and criteria) unique
to subprime residential first lien mortgage and closed-end home equity loan transactions.
   Structured financings are rated based primarily on the creditworthiness of isolated
assets or asset pools, whether sold, contributed, or pledged into a securitization
structure, without regard to the creditworthiness of the seller, contributor, or



  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   81
     borrower. The structured financing seeks to insulate transactions from entities that
     are either unrated and for whom Standard & Poor’s is unable to quantify the likelihood
     of a potential bankruptcy, or that are rated investment grade but wish a higher rating
     for the transaction. Standard & Poor’s worst-case scenario assumes the bankruptcy
     of each transaction participant deemed not to be bankruptcy-remote or that is rated
     lower than the transaction. Standard & Poor’s resolves most legal concerns by analyzing
     the legal documents, and where appropriate, receiving opinions of counsel that
     address insolvency, as well as security interest and other issues. Understanding the
     implications of the assumptions and its criteria enables an issuer to anticipate and
     resolve most legal concerns early in the rating process.


     Securitizations by Code Transferors
     General
     When a transferor of assets in a structured transaction is a Code transferor, as a
     general matter, a pledge of the assets by the transferor as collateral for the rated
     securities being issued in the transaction will not ensure that holders of the rated
     securities would have timely access to the collateral if the transferor became the subject
     of a proceeding under the U.S. Bankruptcy Code. Although, as a matter of law, a
     creditor ultimately should be able to realize the benefits of pledged collateral, several
     provisions of the Bankruptcy Code may cause the creditor to experience delays in
     payment and, in some cases, receive less than the full value of its collateral. Under
     Section 362(a) of the Bankruptcy Code, the filing of a bankruptcy petition automatically
     stays all creditors from exercising their rights to pledged collateral.
       The stay would affect all creditors of the transferor. A bankruptcy court could
     provide relief from the stay under certain circumstances, but it is difficult to estimate
     the likelihood of relief from the stay. Moreover, in most cases, it would be difficult
     to estimate the duration of the stay.
       Similarly, according to Section 363 of the Bankruptcy Code, under certain circum-
     stances a bankruptcy court may permit a debtor to use pledged collateral to aid in
     the debtor’s reorganization or, according to Section 364, to incur debt that has a lien
     on assets that is prior to the lien of existing creditors. Under Section 542, a secured
     creditor in possession of its collateral may be required to return possession of this
     collateral to a bankrupt debtor.
       As a result, in the case of structured transactions involving the transfer of assets
     by Code transferors, the existence of strong assets alone to secure the rated securities
     cannot determine the issue credit rating of these securities. The structure of the
     transaction should provide the means by which the assets would be available to
     make interest payments on the rated securities in a timely manner and to ensure



82
                                             Legal Criteria for Subprime Mortgage Transactions




ultimate recovery of principal upon maturity, notwithstanding the insolvency,
receivership, or bankruptcy of the transferor.
   In general, the desired structure is achieved by having all assets held by any Code
transferor transferred to a “bankruptcy-remote,” special-purpose entity (SPE), which,
in turn, either functions as an “intermediate SPE” and transfers the assets to an
“issuing SPE” that issues the rated securities in a “two-tier transaction” or functions
itself as an issuing SPE and directly issues the rated securities in a “one-tier transaction.”
   To ensure that a given transaction structure, whether two-tier or one-tier, provides
for the timely availability of assets to pay the holders of the rated securities,
Standard & Poor’s analyzes each transfer of assets in a securitization transaction to
determine whether each transfer constitutes a sale or a pledge, the nature of each
transaction party’s property rights in any assets, and whether third parties (that may
be unrated or that are “non-bankruptcy remote”) have retained rights that may
impair timely payment on the rated securities. Depending upon the transaction
structure (as discussed below), Standard & Poor’s has certain requirements including,
but not limited to, the delivery of opinions of counsel regarding these issues.

Two-Tier Transactions
In the typical two-tier transaction, the rated securities are issued by an issuing SPE.
In the “first tier,” each Code transferor holding assets (which, in general, has either
originated the assets or purchased the assets in a chain of transfers from the “origi-
nator”) either sells the assets to an intermediate SPE or makes a capital contribution
of the assets to the intermediate SPE. The intermediate SPE is usually a wholly-owned
subsidiary of one of the transferors. In the “second tier,” the intermediate SPE de-
posits or sells the assets to the issuing SPE or borrows from the issuing SPE and
pledges the assets to the issuing SPE to secure the loan. The issuing SPE then issues
the rated securities and uses the proceeds of the rated securities either to purchase
the assets from the intermediate SPE (if the second-tier transfer constitutes a sale)
or to make a loan to the intermediate SPE (if the second-tier transfer constitutes a
pledge). The intermediate SPE uses the proceeds of the sale or loan to purchase the
assets from the transferors. In a two-tier transaction, in which the transferors are
Code transferors, Standard & Poor’s has the following interrelated criteria.

First Tier: True Sale
First, to avoid the risk that a court, in the event of the bankruptcy of any Code
transferor, would deem any of the assets transferred in the chain of transfers to the
intermediate SPE to be part of the transferor’s bankruptcy estate (and thus subject
to the automatic stay), Standard & Poor’s generally requires that each transfer of
assets from any Code transferor (through all intermediaries that are Code transferors)
to the intermediate SPE be a “true sale,” as further described below. In this regard,


  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria    83
     each transfer of assets in the full chain of transfers from each Code transferor to the
     intermediate SPE is subject to review in terms of the factors courts generally consider
     in determining whether a transfer is a true sale or a secured loan.
       In particular, in this regard, whenever it is necessary that a transfer qualify as a
     true sale, the transfer must be examined for any arrangements by which the transferor
     retains a subordinated interest in the assets, whether the interest is in the form of a
     subordinated note or subordinated certificates that are being issued in the transaction.
     Depending upon the circumstances, Standard & Poor’s may view a transfer that
     incorporates subordinated interests as more likely to be characterized as a secured
     loan transaction, rather than a true sale.
       True sale opinion. To obtain legal comfort that each transfer of assets through the
     chain of transfers from any Code transferor through the first-tier transfer to the
     intermediate SPE constitutes a true sale, Standard & Poor’s will, as a general matter,
     request a “true sale opinion” for each transfer. The true sale opinion should state
     that the assets being transferred and the proceeds thereof will not be property of the
     transferor’s estate under Section 541 of the Bankruptcy Code or be subject to the
     automatic stay under Section 362(a) in the event of the bankruptcy of the transferor.
       Sometimes, assets may pass through multiple owners before coming to rest in the
     intermediate SPE. In general, Standard & Poor’s would want true sale opinions for
     each transfer in the chain. However, in some cases, this request would be burdensome
     and add little real value. Therefore, in certain circumstances, Standard & Poor’s may
     waive true sale opinions for various transfers.
       For example, in cases of “open market transfers,” Standard & Poor’s may waive
     the true sale opinion requirement for intermediate transfers. Standard & Poor’s will
     consider transfers on a case-by-case basis to determine whether they are open market.
     As a general matter, if the transfer satisfies the following criteria, Standard & Poor’s
     will deem the transfer to be open market: (i) the transfer is an arm’s-length nonrecourse
     transfer between unaffiliated entities; (ii) the transferor received payment in full at
     the time of the transfer; (iii) the transferee is purchasing assets from multiple trans-
     ferors; and (iv) the transferor does not receive, as payment, any securities issued in
     the rated transaction.
       Depending on the type of transaction, Standard & Poor’s will consider additional
     factors in determining whether a transfer is open market. For example, in the context
     of most structured transactions, Standard & Poor’s will generally require that the
     transferee purchased the assets in the ordinary course of its business. Standard &
     Poor’s considers open market transfers to be true sales for bankruptcy purposes and
     therefore may not require true sale opinions in connection with such transfers. In
     addition, Standard & Poor’s may view some direct purchases by the intermediate
     SPE from unrelated parties as open market transfers. In many instances, it may be




84
                                            Legal Criteria for Subprime Mortgage Transactions




difficult to determine whether a transfer was indeed an open market transfer. In
these cases, Standard & Poor’s may request a true sale opinion nevertheless.

Nonconsolidation
Second, under the equitable provisions of Section 105 of the Bankruptcy Code, a
court has the power to substantively consolidate ostensibly separate but related entities
and treat the assets and liabilities of the entities as if they belonged to one, thus
enabling the creditors of each to reach the assets of the consolidated estate.
   Therefore, even if a first-tier transfer from a Code transferor constitutes a true
sale, if the transferor becomes insolvent, property transferred to the intermediate
SPE from the transferor may be deemed part of the transferor’s bankruptcy estate,
thereby jeopardizing timely payment to the holders of the rated securities.
   Because of this possibility of substantive consolidation and the resultant risk that
holders of the rated securities would not receive timely payment on their investment,
Standard & Poor’s generally requires that, in circumstances in which consolidation
of the intermediate SPE with a Code transferor is a possibility, it receive a legal
opinion stating that, if the Code transferor were to become insolvent, neither the
intermediate SPE, nor its assets and liabilities, would be substantively consolidated
with the transferor. In this regard, the facts and circumstances of the relationship
between the intermediate SPE and other entities in a transaction in terms of the factors
courts generally consider in determining whether two entities should be substantively
consolidated should be examined. In addition, each SPE should adopt “separateness
covenants” in the transaction documents and/or its charter and by-laws.
   Nonconsolidation opinion. As mentioned above, to obtain legal comfort in regard
to consolidation in bankruptcy, in certain circumstances, Standard & Poor’s will
request a “nonconsolidation opinion” to the effect that, in an insolvency of the
relevant Code transferor, neither the intermediate SPE, nor its assets and liabilities,
would be substantively consolidated with the transferor. Since an intermediate SPE
may take a variety of different forms, for example, corporate, partnership, or limited
liability company (LLC), the particular nonconsolidation opinions that Standard &
Poor’s will request in a given transaction will depend upon the type of entities in-
volved and their relationship to one another. In general, Standard & Poor’s requires
the following nonconsolidation opinions:
I If the intermediate SPE is a corporation, a nonconsolidation opinion stating that,

   under applicable insolvency laws, upon an insolvency of any entity owning 50%
   or more of the equity of the intermediate SPE corporation, the intermediate SPE
   corporation, or its assets and liabilities, would not be substantively consolidated
   with its 50% or more equity owner. (If all equity holders of the intermediate SPE
   are affiliates, Standard & Poor’s will generally require the nonconsolidation opinion
   irrespective of the proportionate ownership.)


 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria    85
     I   If the intermediate SPE is a limited partnership, a nonconsolidation opinion stating
         that, under applicable insolvency laws, in an insolvency of any limited partner
         holding a 50% or more percentage interest in the profits and losses of the interme-
         diate SPE limited partnership or an insolvency of any general partner (that is
         not itself an SPE) of the intermediate SPE limited partnership, the intermediate
         SPE limited partnership, or its assets and liabilities, would not be substantively
         consolidated with the general or limited partner. Furthermore, under Standard &
         Poor’s criteria, at least one general partner of an SPE limited partnership must be
         an SPE. Accordingly, Standard & Poor’s would, as a general matter, require a non-
         consolidation opinion between the SPE general partner and its equity holders
         (if the SPE is a corporation) or partners (if the SPE is a partnership) as
         described above.
     I   If the intermediate SPE is an LLC, a nonconsolidation opinion stating that, under
         applicable insolvency laws, in an insolvency of any member or successor member
         (that is not itself an SPE), the intermediate SPE LLC, or its assets and liabilities,
         would not be substantively consolidated with the member or successor member.
         Furthermore, under Standard & Poor’s criteria, at least one member of a two
         or more member SPE LLC must be an SPE. Accordingly, if the SPE member is a
         corporation, Standard & Poor’s would, as a general matter, require the relevant
         nonconsolidation opinion. In connection with single-member LLCs, Standard &
         Poor’s criteria, at the time of publication, are still in the developing stage. Therefore,
         transferors intending to use a single-member LLC in a structured transaction are
         encouraged to check with Standard & Poor’s regarding its single-member LLC
         criteria, including its opinion requirements.
     I   For two-tier transactions, if the second-tier transfer is structured as a true sale
         rather than a secured loan, the assets transferred to the issuing SPE in the second-
         tier true sale would not be part of the intermediate SPE’s estate. Thus, possible
         consolidation of the intermediate SPE with its parent would not affect the transaction.
         In such circumstances, Standard & Poor’s typically will not request a nonconsoli-
         dation opinion between the Code transferor and the intermediate SPE.
     I   If the parties propose an intermediate SPE that is not subject to the Bankruptcy
         Code, such as an insurance company or bank, or, if the intermediate SPE is an
         “orphan SPE” whose parent is an operating company, Standard & Poor’s will
         address the need for nonconsolidation opinions on a case-by-case basis. If the
         intermediate SPE is owned by a company established for the limited purpose of
         owning and providing management services to securitization vehicles, Standard
         & Poor’s will not typically require a nonconsolidation opinion, provided it
         has already received at least one nonconsolidation opinion with respect to such
         company’s participation in a prior transaction. Depending upon the circumstances,




86
                                              Legal Criteria for Subprime Mortgage Transactions




  Standard & Poor’s may require nonconsolidation opinions between an intermediate
  SPE and certain indirect affiliates.

Second Tier: True Sale or First Priority Perfected Security Interest
Because the second-tier transfer in a two-tier transaction is from an SPE, Standard
& Poor’s does not require the second-tier transfer to be a true sale. A pledge of
assets from a bankruptcy-remote entity is sufficient to make Standard & Poor’s
comfortable that the assets would be available to make timely payments on the rated
securities. Therefore, in connection with the second tier in a two-tier transaction,
Standard & Poor’s will be comfortable if the issuing SPE makes a loan secured by
the assets to the intermediate SPE and obtains a first priority perfected security
interest in the assets and the proceeds thereof.
  In addition, if the rated securities are debt of the issuing SPE, as a general matter,
Standard & Poor’s requires that the “indenture trustee/custodian” obtain a first priority
perfected security interest in the assets and the proceeds thereof. Since the issuing
SPE, like the intermediate SPE, is deemed by Standard & Poor’s to be bankruptcy
remote, a pledge of assets from the issuing SPE, rather than a true sale, is sufficient
to make Standard & Poor’s comfortable that the assets would be available to make
timely payments on the rated securities. The grant of a security interest serves to
reduce the incentive of the equity holders to voluntarily file a bankruptcy petition
against the issuing SPE (an integral component of Standard & Poor’s SPE criteria).
  If the second-tier transfer does not constitute a true sale, Standard & Poor’s generally
requires the parties to the transaction to take all necessary steps under the applicable
laws to ensure that the issuing SPE or indenture trustee/custodian, as applicable, has
a first priority perfected security interest in all of the assets and the proceeds thereof.
  True sale opinion, security interest opinion or either/or opinion; debt security
interest opinion. To obtain legal comfort that the issuing SPE in the second-tier
transfer either purchases the assets and proceeds in a true sale from the intermediate
SPE or obtains a first priority perfected security interest in the assets and the proceeds
thereof, Standard & Poor’s will generally request an opinion regarding the second-tier
transfer. The opinion may be either (i) a true sale opinion, similar to the true sale
opinion given in connection with the first-tier transfer, or (ii) a “security interest
opinion” to the effect that the issuing SPE has obtained, or will have obtained fol-
lowing the taking of certain actions required by the “transaction documents,” a first
priority perfected security interest in the assets and the proceeds thereof, or (iii) an
“either/or opinion” to the effect that the issuing SPE either (a) has purchased the
assets and the proceeds thereof from the intermediate SPE in a true sale or (b) has
obtained, or will have obtained following the taking of certain actions required by
the transaction documents, a first priority perfected security interest in the assets
and the proceeds thereof.


  Standard & Poor’s Structured Finance    I   U.S. Residential Subprime Mortgage Criteria    87
       In addition, if the rated securities are debt of the issuing SPE, to obtain legal comfort
     that the indenture trustee/custodian has obtained, or will have obtained following
     the taking of certain actions required by the transaction documents, a first priority
     perfected security interest in such property and the proceeds thereof, Standard &
     Poor’s will generally request a “debt security interest opinion.”

     Criteria Relating to the Tax Status of the Issuing SPE
     To obtain comfort that the assets would not be needed to pay taxes of the issuing
     SPE, thereby depleting the funds available to make payments on the rated securities,
     Standard & Poor’s typically requires an “entity-level tax opinion” to the effect that
     the issuing SPE would not be subject to federal tax or to state or local tax in the
     applicable jurisdictions. Without this opinion, additional credit enhancement might
     be required to cover any potential taxes of the issuing SPE.

     One-Tier Transactions
     Instead of the two-tier transaction discussed above, some transactions are structured
     with only one tier. In these transactions, the Code transferor does not use an inter-
     mediate SPE, but rather sells the assets and the proceeds thereof directly to an issuing
     SPE, which issues the rated securities. In a one-tier transaction from a Code transferor,
     Standard & Poor’s has the following interrelated criteria.

     True Sale
     First, Standard & Poor’s generally requires that a one-tier transfer of assets and the
     proceeds thereof from any Code transferor to an issuing SPE be a true sale.
       True sale opinion. To obtain legal comfort that a one-tier transfer of assets and
     the proceeds thereof from a Code transferor to an issuing SPE constitutes a true sale,
     as a general matter, Standard & Poor’s will request a true sale opinion with respect
     to the transfer. The true sale opinion should state that the property being transferred
     and the proceeds thereof will not be property of the transferor’s estate under Section
     541 of the Bankruptcy Code or be subject to the automatic stay under Section 362(a)
     in the event of the bankruptcy of the transferor.

     Nonconsolidation
     Second, because of the possibility of substantive consolidation in certain circumstances
     and the resultant risk that holders of the rated securities would not receive timely
     payment on their investment, Standard & Poor’s generally requires that, in circum-
     stances in which consolidation of the issuing SPE with a Code transferor in a one-tier
     transaction is a possibility, it receive assurance that if the Code transferor were to
     become insolvent, neither the issuing SPE nor its assets and liabilities would be
     substantively consolidated with the transferor.


88
                                                 Legal Criteria for Subprime Mortgage Transactions




  Nonconsolidation opinion. Standard & Poor’s generally requests a nonconsolidation
opinion to the effect that, in an insolvency of the Code transferor, neither the issuing
SPE, nor its assets and liabilities, would be substantively consolidated with the trans-
feror. Since the issuing SPE may take a variety of different forms, for example, trust,
partnership, LLC, or corporation, the particular nonconsolidation opinions that
Standard & Poor’s will request in a given transaction will depend upon the type
of entities involved and their relationship to one another.

First Priority Perfected Security Interest
Third, in a one-tier transaction, if the rated securities constitute debt of the issuing
SPE, Standard & Poor’s generally requires that the indenture trustee/custodian obtain
a first priority perfected security interest in the assets and the proceeds thereof. Since
the issuing SPE is deemed by Standard & Poor’s to be bankruptcy remote, a pledge
of assets from the issuing SPE, rather than a true sale, is sufficient to make Standard
& Poor’s comfortable that such property would be available to make timely payments
on the rated securities.
  Standard & Poor’s generally requires that the parties to the transaction take all
necessary steps under the applicable laws to ensure that the indenture trustee/custodian
has a first priority perfected security interest in all of the assets and the proceeds thereof.
  Debt security interest opinion. In a one-tier transaction, if the rated securities are
debt of the issuing SPE, to obtain legal comfort that the indenture trustee/custodian
has obtained, or will have obtained following the taking of certain actions required
by the transaction documents, a first priority perfected security interest in such
property and the proceeds thereof, Standard & Poor’s generally will request a
debt security interest opinion to that effect.

Criteria Relating to the Tax Status of the Issuing SPE
To obtain comfort that the assets would not be needed to pay taxes of the issuing
SPE, thereby depleting the funds available to make payments on the rated securities,
Standard & Poor’s generally requires an entity-level tax opinion to the effect that the
issuing SPE would not be subject to federal tax or to state or local tax in the applicable
jurisdictions. Without this opinion, additional credit enhancement might be required
to cover any potential taxes of the issuing SPE.

Criteria Relating to Preference and Avoidance of Transfers

Fraudulent Conveyance
In certain circumstances (for example, if the purchase price paid by an intermediate
SPE for assets is less than the reasonably equivalent value of the assets, or where a
transferor is insolvent or extremely financially distressed at the time of the transfer)



  Standard & Poor’s Structured Finance       I   U.S. Residential Subprime Mortgage Criteria    89
     there is a risk that the transfer would be voided as a fraudulent conveyance, either
     under Section 548 of the Bankruptcy Code or under applicable state law. If a transfer
     of assets were voided as a fraudulent transfer, the assets would not be available to
     make payments on the rated securities. Each transfer of assets in a structured transaction
     is subject to review to determine if there is a risk that the transfer could be voided
     under the theory of fraudulent conveyance.
        Fraudulent conveyance opinion. If Standard & Poor’s determines that there is a
     fraudulent conveyance risk in connection with any given transfer of assets in a trans-
     action, generally it will request a “fraudulent conveyance opinion” to the effect that
     the transfer and the related payments to the holders of the rated securities would not
     be recoverable as a fraudulent transfer under either Section 548 of the Bankruptcy
     Code or applicable state law. In addition, Standard & Poor’s may request that the
     facts assumed in a fraudulent conveyance opinion be verified with either audits or
     independent valuations of the assets.

     Preferential Transfer
     In other circumstances, there is a risk that the transfer would be voided as a prefer-
     ential transfer under Section 547 of the Bankruptcy Code. If a transfer of assets were
     voided as a preferential transfer, the assets would not be available to make payments
     on the rated securities. Examples of preferential transfers include debt payments made
     that were not in the ordinary course of business or pledges of additional collateral to
     a creditor within the applicable preference period. Each transfer of assets in a structured
     transaction is subject to review to determine if there is a risk that the transfer could
     be voided under the theory of preferential transfer.
       Preference opinion. If Standard & Poor’s determines that there is a preference risk
     in connection with any given transfer of assets in a transaction, Standard & Poor’s
     will generally request a “preference opinion” to the effect that the transfer and the
     related payments to the holders of the rated securities would not be recoverable as
     a preferential transfer under Section 547 of the Bankruptcy Code.
       It should be noted that if, as a credit matter, the value of the assets is not relevant
     to the rating of a structured transaction (for example, the transaction is based on a
     total return swap or credit is not being given for recoveries on any underlying assets
     such as the underlying mortgaged properties), Standard & Poor’s generally will not
     require true sale opinions, security interest opinions, either/or opinions or debt security
     interest opinions regarding such assets.




90
                                            Legal Criteria for Subprime Mortgage Transactions




Securitizations by SPE Transferors
and Non-Code Transferors
General
The previous section above addresses Standard & Poor’s legal criteria for structured
transactions in which the transferor of assets into the securitization structure is a
Code transferor. Standard & Poor’s criteria for structured transactions involving
Code transferors attempt to minimize the risk that the assets would not be available
for timely payment on the rated securities should any of the Code transferors
become a debtor in bankruptcy under the Bankruptcy Code.
  This section addresses Standard & Poor’s legal criteria for structured transactions
in which the transferor of assets into the securitization structure is either an SPE
transferor or a non-Code transferor. Unlike Code transferors, “SPE transferors,”
such as “municipalities” and “public-purpose entities,” while subject to the Bank-
ruptcy Code, are deemed by Standard & Poor’s to be bankruptcy remote in that the
bankruptcy or dissolution of such entities for reasons unrelated to the transaction
structure is deemed unlikely to occur. “Non-Code transferors,” such as banks and
insurance companies, while not deemed by Standard & Poor’s to be bankruptcy
remote, are not eligible to become debtors under the Bankruptcy Code. Because
structured transactions involving either SPE transferors or non-Code transferors
do not pose the same bankruptcy concerns as those involving Code transferors,
Standard & Poor’s criteria for structured transactions involving these entities differ
in detail, but not in purpose, from the criteria for Code transferors.

SPE Transferors
Municipalities are entities that would qualify as municipalities under Section 101(40)
of the Bankruptcy Code. As such, municipalities are not “moneyed, business or
commercial corporations[s]” under Section 303 of the Bankruptcy Code. Public-purpose
entities, such as “501(c)(3) entities” under the Internal Revenue Code (IRC), state or
municipal agencies, or state or municipally chartered corporations, are entities that
are also deemed not “moneyed, business or commercial corporation[s]” under Section
303 of the Bankruptcy Code. According to Section 303(a) of the Bankruptcy Code,
these entities may not be involuntarily filed into bankruptcy by their creditors, and,
thus, their creditors would be unable to cause a timing delay on the rated securities
or reach assets otherwise available to pay the rated securities by filing an involuntary
bankruptcy petition.
  Both municipalities and public-purpose entities may, however, voluntarily file
bankruptcy petitions under the Bankruptcy Code, municipalities under Chapter 9
and public-purpose entities under either Chapter 7 (liquidation) or Chapter 11



 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria    91
     (reorganization). For Standard & Poor’s to deem such entities to be bankruptcy
     remote, Standard & Poor’s evaluates, as a general matter, the likelihood that a
     municipality or public-purpose entity involved in a structured transaction would
     voluntarily file for bankruptcy protection. This evaluation takes into account the
     entity’s need to have access to the financial markets on reasonable terms, the nature
     of its business, its ability to control spending or to raise revenues, and, in case of
     municipal entities, the necessity of the services provided to its citizenry and the
     purpose of the securitization.
       Assuming that Standard & Poor’s evaluation leads it to conclude that a municipality
     or public-purpose entity is unlikely to voluntarily file for bankruptcy protection,
     Standard & Poor’s deems such an entity to be bankruptcy remote. As such, Standard
     & Poor’s has the following interrelated criteria for structured transactions involving
     SPE transferors.

     One-Tier Transactions
     True sale or first priority perfected security interest. An SPE transferor generally
     chooses a one-tier transaction structure and does not interpose an intermediate SPE
     between the SPE transferor and the issuing SPE. In such one-tier transactions involving
     SPE transferors, Standard & Poor’s does not require the transfer from the SPE transferor
     to the issuing SPE to constitute a true sale. A pledge of assets from a bankruptcy-
     remote entity is sufficient to make Standard & Poor’s comfortable that the assets
     would be available to make timely payments on the rated securities. Therefore,
     rather than requiring a true sale, Standard & Poor’s will be comfortable if the issuing
     SPE makes a loan secured by the assets and obtains a first priority perfected security
     interest in the assets and the proceeds thereof.
       In addition, if the rated securities are debt of the issuing SPE, Standard & Poor’s
     generally requires that the indenture trustee/custodian obtain a first priority perfected
     security interest in the assets and the proceeds thereof. Since the issuing SPE, like the
     SPE transferor, is deemed by Standard & Poor’s to be bankruptcy remote, a pledge
     of assets and the proceeds thereof from the issuing SPE, rather than a true sale, is
     sufficient to make Standard & Poor’s comfortable that the property and the proceeds
     thereof would be available to make timely payments on the rated securities. The
     grant of a security interest serves to reduce the incentive of the equity holders to
     voluntarily file a bankruptcy petition against the issuing SPE (an integral component
     of Standard & Poor’s SPE criteria.
       True sale opinion, security interest opinion or either/or opinion; debt security
     interest opinion. To obtain legal comfort regarding the above, in a one-tier transaction
     involving an SPE transferor, Standard & Poor’s generally requires either (i) a true
     sale opinion, or (ii) a security interest opinion, or (iii) an either/or opinion in connection
     with such transfer.


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                                             Legal Criteria for Subprime Mortgage Transactions




  In addition, if the rated securities are debt of the issuing SPE, to obtain legal comfort
that the indenture trustee/custodian has obtained, or will have obtained following
the taking of certain actions required by the transaction documents, a first priority
perfected security interest in such property and the proceeds thereof, Standard &
Poor’s generally will request a debt security interest opinion to that effect.
  Entity status opinion/involuntary filing opinion. If the status of an entity as a
municipality is unclear, to obtain legal comfort, Standard & Poor’s may request
an “entity status opinion” to the effect that the entity would be deemed to be a
municipality under the Bankruptcy Code.
  Similarly, if the status of an entity as one deemed not to be a “moneyed, business
or commercial corporation” is unclear, to obtain legal comfort, Standard & Poor’s
may request an “involuntary filing opinion” to the effect that the entity may not be
involuntarily filed by its creditors under the Bankruptcy Code.
  Criteria relating to the tax status of the issuing SPE. To obtain comfort that the
assets would not be needed to pay taxes of the issuing SPE, thereby depleting the
funds available to make payments on the rated securities, Standard & Poor’s generally
requires an entity-level tax opinion to the effect that the issuing SPE would not be
subject to federal tax or to state or local tax in the applicable jurisdictions. Without
this opinion, additional credit enhancement might be required to cover any potential
taxes of the issuing SPE.

Two-Tier Transactions
A municipality or public-purpose entity, as transferor of assets in a structured trans-
action, may choose, for accounting, tax or other reasons, a two-tier transaction
structure in which it transfers the assets to an intermediate SPE, and the intermediate
SPE transfers the assets directly to the issuing SPE, which issues the rated securities.
In two-tier transactions involving SPE transferors, Standard & Poor’s would permit
either tier to constitute either a true sale or the grant of a first priority perfected
security interest in the assets and the proceeds thereof to the intermediate SPE or the
issuing SPE. If an SPE transferor chooses a two-tier transaction structure, Standard
& Poor’s criteria for the second tier are identical to its criteria for a one-tier transaction
involving an SPE transferor.

Non-Code Transferors
Neither banks nor insurance companies are eligible to become debtors under the
Bankruptcy Code. As such, the various sections of the Bankruptcy Code discussed
in Chapter One do not apply to asset transfers in structured transactions in which
either a bank or an insurance company functions as the transferor.
   Both banks and insurance companies may, however, become insolvent, and, there-
fore, unlike SPE transferors, are not deemed by Standard & Poor’s to be bankruptcy


  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria    93
     remote. As such, Standard & Poor’s criteria for structured transactions involving
     either banks or insurance companies as transferors are somewhat different from its
     criteria for SPE transferors, since in the case of banks and insurance companies,
     Standard & Poor’s criteria seek to insulate the structured transaction from the
     consequences of the bank’s or the insurance company’s insolvency, albeit not
     under the Bankruptcy Code.

     FDIC-Insured Banks
     Bank insolvency regimes vary, depending on whether the bank is a national or state-
     chartered financial institution and whether it is insured by the U.S. Federal Deposit
     Insurance Corp. (FDIC). Standard & Poor’s has the following interrelated criteria
     for structured transactions involving “FDIC-insured banks” as transferors.
       One-Tier transactions. An FDIC-insured bank generally chooses a one-tier trans-
     action structure and does not interpose an intermediate SPE between the bank and
     the issuing SPE. As a general matter, rather than a true sale, as described further
     below, the grant of a first priority perfected security interest in assets from an FDIC-
     insured bank as transferor in a one-tier transaction is sufficient to make Standard
     & Poor’s comfortable with the timely availability of the assets to pay the holders
     of the rated securities.
       Federal Deposit Insurance Act. Under Section 11(c)(3)(A) of the Federal Deposit
     Insurance Act (FDIA), the FDIC is authorized to accept appointment as receiver or
     conservator for an insured state depository institution. Also, under Section 11(c)(1)
     and (2) of the FDIA, the FDIC is authorized to accept appointment as conservator
     and is required to be appointed as receiver for a national bank. Standard & Poor’s
     criteria for transactions in which either an FDIC-insured state-chartered bank or a
     national bank serves as a transferor addresses the powers of the FDIC under the
     relevant provisions of the FDIA should such bank become insolvent.
       Unlike the Bankruptcy Code, the FDIA does not contain an automatic stay provision.
     However, the FDIC, in its capacity as receiver or conservator of the insolvent institution,
     has expansive powers, including the power to ask for a judicial stay of all payments
     and/or to repudiate any contract. To provide for greater flexibility in securitized
     transactions, however, the FDIC has stated that it would not seek to avoid an otherwise
     legally enforceable and perfected security interest so long as the following conditions
     are met:
     I The security agreement evidencing the security interest is in writing, was approved

       by the board of directors of the bank or its loan committee (this approval is reflected
       in the minutes of a meeting of the bank’s board of directors or committee), and
       has been, continuously, from the time of its execution, an official record of the
       bank (this condition, essentially codified in Section 13(e) of the FDIA, is based on




94
                                            Legal Criteria for Subprime Mortgage Transactions




  the holding of the U.S. Supreme Court in D’Oench, Duhme & Co. v. FDIC, 315
  U.S. 447 (1942));
I The security agreement evidencing the security interest was undertaken in the

  ordinary course of business, not in contemplation of insolvency, and with no
  intent to hinder, delay, or defraud the bank or its creditors;
I The secured obligation represents a bona fide and arm’s-length transaction;

I The secured party or parties are not insiders of or affiliates of the bank; and

I The grant of the security interest was made for adequate consideration.

  Based on this advice, if a structured transaction involving the transfer of assets
from an FDIC-insured bank complies with the above conditions, Standard & Poor’s
obtains comfort that a security interest granted by the bank in the assets should not
be avoidable in the event of the bank’s insolvency.
  In addition, Standard & Poor’s derives comfort from a letter written by the General
Counsel of the FDIC, commonly referred to as the “Douglas letter,” stating that the
Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA),
which revised federal law relating to bank conservatorships and receiverships, does
not contain an automatic stay provision similar to that found in the Bankruptcy
Code and that a secured creditor of an FDIC-insured bank for which a receiver had
been appointed may, on the conditions set forth below, undertake to liquidate the
creditor’s properly pledged collateral by commercially reasonable self-help methods.
  The conditions include the following: (i) that no involvement of the receiver was
required; (ii) that there was a default, other than through an ipso facto provision;
and (iii) that the transaction was an arms-length, bona fide transaction, not involving
an affiliate or insider, which would pass muster under appropriate fraudulent con-
veyance law or other applicable law and which involved a legally perfected security
interest enforceable under other applicable law. Standard & Poor’s notes, however,
that the General Counsel also stated in the Douglas letter that if some action is
required by the receiver or liquidation would require judicial action, then the claims
process in FIRREA would have to be followed.
  FDIC/D’Oench opinion. To obtain legal comfort regarding the above, in connection
with the grant of a first priority perfected security interest in assets and the proceeds
thereof from a bank governed by the FDIA directly to the issuing SPE in a one-tier
transaction (in addition to a security interest opinion or either/or opinion discussed
below), Standard & Poor’s generally requires an “FDIC/D’Oench opinion” to the
effect that the above listed conditions have been satisfied and, thus, such security
interest would not be subject to avoidance if the FDIC were appointed as a receiver
or conservator of the bank.
  True sale or first priority perfected security interest. Because of the FDIC advice
stated above, in a one-tier transaction in which an FDIC-insured bank serves as
transferor, Standard & Poor’s does not require the transfer to the issuing SPE to


 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria    95
     constitute a true sale. A pledge of assets from an FDIC-insured bank is sufficient to
     make Standard & Poor’s comfortable that the assets would be available to make
     timely payments on the rated securities.
        Therefore, rather than requiring a true sale, Standard & Poor’s will be comfortable
     if the issuing SPE makes a loan to the bank and obtains a first priority perfected
     security interest in the assets and the proceeds thereof, enforceable notwithstanding
     the insolvency of the bank.
        In addition, if the rated securities are debt of the issuing SPE, Standard & Poor’s
     generally requires that the indenture trustee/custodian obtain a first priority perfected
     security interest in the assets and the proceeds thereof. Since the issuing SPE is deemed
     by Standard & Poor’s to be bankruptcy remote, a pledge of assets and the proceeds
     thereof from the issuing SPE, rather than a true sale, is sufficient to make Standard
     & Poor’s comfortable that such property and the proceeds thereof would be available
     to make timely payments on the rated securities.
        True sale opinion, security interest opinion or either/or opinion; debt security interest
     opinion. To obtain legal comfort regarding the above, in a one-tier transaction in-
     volving an FDIC-insured bank, Standard & Poor’s generally requires, in addition to
     the FDIC/D’Oench opinion discussed above, either (i) a true sale opinion, or (ii) a
     security interest opinion, or (iii) an either/or opinion.
        In addition, if the rated securities are debt of the issuing SPE, to obtain legal comfort
     that the indenture trustee/custodian has obtained, or will have obtained following
     the taking of certain actions required by the transaction documents, a first priority
     perfected security interest in such property and the proceeds thereof, Standard &
     Poor’s generally will request a debt security interest opinion to that effect.
        Criteria relating to the tax status of the issuing SPE. To obtain comfort that the
     assets would not be needed to pay taxes of the issuing SPE, thereby depleting the
     funds available to make payments on the rated securities, Standard & Poor’s generally
     requires an entity-level tax opinion to the effect that the issuing SPE would not be
     subject to federal tax or to state or local tax in the applicable jurisdictions. Without
     this opinion, additional credit enhancement might be required to cover any potential
     taxes of the issuing SPE.
        Two-tier transactions. An FDIC-insured bank, as transferor of assets in a structured
     transaction, may choose, for bank regulatory, accounting, tax, or other reasons, a
     two-tier transaction structure in which it transfers the assets to an intermediate SPE,
     and the intermediate SPE transfers the assets directly to an issuing SPE, which issues
     the rated securities. In two-tier transactions from FDIC-insured banks, Standard &
     Poor’s would permit either tier to constitute either a true sale or the grant of a first
     priority perfected security interest in the assets and the proceeds thereof to the
     intermediate SPE or the issuing SPE. If an FDIC-insured bank chooses a two-tier
     transaction structure, Standard & Poor’s criteria for the second tier are identical
     to its criteria for a one-tier transaction involving an FDIC-insured bank.

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                                             Legal Criteria for Subprime Mortgage Transactions




  Nonconsolidation. Regarding nonconsolidation, if a transaction from an FDIC-
insured bank is structured as a one-tier (with a true sale) or a two-tier (with a true
sale at the first tier and a first priority perfected security interest at the second tier),
Standard & Poor’s may not require a nonconsolidation opinion between the FDIC-
insured bank and the intermediate SPE or the issuing SPE, provided that the rated
securities constitute debt of the issuing SPE and, in connection with the true sale
opinion, there are delivered (i) an “alternative security interest opinion” to the effect
that, if a court did not consider the purported true sale transfer to be a true sale, it
would be a grant of a first priority perfected security interest by the bank to the
intermediate SPE or issuing SPE and (ii) an FDIC/D’Oench opinion.

Non-FDIC-Insured Banks
Insolvency of a “non-FDIC-insured bank” is generally governed by state law, and it
is beyond the scope of this publication to examine and differentiate state insolvency
regimes for state-chartered non-FDIC-insured banks. The principles of securitization
discussed throughout this publication and Standard & Poor’s criteria regarding other
types of transferors, however, can be used to derive, in general, Standard & Poor’s
criteria for structured transactions from non-FDIC-insured banks; that is, the assets
should be sufficiently separated that, as a legal matter, in an insolvency of the non-
FDIC-insured bank they are available in a timely manner to pay principal and interest
on the rated securities. Standard & Poor’s will generally require comfort, including
legal opinions, regarding the treatment of the asset transfer in an insolvency of the
non-FDIC-insured bank, including any possible stay on enforcement, avoidance,
rejection, disaffirmance, or set-off issues.
   Transactions with comfort from state banking regulator. Because state laws governing
state-chartered non-FDIC-insured banks differ, transactions structured from these
banks tend to vary. If the state banking regulator in the state of incorporation of the
non-FDIC-insured bank is able to issue comfort along the lines of the FDIC regarding
FDIC-insured banks, for example, that a first priority perfected security interest
granted by the non-FDIC-insured bank would be respected by the state’s banking
regulator, notwithstanding the bank’s insolvency, and Standard & Poor’s receives a
“non-FDIC-insured bank opinion” to that effect, a non-FDIC-insured bank may be
able to structure a transaction either as a one-tier transaction (with either a true sale
from the bank to the issuing SPE or the grant of a first priority perfected security
interest from the bank to the issuing SPE), or, alternatively, as a two-tier transaction
(with either tier structured as a true sale or a first priority perfected security interest).
If the state banking insolvency law provides for an automatic stay, the transaction
may need to be structured as a true sale. Alternatively, Standard & Poor’s may
become comfortable with a secured loan transaction if the duration of the stay is




  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria    97
     specified by statute and the transaction includes a liquidity facility to cover the
     timing delay.
        Opinion requirements. In these cases, Standard & Poor’s criteria and opinion
     requirements for transactions involving state-chartered non-FDIC-insured banks as
     transferors are the same as its criteria for transactions involving FDIC-insured banks
     as transferors (with the non-FDIC-insured bank opinion being required whenever an
     FDIC/D’Oench opinion would have been required for FDIC-insured banks).
        Transactions without comfort from state banking regulator. If, on the other hand,
     no comfort from the appropriate state banking regulator is available, transactions
     from non-FDIC-insured banks would be required to be structured with a true sale,
     either as a two-tier transaction (with the first tier consisting of a true sale to an
     intermediate SPE that would not be consolidated with the non-FDIC-insured bank,
     and the second tier either as a true sale or the grant of a first priority perfected security
     interest), or as a one-tier transaction constituting a true sale.
        Opinion requirements. In these cases, Standard & Poor’s criteria and opinion re-
     quirements for transactions involving state-chartered non-FDIC-insured banks as
     transferors are the same as its criteria for transactions involving Code transferors,
     including its requirement for comfort regarding nonconsolidation (see Nonconsolidation
     below) between the non-FDIC-insured bank and the intermediate SPE or the
     issuing SPE.
        Nonconsolidation. Although the doctrine of substantive consolidation is an equitable
     doctrine under the Bankruptcy Code and a bank is not eligible to become a debtor
     under the Bankruptcy Code, it would be legally possible for a state banking regulator,
     as the receiver or conservator for an insolvent bank, to administer jointly a substantively
     consolidated insolvency proceeding for the bank and another entity in which the
     bank holds a 50% or more equity or other interest. Based on this, if a first-tier
     transfer to an intermediate SPE from a non-FDIC-insured bank is structured as a
     true sale (and the second tier is a grant of a first priority perfected security interest),
     the facts and circumstances of the relationship between the intermediate SPE and the
     bank in terms of the separateness covenants will be reviewed to determine if there is
     a risk of substantive consolidation of the intermediate SPE, or its assets and liabilities,
     with the bank. Because of the lack of legal certainty in analyzing consolidation in a
     bank insolvency, the structure may need to use an orphan SPE.
        Nonconsolidation opinion. To obtain legal comfort regarding the above, if the
     first-tier transfer from a non-FDIC-insured bank is structured as a true sale (because
     the relevant bank regulator is unable to provide Standard & Poor’s with comfort, as
     discussed above, that a grant of a first priority perfected security interest from the
     bank would be enforceable, notwithstanding the bank’s insolvency), and Standard
     & Poor’s determines there is a risk of consolidation of the intermediate SPE, or
     its assets and liabilities, with its parent (whether the bank or another entity)


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                                            Legal Criteria for Subprime Mortgage Transactions




Standard & Poor’s may require a nonconsolidation opinion stating that, under
applicable insolvency laws, upon an insolvency of the SPE’s parent, the intermediate
SPE, or its assets and liabilities, would not be substantively consolidated with the
SPE’s parent.
  If, however, a transaction from a non-FDIC-insured bank is structured as a true
sale, and Standard & Poor’s receives both (i) an alternative security interest opinion
to the effect that, if a court did not consider the purported true sale transfer to be a
true sale, it would be a grant of a first priority perfected security interest by the
bank to the intermediate SPE or the issuing SPE and (ii) a non-FDIC-insured bank
opinion, Standard & Poor’s generally will not require a nonconsolidation opinion.

Insurance Companies
Insolvency of an insurance company is generally governed by state law, administered
by the insurance commissioner or superintendent of the state. Although the National
Association of Insurance Commissioners has promulgated a uniform insolvency act,
the act has not been enacted uniformly in all states, and it is beyond the scope of
this publication to examine and differentiate state insolvency regimes for insurance
companies. In addition, the act leaves broad discretion to state commissioners in the
conduct of insolvency proceedings.
  The principles of securitization discussed throughout this publication and Standard
& Poor’s criteria regarding other types of transferors, however, can be used to derive,
in general, Standard & Poor’s criteria for structured transactions from insurance
companies; that is, the assets should be sufficiently separated that, as a legal matter,
in an insolvency of the insurance company they are available in a timely manner to
pay principal and interest on the rated securities. Standard & Poor’s will generally
require comfort, including legal opinions, regarding the treatment of the asset transfer
in an insolvency of the insurance company, including any possible stay on enforcement,
avoidance, rejection, disaffirmance or set-off issues.
  Transactions with comfort from state insurance commissioner or superintendent.
Because state laws governing insurance companies differ, transactions structured from
insurance companies tend to vary. If the state insurance commissioner or superintendent
in the state of incorporation of the insurance company is able to issue comfort along
the lines of the FDIC regarding FDIC-insured banks, for example, that a first priority
perfected security interest granted by the insurance company would be respected by
the state’s insurance commissioner or superintendent, notwithstanding the insurance
company’s insolvency, and Standard & Poor’s receives an “insurance law opinion”
to that effect, an insurance company may be able to structure a transaction either
as a one-tier transaction (with either a true sale from the insurance company to the




 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria    99
      issuing SPE or the grant of a first priority perfected security interest from the insurance
      company to the issuing SPE), or, alternatively, as a two-tier transaction (with either
      tier structured as a true sale or a first priority perfected security interest)
         Opinion requirements. In these cases, Standard & Poor’s criteria and opinion
      requirements for transactions involving insurance companies as transferors are the
      same as its criteria for transactions involving FDIC-insured banks as transferors
      (with the insurance law opinion being required whenever an FDIC/D’Oench opinion
      would have been required for FDIC-insured banks).
         Transactions without comfort from state insurance commissioner or superintendent.
      If, on the other hand, no comfort from the appropriate state insurance commissioner
      or superintendent is available, transactions from insurance companies would be
      required to be structured with a true sale, either as a two-tier transaction (with the
      first tier consisting of a true sale to an intermediate SPE that would not be consolidated
      with the insurance company, and the second tier either as a true sale or the grant of
      a first priority perfected security interest), or as a one-tier transaction constituting
      a true sale.
         Opinion requirements. In these cases, Standard & Poor’s criteria and opinion
      requirements for transactions involving insurance companies as transferors are the
      same as its criteria for transactions involving Code transferors, including its require-
      ment for comfort regarding nonconsolidation (see Nonconsolidation below) between
      the insurance company and the intermediate SPE or the issuing SPE.
         Nonconsolidation. Although the doctrine of substantive consolidation is an equitable
      doctrine under the Bankruptcy Code and an insurance company is not eligible to
      become a debtor under the Bankruptcy Code, it would be legally possible for a state
      insurance commissioner or superintendent, as the receiver or conservator for an
      insolvent insurance company, to administer jointly a substantively consolidated
      insolvency proceeding for the insurance company and another entity in which the
      insurance company holds an equity or other interest. Based on this, if a first-tier
      transfer to an intermediate SPE from an insurance company is structured as a true
      sale (and the second tier is a grant of a first priority perfected security interest), the
      facts and circumstances of the relationship between the intermediate SPE and the
      insurance company in terms of the separateness covenants will be used to determine
      if there is a risk of substantive consolidation of the intermediate SPE, or its assets
      and liabilities, with the insurance company. Because of the lack of legal certainty in
      analyzing consolidation in an insurance company insolvency, the structure may need
      to use an orphan SPE.
         Nonconsolidation opinion. To obtain legal comfort regarding the above, if the
      first-tier transfer from an insurance company is structured as a true sale (because
      the relevant insurance commissioner or superintendent is unable to provide Standard
      & Poor’s with comfort, as discussed above, that a grant of a first priority perfected


100
                                             Legal Criteria for Subprime Mortgage Transactions




security interest from the insurance company would be enforceable, notwithstanding
the insurance company’s insolvency), and Standard & Poor’s determines there is a
risk of consolidation of the intermediate SPE, or its assets and liabilities, with its
parent (whether the insurance company or another entity), Standard & Poor’s may
require a nonconsolidation opinion stating that, under applicable insolvency laws,
upon an insolvency of the SPE’s parent, the intermediate SPE, or its assets and liabilities,
would not be substantively consolidated with the SPE’s parent.
   If, however, a transaction from an insurance company is structured as a true sale,
and Standard & Poor’s receives both (i) an alternative security interest opinion to
the effect that, if a court did not consider the purported true sale transfer to be a true
sale, it would be a grant of a first priority perfected security interest by the insurance
company to the intermediate SPE or the issuing SPE and (ii) an insurance law opinion,
Standard & Poor’s generally will not require a nonconsolidation opinion.


Special-Purpose Entities
General
Standard & Poor’s legal criteria for securitization transactions are designed to ensure
that the entity owning the assets required to make payments on the rated securities
is bankruptcy remote, that is, is unlikely to be subject to voluntary or involuntary
insolvency proceedings. In this regard, both the incentives of this entity, known as a
special-purpose entity or an SPE, or its equity holders to resort to voluntary insolvency
proceedings and the incentives for other creditors of the SPE to resort to involuntary
proceedings are considered. The analysis also examines whether third-party creditors
of the SPE’s parent would have an incentive to reach the assets of the SPE (for
example, if the SPE is a trust, whether creditors of the beneficial holder would have
an incentive to cause the dissolution of the trust to reach the assets of the trust.)

The Characteristics of Bankruptcy Remoteness
In this regard, Standard & Poor’s has developed the following “SPE criteria,” which
an entity should satisfy to be deemed bankruptcy remote. An entity that satisfies
these criteria is regarded by Standard & Poor’s as being sufficiently protected
against both voluntary and involuntary insolvency risks:
I Restrictions on objects and powers,

I Debt limitations,

I Independent director,

I No merger or reorganization,

I Separateness, and

I Security interests over assets.




  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   101
        Each of these characteristics is important to the overall concept of bankruptcy
      remoteness and, regardless of the specific organizational structure of the SPE, these
      elements should, generally, be treated in the relevant organizational documents.
      Their rationale is briefly explained below, while the precise terms of these criteria
      are found in the following section.

      Restriction on Objects and Powers
      The fundamental SPE characteristic is that the entity’s objects and powers be restricted
      as closely as possible to the bare activities necessary to effect the structured transaction.
      The purpose of this restriction is to reduce the SPE’s internal risk of insolvency due
      to claims created by activities unrelated to the securitized assets and the issuance of
      the rated securities.
         In structured transactions, Standard & Poor’s generally requests that the SPE
      embed in its organic document of establishment (articles/certificate of incorporation
      for corporations, deed of partnership/partnership agreement for limited partnerships,
      articles of organization for limited liability companies (LLCs) or deed of trust/trust
      agreement for trusts, etc.) an objects clause that constrains the SPE to those activities
      needed to ensure the sufficiency of cash flow to pay the rated securities and powers
      incidental to this purpose. The organic documents are the preferred locus for this
      constraint (as well as the other SPE restrictions discussed below) for two reasons.
         First, these documents are publicly available and provide some measure of public
      notice of the restriction, rather than merely notice to the parties to a particular trans-
      action. Second, an organic restriction is less likely to become lost in the corporate
      files and more likely to remind the management of the SPE to act in accordance
      with its charter. Standard & Poor’s generally requests that, where possible, this
      limited objects clause, as well as the other SPE criteria, be reiterated in appropriate
      transaction documents.
         In brief, the SPE should not engage in unrelated business activities unless the parties
      to a transaction are willing to allow the rating to reflect the effect of these activities
      on the entity’s resources, cash flows, and the ability to pay the entity’s obligations in
      a full and timely manner.

      Debt Limitation
      An SPE should be restricted from issuing other debt except in circumstances that are
      consistent with the rated issuance. For example, an SPE may issue multiple classes of
      debt as long as the classes all have the same issue credit rating and, if any class’ rating
      is downgraded, the rating of the other classes will be similarly downgraded (or the
      SPE complies with Standard & Poor’s segregation of assets criteria). In some cases,
      the SPE may be able to issue subordinated nonrecourse debt that is related to the
      rated issuance. Because creditors can file involuntary petitions against an entity,


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                                            Legal Criteria for Subprime Mortgage Transactions




determining whether an entity is bankruptcy remote (thus an SPE) involves analyzing
the likely creditors of the SPE and their incentives to reach the assets supporting the
rated securities.
  The thrust of additional debt criteria is to ensure that a holder of additional
indebtedness would be unable to affect the creditworthiness of the SPE and would
be unable or unwilling to file the SPE (because there is no recourse to the SPE and
the holder is subordinated to the rated securities), or, alternatively, the risk to the
SPE would be no greater than that posed by the original issue (because the additional
debt is rated at least as high). In this regard, Standard & Poor’s looks for nonpetition
language in any agreement between the SPE and its creditors whereby the creditors
agree not to file the SPE into bankruptcy and not to join in any bankruptcy filing.

The Independent Director
An SPE acts through its board of directors, general partner, management committee
or managing member. For example, corporate activity is conducted at the direction
and under the supervision of the board, although day-to-day management of the
corporation is generally delegated by the board to the corporation’s officers. The
directors are elected by the shareholders, the corporation’s owners.
   Among the major decisions taken by the board of directors is the decision to file
the corporation into bankruptcy, and it is this concern that prompts Standard &
Poor’s to request the “independent director.” In many structured transactions, the
SPE is established by a non-SPE operating entity parent. This parent is, at times,
either unrated or has an “issuer credit rating” below its SPE subsidiary. Moreover,
the directors of the parent may well serve as the directors for the SPE. These inter-
locking directorates present a potential conflict of interest. If the parent becomes
insolvent in a situation where the SPE is performing adequately, there may be an
incentive for the parent entity to voluntarily file the SPE into bankruptcy and con-
solidate its assets with those of the parent. If the SPE has at least one director who
is independent from the parent and this director’s vote is required in any board
action seeking bankruptcy protection for the SPE or the amendment of the organic
documents of the SPE, the SPE is unlikely to voluntarily file an insolvency petition.
   Standard & Poor’s requests that, where possible, the organic documents of the
SPE recite that, in voting on bankruptcy matters, the independent director take into
account the interests of the holders of the rated securities, as well as those of the
stockholders. This approach is designed to provide additional protection against the
SPE being filed into bankruptcy. In cases where an SPE is a limited partnership or an
LLC, Standard & Poor’s requests that a general partner or a member be constituted
as an SPE, usually a corporation, with an independent director.




 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   103
      No Merger or Reorganization
      This requirement ensures that, while the rated securities are outstanding, the bankrupt-
      cy-remote status of the SPE will not be undermined by any merger or consolidation
      with a non-SPE or any reorganization, dissolution, liquidation, or asset sale. Standard
      & Poor’s generally also requests that the SPE not amend its organizational documents
      without prior written notice to Standard & Poor’s.

      Separateness Covenants
      Separateness covenants are designed to ensure that the SPE holds itself out to the
      world as an independent entity, on the theory that if the entity does not act as if it
      had an independent existence, a court may use principles of piercing the corporate
      veil, alter ego, or substantive consolidation to bring the SPE and its assets into the
      parent’s bankruptcy proceeding. The involvement of an overreaching parent is a
      threat to the independent existence of the SPE.
         Piercing the corporate veil is the remedy exercised by a court when a controlling
      entity, such as the parent of an SPE, so disregards the separate identity of the SPE
      that their enterprises are seen as effectively commingled. The remedy is sought by
      creditors with claims against an insolvent parent who believe funds can be properly
      traced into the subsidiary. The alter ego theory is used when the subsidiary is a mere
      shell and all its activities are in fact conducted by the parent. Substantive consolidation
      is an equitable doctrine under the Bankruptcy Code that combines elements of both
      piercing the corporate veil and alter ego analyses. Successful motions for consolidation
      are based on this overly familiar relationship between parent and the subsidiary or
      partner and partnership.
         An important element of the SPE analysis is the comfort that the SPE entity would
      not be consolidated with its parent. In this regard, the entity should observe certain
      separateness covenants, set forth in the following section. In addition, Standard &
      Poor’s generally requests legal opinions to the effect that the SPE would not be
      consolidated with its parent.

      Security Interests Over Assets
      There is a requirement that, in the case of the issuance of debt securities, the issuing
      SPE grant a security interest over its assets to the holders of the rated securities. In
      connection with this grant, Standard & Poor’s generally also requires a debt security
      interest opinion. This element helps Standard & Poor’s in reaching the analytic con-
      clusion that an issuer is in fact an SPE by reducing the incentives of the parent to
      involuntarily file the entity. By reducing the practical benefit of an insolvency filing,
      the likelihood of voluntary insolvency is decreased.




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                                             Legal Criteria for Subprime Mortgage Transactions




SPE Criteria

General SPE Criteria
Based on the principles discussed above, Standard & Poor’s has developed criteria to
help it conclude that an entity is an SPE:
1. The entity should not engage in any business or activity other than those necessary
   for its role in the transaction.
2. The entity (and, as applicable, its partners, members, and affiliates) should not
   engage in any dissolution, liquidation, consolidation, merger or asset sale, or
   amendment of its organizational documents as long as the rated securities are
   outstanding, unless Standard & Poor’s provides written confirmation of any
   outstanding ratings.
3. Thehe entity should not incur any debt (other than indebtedness that secures the
   rated securities) unless (a) the additional debt is rated by Standard & Poor’s at
   least as high as the issue credit rating requested for the rated securities in a given
   structured transaction, (b) all of the entity’s debt meets Standard & Poor’s segregation
   of assets criteria, or (c) the additional debt:
I Is fully subordinated to the rated securities,

I Is nonrecourse to the entity or any of its assets other than cash flow in excess of

   amounts necessary to pay holders of the rated securities, and
I Does not constitute a claim against the entity to the extent that funds are insufficient

   to pay such additional debt.
4. The entity should be qualified to do business under the applicable law in the state
   in which any assets are located.
5. The entity (and, as applicable, the entity’s partners, members, and affiliates)
   should agree to abide by the following separateness covenants:
I To maintain books and records separate from any other person or entity;

I To maintain its accounts separate from those of any other person or entity;

I Not to commingle assets with those of any other entity;

I To conduct its own business in its own name;

I To maintain separate financial statements;

I To pay its own liabilities out of its own funds;

I To observe all corporate, partnership, or LLC formalities and other

   formalities required by the organic documents;
I To maintain an arm’s-length relationship with its affiliates;

I To pay the salaries of its own employees and maintain a sufficient

   number of employees in light of its contemplated business operations;
I Not to guarantee or become obligated for the debts of any other entity

   or hold out its credit as being available to satisfy the obligations of others;




  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   105
      I   Not to acquire obligations or securities of its partners, members,
          or shareholders;
      I   To allocate fairly and reasonably any overhead for shared office space;
      I   To use separate stationery, invoices, and checks;
      I   Not to pledge its assets for the benefit of any other entity or make any loans
          or advances to any entity;
      I   To hold itself out as a separate entity;
      I   To correct any known misunderstanding regarding its separate identity; and
      I   To maintain adequate capital in light of its contemplated business operations.

      SPE Corporations
      In addition to the general SPE criteria set forth above, an SPE corporation should
      conform to the following additional criteria:
      I The corporation should have at least one independent director.

      I The unanimous consent of the directors, including that of the independent director(s),

        should be required to: (i) file, consent to the filing of, or join in any filing of, a
        bankruptcy or insolvency petition or otherwise institute insolvency proceedings;
        (ii) dissolve, liquidate, consolidate, merge, or sell all or substantially all of the
        assets of the corporation; (iii) engage in any other business activity; and (iv)
        amend the articles of incorporation of the corporation.
      I The directors should be required to consider the interests of the corporation’s

        creditors when making decisions.
      I Standard & Poor’s generally requests nonconsolidation opinion(s).




      SPE Limited Partnerships
       In addition to the general SPE criteria set forth above, an SPE limited partnership
      should conform to the following additional criteria:
      I At least one general partner of a limited partnership should be a bankruptcy-remote

        entity, usually an SPE corporation.
      I The consent of the bankruptcy-remote general partner should be required to: (i)

        file, consent to the filing of, or join in any filing of, a bankruptcy or insolvency
        petition, or otherwise institute insolvency proceedings; (ii) dissolve, liquidate,
        consolidate, merge, or sell all or substantially all of the assets of the partnership;
        (iii) engage in any other business activity; and (iv) amend the limited partnership
        agreement.
      I If there is more than one general partner, the limited partnership agreement should

        provide that the partnership will continue (and not dissolve) as long as another
        solvent general partner exists.




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                                               Legal Criteria for Subprime Mortgage Transactions




I   The general partner(s) should be required to consider the interests of the partnership’s
    creditors when making decisions.
I   Standard & Poor’s generally requests nonconsolidation opinion(s).

SPE General Partners
 An SPE general partner should meet all criteria set forth for SPE corporations, SPE
limited partnerships or SPE LLCs, depending on whether the general partner is a
corporation, a limited partnership, or an LLC.

SPE LLCs
 In addition to the general SPE criteria set forth above, an SPE LLC should conform
to the following additional criteria:
I At least one member of an LLC should be a bankruptcy-remote entity, usually an

  SPE. Generally, only the bankruptcy-remote member should be designated as the
  manager by the law under which the LLC is organized, and the LLC’s articles
  of organization should provide that it will dissolve only on the bankruptcy of a
  managing member.
I The unanimous consent of the members, including the vote of the independent

  director of the bankruptcy-remote member, should be required to: (i) file, consent
  to the filing of, or join in any filing of, a bankruptcy or insolvency petition or
  otherwise institute insolvency proceedings; (ii) dissolve, liquidate, consolidate,
  merge, or sell all or substantially all of the assets of the LLC; (iii) engage in any
  other business activity; and (iv) amend the LLC’s organizational documents.
I The member(s) should be required to consider the interests of the entity’s creditors

  when making decisions.
I To the extent permitted by tax law, the articles of organization should provide that,

  upon the insolvency of a member, the vote of a majority-in-interest of the remaining
  members is sufficient to continue the life of the LLC. If the required consent of the
  remaining members to continue the LLC is not obtained, its articles of organization
  must provide that the LLC not liquidate collateral (except as provided under the
  transaction documents) without the consent of the holders of rated securities.
  Such holders may continue to exercise all of their rights under the existing security
  agreements or mortgages and must be able to retain the assets until the rated
  securities have been paid in full or otherwise completely discharged.
I Standard & Poor’s generally requests nonconsolidation opinions.

I Standard & Poor’s generally requests a tax opinion to the effect that the LLC will

  be taxed as a partnership and not as a corporation.
  In connection with single-member LLCs, Standard & Poor’s criteria, at the time
of publication, are still in the developing stage. Therefore, transferors intending to




    Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   107
      use a single-member LLC in a structured transaction are encouraged to check with
      Standard & Poor’s regarding its single-member LLC criteria, including its
      opinion requirements.

      SPE Trusts
      Based on an analysis of Sections 101 and 109 of the Bankruptcy Code, only a trust
      that is determined to be a “business trust” under the Bankruptcy Code is eligible to
      become a debtor under the Bankruptcy Code. Thus, if the entity holding assets in a
      structured transaction is not a business trust for Bankruptcy Code purposes, Standard
      & Poor’s generally will not be concerned with the entity’s ability to make payments
      on the rated securities as a consequence of the entity’s insolvency. In such a case,
      Standard & Poor’s SPE criteria for bankruptcy remoteness would be inapplicable.
         The term business trust, however, is not defined in the Bankruptcy Code. Rather,
      whether a particular trust will be determined to be a business trust for bankruptcy
      law purposes depends upon a very fact-specific analysis of the trust, focusing on
      factors such as the purposes, organization, and activities of the trust and whether
      the trust is a business trust under applicable state law or under the IRC.
         In the absence of settled legal standards, Standard & Poor’s legal review assumes,
      as a general matter, that any trust, whether the trust is a state common law trust, a
      statutory business trust, or an owner trust, is eligible to become a debtor under the
      Bankruptcy Code. Therefore, to conclude that a trust is bankruptcy remote, the trust
      should meet Standard & Poor’s SPE criteria, including in the appropriate cases,
      nonconsolidation opinions.
         In addition, in the case of state common law trusts, Standard & Poor’s generally
      requires that the trust agreement provide that the bankruptcy of one or more of the
      beneficiaries of the trust will not result in the dissolution of the trust.
         In some cases, Standard & Poor’s may also ask for comfort that a trust will not be
      subject to early termination. In this regard, Standard & Poor’s may request a “trust
      opinion” to the effect that, under the law of the relevant state, the trust is irrevocable
      and that, under such state’s law, no creditor of a beneficiary would have the right to
      terminate the trust and reach the assets and that no receiver, liquidator, or bankruptcy
      trustee would have any rights to the trust’s assets greater than the rights of the bene-
      ficiaries of the trust.
         This section discusses Standard & Poor’s legal criteria that arise in part because of
      the specific nature of the collateral being securitized i.e. subprime mortgage loans
      and closed-end home equity loans.
         As stated above, as a general matter, Standard & Poor’s requires that all necessary
      steps be taken to perfect any sale of, or grant of a security interest in the assets
      being securitized.




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                                             Legal Criteria for Subprime Mortgage Transactions




  In structured subprime residential mortgage loan transactions, the assets baking
the rated securities are made up of the original mortgage notes, the mortgages, all
“mortgage-related documents,” (generally consisting of all mortgage assignments,
modification and consolidation agreements, and the original title insurance policy),
and related property, such as insurance policies. The mortgage notes evidence the
debt and the mortgages evidence liens on the underlying mortgaged properties,
including both the real property and any property permanently affixed as “fixtures.”


Collateral-Specific Criteria
This section discusses Standard & Poor’s legal criteria that arise in part because of
the specific nature of the collateral being securitized, i.e. subprime first lien residential
mortgage loans and closed-end home equity loans.
   As stated above, as a general matter, Standard & Poor’s requires that all necessary
steps be taken to perfect any sale of, or grant of a security interest in, the assets
being securitized.
   In structured subprime residential mortgage loan transactions, the assets backing
the rated securities are made up of the original mortgage notes, the mortgages, all
“mortgage-related documents,” (generally consisting of all mortgage assignments,
modification and consolidation agreements, and the original title insurance policy),
and related property, such as insurance policies. The mortgage notes evidence the
debt and the mortgages evidence liens on the underlying mortgaged properties, including
both the real property and any property permanently affixed as “fixtures.”
   In closed-end home equity loans, in accordance with the loan agreement, a fixed
amount of money is loaned to the obligor at closing. The obligor’s repayment oblig-
ation is secured by a mortgage on the underlying mortgaged property (including
both the real property and any fixtures). Generally the funds borrowed are used for
purposes other than purchasing the underlying mortgaged property. Thus, except for
the purpose of the loans, closed-end home equity loans are essentially the same as
residential first lien mortgage loans.
   Under the laws of most states (i) delivery of the original mortgage notes to the
issuing SPE or indenture trustee/custodian, as applicable, is required to perfect the
security interest in the notes and (ii) as the mortgages evidence liens on the underlying
mortgaged properties, recordation of mortgage assignments with the appropriate
recording offices is required to perfect assignments of the mortgage liens on the
underlying mortgaged properties. Recordation generally entitles the secured party
to foreclose upon and sell the underlying mortgaged properties upon a payment
default.
   Based on the above, in structured subprime residential mortgage loan transactions
and closed-end home equity loans, Standard & Poor’s requires, as a general matter



  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   109
      (i) delivery of the original mortgage notes (endorsed in blank or in the name of the
      appropriate transferee) to the issuing SPE or indenture trustee/custodian, as applicable,
      and (ii) recordation of all mortgage assignments. In addition, the original or certified
      copies of all mortgages and mortgage assignments, showing evidence of recordation,
      and all other mortgage-related documents should be delivered to the issuing SPE or
      indenture trustee/custodian, as applicable.
         In connection with its requirement for delivery of the mortgage notes, Standard &
      Poor’s recognizes that sales of instruments, as opposed to pledges, are not governed
      by the UCC, but they are governed by the law of the state in which the property is
      located. As a general matter, if the transferor delivers the mortgage notes to the trustee,
      as set forth above, Standard & Poor’s will not require specific state sale opinions
      regarding the notes. This criterion is based on the belief that delivery of the mortgage
      notes would, at a minimum, be sufficient to perfect a sale under the laws of the
      relevant states (that is, potentially any state in which property is located).
         Related to the above, in subprime residential mortgage loan transactions and
      closed-end home equity loan transactions, true sale, either/or, security interest, and
      debt security interest opinions need opine only as to the mortgage notes and the
      proceeds thereof. Regarding the mortgages (which are governed by the real property
      laws of each of the states in which the mortgaged properties are located), Standard
      & Poor’s derives comfort that the issuing SPE or indenture trustee/custodian, as
      applicable, has a first priority perfected lien on the underlying mortgaged properties
      because the mortgage assignments are recorded in the name of the issuing SPE or
      indenture trustee/custodian, as applicable. Standard & Poor’s does not generally
      require an opinion to this effect.
         In some states, delivery of a mortgage note alone, without recordation, is sufficient
      to transfer rights to the related mortgage, including foreclosure rights. As a general
      matter, in those “nonrecordation states,” Standard & Poor’s will not require recor-
      dation of the mortgage assignments; provided, however, that for mortgages secured
      by mortgaged properties located within nonrecordation states, Standard & Poor’s
      typically will request a state “nonrecordation opinion” (or memorandum of law)
      stating that recordation is not required for transfer to the intermediate SPE or issuing
      SPE, as applicable, of a first priority perfected lien on the underlying mortgaged
      properties. Standard & Poor’s will generally still require that all original mortgage
      notes (endorsed in blank or in the name of the appropriate transferee), mortgages,
      mortgage assignments (endorsed in blank or in the name of the appropriate transferee),
      and mortgage-related documents be delivered to the issuing SPE or indenture
      trustee/custodian, as applicable. For a limited percentage of mortgaged properties
      located within nonrecordation states (generally not more than 10% of the total
      pool of mortgages being securitized) and depending upon concentrations, Standard
      & Poor’s may waive its request for a nonrecordation opinion.


110
                                             Legal Criteria for Subprime Mortgage Transactions




  As an exception to its standard criteria, if a structured subprime residential mortgage
transaction or closed-end home equity loan transaction is insured by a financial
guarantee insurance company and the transferor of the assets into the structured
transaction is investment grade, Standard & Poor’s will not require recordation of
the mortgage assignments (on the assumption that, if recordation in the name of
the issuing SPE or indenture trustee/custodian becomes necessary, the “insurer”
will cover the recordation expenses and also that the precipitous insolvency of an
investment-grade issuer is unlikely). In such circumstances, however, all original
mortgage notes (endorsed in blank or in the name of the appropriate transferee),
mortgages, mortgage assignments (endorsed in blank or in the name of the appropriate
transferee), and mortgage-related documents for all mortgaged properties constituting
part of the assets should be delivered to the issuing SPE or indenture trustee/custodian,
as applicable.
  The transaction documents will provide that, if, at any time, the transferor’s rating
falls below investment grade, all mortgage assignments should be recorded (except
for mortgaged properties located within nonrecordation states, in which case, depending
upon the concentration, a nonrecordation opinion may be required). Any true sale,
security interest, either/or, and debt security interest opinion delivered in a structured
insured residential mortgage loan transaction involving an investment-grade transferor
should state that, upon delivery of the mortgage notes, the transferee will have either
all of the transferor’s right, title, and interest in the mortgage notes (in the case of a
sale) or a first priority perfected security interest in the notes (in the case of a pledge),
and upon recordation of the mortgage assignments, the transferee would have a first
priority perfected lien on the underlying mortgaged properties.
  If a transferor in a structured subprime residential mortgage loan transaction or
closed-end home equity loan transaction seeks a weak-link-dependent issue credit
rating, that is, one that is no higher than the issuer credit rating of any of the trans-
action participants, Standard & Poor’s will not require either recordation of the
mortgage assignments or delivery of the original mortgage notes, mortgages, mortgage
assignments, or mortgage-related documents and, consequently, will not require
delivery of a security interest, either/or, or debt security interest opinion.
  If, however, the transferor’s issuer credit rating falls below the issue credit rating
of the rated securities, Standard & Poor’s generally will require the following: (i)
that all mortgage assignments be recorded (except for mortgaged properties located
within nonrecordation states, in which case, depending upon the concentration, a
nonrecordation opinion may be required); (ii) delivery of all original mortgage notes
(endorsed in blank or in the name of the appropriate transferee), mortgages, mortgage
assignments (showing evidence of recordation), and mortgage-related documents to
the issuing SPE or indenture trustee/custodian, as applicable; and (iii) delivery of a
security interest, either/or, or debt security interest opinion, as applicable, to the


  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   111
      effect that the issuing SPE or indenture trustee/custodian, as applicable, has either all
      of the transferor’s right, title, and interest in the mortgage notes (in the case of a
      sale) or a first priority perfected security interest in the mortgage notes (in the case
      of a pledge).


      Criteria Relating to Various Forms of Credit Enhancement
      Credit enhancement can take many forms in structured finance, most of which trigger
      the application of specific criteria. Cash collateral accounts (CCA), collateral investment
      amounts (CIA), and reserve accounts are frequent choices for enhancement in structured
      transactions. A CCA or a CIA is typically provided for in a loan agreement among
      the provider, the issuing SPE, the intermediate SPE, and the original transferor into
      the securitization structure. Standard & Poor’s looks for nonpetition language in the
      loan agreement, whereby the provider agrees not to file any intermediate SPE and
      the issuing SPE into bankruptcy and not to join in any bankruptcy filing, and for
      clear language as to the subordinated position of the provider.
         Standard & Poor’s may require an “enforceability opinion” that the loan agreement
      is the legal, valid, and binding obligation of the provider, enforceable in accordance
      with its terms. To the extent the provider is a U.S. branch or division of a non-U.S.
      institution, Standard & Poor’s will generally require a “home country enforceability
      opinion” under the law of the country where the non-U.S. institution’s head office is
      located, addressing the enforceability of the obligation against the non-U.S. institution,
      among other matters.
         To the extent that a transaction relies on funds invested under an investment
      agreement with a rated entity, Standard & Poor’s may require the opinions described
      above in connection with the use of a CCA or CIA. The investment agreement should
      not contain any provisions that would relieve the institution from its obligation to
      pay. In both cases, the issuer credit rating of the provider must be consistent with
      the issue credit rating of the transaction.
         If credit enhancement takes the form of a reserve fund or account, the transfers of
      funds deposited in the account will be subject to review. To the extent that monies
      other than proceeds of the rated securities are used to fund the account, Standard &
      Poor’s may require a preference opinion to the effect that the funds transferred and
      the related payments to the holders of the rated securities would not be recoverable
      as a preference under Section 547(b) of the Bankruptcy Code.
         Standard & Poor’s also may require a fraudulent conveyance opinion to the effect
      that the funds transferred and related payments would not be deemed a fraudulent
      conveyance under state and federal laws. In addition, if the reserve account is kept
      in the name of a party other than the issuing SPE or indenture trustee/custodian,
      as applicable, Standard & Poor’s generally requires that the owner of the reserve



112
                                            Legal Criteria for Subprime Mortgage Transactions




account grant a first priority perfected security interest in the account to the issuing
SPE and deliver a security interest, either/or, and debt security interest opinion, as
applicable. Moreover, all credit enhancement funds must be held in accordance with
Standard & Poor’s criteria for eligible deposit accounts (see Criteria Related to the
Trustee, the Servicer, and the Custodian; Criteria Related to Eligible Deposit Accounts;
Criteria Related to Eligible Investments).


Criteria Related to Retention of Subordinated
Interests by Transferor in a True Sale
In certain circumstances, Standard & Poor’s is unwilling to rely on the characterization
of a transaction as a true sale even though the parties to the transaction are com-
fortable that they have achieved a true sale and counsel is willing to deliver a true
sale opinion as required by Standard & Poor’s criteria. For example, Standard &
Poor’s will generally not rely on true sale opinions if the transferor takes back a
subordinated interest in assets that, in Standard & Poor’s opinion, do not have an
adequate capacity to pay principal and interest on the subordinated interest.
  This subordinated interest may be in the form of a deferred purchase price, subor-
dinated note, or subordinated certificates. Similarly, Standard & Poor’s generally
will not rely on true sale opinions if the transferor guarantees payments significantly
higher than reflected by the level of historical losses on the assets being sold.
Standard & Poor’s believes that, although these transactions may actually be
true sales, they have a higher likelihood of being recharacterized as secured
loan transactions.
  In structured transactions in which the securities issued are rated ‘AAA’, the assets
should be able to withstand severe economic stress scenarios. Thus, the value of the
assets purchased will be in excess of the amount of rated securities issued. On the
other hand, to avoid fraudulent conveyance concerns, the purchase price should
reflect the fair market value of the assets. The balance required to pay the purchase
price may be contributed as capital to the SPE. Alternatively, the SPE, regardless of
whether it is a subsidiary of the transferor, may use a subordinated promissory note
to cover the balance of the purchase price of the assets. The subordinated note permits
the deferral of the payment of a portion of the purchase price until the SPE has funds
available for the payment. Payment is usually made in accordance with a schedule
based upon anticipated cash flow on the assets.
  In other instances, a transferor may retain a subordinated interest in a senior/
subordinated transaction characterized by the subordination of certain certificates
to serve as credit support for the senior certificates. (More complex transactions
involve multiple levels of subordination and also may be structured to contain
reserve funds and/or insurance policies to provide credit support for certain



 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   113
      enhanced classes of subordinated certificates.) In these instances, the SPE usually
      sells the senior certificates and the enhanced subordinated certificates either to the
      public through an underwriter or through a private placement offering and transfers
      the unenhanced subordinated certificates to the transferor as partial consideration
      for the sale of the assets.
         When a transferor takes back either a subordinated note or subordinated certificates
      (either in partial payment for the assets that are sold or otherwise) or guarantees
      payment on the sold assets, the sale from the transferor to the intermediate SPE (or
      directly to the issuing SPE) can be undermined. The transferor could arguably be
      said not to have fully divested itself of all rights to the assets (one of the legal tests
      of ownership) by holding the subordinated note or subordinated certificates or by
      guaranteeing payment on the assets. A court could view and recharacterize the trans-
      fer of assets and the holding of the subordinated note or subordinated certificates or
      the making of the guarantee as a financing by the transferor (secured by a pledge of
      or lien on the assets), rather than a true sale of such assets. Standard & Poor’s is
      concerned that the use of a subordinated note or retention by the transferor of sub-
      ordinated certificates (or the provision of a guarantee) may be viewed as recourse
      retained by the transferor, that is, that the transferor has not transferred all of
      the risks and benefits of owning the assets because, to be repaid, the transferor
      is dependent on the performance of the assets.
         Accordingly, Standard & Poor’s will evaluate the likelihood of repayment of the
      subordinated note or payment of the retained subordinated certificates (or the likeli-
      hood of the need for the guarantee) in adequately stressed economic conditions to
      get comfort that no recourse was retained by the transferor. Generally, Standard &
      Poor’s requires that the subordinated note or retained subordinated certificates be
      shadow rated on a pool default analysis, that is, without regard to possible dilutions
      in the pool, at an investment-grade level. In the case of a retained subordinated note,
      Standard & Poor’s analysis typically focuses on, among other things, the amount of
      equity that is contributed to the SPE and is available for payment of the subordinated
      note. This requirement offers Standard & Poor’s additional comfort that the risks
      and benefits analysis (because of the likely repayment of the subordinated note or
      payment of the retained subordinated certificates) would result in the transaction
      being deemed a sale.
         In many cases, the transaction can be structured in a manner acceptable to
      Standard & Poor’s or the transaction can be analyzed under a blended rating
      approach (relying in part on the issuer credit rating of the parent). In some situations,
      the transferor may hold the subordinated note or subordinated certificates if they
      represent only a small portion of the assets or if the retained subordinated certificates
      constitute a strip or noneconomic residual. Alternatively, the transferor may retain
      subordinated certificates if it represents that it intends to resell the retained subordinated


114
                                             Legal Criteria for Subprime Mortgage Transactions




certificates. If the transferor retains all of the securities issued in a structured transaction,
Standard & Poor’s generally requires the true sale opinion to state that when the
securities are sold to a third party, the transfer of assets by the transferor will be
deemed a true sale, except for any portion remaining with the transferor.
  In other cases, an affiliate (either a wholly owned subsidiary or a sister company
of the transferor) may hold the subordinated certificates or subordinated note. The
affiliate may or may not be an SPE. If the affiliate is newly created solely for the
purpose of holding the subordinated certificates or subordinated note, there is an
increased concern that the affiliate is really the transferor. In such circumstances, in
addition to the opinions otherwise required by the transaction structure, Standard &
Poor’s will generally request a nonconsolidation opinion to the effect that the affiliated
entity holding the subordinated certificates or subordinated note would not be
consolidated with the transferor in the event of the latter’s bankruptcy.


Swap Opinion Criteria
Structured finance transactions frequently include swap agreements that transform
the cash flow characteristics of an issuing SPE’s assets into payment terms desired by
investors in the rated securities. For example, interest payments on a specified principal
amount of the issuing SPE’s assets may be calculated based on a fixed rate and de-
nominated in a non-U.S. currency. Investors in the rated securities may be willing to
accept the credit risk of the asset but desire payments calculated based on a margin
above a specified index and denominated in U.S. currency. In this event, the issuing
SPE would enter into an agreement with a swap counterparty providing that the
fixed rate, non-U.S. currency payments that the issuing SPE receives on the assets
will be paid to the swap counterparty in return for the swap counterparty’s floating-
rate payments to the issuing SPE in U.S. currency. The issuing SPE will make its
payments on the rated securities from the payments received from the swap
counterparty.
   In this example, Standard & Poor’s issue credit rating would depend on the issuer
credit rating of the swap counterparty and on the issue credit rating of the issuing
SPE’s assets. If the swap counterparty does not have an issuer credit rating or has an
issuer credit rating that is lower than the issue credit rating sought for the transaction,
its obligations must be guaranteed by an affiliate or another entity of sufficient credit
quality to attain the desired rating.
   In transactions where the issue credit rating is dependent on a swap agreement and
guarantee, if any, Standard & Poor’s generally requests the following legal opinions
for the swap counterparty and guarantor, as applicable, under the law of the juris-
diction of organization of the relevant entity and under the governing law of the
swap agreement and guarantee, as applicable:



  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria      115
      I An enforceability opinion in connection with the swap agreement and guarantee
        against the swap counterparty and the guarantor, as applicable, according to their
        respective terms;
      I A “pari passu opinion” stating that payments due under the swap agreement and

        the guarantee, as applicable, rank at least pari passu with the unsecured and
        unsubordinated obligations of the swap counterparty and the guarantor, as the
        case may be;
      I A “choice of law opinion” stating that local courts in the jurisdictions of the swap

        counterparty and the guarantor, as applicable, would recognize the choice of law
        in the swap agreement and the guarantee, as the case may be, and the choice of
        law is prima facie valid and binding under such local law;
      I A “recognition of claim opinion” stating that local courts in the jurisdictions of

        the swap counterparty and the guarantor, as applicable, would recognize and
        enforce as a valid judgment any final and conclusive civil judgment of a court of
        competent jurisdiction for monetary claims made under the swap agreement and
        the guarantee, as the case may be;
      I If payments to the holders of the rated securities may be affected by the subsequent

        imposition of taxes on payments made by the swap counterparty or the guarantor
        under the swap agreement or guarantee, as the case may be, a “swap counterpar-
        ty/guarantor tax opinion” stating that, under current law, no such tax applies and
        that there is no pending legislation to create such a tax; and
      I If payments to the holders of the rated securities may be affected by the subsequent

        imposition of taxes on payments made by the issuing SPE under the swap agreement,
        an “issuing SPE swap tax opinion” confirming that under current law no such tax
        applies and that there is no pending legislation to create such a tax.
        Standard & Poor’s may waive the enforceability opinion described above for swap
      counterparties and guarantors if Standard & Poor’s previously has received similar
      opinions under the same governing law in similar transactions.


      Interim Criteria for the Tenth Circuit
      Court of Appeals Eliminated
      Based upon the decision of the Tenth Circuit Court of Appeals in Octagon Gas
      System Inc. v. Rimmer, 1993 U.S. App. Lexis 12423 (Tenth Cir. May 27, 1993) in
      June 1993, Standard & Poor’s adopted certain criteria for transactions involving
      the sales of receivables by originators that have a principal place of business in the
      Tenth Circuit. The Octagon decision, contrary to existing authority, suggests that in
      a bankruptcy of a seller of accounts or chattel paper, the sold accounts or chattel
      paper would be considered part of the seller’s property. The interim criteria imposed
      an ‘AA’ ceiling on transactions originated by Tenth Circuit Code transferors and



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                                             Legal Criteria for Subprime Mortgage Transactions




required an amortization trigger if the entity’s issuer credit rating fell below
“investment grade.”
   Standard & Poor’s believes that two developments have reduced significantly the
likelihood that a Tenth Circuit Court would follow the Octagon decision. These
developments are the rejection of the Octagon court’s interpretation of Article 9 of
the UCC by the Permanent Editorial Board for the UCC in PEB Commentary No.
14 (June 1994) and the amendment of the Oklahoma UCC (April 1996) to provide
that Article 9 does not prevent the transfer of ownership of accounts or chattel
paper and that the determination of whether a particular transfer of accounts or
chattel paper constitutes a sale or a transfer for security purposes is not governed
by Article 9.
   As a result, Standard & Poor’s has eliminated the interim criteria adopted in June
1993 for transactions originated in the Tenth Circuit. Standard & Poor’s rates these
transactions under its usual criteria.
   Standard & Poor’s recognizes that, as a matter of law, the Octagon decision has
not been overruled in the rest of the Tenth Circuit and will, therefore, accept opinions
of counsel that include a discussion of Octagon as long as counsel also opines that
Octagon was wrongly decided.


Criteria: Trustee, Servicer, Custodian, Eligible
Accounts, and Eligible Investments
Criteria Related to the Trustee and the Affiliated Trustee
The indenture trustee/custodian in a structured transaction is primarily responsible
for receiving payments from servicers, guarantors, and other third parties and remitting
these receipts to investors in the rated securities in accordance with the terms of the
indenture, in addition to its monitoring, custodial, and administrative functions. To
ensure that the indenture trustee/custodian performs these functions and preserves
investor rights, Standard & Poor’s generally requires that the following criteria
be met:
I The indenture trustee/custodian should hold dedicated assets in funds

  and accounts designated for a particular transaction.
I The funds and accounts should be held, in trust, for the benefit of investors in

  the rated securities. Such funds should be held in the indenture trustee/custodian
  bank’s trust department unless such bank has the required rating.
I The funds should not be commingled with other funds of the

  indenture trustee/custodian.
I The indenture trustee/custodian cannot resign without the appointment

  of a qualified successor.



  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   117
      I   If the servicer resigns or is removed, the indenture trustee/custodian should
          be willing and able to assume the responsibility for interim servicing.
      I   The presence of trust funds and accounts protects the transaction against the
          indenture trustee/custodian’s insolvency. Funds held in trust for the benefit of
          investors in the rated securities cannot be enjoined with an insolvent indenture
          trustee/custodian’s estate.

      Affiliated Trustees
      As a general matter, in a structured transaction, Standard & Poor’s derives comfort
      from the independence of the trustee from any transferor of assets into the securiti-
      zation structure. In this regard, Standard & Poor’s has several concerns. First, if an
      affiliate of any transferor serves as trustee, the true sale of assets from the transferor
      might be negated. Second, according to the commentary to Section 9-305 of the
      UCC, for certain types of collateral, possession of the collateral by an agent of the
      secured party is sufficient to perfect a security interest in the collateral. The section
      states, however, that “the debtor or a person controlled by [the debtor] cannot qualify
      as such an agent for the secured party.” Thus, Standard & Poor’s is concerned that
      if an affiliate of a transferor serves as trustee, the trustee might be deemed to be
      controlled by the transferor and the trustee’s security interest in the assets might
      not be perfected.
         Consequently, Standard & Poor’s typically will permit an affiliate of a transferor
      to serve as trustee, only if the following conditions are met: (i) the affiliated trustee
      is an entity that is in the business of functioning in the trustee capacity for other
      parties; (ii) if the transfer of assets to the issuing SPE is a true sale, the true sale
      opinion delivered in connection with the transfer (a) should cite the affiliated rela-
      tionship between the transferor and the trustee and (b) give an opinion to the effect
      that the trustee is holding the assets on behalf of the holders of the rated securities
      and that, by delivering the assets to the trustee, there has been a valid true sale of
      the assets by the transferor to the issuing SPE; and (iii) the security interest opinion
      delivered in connection with the trustee’s first priority perfected security interest in
      the assets on behalf of the holders of the rated securities includes the opinion that
      the trustee would not be deemed to be controlled by the affiliated transferor in
      accordance with Section 9-305 of the UCC.
         In some circumstances, Standard & Poor’s may require that the trustee be
      replaced by an unaffiliated trustee based on a downgrading of the trustee or
      its affiliated parent/transferor.




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                                             Legal Criteria for Subprime Mortgage Transactions




Criteria Related to the Servicer
In a structured transaction, the servicer agrees to service and administer assets in
accordance with its customary practices and guidelines and has full power and
authority to make payments to and withdrawals from deposit accounts that are
governed by the documents.
  The servicer’s fee should cover its servicing and collection expenses and be in line
with industry norms for securities of similar quality. If the fee is considered below
industry averages, an increase may be built into the transaction. The increase might
be needed to entice a substitute servicer to step in and service the portfolio. If the
servicing fee is calculated based on a certain dollar amount per contract, the fee will
increase as a percentage of assets due to amortization of the pool. This is an important
consideration when assessing available excess spread to cover losses and fund any
reserve account.
  Independent accounting reports should be provided at least annually. The reports
should state whether the servicer is in compliance with the transaction documents
and whether its policies and procedures were sufficient to prevent errors.
Exceptions, if any, should be listed.
  To ensure continuity, the transaction documents should provide that a servicer is
not allowed to resign unless it is no longer able to service under law or finds a successor.
No resignation should become effective until a successor or the trustee, as successor,
has assumed the servicer’s responsibilities. The trustee generally has the power to
replace the servicer if the servicer is not performing its servicing functions adequately.

Commingling
The filing of a bankruptcy petition would place a stay on all funds held in a servicer’s
own accounts. As a result, receipt of these funds to make payments on the rated
securities would be delayed. In addition, funds commingled with those of the servicer
would be unavailable to the structured transaction. As a general matter, Standard &
Poor’s addresses this commingling risk by looking both to the rating of the servicer
and the amount of funds likely to be held in a servicer account at any given time.
(see “Servicer Requirements” and “Servicer Evaluation Criteria” see sections).

Criteria Related to the Custodian and Affiliated Custodians
As a general matter, in a structured transaction, Standard & Poor’s derives comfort
from the independence of a custodian from any transferor of assets into the securiti-
zation structure. In this regard, Standard & Poor’s has several concerns. First, if an
affiliate of any transferor serves as custodian, the true sale of assets from the transferor
might be negated. Second, according to the commentary to Section 9-305 of the
UCC, for certain types of collateral, possession of the collateral by an agent of the



  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   119
      secured party is sufficient to perfect a security interest in such collateral. The section
      states, however, that “the debtor or a person controlled by (the debtor) cannot qualify
      as such an agent for the secured party.”
         Thus, Standard & Poor’s is concerned that if an affiliate of a transferor serves as
      custodian, the custodian might be deemed to be controlled by the transferor and the
      custodian’s security interest in the assets might not be perfected. Consequently,
      Standard & Poor’s generally will permit an affiliate of a transferor to serve as custo-
      dian, only if the following conditions are met: (i) the affiliated custodian is an entity
      that is in the business of functioning in the custodial capacity for other parties; (ii) if
      the transfer of assets to the issuing SPE is a true sale, the true sale opinion delivered
      in connection with the transfer (a) should cite the affiliated relationship between the
      transferor and the custodian and (b) give an opinion to the effect that the custodian
      is functioning as an agent of the trustee (that is, the agency relationship may not be
      assumed) and that, by delivering the assets to the custodian, there has been a valid
      true sale of the assets by the transferor to the issuing SPE; and (iii) the security interest
      opinion delivered in connection with the custodian’s first priority perfected security
      interest in the assets on behalf of the trustee includes the opinion that the custodian
      would not be deemed to be controlled by the affiliated transferor pursuant to
      Section 9-305 of the UCC.
         In some circumstances, Standard & Poor’s may require that the custody arrange-
      ments terminate and the assets be returned to the trustee for safekeeping, based on
      a downgrading of the custodian or its affiliated parent/transferor.

      Criteria Related to Eligible Deposit Accounts
      A structured financing provides for different accounts to be established at closing to
      serve as collection accounts in which revenues generated by the securitized assets are
      deposited and to establish reserves funds. Often the accounts in which the reserves
      are held contain significant sums held over a substantial period of time. Standard &
      Poor’s has developed criteria regarding these accounts. The criteria are intended to
      immunize and isolate a transaction’s payments, cash proceeds, and distributions
      from the insolvency of each entity that is a party to the transaction. An insolvency
      of the servicer (sub or master), trustee, or other party to the transaction should not
      cause a delay or loss to the investor’s scheduled payments on the rated securities. As
      a general matter, Standard & Poor’s relies on credit, structural, and legal criteria to
      ensure that a structured transaction’s cash flows are protected at every link in the
      cash flow chain.
        When analyzing a structured financing, Standard & Poor’s criteria adjust to the
      specific circumstances presented by a transaction. The criteria for the collection of
      funds will depend on who will hold the funds and how the funds will be held. The
      subservicer and the institution where the collection account is established can be


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different entities. When two entities are involved with the collection of funds (the
servicer and the institution holding the account), investors should be protected from
the insolvency of either party. The following criteria address many of the potential
combinations typically found in a structured finance transaction.

Collection Accounts
Unless collections on assets are concentrated at certain times of the month, for a
period of up to two business days after receipt, any servicer, whether or not rated,
may keep collections on the assets in any account of the servicer’s choice, commingled
with other money of the servicer or of any other entity. Before the end of the two
business day period, the collections on the assets should be deposited into an “eligible
deposit account,” as described below. As a general matter, all servicers, including
unrated servicers, may keep/commingle collections for up to two business days,
based on Standard & Poor’s credit assumption, made in connection with all structured
transactions, that two days’ worth of collections on assets will be lost.
  If, however, collections on the assets are concentrated at certain times within a
month (for example, the first, 15th, or 30th of a month), a servicer rated below ‘A-1’
should not be able to keep/commingle collections on the assets even for the two
business day period, as described above. Rather, to prevent a potentially significant
loss on assets, Standard & Poor’s generally requires that, in transactions involving
concentrated collections in which the servicer is rated below ‘A-1’, either additional
credit support be provided to cover commingling risk or obligors be instructed to
make payments to lockbox accounts, which, in turn, are swept daily to an eligible
deposit account. The servicer, unless rated the same as the rating sought on the
structured transaction, should be prevented from accessing either the lockbox or
sweep accounts.
  In addition, if a transferor does not wish that Standard & Poor’s factor two days’
worth of losses on collections into its credit analysis, it may structure the transaction
(whether or not collections are concentrated at certain times of a month) to have a
lockbox account, whose deposits are swept daily to an eligible deposit account.
  Beyond the two business day period discussed above, a servicer rated at least ‘A-1’
may keep/commingle collections on assets or deposit collections in an account of its
choice, at any institution, provided the servicer obligates itself unconditionally to
remit all collections to an eligible deposit account once a month. In addition, the
transaction documents should provide that, if the servicer’s rating falls below ‘A-1,’
the servicer will establish an eligible deposit account within not more than 10 calendar
days and transfer collections to this account within two business days of receipt.
  If a servicer is rated below ‘A-1’ or is unrated, or if an ‘A-1’ rated servicer’s
obligation to remit collections is not unconditional, the servicer should deposit all
collections into an eligible deposit account within two business days of receipt.


 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   121
        Other accounts. All other accounts maintained by the master servicer, special
      servicer, or trustee in a structured transaction (for example, reserve accounts)
      should qualify as eligible deposit accounts.

      Eligible Deposit Accounts
      An eligible deposit account is one that is either:
      I An account or accounts maintained with a federal or state-chartered depository

        institution or trust company that complies with the definition of “eligible institution,”
        as described below; or
      I A segregated trust account or accounts maintained with the corporate trust depart-

        ment of a federal depository institution or state-chartered depository institution
        subject to regulations regarding fiduciary funds on deposit similar to Title 12 of
        the Code of Federal Regulation Section 9.10(b), which, in either case, has corporate
        trust powers, acting in its fiduciary capacity.
        In transactions rated ‘AAA’ by Standard & Poor’s, eligible institutions means
      institutions whose:
      I Commercial paper, short-term debt obligations, or other short-term deposits are

        rated at least ‘A-1+’ by Standard & Poor’s if the deposits are to be held in the
        account for less than 30 days; or
      I Long-term unsecured debt obligations are rated at least ‘AA-’ if the deposits are to

        be held in the account more than 30 days. Following a downgrade, withdrawal, or
        suspension of such institution’s rating, each account should promptly (and in any
        case within not more than 10 calendar days) be moved to a qualifying institution
        or to one or more segregated trust accounts in the trust department of such insti-
        tution, if permitted.
        Each eligible account should be a separate and identifiable account, segregated
      from all other funds held by the holding institution. The account should be established
      and maintained in the name of the trustee on behalf of the issuing SPE, bearing a
      designation clearly indicating that the funds deposited therein are held for the benefit
      of the holders of the rated securities. An eligible account should not be evidenced by
      a CD, passbook, or other instrument. The trustee should possess all right, title, and
      interest in all funds on deposit from time to time in the account and in all proceeds
      thereof. The account should be under the sole dominion and control of the trustee
      for the benefit of the holders of the rated securities and should contain only funds
      held for their benefit.

      Criteria Related to Eligible Investments
      The recent proliferation of market risk in securities being issued in the debt markets
      has caused Standard & Poor’s, as a general matter, to restrict eligible investments for




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structured financings. Standard & Poor’s generally will not accept as an eligible
investment, without prior review, the following:
I Any security with the ‘r’ symbol attached to the rating;

I Any security that contains a noncredit risk that the ‘r’ was intended to highlight,

  whether or not the issue is rated; and
I All mortgage-backed securities.

  These requirements are part of an ongoing effort by Standard & Poor’s to address
the increase of noncredit risk in the fixed-income markets. In July 1994, Standard &
Poor’s introduced the ‘r’ symbol to alert investors that certain debt instruments may
experience high volatility or dramatic fluctuations in their expected returns because
of market risk. Standard & Poor’s first started to address market risk with the
introduction of market risk ratings on bond funds in January 1994.

Government Securities Not Immune
Standard & Poor’s believes the obligations of the U.S. and certain other issuers
whose securities would be classified as government securities are of very strong credit
quality. However, a credit opinion does not take into consideration noncredit factors,
such as market risk or timing of payments, which are a part of the overall investment
decision. Standard & Poor’s does not believe that the government securities market
is immune from market risk.
   The Standard & Poor’s eligible investment list contains both government and non-
government securities. While the list is widely used, it is sometimes used inappropri-
ately. When used by Standard & Poor’s in rating a structured financing, the list provides
the low-risk, short-term investments eligible to house, temporarily, the cash flows
of the transaction (usually 30 days or less). Eligible investments generally mature
before the next scheduled distribution date. Longer-term reserve funds also are
invested in eligible investments. Because the funds may be needed to make the next
scheduled distribution, at least a portion of the funds should be invested in short-term
investments. The following eligible investments should not have maturities in excess
of one year. Any use other than those listed above may not be appropriate.

Eligible Investments
The following investments are eligible for ‘AAA’ rated transactions:
1. Certain obligations of, or obligations guaranteed as to principal and interest by,
   the U.S. government or any agency or instrumentality of the U.S. government,
   when such obligations are backed by the full faith and credit of the U.S. As
   Standard & Poor’s does not explicitly rate all such obligations, the obligation
   must be limited to those instruments that have a predetermined fixed-dollar
   amount of principal due at maturity that cannot vary or change. If the obligation
   is rated, it should not have an ‘r’ highlighter affixed to its rating. Interest may be


  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   123
         either fixed or variable. If the investments may be liquidated before their maturity
         or are being relied on to meet a certain yield, additional restrictions are necessary.
         Interest should be tied to a single interest rate index plus a single fixed spread, if
         any, and move proportionately with that index. These investments include, but are
         not limited to:
      I U.S. Treasury obligations—all direct or fully guaranteed obligations;

      I Farmers Home Administration—certificates of beneficial ownership;

      I General Services Administration—participation certificates;

      I Maritime Administration—guaranteed Title XI financing;

      I Small Business Administration—guaranteed participation certificates and guaranteed

         pool certificates;
      I U.S. Department of Housing and Urban Development—local authority bonds; and

      I Washington Metropolitan Area Transit Authority—guaranteed transit bonds.

      2. FHA debentures.
      3. The Certain obligations of government-sponsored agencies that are not backed by
         the full faith and credit of the U.S. As Standard & Poor’s does not explicitly rate
         all such obligations, the obligation must be limited to those instruments that have
         a predetermined fixed-dollar amount of principal due at maturity that cannot vary
         or change. If the obligation is rated, it should not have an ‘r’ highlighter affixed to
         its rating. Interest may be either fixed or variable. If the investments may be liquidated
         before their maturity or are being relied on to meet a certain yield, additional
         restrictions are necessary. Interest should be tied to a single interest rate index
         plus a single fixed spread, if any, and move proportionately with that index.
         These investments are limited to:
      I Federal Home Loan Mortgage Corp.—debt obligations;

      I Farm Credit System (formerly Federal Land Banks, Federal Intermediate Credit

         Banks, and Banks for Cooperatives)—consolidated systemwide bonds and notes;
      I Federal home loan banks—consolidated debt obligations;

      I Federal National Mortgage Association—debt obligations;

      I Student Loan Marketing Association—debt obligations;

      I Financing Corp.—debt obligations; and

      I Resolution Funding Corp. (Refcorp)—debt obligations.

      4. Certain federal funds, unsecured CDs, time deposits, banker’s acceptances, and
         repurchase agreements having maturities of up to 365 days, of any bank whose
         short-term debt obligations are rated ‘A-1+’ by Standard & Poor’s. In addition,
         the instrument should not have an ‘r’ highlighter affixed to its rating, and its
         terms should have a predetermined fixed-dollar amount of principal due at maturity
         that cannot vary or change. Interest may be either fixed or variable. If the investments
         may be liquidated before their maturity or are being relied on to meet a certain
         yield, additional restrictions are necessary. Interest should be tied to a single


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     interest rate index plus a single fixed spread, if any, and move proportionately
     with that index.
5.   Certain deposits that are fully insured by the FDIC. The deposit’s repayment terms
     should have a predetermined fixed-dollar amount of principal due at maturity that
     cannot vary or change. If the deposit is rated, it should not have an ‘r’ highlighter
     affixed to its rating. Interest may be either fixed or variable. If the investments
     may be liquidated before their maturity or are being relied on to meet a certain
     yield, additional restrictions are necessary. Interest should be tied to a single interest
     rate index plus a single fixed spread, if any, and move proportionately with
     that index.
6.   Certain debt obligations maturing in 365 days or less that are rated ‘AA-’ or higher
     by Standard & Poor’s. The debt should not have an ‘r’ highlighter affixed to its
     rating, and its terms should have a predetermined fixed-dollar amount of principal
     due at maturity that cannot vary or change. Interest can be either fixed or variable.
     If the investments may be liquidated before their maturity or are being relied on
     to meet a certain yield, additional restrictions are necessary. Interest should be tied
     to a single interest rate index plus a single fixed spread, if any, and move propor-
     tionately with that index.
7.   Certain commercial paper rated ‘A-1+’ by Standard & Poor’s and maturing in 365
     days or less. The commercial paper should not have an ‘r’ highlighter affixed to
     its rating, and its terms should have a predetermined fixed-dollar amount of principal
     due at maturity that cannot vary or change. Interest may be either fixed or variable.
     If the investments may be liquidated before their maturity or are being relied on
     to meet a certain yield, additional restrictions are necessary. Interest should be tied
     to a single interest rate index plus a single fixed spread, if any, and move propor-
     tionately with that index.
8.   Investments in certain short-term debt of issuers rated ‘A-1’ by Standard & Poor’s
     with certain restrictions. In this case, short-term debt is defined as: commercial
     paper, federal funds, repurchase agreements, unsecured CDs, time deposits, and
     banker’s acceptances. The total amount of debt from ‘A-1’ issuers must be limited
     to the investment of monthly principal and interest payments (assuming fully
     amortizing collateral). The total amount of ‘A-1’ investments should not represent
     more than 20% of the rated issue’s outstanding principal amount, and each
     investment should not mature beyond 30 days.
       Investments in ‘A-1’ rated securities are not eligible for reserve accounts, cash
       collateral accounts, or other forms of credit enhancement in ‘AAA’ rated issues.
       In addition, none of the investments may have an ‘r’ highlighter affixed to its rat-
       ing. The terms of the debt should have a predetermined fixed-dollar amount of
       principal due at maturity that cannot vary or change. Interest may be either fixed
       or variable. If the investments may be liquidated before their maturity or are


     Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   125
          being relied on to meet a certain yield, additional restrictions are necessary.
          Interest should be tied to a single interest rate index plus a single fixed spread,
          if any, and move proportionately with that index.
      09. Investment in money-market funds rated ‘AAAm’ or ‘AAAm-G’ by
          Standard & Poor’s.
      10. Certain stripped securities where the principal-only and interest-only strips of
          noncallable obligations are issued by the U.S. Treasury and of Refcorp securities
          stripped by the Federal Reserve Bank of New York.
          Any security not included in this list may be approved by Standard & Poor’s
          after a review of the specific terms of the security and its appropriateness for
          the issue.


      Select Specific Opinion Criteria/Language
      General
      I As a general matter, Standard & Poor’s requires that true sale, nonconsolidation,

        security interest, either/or, and debt security interest opinions be delivered by outside
        counsel to any participant in a structured transaction.
      I As a general matter, in connection with security interest opinions, either/or opinions,

        debt security interest opinions, characterization opinions, and certificate of title
        opinions (all opinions based on state law), Standard & Poor’s accepts an opinion
        of counsel not admitted to the bar of the relevant state, provided such counsel
        states that it bases its opinions on a review of the laws of such state, including
        both the state’s relevant statutes and case law.
      I As a general matter, Standard & Poor’s will not accept an opinion based on the

        Legal Opinion Accord of the American Bar Association Section of Business Law
        (1991) unless such opinion specifically identifies (by number) those sections of the
        Accord on which the opinion is relying. Standard & Poor’s will accept an opinion
        stating that it should be interpreted in accordance with the Special Report by the
        TriBar Opinion Committee, Opinions in the Bankruptcy Context; Rating Agency,
        Structured Financing and Chapter 10 Transactions, 46 BUS. LAW 717 (1991).
      I As a general matter, Standard & Poor’s requires “would” opinions except for

        nonconsolidation opinions and common law security over deposit accounts. In
        these two cases, “should” opinions are accepted based on the fact dependent
        nature of nonconsolidation opinions and the scarcity of deposit account
        jurisprudence, respectively.
      I Language to the effect that the “issue is not free from doubt” or that the conclusion

        is “more probable than not” is not acceptable.
      I The proviso “although a court may find otherwise” is not preferred but is acceptable.




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                                               Legal Criteria for Subprime Mortgage Transactions




I  A statement that the “opinion is not a guarantee of outcome or result” is acceptable.
   Bring-down opinion. Counsel delivering a bring-down opinion in the context of a
subsequent transfer should state that it has reviewed (i) the facts of the subsequent
transfer and that such facts do not differ from those recited in the previously delivered
opinion and (ii) the assumptions set forth in the previously delivered opinion, which
assumptions are the only assumptions being made in the bring-down opinion. Standard
& Poor’s accepts bring-down opinions only from the same counsel that delivered the
opinions being brought down.
   Corporate opinion. As a general matter, in U.S. transactions, Standard & Poor’s
receives comfort as to the due organization, valid existence, and good standing of
transaction participants from the representations and warranties of the transaction
participants. Depending upon the circumstances, however, Standard & Poor’s may
request a corporate opinion to the following effect: (i) that each party to the transaction
is duly organized, validly existing under the laws of the jurisdiction of its formation,
and is in good standing under the laws of such jurisdiction and any other jurisdictions
in which it is required to qualify to do business; (ii) that each party to the transaction
has the full power and authority to carry on its business and to enter into the trans-
actions documents to which it is a party and the transactions thereby contemplated;
(iii) that the execution, delivery, and performance of the transaction documents by
the relevant party will not violate any law, regulation, order, or decree of any gov-
ernmental authority or constitute a default under or conflict with the organizational
documents or other agreements governing or to which the relevant party is a party;
(iv) that no approval, consent, order, or authorization is required in connection with
the execution, delivery, and performance of the transaction documents other than
those approvals, consents, orders, and authorizations that have been obtained in
connection with the closing of the transaction; and (v) that the payments set forth
in there transaction documents do not violate applicable usury laws. Standard &
Poor’s generally requests corporate opinions in international transactions and in
connection with a transaction participant that is a non-U.S. entity.
   Enforceability opinion. As a general matter, in U.S. transactions, Standard &
Poor’s receives comfort as to the legality, validity, and enforceability of the transaction
documents from the representations and warranties of the transaction participants.
Depending upon the circumstances, however, Standard & Poor’s may request an
enforceability opinion to the effect that the transaction documents, or any particular
transaction document, constitutes the legal, valid, binding, and enforceable obligations
of the signatories. Standard & Poor’s generally requests enforceability opinions in
international transactions and in connection with a transaction document to which
a non-U.S. entity is a signatory.




    Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   127
      Representations and Warranties
      The following are representations and warranties generally requested by Standard
      & Poor’s on rated transactions:

      Representations and Warranties of the Originator, the Seller, and the Servicer
      1. Organization and Good Standing. The seller/originator is a national banking asso-
         ciation or corporation duly organized and validly existing in good standing under
         the laws of the U.S. and has full corporate power, authority, and legal right to
         own its properties and conduct its business as such properties are presently owned
         and such business is presently conducted, and to execute, deliver, and perform its
         obligations under this agreement and to execute and deliver to the trustee the
         certificates pursuant hereto.
      2. Due Qualification. Each of the seller, the originator and the servicer is duly qualified
         to do business and is in good standing (or is exempt from such requirement) in
         any state required in order to conduct business and has obtained all necessary
         licenses and approvals with respect to the seller required under federal and the
         applicable state law; provided however, that no representation or warranty is
         made with respect to any qualifications, licenses, or approvals that the trustee
         would have to obtain to do business in any state in which the trustee seeks to
         enforce any receivable.
      3. Due Authorization. The execution and delivery of this agreement and the execution
         and delivery to the trustee of the certificates by the seller or the originator and the
         consummation of the transactions provided for in this agreement have been duly
         authorized by each of the seller, the originator and the servicer by all necessary
         corporate action on its part and this agreement will remain, from the time of its
         execution, an official record of the seller, the originator and the servicer.
      4. Binding Obligation/Enforceability. Each of the agreements constitutes a legal,
         valid, and binding obligation each of the seller, the originator and the servicer
         enforceable against the seller, the originator and the servicer except when limited
         by bankruptcy, reorganization, insolvency, moratorium, or other similar laws
         affecting creditors’ rights. The agreements are in full force and effect, and are
         not subject to any specific dispute, offset, counterclaim, or defense.
      5. No Conflict. The execution and delivery of this agreement and the certificates, the
         performance of the transaction contemplated by this agreement, and the fulfillment
         of the terms hereof will not conflict with, result in any breach of any of the material
         terms and provisions of, or constitute (with or without notice or lapse of time or
         both) a material default under any indenture, contract, agreement, mortgage, deed
         of trust, or other instrument to which the seller, the originator and the servicer is
         a party or by which it or any of its propriety are bound.



128
                                             Legal Criteria for Subprime Mortgage Transactions




06. No Violation. The execution and delivery of this agreement, any supplement and
      the certificates by the seller, the originator and the servicer, the performance by
      the seller, the originator and the servicer of the transaction contemplated by this
      agreement and any supplement, and the fulfillment by the seller, the originator
      and the servicer of the terms hereof and thereof will not conflict with, violate, or
      result in any breach of any of the material terms and provisions of, or constitute
      (with or without notice or lapse of time or both) a default under any requirement
      of law applicable to the seller, the originator and the servicer or any material
      indenture, contract, agreement, mortgage, deed of trust, or other instrument to
      which the seller, the originator and the servicer is a party or by which it or any
      of its properties are bound.
07.   No Proceedings. There are no proceedings or investigations, pending or, to the
      best knowledge of each of the seller, the originator and the servicer threatened
      against the seller, the originator and the servicer before any court, regulatory
      body, administrative agency, or there tribunal or governmental instrumentality (i)
      asserting the invalidity of this agreement or the certificates (ii); seeking to prevent
      the issuance of the certificates or the consummation by the seller of any of the
      transactions contemplated by this agreement or the certificates; (iii) seeking any
      determination or ruling that, in the reasonable judgment of the seller, the originator
      and the servicer would materially and adversely affect the performance by each
      of the seller, the originator and the servicer of its obligation under this agreement;
      (iv) seeking any determination or ruling that would materially and adversely
      affect the validity or enforceability of this agreement or certificates of any series;
      or (v) seeking to affect adversely the income tax attributes of the trust or the cer-
      tificates under the U.S. federal or applicable state income tax systems.
08.   All Consents Obtained. All approvals, authorizations, consents, orders, or other
      actions of any persons or of any governmental body or official required in con-
      nection with the execution and delivery by each of the seller, the originator and
      the servicer, as applicable, of this agreement and the certificates, the performance
      by each of the seller, the originator and the servicer of the transactions contemplated
      by this agreement, and the fulfillment by each of the seller, the originator and the
      servicer, as applicable of the terms hereof and thereof, have been obtained, except
      such as may be required by state securities or “blue sky” laws in connection with
      the distribution of any certificates.
09.   Not an Investment Company. The seller/originator is not an “investment company”
      within the meaning of the Investment Company Act, nor is it exempt from all
      provisions of such act.
10.   Misstatement of Fact. No statement of fact made in the pooling and servicing
      agreement contains any untrue statement of a material fact or omits to state
      any material fact necessary to make statements contained herein or therein not


  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   129
         misleading. (If the deal is public, this statement is implied. While Standard &
         Poor’s appreciates seeing it in the documents, it is more critical on a private
         placement or in the overseas markets.)

      Additional Representations and Warranties of the Servicer
      I The collection practices used by the servicer with respect to the mortgage loans

        have been, in all material respects, legal, proper, prudent and customary in the
        non-conforming mortgage servicing business;
      I The servicer shall cause the related obligor to maintain for each mortgage loan,

        and if the obligor does not so maintain, shall itself maintain (A) fire and hazard
        insurance with extended coverage on the related mortgaged property in an amount
        which is at least equal to the lesser of (i) 100% of the then “full replacement cost”
        of the improvements and equipment, without deduction for physical depreciation,
        and (ii) the outstanding principal balance of the related mortgage loan, and (B)
        such other insurance as provided in the related mortgage loan;
      I The servicer will keep in force during the term of this agreement a policy or policies

        of insurance covering errors and omissions for failure in the performance of the
        servicer’s obligations under this agreement, which policy or policies shall be in
        such form that would meet the requirements of FNMA or FHLMC if it were the
        purchaser of the mortgage loans or industry standards;
      I The servicer shall also maintain a fidelity bond in the form and amount that

        would meet the requirements of FNMA and FHLMC or industry standards;
      I The servicer shall also cause any sub-servicer to maintain a policy of insurance

        covering errors and omissions and a fidelity bond would meet such requirements;
      I If the mortgaged property is located in a federally designated special flood hazard

        area, the servicer will cause the related obligor to maintain or will itself obtain
        flood insurance in respect thereof. Such flood insurance shall be in an amount
        equal to the lesser of (i) the unpaid principal balance of the related mortgage loan
        and (ii) the maximum amount of such insurance required by the terms of the related
        mortgage and as is available for the related property under the national flood
        insurance program (assuming that the area in which such property is located is
        participating in such program);
      I The servicer will examine any subservicing agreement. Any designated subservicer

        and the terms of each subservicing agreement will be required to comply with the
        representations and warranties. The terms of any subservicing agreement will not
        be inconsistent with any of the provisions of this agreement; and
      I The transactions contemplated by this agreement are in the ordinary course

        of business of the servicer.




130
                                            Legal Criteria for Subprime Mortgage Transactions




Representations and Warranties Relating to the Mortgage Loans
01. The seller/originator has good title to the assets and is sole owner of the assets,
    free and clear of any mortgage, pledge, lien, security interest, charge or other
    encumbrance and has full authority to sell the assets.
02. The mortgage loans comply with all applicable state and federal lending laws
    and regulations, including without limitation, usury, equal credit opportunity
    disclosure and recording laws.
03. No default or waiver exists under the mortgage documents, and no modifications
    to the mortgage documents have been made that have not been disclosed.
04. Each mortgage loan is and will be a mortgage loan arising out of the originator’s
    practice in accordance with the seller/originator’s underwriting guidelines. The
    seller has no knowledge of any fact that should have led it to expect at the time
    of the initial creation of an interest in the mortgage loan that such mortgage loan
    would not be paid in full when due.
05. No selection procedures believed by such seller/originator to be adverse to
    the interests of the investor certificateholders have been used in selecting the
    mortgage loans.
06. Loan schedule (as displayed in an exhibit to the pooling & servicing agreement)
    information regarding loans are true and correct.
07. As of issuance, each mortgage is a valid and enforceable subject only to (a) the
    lien of current real property taxes, (b) covenants, conditions and restrictions,
    right of way, easements.
08. As of closing, there is no mechanics’ lien or claim for work, labor or material
    affecting the premise except those which are insured against by the title
    insurance policy.
09. As of closing, there is no delinquent tax or assessment lien against the property.
10. As of closing, there is no valid offset, defense or counterclaim to any note or
    mortgage.
11. As of closing, the physical property subject to any mortgage is free of material
    damage and is in good repair.
12. Each loan at the time it was made compiled in all material respects with applicable
    state and federal laws.
13. At time of origination, no improvement located on or being part of mortgage
    property was in violation of any applicable zoning and subvision laws or
    ordinances.
14. Each original mortgage has been recorded or is in the process of being recorded
    in the appropriate jurisdictions wherein such recordation is required to perfect
    the lien thereof for the benefit of the Trust.
15. The related mortgage file contains each of the documents and instruments specified.
16. Loans originated are being serviced according to the seller/servicer guidelines.


 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   131
      17. In terms of the mortgage note and the mortgage have not been impaired, altered
            or modified in any material respect, except by a written instrument which has
            been recorded or is in the process of being recorded.
      18.   A lender’s title policy or binder, or other assurance of title insurance customary
            in a form acceptable to FNMA or FHLMC was issued at origination and each
            policy or binder is valid and remains in full force and effect.
      19.   Appraisal Form 1004 or Form 2055 with an interior inspection for first lien
            mortgage loans has been obtained. Form 704, 2065 or 2055 with an exterior
            only inspection for junior lien mortgage loans has been obtained.
      20.   If an alternative collateral valuation method acceptable to Standard & Poor’s is
            used to determine the value of a property, the percentage of loans and method
            should be stated.
      21.   If the property is in a FEMA designated flood area, the flood insurance policy is
            in effect.
      22.   As of closing, a hazard insurance policy are in place.
      23.   No loans secured by a leasehold interest.
      24.   Percentage of mortgage loans where the borrower’s down payment was financed.
      25.   Pool Characteristics Representation and Warranties
            I As of closing if applicable, no payments of principal and interest is 30 or more

               days past due and none of the loans have been past due 30 or more days more
               than once during the preceding 12 months;
            I As of closing, the percent of loans that are 30/60/90+ delinquent;

            I Percent of loans 2-5 times and 6+ times delinquent in the last 12 months;

            I Percent of mortgage loans with loan to value’s (LTV’s) over 80% that have pri-

               mary mortgage insurance, if applicable;
            I Percent of mortgage loans with LTV’s over 80% which do not have primary

               insurance, if applicable;
            I The range of LTV’s;

            I The range of mortgage interest rates;

            I Percent of net mortgage rates less than the pass-through rate;

            I Percent of loans whose scheduled balance over $400,000;

            I Highest percent in one zip code;

            I Percentage of primary residences;

            I Percentage of single family detached residences;




132
                                           Legal Criteria for Subprime Mortgage Transactions




 I   Percentage of condominiums, 2 to 4 family residential properties;
     second homes and investor properties;
 I   Average FICO score;
 I   Weighted average FICO score;
 I   Percent of each A/A-/B/C/D quality loans;
 I   Number of buydown loans;
 I   Range of loans’ principal balances;
 I   Percent of second homes, and investor owned properties;
 I   Percent of cashout loans;
 I   Percent of full documentation loans; and
 I   Percent of streamlined program loans.




Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   133
Servicer Requirements

T
       he quality of servicing of the subprime mortgage loans backing rated certificates
       is an integral component to the performance results of a transaction. A servicer
       is expected to perform certain functions in addition to being reviewed and
approved by Standard & Poor’s (see “Servicer Evaluation Criteria” section).


Role of the Servicer
Typically, the functions performed by a primary servicer include, but are not limited
to, the following:
I Setting up the mortgage loan on the servicer’s computer system;

I Accepting and processing all mortgage loan payments from the borrower;

I Remitting funds that are designated for payment to the certificateholders from the

  custodial account to the certificate account held by the master servicer or trustee;
I Reconciling custodial accounts;

I Monitoring and/or disbursing property insurance and real estate tax payments

  (in escrow or otherwise);
I Performing customer service, processing loan payoffs and ensuring proper lien

  disposition upon full repayment of the outstanding mortgage loan;
I Reporting monthly all loan activities, as applicable, to the master servicer

  or trustee;
I Managing adjustable-rate mortgage (ARM) loans and subsequent interest rate

  adjustments;
I Performing default management functions, including collections on delinquent

  loans, loss mitigation efforts, initiating and monitoring of foreclosure activities,
  monitoring bankruptcies, and the Real Estate Owned (REO) disposition process;
  and
I Advancing for delinquent mortgage loans and any costs and expenses incurred (if

  they are deemed to be recoverable) in the performance of its servicer obligations.
  In addition, the servicer should cause to be maintained, with respect to each mortgage
loan, a hazard insurance policy in an amount covering at least the outstanding principal
balance of that loan. The servicer should maintain the insurance policies in the name



  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   135
      of the mortgagee, its successors, and assigns, and be named loss payee. The servicer
      may maintain a blanket hazard insurance policy, as long as the servicer covers the
      deductible. If a mortgage property, at the closing of the mortgage loan, is identified
      in the Federal Register by the Federal Emergency Management Agency (FEMA) as
      having special flood hazards, the servicer should maintain a flood insurance policy
      in an amount equal to at least the outstanding mortgage loan balance. The servicer
      should also maintain errors and omissions coverage and a fidelity bond in an
      amount equal to FNMA and FHLMC standards.
        If Standard & Poor’s does not approve a servicer, a master servicer with an
      approved ranking should be in place on the closing date of the transaction.
      Typically, a master servicer is involved in a transaction for the following reasons:
      I The primary servicer is involved in a correspondent relationship with a conduit

        that is issuing the securities;
      I The primary servicer has operational deficiencies; or

      I There is a financial concern with the primary servicer.

        The role of the master servicer can vary depending upon the reasons stated above.
      The involvement of three or more servicers in a transaction is typical when a conduit
      has many small correspondent sellers who sell their loans servicing retained, or if,
      upon a servicer evaluation, the underlying servicer is found to have operational defi-
      ciencies. When either of these circumstances occurs, the role of the master servicer is
      one of oversight. The master servicer should be in place on the closing date of the
      transaction and should be prepared to supervise, and take such actions as are necessary
      to ensure, that the mortgage loans are serviced in accordance with the requirements
      under the pooling and servicing agreement and normal servicing practices.
        On a monthly basis the master servicer should receive and review trial balance
      and remittance report information for accuracy, update loan level data, aggregate
      the servicer remittance reports and distributions to investors, and segregate funds
      for the payment to certificateholders.
        For the master servicer to fulfill these responsibilities, the underlying servicer
      should provide to the master servicer on a monthly basis the following:
      I Trial balance information on a loan-by-loan basis;

      I Aggregate advancing amounts;

      I Aggregate reporting and distribution amounts to investors;

      I The servicer’s remittance reports; and

      I Monthly status of delinquency, foreclosure, and REO amounts.

        The master servicer should also have the authority to remove and replace any
      underlying servicer that is not performing according to its responsibilities under the
      pooling and servicing agreement. The master servicer should perform operational
      reviews on the underlying servicer(s), and these reviews may vary in scope, from
      focusing on delinquency performance to on-site reviews encompassing all functional


136
                                                                        Servicer Requirements




areas of a servicer. These reviews allow the master servicer to ensure that its servicers
are in compliance with its requirements and those of the pooling and servicing
agreement. Equally important, reviews allow the master servicer to act proactively,
detecting any potential problems before they have a chance to escalate.
   If there is a financial concern with the primary servicer, the master servicer’s
responsibilities, including those listed above, should also include a more detailed
default management activity as well as the monthly monitoring of custodial, servicing
and escrow account status. The master servicer should follow up on a monthly basis
with the primary servicer regarding its defaulted loan servicing activities. This over-
sight function ensures that collection efforts and foreclosure activities are consistently
applied to the underlying collateral. To accomplish this, besides including monthly
status reports regarding delinquency, foreclosure, and REO amounts, the reports
need to include the comments from the mortgagors and the collection and loss
mitigation staff.
   If a transfer of servicing becomes necessary, the master servicer should ensure that
it is done properly and efficiently. The master servicer should be named as the subse-
quent servicer should the underlying servicer default in its obligations. This ability to
transfer servicing from one to the other should be able to take place upon 24-hour
notification. Should this happen, all servicer responsibilities pursuant to the pooling
and servicing agreement are assumed by the master servicer, and the servicer is relieved
of its responsibilities and obligations detailed in the pooling and servicing agreement.
To effect such a transfer, the underlying servicer and master servicer need to under-
stand any conversion requirements, such as system capabilities, prior to closing.


Servicing Fee
A minimum servicing fee of 50 basis points (bps) has been established to provide
greater flexibility in obtaining successor servicers, if necessary. Higher fees are necessary
for subprime loans because of the cost associated with the increased levels of delin-
quencies and foreclosures that typically occur with these loans. If an entity is willing
to service the mortgage loans for less than the minimum, Standard & Poor’s still
requires that at least 50bps be made available in the transaction if a servicing transfer
becomes necessary.
  If the servicing fee is calculated based on a certain dollar amount per loan, the fee
will increase as a percentage of assets due to amortization of the pool. This is an
important consideration when assessing available excess spread to cover losses and
fund any reserve account.




  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   137
      Accounting Reports
      Independent accounting reports should be provided annually to the master servicer
      or trustee, as applicable. The reports should state whether the servicer is in compliance
      with the transaction documents, and whether its policies and procedures are sufficient
      to prevent errors. Exceptions, if any, should be listed.


      Resignation of a Servicer
      To ensure continuity, the transaction documents should provide that a servicer is
      not allowed to resign unless it is either no longer able to service under law, or finds
      a successor. No resignation should become effective until a successor (or the trustee,
      as successor) has assumed the servicer’s responsibilities. The trustee generally has
      the power to replace the servicer if the servicer is not performing its servicing
      functions adequately.


      Servicer Removal Triggers
      Standard & Poor’s also looks for investors to have a direct say in removing the servicer
      from its responsibilities, if need be. The trustee should initiate an investor vote re-
      garding this action when the credit quality of the loans in the transactions deteriorates.
      A test measuring loss and delinquency experience against outstanding credit support
      should be in place for all entities that are not rated at least investment grade for all
      subprime transactions. Failure to pass this test should initiate a certificateholder vote
      on the state of servicing. If a majority agree, the trustee must remove the servicer
      from its duties and actively seek a replacement.
        This test has two triggers:
      I Total expected losses exceed 50% of the initial loss coverage on the current

        determination date up to the fifth anniversary of the cutoff date; or
      I Total expected losses exceed 75% of the initial loss coverage on the current

        determination date up to the 10th anniversary of the cutoff date.
        Total expected losses equal the sum of the cumulative amount of losses that
      have been experienced as of the determination date plus the delinquency calculation.
      The delinquency calculation is the sum of:
      I The percentage of mortgage loans 30-59 days delinquent multiplied by 25%

        (expected foreclosure frequency), and then multiplied by 43% (‘AAA’ loss severity);
      I The percentage of mortgage loans 60-89 days delinquent multiplied by 50%, then

        multiplied by 43%; and
      I The percentage of mortgage loans 90 days or more delinquent, loans in foreclosure,

        and REO property, multiplied by 100%, then multiplied by 43%.




138
                                                                       Servicer Requirements




  The above calculation uses the ‘AAA’ loss severity (43%); the appropriate severities
will be applied at different rating levels.
  In the case of transactions structured with a bond insurer, the bond insurer will
often present variations of these performance-based triggers. In certain circumstances,
term-to-term servicing contracts have been used to give the bond insurer more control.
All alternatives to Standard & Poor’s triggers must be evaluated and deemed acceptable.




 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   139
Servicer Evaluation Criteria

T
         he servicer evaluation criteria were developed in 1989 to meet the increasing
         industry demand for a means of assessing the operational abilities of servicers
         in the mortgage servicing industry. The evaluation is intended to accurately
assess a servicer’s strengths, weaknesses, opportunities, and limitations through
an examination of its management, organization, loan administration, and
financial position.
   Standard & Poor’s assigns an individual ranking of Strong, Above Average, Average,
Below Average, or Weak to each of these areas, and then an overall ranking to the
company itself. Average servicers have achieved an acceptable level of competence,
while Below Average and Weak servicers lack the necessary internal controls and
workflow efficiencies to effectively manage their portfolio of loans and minimize
risk to investors. Above Average and Strong servicers, on the other hand, have
honed and augmented their operations to offer a superior level of service to investors
and borrowers. Management and organization together with loan administration
comprise 80% of the overall ranking, while financial position accounts for the
remaining 20%.
   Upon assignment of a ranking, a firm may choose either to publish the report,
thereby making the ranking public, or to have Standard & Poor’s maintain its confi-
dentiality. In either case, if a company meets the minimum criteria for an average
ranking, it appears on an Approved Servicer List. Specific rankings do not appear on
the Approved Servicer List. However, as the rating criteria require a servicer review
for all residential mortgage-backed security transactions, a servicer must be on the
approved list to be able to service a new transaction.
   Though servicer evaluations consist of rankings, they follow the Standard & Poor’s
debt-rating process. Analysts work closely with company management, basing their
analysis on established criteria, and all rankings undergo a committee approval
process. All changes to analytic criteria must similarly receive committee approval.
Approval committees are comprised of the managing director of the department,
team leaders, senior analysts, financial analysts, transaction analysts, and surveillance
analysts. Often, a servicer will use its evaluation as an effective marketing tool to
advertise its capabilities in the industry.



  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   141
      The Evaluation Process
      The servicer evaluation process begins with a review of the company’s documentation.
      The primary analyst requests an extensive list of informational requirements from
      the servicer, which includes:
      I A detailed organizational and operational description;

      I Managerial resumes;

      I Audited financial statements;

      I The company’s policy and procedure manual;

      I The company’s business plan and projections;

      I Copies of all internal and external servicing audits performed over the past

         18 month;
      I Documentation of the portfolio’s insurance coverage;

      I A description of the servicer’s accounting and data systems;

      I Samples of custodial bank account statements;

      I Six sample investor reports;

      I The company’s most-recent tax and insurance reports;

      I The servicer’s most-recent delinquency report;

      I Real estate owned marketing material;

      I Details of any substantive pending litigation; and

      I Any unique factors that may be significant, such as Year 2000 compliance.

         A two-analyst team then visits the servicer on site, for a complete company review
      that typically lasts two days. The analysts tour the facility and all operational depart-
      ments, and interview key staff at all levels, from line managers to chief executive
      officers. Analysts closely examine cash management processes and all operational
      policies and procedures, to ensure that the servicer is adhering to its documented
      policies. Further, Standard & Poor’s prefers that companies offer their employees
      electronic access to company policies and procedures in order to optimize staff
      knowledge and performance. Analysts will assess company management and opera-
      tions by reviewing company history, managerial structure, experience, and tenure,
      the scope and effectiveness of training programs, and the extent and quality of
      the servicer’s strategic planning. The company’s internal audit practices will also
      be reviewed, along with its computer systems, level of automation, and disaster
      recovery plans.
         Within the servicing function itself, analysts examine portfolio acquisitions, payment
      processing, and investor accounting and reporting. Loss mitigation, foreclosure, and
      Real Estate Owned (REO) functions also come under close scrutiny. Analysts make
      sure that insurance coverages are adequate, and discuss any litigation involving the
      servicer. Upon assigning a servicer ranking, each servicer is continuously monitored
      to ensure that operational quality has not changed markedly.



142
                                                                  Servicer Evaluation Criteria




Subprime Servicer Differences From Other Servicers
Unlike prime servicers, who manage loans to borrowers with solid credit ratings,
subprime loan servicers administer portfolios of loans to borrowers with less-than-
pristine credit histories. Frequently, subprime borrowers have experienced personal
and/or professional problems which inhibit their ability to pay their bills on time.
Abrupt lifestyle changes, such as divorce or unemployment, coupled with an overall
inability to properly manage personal finances effectively, can disrupt timely pay-
ments. Subprime servicing, therefore, requires loan counseling, together with a
more proactive and aggressive collection methodology.
   In addition, collections for subprime portfolios must begin sooner than their prime
counterparts; because subprime borrowers typically do not properly budget their
finances, they often pay the first debt collector to reach them. Loss mitigation plays
a greater role in recovery than it does for prime loans and requires early intervention,
as the subprime borrower often does not have access to the financial resources needed
to reinstate a seriously delinquent loan. Accordingly, foreclosure and bankruptcy
management require a proactive stance.


Approved Servicer Requirements
To attain a minimum ranking of Average and to become an approved servicer, a
company must display competency in a number of crucial operational areas, such as
payment processing, employee training, cash management, and disaster recovery.
The company’s business plan should be clear and attainable. Servicer management
should possess seven to 10 years of applicable managerial experience. Approved
servicers must provide their employees with adequate policy and procedure manuals
to ensure a cognizant staff.
  Companies should also display attentive supervision over the cash management
process, as misdirected or lost checks become a liability. Servicers need to show evidence
of a thorough internal audit process and appropriate disaster recovery measures.
Overall, competent servicers should possess a coherent organizational structure that
adequately delegates responsibilities among the dedicated staff.
  Should a servicer fall short of approved status, Standard & Poor’s will help the
company’s management identify inadequate operational functions and other areas of
concern. In this way, many companies who might otherwise have been exposed to
unnecessary risk are able to improve their operational abilities and efficiency, and to
become approved servicers. Should a servicer earn approval, analysts will provide
the servicer with recommendations to improve internal controls and operational
efficiencies, to enhance or maintain its evaluation.




 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   143
Surveillance Criteria
General Overview



I
     n recent years, use of the label “home equity loan” has widened and is now used
     to identify a larger breadth of loan types. While the term “home equity” suggests
     junior lien status, most of the home equity loans collateralizing rated MBS cer-
tificates are actually first lien mortgages. The characteristics of a pool of fixed-rate
home equity loans securitized today include a junior lien component ranging from
5%-10%, a weighted average combined loan to value ratio (CLTV) ranging from
75%-80%, and an average FICO score ranging from 563-626.
   However, the lending climate continues to generate new products targeted at specific
borrower characteristics, which has further blurred the traditional meaning of a
home equity loan. As a result, ratings analyses distinguish between collateral types
based on borrower credit (prime or subprime). Therefore, in the remainder of this
section what was traditionally referred to as home equity will be referred to
as subprime. This section will discuss the surveillance criteria for subprime
mortgage loans.


Methodology
Standard & Poor’s Subprime Surveillance Program was developed from its prime
loan surveillance platform and it applies a similar stress test/loss projection methodology.
Adjustments were made, however, to accommodate (i) the wider breadth of credit


  Forms of Credit Support
  A mong the various forms of credit support are the following:

  I   Subordination,                                          I   Reserve fund and/or spread account,
  I   Excess interest,                                        I   Letter of credit (LOC),
  I   Overcollateralization,                                  I   Financial guarantee insurance, and
  I   Excess interest building overcollateralization,         I   Other external/third party support.




  Standard & Poor’s Structured Finance            I     U.S. Residential Subprime Mortgage Criteria     145
      support structures utilized in the subprime market (see box, “Forms of Credit
      Support”), and (ii) the characteristics of the collateral. Ultimately the program relies
      on four performance tests which serve as the cornerstones of the subprime risk
      assessment methodology (see chart 1).
        The program assesses ratings integrity by comparing the current credit support
      percentage to the original requirement, and by analyzing the extent to which projected
      losses may erode available credit support. However, the vital focus is the evaluation
      of overall structural transaction performance. The program evaluates structural
      performance primarily by examining:
      I Collateral characteristics;

      I Trend analysis of payment delinquency rates;

      I Trend analysis of period losses as a percent of period excess interest cashflow

        production (e.g., adequacy of excess interest to cover losses);
      I Potential for erosion of overcollateralization by losses;

      I Achievement of the overcollateralization target;




                                                                 Chart 1
                             Subprime Mortgage Surveillance Methodology




                                                          Standard & Poor's


                                                           Rating Integrity



                                Test 1                                                              Test 2


                                                             Surveillance
                                                              Committee


                                Test 4                                                              Test 3




                    Test 1: Has o/c been used to cover losses in each of the three prior months?
                    Test 2: When giving 12 months credit to excess interest production, is the certificate's current
                            credit support percentage less than Standard & Poor's loss coverage requirement?
                    Test 3: Is the three month rolling average of the 90+ day delinquency percentage more than 1/2
                           of the current credit support percentage for the certificate?
                    Test 4: Is erosion of credit support to the most junior class expected to occur within the next 12
                           month period? Brech of this test alone can result in negative rating adjustment.




146
                                                                            Surveillance Criteria




I Potential for a projected shortage in credit support to the most junior class within
  the following 12 months; and
I Impact or potential impact of loan repurchase practices on credit risk.

  Surveillance takes all of these dynamics into account when formulating rating
recommendations. In addition, rating recommendations reflect the presence of
overcollateralization step-up and/or step-down triggers. The impact these transaction
specific triggers have on credit risk to the certificates can be a critical aspect of
the performance outlook.


Building the Analysis
The subprime surveillance analysis employs certain standard assumptions centered
around default frequency, loss severity, and excess interest credit. However, if an
issuer’s historical performance warrants a ramp-up or down of various assumptions,
adjustments are made accordingly.

Credit Support
Excess interest and overcollateralization. The program treats subordination, LOC,
financial guarantee insurance, reserve funds, and other forms of third party support
the same as they are treated in the prime collateral surveillance methodology. However,
assessing the strength of excess interest (a feature not generally found in prime secu-
ritizations) and overcollateralization is a different exercise entirely. The program
examines performance of excess interest production versus net (monthly) losses.
Should net losses exceed the amount of excess interest production for three months
in succession, the transaction will breach test 1 (see chart 1).
   Test 1 indicates whether excess interest production alone is sufficient to cover losses.
Since excess interest is usually directed first to cover losses and then to create
overcollateralization by accelerating principal payments to certificateholders (until
overcollateralization target percentage is reached), a breach of test 1 is more crucial
if a transaction has not reached its overcollateralization target. Such an event calls
into question whether the transaction has capacity to reach its overcollateralization
target percentage and continue to cover losses. When an issue breaches test 1, the
criteria calls for a review of:
I Twelve months of delinquency performance to determine if defaults and losses are

   expected to continue at a rate commensurate with that of the prior three months,
I Twelve months of excess interest production to determine the rate at which it is

   diminishing, and
I Twelve months of net losses compared against the volume of excess interest

   production over the same period.




    Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   147
         A close review of these performance dynamics allows the surveillance analyst
      to project whether the transaction is expected to meet its overcollateralization
      target percentage and/or adequately protect rated certificates from suffering
      principal losses.
         Sizing credit for excess interest cashflow. Credit is given for 12 months of excess
      interest cashflow production when computing the excess interest portion of a certifi-
      cate’s current credit support percentage. The 12 month timeframe is employed as a
      reflection of the typical default liquidation period, and provides for an assessment
      of the adequacy of current credit support to cover projected losses on presently
      delinquent loans.
         Excess interest cashflow is projected for the upcoming 12 months using level pay-
      down cashflow assumptions. The cashflows are a simulation of how interest and
      principal generated by the collateral is likely to cover debt service on the certificates
      based upon (i) the pool’s prepayment experience over the preceding 12 months, and
      (ii) the unique payment structure and provisions of the certificates. Based upon those
      assumptions the cashflow model computes the amount of excess interest expected in
      each of the upcoming 12 months. The sum of this 12 months projected excess-interest
      cashflow is the amount of credit the surveillance department gives to excess interest.
      Credit for excess interest is then added to the dollar amount of other forms of loss
      coverage in place for the certificate (i.e., overcollateralization, subordination, reserve
      fund, LOC, etc.).
         Once credit for excess interest is given and that amount added to the sum of all
      other forms of credit support available to the certificate, the current credit support
      percentage is calculated by dividing the total credit support amount by the outstanding
      mortgage pool balance. Should the resulting current credit support percentage be
      less than the loss coverage requirement for the class, test 2 (see chart 1) is breached.
      Exceeding the loss coverage requirement with only 12 months of excess interest
      credit is a favorable observation, and is frequently the case for ‘AA’ to ‘AAA’ rated
      classes of issues at least 12 months old.

      Mortgage Performance
      As mentioned earlier, subprime borrowers typically have less-than-pristine credit
      histories and have experienced personal and/or professional problems which inhibit
      their ability to pay their bills on time. This can result in higher delinquency rates for
      subprime mortgage pools. Higher delinquency percentages generally lead to more
      defaults and losses. Therefore, test 3 has been employed to gauge the degree of risk
      a given delinquency trend presents to a rated certificate (see chart 1).
        Test 3 computes the three-month, rolling average, total 90-plus day delinquency
      percentage (inclusive of foreclosures and REO) and compares it with the total per-
      centage of credit support currently available to the rated certificate. Should the


148
                                                                                         Surveillance Criteria




three-month, rolling average, 90-plus day delinquency percentage be more than half
of the current credit support percentage for the certificate, test 3 is breached. By
quantifying the trend of seriously delinquent loan volume versus the credit support
percentage for a particular certificate, the program proactively identifies the potential
for sizable erosion of credit support.

Lien position and loss severity
Adjustments are made for the junior lien component of a mortgage pool by assigning
it a higher loss severity assumption if the weighted average combined loan to value
ratio (WACLTV) is greater than 80%. For those pools with WACLTV greater than
80%, the program utilizes a loss severity assumption for the junior liens, which is
derived from the pool’s junior lien-to-value ratio. Than is, loss severity is equal to 1
minus the pool’s junior lien-to-value ratio. If the CLTV is less than 80%, the standard
prime mortgage loss severity assumptions are utilized in the stress test/loss projection
model. A pool’s junior lien to value ratio relates the principal balance of junior lien
mortgages to the principal balance of the borrower’s total mortgage debt outstanding
(see box).
   When a mortgage pool has a WACLTV greater than 80%, the program uses a
weighted average approach to derive a stress test loss-severity assumption for each
rating category. Under these conditions, the portion of the pool secured by first lien
mortgages is assigned a standard loss severity dependent on the rating category of
the certificate being assessed. The portion of the pool secured by junior lien mort-
gages is assigned a loss severity explained earlier. The program then determines the
pool’s loss severity assumption by computing the weighted average of the first lien
loss severity assumption and the junior lien loss severity assumption. This weighted
average loss severity computation is weighted by the respective principal balances of
the first lien and the junior lien portions of the mortgage pool.



   Junior Lien to Value Ratio
   The junior lien to value ratio is defined as follows:
      A
     A+B
     Where,
     A = Principal balance of the junior lien mortgages populating the securitized mortgage pool, and
     B = Principal balance of the first lien mortgages with priority over the junior lien mortgages populating
         the securitized mortgage pool. These first lien mortgages may or may not populate the securitized
         mortgage pool.




  Standard & Poor’s Structured Finance           I   U.S. Residential Subprime Mortgage Criteria                 149
      Stress Tests
      The program employs the use of two separate stress tests, a standard stress test and
      a cashflow stress test. The standard stress test applies a loss projection methodology
      which analyzes the adequacy of current credit support to cover potential losses on
      delinquent loans. This model applies a standard foreclosure frequency assumption
      which becomes more conservative as delinquencies age. It also assumes a loss severity
      assumption, discussed above, which increases in severity at the higher rating categories
      and is increased further for the junior lien mortgages when the WACLTV greater
      than 80% (see “Lien Position and Loss Severity”).
        The standard stress test computes a projected default balance and the corresponding
      projected losses (foreclosure frequency x-times loss severity) for each rating category.
      The foreclosure frequency for each delinquency category is applied in order to arrive
      at the projected default balance. Then the projected default balances from each
      delinquency category are summed and multiplied by the loss severity assumption
      (which increases at higher rating categories) to arrive at the corresponding projected
      pool losses at each rating category.
        The projected losses are then deducted from the total credit support at the corre-
      sponding rating category to arrive at the projected credit support balance (that is,
      after projected losses are absorbed by credit support). Surveillance uses this projected
      credit support balance to determine whether the rated certificate can be expected to
      continue to meet its loss coverage requirement once losses on the delinquent loans
      are absorbed and the pool balance is negatively adjusted to reflect the defaulted
      loans (projected default balance) exiting the mortgage pool.
        The cashflow stress test applies a 12 month cashflow approach to assess the ade-
      quacy of current credit to cover projected losses on default liquidations over the
      next year. It is specifically structured to assess the risk profile of the most junior
      class, usually rated ‘BBB’. The test runs a modeled scenario whereby loans currently
      in foreclosure and REO are liquidated evenly over the next 12 months. The BBB loss
      severity assumption is then applied to those liquidations. The model assumes the
      identical assumptions used in the section “Sizing Credit for Excess Interest Cashflow,”
      with the exception of incorporation of the loss assumption. The model then reviews
      the 12 months of cashflows produced using these level-pay assumptions. Surveillance
      staff is alerted if total credit support is expected to fall below zero in any one of the
      upcoming twelve months (test 4). Since the model accounts for overcollateralization,
      excess interest, and any reserve fund or third party support, projected losses in a test
      4 breach scenario would potentially erode the principal of the most junior class. The
      outcome of test 4 is the most crucial risk assessment of the subprime surveillance
      methodology (see chart 1).




150
Appendix A

Standard & Poor’s
Ratings File Format
The following table lists all mortgage input fields. The input character string must
be exactly 444 characters long. All numeric fields must be formatted as specified.
This applies to all numeric fields whether or not the field is being used for a
particular loan. Certain fields are only required for ARM loans, where the Loan
Type Code is 16, 17, 18, 19, 20, 21, 60, 61, 62 or 63.



                                             Table 1
                               S & P’s Ratings File Format

 Field   Field name            Length       Location    Format    Description and valid values
 1       Loan ID Number            12            1-12     x(12)   Each loan ID should be unique
 2       Occupancy status           1              13        x    P = Owner occupied
                                                                  I = Investor owned
                                                                  S = Second home
 3       Property type              2          14-15        xx    01 = Single family detached
                                                                  02 = Deminiums
                                                                       (detached) PUD
                                                                  03 = Single family attached
                                                                  04 = Two family
                                                                  05 = Townhouse
                                                                  06 = Low-rise condominium
                                                                       (<= 4 stories)
                                                                  07 = PUD
                                                                  08 = Duplex
                                                                  09 = Three/four family
                                                                  10 = Hi-rise condominium
                                                                       (> 4 stories)
                                                                  12 = Cooperative
 4       Loan purpose               1              16        x    P = Purchase or construction
                                                                      to permanent
                                                                  R = Rate/term refinance
                                                                      (also input fields
                                                                      52 and 53)




 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria          151
                                              Table 1 (cont’d)
                                     S & P’s Ratings File Format

      Field   Field name             Length     Location         Format     Description and valid values
                                                                            C = Cash-out refinance
                                                                                (also input fields
                                                                                51, 52 and 53)
      5       Documentation type          1              17            x    C = No employment/
                                                                                income verification
                                                                            E = No asset verification
                                                                                and no employment/
                                                                                income verification
                                                                            V = Verbal verification of
                                                                                employment (VVOE)
                                                                            W = One paystub obtained
                                                                            X = One paystub obtained
                                                                                and VVOE
                                                                            Y = One paystub and one W-2
                                                                                and VVOE, OR one year
                                                                                1040 (self employed)
                                                                            S = Streamline
                                                                            Z = Full documentation
                                                                                (two years employment
                                                                                verification)
      6       Product description         1              18            x    P = Prime/jumbo
                                                                            S = Subprime/home equity
                                                                            A = Alternative “A”
                                                                            H = Home improvement loan
                                                                            G = High CLTV
                                                                            T = Title 1
                                                                            C = Home equity line of
                                                                                credit (HELOC)
                                                                            F = FHA/VA
                                                                            N = Non/sub/re-perfoming
                                                                            X = Tax lien
                                                                            R = Reverse mortgage
      7       SPACES                      3          19-21           x(3)   MUST BE SPACES
      8       First payment date          8          22-29       Date (8)   YYYYMMDD or SPACES
                                                                            (SPACES = today’s date)
      9       Original LTV ratio          7          30-36       999.999    > = 1.0 and < = 150.0
                                                                            (Indicate 1st lien original LTV if
                                                                            loan is a 1st lien, or 2nd lien
                                                                            original LTV if loan is a 2nd lien)
      10      Current loan balance       10          37-46        9(7).99   >0
                                                                            (Indicate 1st lien current balance
                                                                            if loan is a 1st lien, or 2nd lien
                                                                            current balance if loan is a
                                                                            2nd lien)



152
                                                                               S&P’s Ratings File Format




                                                Table 1 (cont’d)
                                   S & P’s Ratings File Format

Field   Field name                 Length         Location         Format     Description and valid values
11      Original term                   3              47-49           999    > = 60 and < = 480
                                                                              (For balloon loans, indicate
                                                                              amortizing term of loan, not
                                                                              maturity term of balloon)
12      Current interest rate           7              50-56       99.9999    > = 1.0 and < = 25.0
13      Loan type                       2              57-58            xx    10 = Fixed rate
                                                                              11 = Buy down
                                                                              13 = GPM
                                                                              14 = GEM
                                                                              16 = ARM
                                                                              17 = 3/1 ARM
                                                                              18 = 5/1 ARM
                                                                              19 = 7/1 ARM
                                                                              20 = 10/1 ARM
                                                                              21 = 2/1 ARM
                                                                              50 = Balloon other
                                                                              51 = 5 Year balloon
                                                                              52 = 7 year balloon
                                                                              53 = 10 year balloon
                                                                              54 = 15 year balloon
                                                                              60 = 3/27 two step
                                                                              61 = 5/25 two step
                                                                              62 = 7/23 two step
                                                                              63 = 10/20 two step
14      Original loan balance          10              59-68        9(7).99   >0
                                                                              (Indicate 1st lien original
                                                                              balance if loan is a 1st lien,
                                                                              or 2nd lien original balance if
                                                                              loan is a 2nd lien)
15      SPACE                           1                  69            x    MUST BE SPACE
16      Negative amortization indicator 1                  70            x    For ARMs only: Y = YES, N = NO
                                                                              Otherwise: SPACE
17      SPACES                          2              71-72            xx    MUST BE SPACES
18      Margin                          6              73-78        99.999    For ARMs only
19      Interest rate adjustment        3              79-81           999    For ARMs only
        frequency                                                             > = 1 and < = 120 (in months)
20      Original interest rate          7              82-88       99.9999    For ARMs only
                                                                              > = 1.0 and < = 25.0
21      Annual payment cap              7              89-95       99.9999    For ARMs only
                                                                              > = 0.0 and < = 25.0
                                                                              (Indicates % of payment)




Standard & Poor’s Structured Finance        I    U.S. Residential Subprime Mortgage Criteria                    153
                                               Table 1 (cont’d)
                                      S & P’s Ratings File Format

      Field   Field name              Length     Location         Format    Description and valid values
      22      Periodic rate cap on         7        96-102        99.9999   For 2/1, 3/1, 5/1, 7/1 and
              first adjustment date                                         10/1 ARMs only
                                                                            > = 0.0 and < = 25.0
                                                                            (Also input field 25)
      23      Lifetime maximum rate        7       103-109        99.9999   For ARMs only
                                                                            > = 8.0 and < = 25.0
                                                                            (Must be absolute lifetime rate)
      24      Negative amortization        7       110-116        999.999   For ARMs only
              limit %                                                       > = 100.0 and < = 150.0
      25      Periodic rate cap            7       117-123        99.9999   For ARMs only
              subsequent to first                                           > = 0.0 and < = 25.0
              adjustment date
      26      SPACES                       3       124-126            xxx   MUST BE SPACES
      27      Mortgage insurance           7       127-133        999.999   > = 6.0 and < = 50.0
              coverage                                                      (Indicates % of loan
                                                                            balance covered)
      28      Primary mortgage             2       134-135             xx   00 or SPACES = No
              insurer                                                       mortgage insurance
                                                                            01 = Radian Guaranty, Inc.
                                                                            02 = Capital Mortgage
                                                                                 Reinsurance Co.
                                                                            04 = GE Mortgage
                                                                                 Insurance Corp.
                                                                            10 =Mortgage Guaranty
                                                                                Insurance Corp. (MGIC)
                                                                            11 = PMI Mortgage
                                                                                 Insurance Co.
                                                                            12 = Republic Mortgage
                                                                                 Insurance Co.
                                                                            15 = Verex Assurance Inc.
                                                                            16 = Wisconsin Mortgage
                                                                                 Acceptance Co.
                                                                            17 = United Guarantee
                                                                                 Residential Insurance Co.
                                                                            19 = Triad Guaranty Insurance
                                                                                 Insurance Co.
                                                                            20 = MI Provider Unknown—
                                                                                 ‘AAA’ or ‘AA’ Assumed
                                                                            21 = Lender Paid MI
                                                                            22 = Radian Guaranty, Inc.
                                                                            98 = FHA
                                                                            99 = VA




154
                                                                                  S&P’s Ratings File Format




                                                  Table 1 (cont’d)
                                     S & P’s Ratings File Format

Field   Field name                   Length         Location         Format     Description and valid values
29      Zip code                          5           136-140            x(5)   Postal zip codes
30      State code                        2           141-142             xx    Postal state abbreviation
                                                                                Must be: 50 States, or
                                                                                PR = Puerto Rico
                                                                                VI = Virgin Islands
                                                                                DC = Washington, DC
                                                                                GU = Guam
31      Borrower credit                   2           143-144             xx    Valid codes (left justified):
        quality                                                                 A or SPACES
                                                                                A-
                                                                                B
                                                                                C
                                                                                D
32      Risk grades                       4           145-148            x(4)   Valid codes:
                                                                                RG1             RG6
                                                                                RG2             RG7
                                                                                RG3             RG8
                                                                                RG4             RG9
                                                                                RG5             RG10
33      Current FICO score                3           149-151            999    Indicate applicable
                                                                                current FICO score
34      Original FICO score               3           152-154            999    Indicate applicable
        (if different from current                                              at time of origination
        FICO score)
35      Mortgage score                    4           155-158           9999    Mortgage score from
                                                                                approved automated
                                                                                underwriting system
                                                                                (if available) (also input field 37)
36      Date of mortgage score            8           159-166        Date (8)   YYYYMMDD
37      Approved automated               10           167-176           x(10)   System that determined
        underwriting system                                                     mortgage score. Codes
                                                                                for approved systems (left
                                                                                justified):
                                                                                CMAC           GE
                                                                                CMI            MGIC
                                                                                FHLMC          PMI
38      Second lien                       1                177             x    Second lien indicator:
                                                                                Y = YES,
                                                                                N or SPACE = NO (Indicates
                                                                                if loan in pool is a second
                                                                                lien loan)




Standard & Poor’s Structured Finance          I    U.S. Residential Subprime Mortgage Criteria                    155
                                             Table 1 (cont’d)
                                    S & P’s Ratings File Format

      Field   Field name            Length     Location         Format     Description and valid values
      39      Combined original          7       178-184        999.999    Combined original LTV of 1st
              LTV ratio                                                    and 2nd lien loans of mortgagor
                                                                           (only to be used if loan in pool
                                                                           is a second lien loan or if
                                                                           loan in pool has a second
                                                                           lien behind it)
      40      Combined current          10       185-194         9(7).99   Combined current balance of
              loan balance                                                 1st and 2nd lien loans of
                                                                           mortgagor (only to be used if
                                                                           loan in pool is a second lien
                                                                           loan or if loan in pool has a sec-
                                                                           ond lien behind it)
      41      Silent second              1            195             x    Silent second indicator:
                                                                           Y = YES,
                                                                           N or SPACE = NO (indicates
                                                                           if there is a second lien behind
                                                                           the loan in pool)
      42      Current delinquency        3       196-198            999    Indicate in days (ie., 30, 60, 90)
              status                                                       Input 120 if loan is more than
                                                                           90 days delinquent, in
                                                                           foreclosure or is an REO
      43      Pay history                2       199-200             99    Indicate number of
                                                                           mortgage delinquencies in
                                                                           past 12 months
      44      Sales price               10       201-210         9(7).99   For purchase only
                                                                           > 0 (Indicate sales price
                                                                           of property)
      45      Appraised value           10       211-220         9(7).99   > 0 (Indicate appraised value
                                                                           of property)
      46      Appraisal type             2       221-222             xx    First Liens
                                                                           10 = URAR Form 1004/Form
                                                                           2055(int. and ext.)
                                                                           Second Liens
                                                                           20 = Drive-By Form 704/Form
                                                                           2065
                                                                           First or Second Liens
                                                                           Insured property valuations
                                                                           31 = MGIC PVI
                                                                           32 = Other




156
                                                                                    S&P’s Ratings File Format




                                                   Table 1 (cont’d)
                                      S & P’s Ratings File Format

Field   Field name                    Length         Location         Format     Description and valid values
                                                                                 ****FOR DACSS USE ONLY****
                                                                                 01 = Tax assessment
                                                                                 02 = Broker price opinion (BPO)
                                                                                 03 = Drive-By Form 704
                                                                                 04 = URAR Form 1004
                                                                                 05 = Form 2075
                                                                                 06 = Form 2065
                                                                                 07 = Form 2055
                                                                                 08 = Approved automated
                                                                                 appraisal system (also indicate
                                                                                 system code in field 47)
                                                                                 09 = Other
47      Approved automated                2           223-224              xx    EX = Experian
47      appraisal system
        Approved automated                 2           223-224             xx    HN ==HNC
                                                                                  EX Experian
         appraisal system                                                        MR ==MRAC
                                                                                  HN HNC
48      Appraisal date                     8           225-232        Date (8)    YYYYMMDD
49      Cut-off date (“as of” date)        8           233-240        Date (8)   YYYYMMDD
50      Closing date of loan               8           241-248        Date (8)   YYYYMMDD
51      Use of cash-out                    1                249             x    H = Home improvement
        refinance proceeds                                                       D = Debt consolidation
                                                                                 U = Other/unknown
52      Refinance loans—                   8           250-257        Date (8)   For refinance loans only
        prior loan origination date                                              YYYYMMDD
53      Refinance loans—                  10           258-267         9(7).99   For refinance loans only
        prior loan purchase price                                                > 0 (Indicate purchase price
                                                                                 of property)
54      Cash reserves at closing           8           268-275            9(8)   Cash reserves of borrower
                                                                                 and co-borrower ($)
55      Number of months                   3           276-278            999    Number of months of PITI
        reserves at closing                                                      payments as cash reserves of
                                                                                 borrower and co-borrower
56      Borrower income                    6           279-284            9(6)   Indicate monthly gross income
57      Co-borrower income                 6           285-290            9(6)   Indicate monthly gross income
58      Borrower and co-                   6           291-296            9(6)   Indicate combined
        borrower disposable income                                               monthly disposable income
59      PITI payment                       6           297-302            9(6)   Indicate current monthly
        amount                                                                   payment amount for principal,
                                                                                 interest, taxes and insurance
60      Length of employment of
        borrower at present job            3           303-305            999    In months




Standard & Poor’s Structured Finance           I    U.S. Residential Subprime Mortgage Criteria                  157
      Field   Field name                 Length   Location   Format    Description and valid values
      61      Self employed                   1       306         x    Y = YES,
              borrower                                                 N or SPACE = NO
      62      Total other debt                6    307-312      9(6)   Indicate monthly payment amount
                                                                       for all other debt
                                                                       payments
      63      Originator of loan             20    313-332     x(20)   Indicate entity that
                                                                       originated this loan
      64      Primary servicer of loan       20    333-352     x(20)   Indicate entity that is
                                                                       performing the primary
                                                                       servicing on this loan
      65      Master servicer of loan        20    353-372     x(20)   Indicate entity that is
                                                                       performing the master servicing
                                                                       function on this loan (if any)
      66      Special servicer of loan       20    373-392     x(20)   Indicate entity that is
                                                                       performing the special servicing
                                                                       function on this loan (if any)
      67      Property address               30    393-422     x(30)   Indicate address and street name
                                                                       of property
      68      City/town                      20    423-442     x(20)   Indicate city of property
      69      Loan origination source         1       443         x    R = Retail
                                                                       B = Broker
                                                                       C = Correspondent
      70      Mortgage payment method         1       444         x    C = Coupon Book
                                                                       M = Monthly Statement
                                                                       A = Automatic Debit to Account




158
                                                  Table 1 (cont’d)
                                         S & P’s Ratings File Format

      Field   Field name                 Length     Location         Format    Description and valid values
      61      Self employed                   1            306            x    Y = YES,
              borrower                                                         N or SPACE = NO
      62      Total other debt                6       307-312           9(6)   Indicate monthly payment
                                                                               amount for all other debt
                                                                               payments
      63      Originator of loan             20       313-332          x(20)   Indicate entity that
                                                                               originated this loan
      64      Primary servicer of loan       20       333-352          x(20)   Indicate entity that is
                                                                               performing the primary
                                                                               servicing on this loan
      65      Master servicer of loan        20       353-372          x(20)   Indicate entity that is
                                                                               performing the master servicing
                                                                               function on this loan (if any)
      66      Special servicer of loan       20       373-392          x(20)   Indicate entity that is
                                                                               performing the special servicing
                                                                               function on this loan (if any)
      67      Property address               30       393-422          x(30)   Indicate address and street
                                                                               name of property
      68      City/town                      20       423-442          x(20)   Indicate city of property
      69      Loan origination source         1            443            x    R = Retail
                                                                               B = Broker
                                                                               C = Correspondent
      70      Mortgage payment method         1            444            x    C = Coupon Book
                                                                               M = Monthly Statement
                                                                               A = Automatic Debit to Account




159
Appendix B

Glossary for
Standard & Poor’s
Ratings File Format
Alternative “A”—A first-lien mortgage loan that generally conforms to traditional
prime credit guidelines, although the LTV, loan documentation, occupancy status
or property type, or other factors may cause the loan not to qualify under standard
underwriting programs.
Annual Payment Cap—Maximum percentage per year by which an adjustable rate
mortgage borrower’s monthly principal and interest payment can increase.
Appraisal Types:
I Drive-by Form 704— More commonly known as the “drive-by” report. This

  “Second Mortgage Appraisal Report” is used to derive a value from an exterior-only
  inspection and may or may not include photos. There is no neighborhood or
  interior analysis.
I Form 2055—This form is a property inspection report where an interior and exterior

  inspection is performed. It requires a quantitative sales comparison analysis in
  which the appraiser assigns a dollar value to reflect the market’s reaction to any
  features of the comparable sales that differ from those of the subject property.
I Form 2065—This form offers an exterior-only property inspection option and

  the use of a qualitative sales comparison analysis (instead of the traditional dollar
  adjusted quantitative analysis). The qualitative sales comparison analysis looks
  at market data in terms of value relationships between the comparable properties
  and the subject property, without assigning an estimated dollar value to those
  relationships.
I Form 2075—This form is a property inspection report that requires an exterior-only

  inspection of the subject from the street by a state licensed or certified appraiser.
  Note: Form 2075 is not an appraisal, Uniform Standards of Professional Appraisal
  Practice (USPAP) does not apply.



  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   160
      I   URAR Form 1004—More commonly known as the “full appraisal”. The actual
          name of the report is the Uniform Residential Appraisal Report (URAR). This report
          encompasses a detailed interior and exterior inspection (including neighborhood
          analysis) and has several addendum’s including plot graphs, photos, appraiser
          reps and warranties and environmental information. The Uniform Residential
          Appraisal Report (1004) is a unique blend of quantitative and qualitative
          information about a subject property.
      Appraised Value—An opinion of the value from a certified appraiser of a property
      at a given time, based on facts regarding the location, improvements, etc., of the
      property and surroundings.
      Automated Appraisal System—Automated system that is used to derive a property
      value without the opinion of an appraiser. These systems are typically hedonic
      models or repeat sales indices.
      Approved Automated Appraisal System—A Standard & Poor’s-accepted automated
      system used to derive a property value. The process for validating such systems includes:
      I Reviewing the system’s quality controls;

      I Reviewing the system’s data sources;

      I Analyzing the results of a test portfolio for such variables as variance, geographic

        coverage, and hit rate; and
      I Reviewing user aspects of the system such as comparable sales and

        timeframe averaging.
      Approved Automated Underwriting System—A system that evaluates borrower and
      loan characteristics for loan default risk. State the code of the system which has
      been approved by Standard & Poor’s. The process for validating such automated
      underwriting system includes:
      I Review of the system development process;

      I Analysis of systems test and results including a review of comparative statistical

        measures;
      I Review of the documentation requirement, including collateral assessment guidelines;

      I Audit of the quality control and fraud checks incorporated into the system;

      I Empirical analysis of the predictive power of the system through studies of the

        results of scoring current production; and
      I Validation of the predictive power of the system with Standard & Poor’s internal

        risk model.
      ARM—A mortgage loan whose interest rate adjusts at a specified interval based on
      a specific index. A form of ARM loan is a hybrid ARM loan whose interest rate is
      fixed for a specified period, and then adjusts at specified intervals (usually every 6
      or 12 months) for the remainder of the loan’s life. The most common types are:




161
                                               Glossary for Standard & Poor’s Ratings File Format




I   2/1 ARM: adjustable rate mortgage with an initial fixed rate period of 24 months;
I   3/1 ARM: adjustable rate mortgage with an initial fixed rate period of 36 months;
I   5/1 ARM: adjustable rate mortgage with an initial fixed rate period of 60 months;
I   7/1 ARM: adjustable rate mortgage with an initial fixed rate period of 84 months;
    and
I   10/1 ARM: adjustable rate mortgage with an initial fixed rate period of 120 months.
Balloon Loan—A loan which amortizes according to a specified term but whose
total unpaid principal balance is due at a point prior to when the loan fully amortizes,
usually as follows:
I 5-year balloon: the final payment of the loan is due on the fifth anniversary

  after origination;
I 7-year balloon: the final payment of the loan is due on the seventh anniversary

  after origination;
I 10-year balloon: the final payment of the loan is due on the tenth anniversary

  after origination; and
I 15-year balloon: the final payment of the loan is due on the fifteenth anniversary

  after origination;
Borrower and Co-Borrower Disposable Income—The total amount of gross household
income minus gross household expenses (reported as a monthly dollar amount, i.e.
divide outcome by 12).
Borrower Credit Quality—The credit quality of the borrower, as defined by the
rules-based underwriting matrix of the originator or conduit. Analysts will adjust
credit quality codes according to Standard & Poor’s credit matrix.
Borrower Income—Annual income (expressed as a monthly number) derived from
base salary, commission, tips & gratuities, overtime & bonus, part time or second
job earnings, alimony, child support, interest and dividend income, notes receivables,
trust income, rental income, retirement income, social security, veterans income,
military income, foster care income and self-employed income. (For details on the
calculation of income, see appendix D).
Broker Price Opinion (BPO)—An opinion of the value of a property from a local
real estate broker based on comparable properties for sale (or sold) in the subject
property’s location.
Buy-Down Mortgage Loan—A cash payment from a borrower to a lender at
origination which reduces the interest rate of the mortgage loan.
Cash-Out Refinance Mortgage Loan—A refinance transaction in which the amount
of money received from the new mortgage loan exceeds the total amount for: repayment
of the existing first mortgage loan, closing costs, points, and to satisfy any outstanding
subordinate mortgage liens, by more than 1%. The mortgage loan allows the borrower
to receive additional cash that can be used for any purpose.


    Standard & Poor’s Structured Finance   I    U.S. Residential Subprime Mortgage Criteria   162
      Cash Reserves at Closing—The amount of funds that a borrower has available after
      making a down payment and paying all closing costs for the purchase of a home
      (reported as a dollar amount).
      Co-Borrower Income—See Borrower Income; calculated similarly.
      Combined Current Loan Balance—The sum total of the senior- and junior-lien
      mortgage loan balances (used also for silent-second lien loans).
      Combined Original LTV Ratio—The total amount of all of the outstanding mortgage
      liens on a property at origination divided by the lesser of the appraised value or the
      sales price.
      Construction to Permanent Mortgage Loan—A mortgage loan on completed con-
      struction under one mortgage or trust deed where the completion certificate and the
      certificate of occupancy have been obtained.
      Cooperative—Also called a stock cooperative or a co-op. A structure of two or
      more units in which the right to occupy a unit is obtained by the purchase of stock
      in the corporation which owns the building.
      Current Delinquency Status—Indicates the number of days (i.e. 30,60,90) the borrower
      is contractually past due as of the cut-off date. Standard & Poor’s accepts the Office
      of Thrift Supervision (OTS) calculation method for home-equity products and
      the Mortgage Banker Association’s (MBA) calculation method for traditional
      prime products.
      Current FICO Score—A FICO score obtained within 180 days of submission of the
      mortgage loan to Standard & Poor’s (see appendix F).
      Cut-Off Date—The date as of the end of the applicable reporting period.
      Debt Consolidation Loan—A cash-out loan from which the proceeds are used
      to satisfy outstanding debt.
      Deminimus (Detached) PUD—A planned unit development containing
      detached units.
      Documentation Types:
      I   No Employment/Income Verification;
      I   No Asset Verification and No Employment/Income Verification
          (for purchase loans only);
      I   Verbal Verification of Employment (VVOE-encompassing currently employed,
          start date, position, and probability of continued employment);
      I   One Paystub Obtained (computer generated showing year to date income and any
          union dues owed and employee loans outstanding);
      I   One Paystub Obtained and VVOE;




163
                                               Glossary for Standard & Poor’s Ratings File Format




I   One Paystub and One W-2 and VVOE for salaried borrowers or One Year Federal
    Tax Form 1040 for self-employed borrowers;
I   Streamline (A refinance program designed for portfolio retention whereby the
    current servicer may refinance an existing borrower. This field is only to be used
    for an Standard & Poor’s approved streamlined refinance program); and
I   Full Documentation (Two years Employment Verification: 2 years W-2’s and
    current pay stub or 2 years 1040’s for self-employed borrowers).
Duplex—An apartment containing two floors or levels.
FHA Mortgage Loan—A mortgage loan insured under the Federal Housing
Administration (FHA) mortgage loan program.
FICO Score—A consumer credit score developed by Fair, Isaac and Co. which is a
numerical summary of the relative likelihood that an individual will pay back a
loan. The FICO score is derived using a statistical method of assessing repayment
risk based on the borrower’s credit history as reported to the three major credit
repositories: Experian, Trans Union and Equifax (see appendix F).
Fixed Rate Mortgage Loan (loan type code “10”)—Fixed rate, level payment, fully
amortizing mortgage loan that repays the debt in constant monthly installments.
GPM Loan—Graduated Payment Mortgage loan which has a fixed rate of interest
but where the monthly payments start at an amount lower than the monthly interest
due, and increase over time. The unpaid interest amount is added to the loan’s principal
balance causing negative amortization to occur.
GEM Loan—Growing Equity Mortgage loan which has a fixed rate of interest but
where the monthly payments increase over time, with the additional funds applied
towards the principal balance of the loan, allowing the loan to repay faster.
High CLTV Mortgage Loan—Usually a junior-lien mortgage loan, that when combined
with any additional mortgage liens, allows for a loan to value ratio that exceeds
the value of the home by up to 125%. The mortgage loan is usually used for debt
consolidation or home improvement but may allow for the ability of the borrower
to cash-out a limited portion of the proceeds.
High-rise Condominium—A system of ownership of individual units in a multi-unit
structure, combined with joint ownership of commonly used property (sidewalks,
hallways, stairs, etc.). Standard & Poor’s considers a high-rise condominium to
contain more than 4 stories.
Home Equity Line of Credit (HELOC) Mortgage Loan—Usually a junior-lien mortgage
loan, that makes available to the borrower a revolving line of credit, allowing for
periodic borrowings and subsequent repayments.




    Standard & Poor’s Structured Finance   I    U.S. Residential Subprime Mortgage Criteria   164
      Home Improvement Mortgage Loan—Usually a junior lien mortgage loan that
      enables eligible borrowers to obtain financing to remodel, repair, and/or upgrade
      their existing home or home that they are purchasing.
      Interest Rate Adjustment Frequency—Time between coupon adjustments of a floating
      rate mortgage loan.
      Investor Owned Property—Generally, any non-owner occupied property purchased
      for the primary purpose of profit. The profit may come from rental income or
      from re-sale.
      Length of Employment of the Borrower at Their Present Job—The number of
      months the borrower has been employed with their current employer.
      Lifetime Maximum Rate—Maximum rate of interest which can be applied to an
      adjustable rate loan over the course of the loan’s life.
      Loan Origination Sources:
      I Broker—A person who, for a commission or a fee, brings the originator and

        the borrower together for the purpose of obtaining a mortgage loan.
      I Correspondent—An entity who originates a mortgage loan for the purpose of

        delivering and/or selling the mortgage loan to a third party.
      I Retail—A loan originated at a branch office of the originator whereby direct

        contact is made between the lender an the borrower.
      Low-rise condominium—A system of ownership of individual units in a multi-unit
      structure, combined with joint ownership of commonly used property (sidewalks,
      hallways, stairs, etc.). Standard & Poor’s considers a low-rise condominium to
      contain 4 stories or less.
      Margin—The amount expressed as a percentage, which when added to an index
      results in the coupon of a floating rate mortgage loan.
      Master Servicer—The entity who oversees the activities of the primary servicer(s).
      These oversight functions typically include: (1) tracking the movement of funds
      between the primary and master servicer accounts; (2) ensuring orderly receipt of
      the servicer’s monthly remittance and servicing reports; (3) monitoring the collection
      comments, foreclosure actions and REO activities; (4) aggregate reporting and distri-
      bution of funds to trustees/investors; and (5) having the authority, if necessary to
      remove and replace a servicer. Additional requirements may be added on a case by
      case basis.
      Mortgage Banker Association (MBA) Delinquency Calculation Method—Under
      the MBA method, a loan would be considered delinquent if the payment had not
      been received by the end of the day immediately preceding the loan’s next due
      date (generally the last day of the month which the payment was due). Using the
      example above, a loan with a due date of Aug. 1, 1998 would have been reported



165
                                            Glossary for Standard & Poor’s Ratings File Format




as delinquent on the September statement to certificateholders. Foreclosure and
REOs are treated identically under both methods.
Mortgage Insurance Coverage—The percentage of the mortgage loan’s principal
balance covered by primary mortgage insurance.
Mortgage Payment Method—The method a mortgagor uses to make a mortgage
payment each month.
Mortgage Score—The score produced by an automated underwriting system that
has been validated by Standard & Poor’s. It is a statistical representation of the fore-
closure or loss risk, on either a relative or an absolute basis, correlating the key
attributes of the borrower’s credit history, the property characteristics, and the terms
of the mortgage note.
Negative Amortization Limit—Maximum LTV that a negative amortization loan can
increase to, due to unpaid interest being added to the principal balance of the loan.
Negative Amortization Loan—A loan whose principal balance will increase over
time due to the addition of unpaid interest amounts to the outstanding mortgage
loan principal balance. The unpaid interest amount results from the borrower’s
monthly payment being insufficient to cover accrued interest due.
Non-, Re- and Sub-Performing Loans:
I A non-performing mortgage loan is at least three payments in arrears.

I A re-performing mortgage loan is no longer in arrears and has made three

  consecutive contractual payments.
I A sub-performing mortgage loan is in arrears but has made three payments

  according to a forbearance plan.
Number of Months of Reserves at Closing—The amount of funds remaining that a
borrower has available after making a down payment and paying all closing costs
for the purchase of a home; reported as a dollar amount divided by the principal,
interest, taxes, and insurance (PITI) amount.
Office of Thrift Supervision (OTS) Delinquency Calculation Method—Under the
OTS method, a loan is considered delinquent if a monthly payment has not been
received by the close of business on the loan’s due date in the following month. The
cut-off date for information under both methods is as of the end of the calendar
month. Therefore a loan with a due date of Aug. 1, 1998, with no payment received
by the close of business on Aug. 1, 1998, would be reported as current on the
September statement to certificates. Assuming no payments are made during
September, the loan would be reflected as delinquent on the October statement.




 Standard & Poor’s Structured Finance   I    U.S. Residential Subprime Mortgage Criteria   166
      Original FICO Score (if different from Current FICO score)—On a seasoned loan,
      the borrower’s FICO score at the time of the mortgage loan’s origination. Standard
      & Poor’s criteria mandates the use of a FICO score that is no more than 180 days
      old (see appendix F).
      Original Interest Rate—The annual percentage rate as specified on the mortgage
      note at the time of the loan’s origination.
      Original Loan Balance—The dollar amount of the mortgage loan at the time of the
      loan’s origination as specified on the mortgage note.
      Original Loan-to-Value Ratio—The ratio of the mortgage loan amount to the
      lesser of the property’s appraised value or selling price at the time of the mortgage
      loan’s origination.
      Original Term—The number of months between loan origination and the loan
      maturity date as specified on the mortgage note.
      Originator of the Loan—The entity lending funds to a borrower who in return
      places a lien on the mortgage property as collateral.
      Owner Occupied Property—A property which is physically occupied by the owner.
      Pay History—The number of months the mortgage loan has been delinquent
      (see definition) over the immediately preceding 12 months.
      Periodic Rate Cap on First Adjustment Date—For an adjustable rate mortgage loan
      on its first adjustment date, the maximum amount the interest rate can change.
      Periodic Rate Cap Subsequent to First Adjustment Date—For an adjustable rate
      mortgage loan, the maximum amount the interest rate can change on any subsequent
      adjustment date.
      Planned Unit Development (PUD)—A planned unit development containing attached
      units. The zoning classification allows for the flexibility in the design of a subdivision.
      Characteristics generally include an overall density limit for the entire subdivision,
      and clustered dwelling units which provide common open space.
      Primary Mortgage Insurer—The entity who provides a specified amount of insurance
      to cover losses on the mortgage loan.
      Primary Residence—The residential property physically occupied by the owner for
      the majority of the year. It is the address of record for the borrower for such activities
      as federal income tax reporting, voter registration, and occupational licensing.
      Primary Servicer—The entity typically responsible for: collection of monthly payments,
      remitting of funds to the trust account or master servicer, ongoing maintenance of
      escrow accounts, following up on all delinquent borrowers including loss mitigation
      efforts, initiating foreclosure proceedings when necessary, disposing of the real estate
      owned (REO) property and delivering investor reports and default management activity.



167
                                            Glossary for Standard & Poor’s Ratings File Format




Prime/Jumbo Mortgage Loan—A first-lien mortgage loan that generally conforms to
traditional ‘A’ credit guidelines with a loan balance that exceeds the Government
Sponsored Entity’s (GSE’s) requirement. Standard & Poor’s considers prime borrowers
to have a FICO credit score of 660 or above.
Principal, Interest, Taxes and Insurance (PITI) Payment—The four components of a
monthly mortgage payment. Principal refers to the part of the monthly payment that
reduces the remaining balance of the mortgage; interest is the amount charged for
borrowing money; and taxes and insurance refer to the amounts that are paid each
month into an escrow account for property taxes, primary mortgage and hazard
insurance and any association dues.
Purchase Money Mortgage Loan—A mortgage loan used to finance the purchase of
real property.
Rate/Term Refinance Mortgage Loan—A refinance transaction in which the new
mortgage loan amount is limited to no more than 1% greater than the sum of the
remaining balance of the previous first mortgage, closing costs (including prepaid
items), points, the amount required to satisfy any mortgage liens that are more
than one year old (if the borrower chooses to satisfy them).
Refinance Loan’s Prior-Loan Origination Date—The origination date of the mortgage
loan being refinanced.
Refinance Loan’s Prior-Loan Purchase Price—The purchase price of the property
which is collateralizing the mortgage loan being refinanced.
Reverse Mortgage Loan—A non-recourse mortgage loan generally made to a home-
owner that is 62 years old or older that requires no repayment for as long as one
lives in such home.
Risk Grades—Standard & Poor’s risk grades stratify the relative foreclosure risk
encompassing mortgage, property and borrower characteristics. Risk grades segregate
the mortgage loan into a number of defined categories; RG1 loans have the lowest
degree of default risk.
Sales Price—The negotiated price of a given property between the buyer and seller.
Second Home—A borrower’s property that is not their primary residence.
Second Lien Mortgage Loan—A loan secured by a mortgage or trust deed, which
lien is junior to another mortgage or trust deed. This is the mortgage loan which is
being analyzed.
Self-Employed Borrower—A borrower who owns at least 25% in a partnership or a
corporation, is a sole proprietor, or obtains at least 25% of their annual income
from commissions or bonus.




 Standard & Poor’s Structured Finance   I    U.S. Residential Subprime Mortgage Criteria   168
      Silent Second Mortgage Loan—A second lien mortgage loan on a property whose
      first lien mortgage loan is being submitted for analysis. The originator of the second
      mortgage loan may differ from the originator of the first lien mortgage loan.
      Single Family Attached—A single family dwelling unit which has one or more
      attached units. Adjacent units may share walls and other structural components but
      generally have separate access to the outside.
      Single Family Detached—A type of residential structure containing one dwelling unit.
      Special Servicer—A servicer who is responsible for managing all delinquent loans
      upon a specified stage of delinquency as well as directly performing loss mitigation
      functions, and real estate owned management.
      Subprime/Home Equity Mortgage Loan—A first or junior-lien mortgage loan made
      to a borrower who has a history of delinquency or other credit problems. Standard
      & Poor’s considers subprime borrowers to have a FICO credit score of 659 or below.
      Tax Assessment—The valuation for purpose of taxation on a property by a public
      tax assessor.
      Tax Lien—A tax lien is placed upon a residential property by a municipality for
      failure to pay property taxes and other municipal assessments.
      Three/Four Family Property—A residential structure that provides living space
      (dwelling units) for three to four families, although ownership typically is enhanced
      by a single deed.
      Title I Mortgage Loan—A junior lien-mortgage loan insured under the Housing and
      Urban Development’s (HUD’s) Title I home improvement loan program.
      Total Other Debt—The liabilities of the borrower excluding the debt on the subject
      property. These liabilities include: all installment loans, revolving charge accounts,
      other real estate loans, alimony, child support and other debts of a continuing
      nature (see appendix E).
      Town House—A dwelling unit generally having 2 or more floors and attached to
      other similar units via common walls. Town houses are often used in condominium
      and planned unit developments.
      Two Family Property—A structure that provides living space (dwelling units) for
      two families, although ownership of the structure is enhanced by a single deed.




169
                                            Glossary for Standard & Poor’s Ratings File Format




Two Step Mortgage Loan—A fixed rate mortgage loan whose coupon resets once
at a specified date and is fully amortizing over thirty years, usually in one of the
following methods:
I 3/27 two step: the interest rate reset occurs 36 months after origination;

I 5/25 two step: the interest rate reset occurs 60 months after origination;

I 7/23 two step: the interest rate reset occurs 84 months after origination; or

I 10/20 two step: the interest rate reset occurs 120 months.


VA Mortgage Loan—A mortgage loan insured under the Veteran Administration’s
(VA) mortgage loan program.




 Standard & Poor’s Structured Finance   I    U.S. Residential Subprime Mortgage Criteria   170
Appendix C

Information Required for
On-Site Review of Company
Company Name:
Contact Person for follow up questions:
Phone number of contact person:
On-site servicing review scheduled for:
Products to be reviewed for securitization:
(NOTE: Please provide information for total portfolio and for product (i.e., Reverse) being reviewed. Questions can be
answered on a form provided by Standard & Poor’s (please print) OR typed up separately).




                                                                     Table 1
                                             Key Portfolio/Product Statistics†

 Loan production                                             20__*             20___**            19__*            19__**            19___**
 Total loan count
 Volume ($MM)
 Average cost to originate
 Weighted average LTV
 Weighted average age of borrowers
 Loan administration
 Total loan count
 Volume ($MM)
 Average cost to service
 Number of loans serviced per employee
 Weighted average LTV
 Weighted average age of borrowers
 Foreclosure (%)
 Losses as a percentage of UPB
 †
  Please provide statistical information in the following format: Portfolio statistic/Product statistic (ie: Total Loan Count:1,234/565—
  total loan count for the portfolio is 1,234 and the total loan count for the product is 565.)
 *YTD 20 **Ending December




     Standard & Poor’s Structured Finance                     I   U.S. Residential Subprime Mortgage Criteria                              172
      Standard & Poor’s On-Site Review

      Management & Organization
      How long has the company been in operation?

      How long has the company been originating/servicing the product being securitized?



      Management’s tenure with company:

      Management’s industry experience:

      Management turnover rate:

      Total number of employees:

      Does the company have a formal training function?

      Are procedure manuals present for all operational areas? If no, explain.


      Are all licenses and insurance coverages in place and conform to FNMA/HUD
      standards? If no, explain.


      List all material lawsuits outstanding against the company and circumstances:


      Is there a written strategic plan for the achievement of short and long-term goals?


      Who is servicing this product?


      Who is the master servicer (if applicable)?




                                                                     Table 2
                                              Financial Position (Consolidated)†

                                           1999*                1998**                1997**              1996**   1995**
       Revenue ($ mil.)
       Net income ($ mil.)
       Net worth ($ mil.)
       *YTD 20__. **Ending December. †Specify organization for which financial information is reported.




173
                                         Information Required for On-Site Review of Company




Loan Production
List production channels and corresponding % of volume received through each:


Front end system(s) utilized:

List the top 5 states and their corresponding percentages of volume:


Number of Branches:                              Number of Acct Reps:

Number of Approved Brokers:                      No. of Approved Correspondents:

Does any one seller provide over 10% of total volume to the company?

If yes, explain situation:


Do you have a formal broker/correspondent approval process?

Are brokers/correspondents monitored for delinquency performance, annual licensing
renewals, and documentation exceptions through QC audits? If no, explain.




Is processing centralized? If no, explain the process.


Is funding centralized? If no, explain the process.


Are closing/escrow agents monitored?

Are state-specific documents generated through the system?

Are FNMA/HUD forms utilized? If not, explain:


Who can clear u/w conditions and what types?


How are branch managers compensated?


Do you conduct a pre- or post-closing audit? If yes, explain.




  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   174
      Underwriting
      Average experience for u/w’s:                  U/w’s tenure with company:

      Do the u/w’s have experience with the specific product type being reviewed?

      If yes, number of years:


      Is u/w centralized? If no, explain:



      Average pre-approval turnaround time:

      % Approved:                     % Suspended:                 % Denied:

      Average final turnaround time:

      % Approved:                     % Suspended:                 % Denied:

      Is there a second look decline process in place?

      Percentage of loans approved on an exception basis:

      Most common exception type:

      Is there an exception approval process in place? If no, explain.


      Are lending authority limits in place:

      How are u/w guidelines documented (what format; manual, on-line)?


      How are u/w’s compensated?

      Is there an appraiser approval process:

      Is an approved appraiser list maintained:

      Are appraisals performed by in-house and/or independent appraisers?

      No. of in-house appraisers:

      Average experience of in-house appraisers:

      Are in-house appraisers monitored for the quality of their work? If yes, explain:



      Are appraisers monitored at least annually for licensing?




175
                                         Information Required for On-Site Review of Company




What types of appraisals or collateral assessment types are utilized:


Are forms FNMA?

Are all active appraisers monitored by QC at least annually?


Complete the following, if an automated collateral system(s) are utilized:
Name of automated collateral system:

How long has this system been used?

For what product(s) is the automated collateral system used?



Quality Control
Percent of sample having minor exceptions requiring no corrections:

Percent of sample having minor exceptions where corrections were required:

Percent of sample having serious exceptions:

Percent of exceptions by severity in most recent audit:

Are responses required to exceptions and followed up on by QC?



Number of repurchases made in the past 12 months for which the company
did not have recourse to a third party:
Number of field appraisals obtained on sample size:


Variance tolerance allowed between original appraised value and QC field review:




Are all sellers included in the QC sample at least annually?


Secondary Marketing
Who sets prices?                                How often are they set?

How are they disseminated to the branches and third party originators?




  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   176
      Describe the process for tracking rate-lock commitments outstanding:


      Describe the process for tracking loans in the pipeline:


      What is the average monthly closure rate?

      Who has the authority to execute trades?

      Are trading authority limits in place?

      How is trading activity monitored?

      Does the company hedge its pipeline?

      Its servicing portfolio?

      What types of hedging vehicles are utilized?

      Percentage of hedge position:

      How often are securitizations issued?

      How long has the company been issuing securitizations?

      Who funds the related warehouse and for what amounts?


      How are loans pooled or designated to a securitization?

      What investor commitments are typically used (forward sales contract,
      options delivery)?


      Are mark-to-market forward valuations performed?

      How frequently are mark-to-market valuations performed?

      Who prepares mark-to-market valuations?

      Does the company outsource its hedging function? If so, to whom?


      What source of funds are utilized to fund the reverse mortgages?


      Are warehouse lines utilized? If yes, what percentage of your funding needs
      are covered by warehouse lines?
      How many warehouse lines do you have?



177
                                         Information Required for On-Site Review of Company




What are the terms of the warehouse lines?

What is the typical advance rate on the warehouse lines?

Do all of the reverse mortgages have a take out commitment?

If yes, with whom are the take out commitments with?


What are the terms of the take out commitments?



What is the typical price of a take out commitment?


Management Information Systems (MIS)
Describe the disaster recovery plan in place:


Does it encompass systems and sites?

Is the system “back up” nightly?

Are back-up tapes stored off-site?

Is their a hot-site?

Are there any system capacity issues?

Are there system security features?


Loan Administration
Management’s average industry experience:                      Average tenure:

Top five states and correspondence % of portfolio:


Weighted Average LTV:                            Weighted Average Maturity:

Servicing System(s) utilized:

Linked to front-end systems:

Is there a servicing QC program? If yes, describe:


Are any loans serviced off the system?




  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   178
      Loan Set-Up
      Are loans boarded manually, via tape, modem, etc. and corresponding %:



      What type of data integrity check is performed?


      Payment Disbursement
      Are all disbursements made to borrowers only?

      Is there a segregation between personnel disbursing funds and those who
      reconcile the accounts?

      Customer Service
      Average experience of customer service reps in industry:

      Average experience of customer service reps with company:

      Average hold time:

      Is abandon rate and nature of the inquiry tracked?

      Is the system backed up nightly?

      Are inquiries handled by customer service or are they forwarded to the various
      departments for resolution?
      Are customer service reps required to answer a certain number of calls per day?

      If yes, how many?

      Percentage of calls answered through VRU:

      Does the customer service dept have shifts to cover the geographic areas of the portfolio?



      How are written inquiries handled?

      Average response time:

      How are customer service reps monitored?


      Taxes and Insurance
      Tax service utilized:

      Insurance carrier




179
                                         Information Required for On-Site Review of Company




Forceplaced carrier

What amount of coverage are loans forceplaced?

Are any taxes or insurance paid in house? If yes, explain.


Have any tax penalties been assessed in the past 12 months? If yes, for what?



Have any insurance coverages lapsed in the past 12 months due to non-payment?


Are tax payments advanced if a loan is delinquent? If no, explain




ARMs
Describe the loan set up controls and QC checks that are in place:



Is the ARM information compared to the loan file?

Has an ARM portfolio audit been performed?

Are controls in place for index input? If none, explain:


Describe the frequency of ARM audits:

Release of Liens
Are state requirements (time frames) on the system for release?
If no, how are they prioritized?


Have all loans been released within the required time frames for the past 12 months?

If no, explain:


Have any penalties been incurred due to late releases for the past 12 months?

Are state specific release forms on the system?

How are documents retrieved from custodians, trustees?




  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   180
      Investor Reporting/Accounting
      Average experience of staff?                   Tenure with company

      Type of reports prepared?

      Number of reports prepared monthly:



      Have any penalties been incurred in the past 12 months due to late or incurred
      reporting or remitting? If yes, explain.


      Who has the authority to release funds?

      Are system controls in place for fund transfers (destinations)?

      Is there a separation between inventory reporters and the people preparing
      reconciliations? If no, explain:


      Are all reconciliations required to be completed within 30 days? If no, explain:




      Are all reconciliations completed within 30 days? If no, explain:


      How are reconciling items aged and tracked?

      What is the oldest reconciling item?

      Who monitors the titling and eligibility of custodial accounts and how often?



      Foreclosure
      Are foreclosures handled by in-house or an attorney network?

      Is there a foreclosure committee?

      Average number of days delinquent at foreclosure initiation:

      How is attorney performance monitored?


      Are state specific procedures and timeframe on the system?

      Who has the authority to change the timeframes?



181
                                        Information Required for On-Site Review of Company




What are the average foreclosure times for the top five states?

Average experience of foreclosure staff:

Are property inspections ordered monthly? If no, explain:



Real Estate Owned
Average experience of the REO staff?                  Tenure with the company:

Are REO’s marketed in house? If no, explain:


What percentage of property’s acquired are occupied?

What is the average eviction time?

What type of property valuations are performed and timeframes?


Who has the authority to enter into listing agreements?

How is the listing price derived?

Who has the authority to sign a contract?

What is the company’s policy toward repairs?


What is the average sales price to appraised value?

What is the average marketing time (not including eviction)?

How often is a marketing strategy reviewed?

Master Servicing
How long has the company been performing this function?

List the top five states and corresponding percentage of portfolio:


Management’s average experience:                      With company:

Number of investors:

System(s) utilized:

Is information maintained at the loan level?




 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   182
      Are servicer’s financial officer’s certs, insurance coverages monitored? at least annually?



      Are delinquent loan actions monitored at least annually?

      Are fcl/REO comments maintained in the data base?


      Has the company received any penalties due to late or incorrect reporting or
      remitting the past 12 months?

      Is there a formal servicer monitoring area which performs on-site
      operational reviews?

      Are all custodial accounts reconciled monthly and within 30 days?

      Are all clearing accounts reconciled daily?

      Must all reconciling items be identified and cleared within 30 days?

      How many investor reports are prepared manually?

      Is management signoff required on reconciliations?

      Are any loans maintained off of the system?



      Document Requirements
      Please forward to Standard & Poor’s the following
      items as early as possible preferably prior to the on-site visit:
      I   Copies of your underwriting guidelines, procedures, and product matrix.
      I   Company background and organization chart.
      I   Management profile (senior management and department heads).
      I   Copies of your audited financial statements for the past five years.
      I   Copies of your two most recent quality control reports.
      I   Copies of articles of incorporation (if applicable).
      I   Lost information reported on a static pool basis for the past ten years.
      I   Copies of the most recent audits including FNMA, HUD,
          and Uniform Single Audit Program (USAP).
      I   Copies of restrictive covenants within existing debt agreement
          and most recent compliance certification.




183
Appendix D

Income Calculations
Borrowers receive income, of course, from many different sources. Following is a list
of the general forms of remuneration.
Weekly—If the borrower is paid on a weekly basis, multiply the weekly income by
52 and divide by 12 to arrive at the gross monthly income.
Bi-Weekly—If the borrower is paid bi-weekly, multiply the bi-weekly income by 26
and divide by 12 to arrive at the gross monthly income.
Bi-Monthly—If the borrower is paid bi-monthly, multiply the bi-monthly income by
24 and divide by 12 to arrive at the gross monthly income.
Monthly—If a borrower is paid on a monthly basis, verify that the salary is consistent
with the reported annual income.
Commission—This type of income must be substantiated by two years of federal tax
returns and W-2’s in conjunction with Verification of Employment (VOE) and current
pay stubs.
Commission income may be subject to fluctuation from year to year, therefore, an
average of the previous two years income is used in evaluating the borrower’s quali-
fications. If the borrower receives 25% or more of his/her income from commission,
the income on the tax returns and VOE with year to date earnings is averaged over
the most recent 24 to 36 months, less any applicable business expense.
An earning trend must be established for commission income. Annual earnings that
are level or increasing from year to year are acceptable. However, if the earnings
show a decline towards the current year, there must be strong offsetting factors for
the commission to be acceptable.
Tips and Gratuities—Borrowers may receive tips and gratuities as a portion of their
income. Borrowers must provide 2 years of tax returns or W-2’s and year to date
earnings. Average the income over a two year period.
Union Members Employee—If a borrower is a member of a trade union, income is
averaged over a two year period. Income may be verified by the following:
I   Two years’ tax returns,




    Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   184
      I   Two years’ W-2’s, or
      I   VOE from union showing year to date earnings and previous two years earnings.
      Contract Employees—Borrowers are sometimes paid on a contractual basis. If this is
      so, consider the borrower as self employed, therefore, two years’ tax returns and/or
      W-2’s are averaged over a two year period. The borrower should also submit a copy
      of the contract to show the length of time the contract is valid.
      Overtime and Bonus—If a borrower receives overtime or bonus pay, it must be
      evidenced that it has been received for the last two years and that the pay will
      probably continue. This can be verified from the W-2’s, tax returns or VOE.
      An earning trend should be established to show if the overtime and bonus are level
      or increasing from year to year. If there is a decline towards the current year, there
      must be strong offsetting factors for the overtime and bonus to be acceptable.
      Part Time or Second Job—Part time or second job income may be used to qualify a
      borrower as long as the income can be verified as having been uninterrupted for the
      previous two years and is likely to continue. A VOE or W-2 should be provided to
      verify the income.
      Some borrowers work part time on a seasonal basis (i.e., summer) and can be
      considered as uninterrupted if the borrower has worked in the same job “in season”
      for the past two years and expects to be rehired next season.
      Alimony or Child Support—If a borrower indicates receipt of alimony or child support,
      verification as follows must be obtained:
      I Photocopy of divorce decree, and

      I Photocopy of separation agreement.


      These documents must indicate the amount of the award and the time period over
      which it will be received. In order for this to be considered as income, the time period
      for receipt must continue for three years after the date of mortgage application.
      Evidence that the funds have been received for the last 12 months must be provided.
      Acceptable documents are:
      I Deposit slips,

      I Court records,

      I Tax returns, and

      I Copies of borrowers bank statements.


      Interest and Divided Income—Interest and dividend income may be used as long as
      it is properly documented and has been received for the pasted two years. Photocopies
      of tax returns or account statements are used to verify this income. Income from
      investments that will be liquidated towards the down payment and/or settlement
      costs are not included as income.




185
                                                                         Income Calculations




Notes Receivable—If a borrower receives income generated from a note, a copy of
the note is required to establish the amount and length of payment. Payments must
continue for at least three years from the date of the mortgage application. Evidence
must be provided by the borrower that they have received funds for the last 12 months.
Acceptable proof includes:
I Deposit slips,

I Tax returns, and

I Copies of borrowers bank statement.


Trust Income—Borrowers may use trust income as long as the borrower submits a
photocopy of the Trust Agreement or the trustee’s statement confirming the amount,
frequency and duration of the payments. Payments must continue for a least 3 years
from the date of the mortgage application. Lump sum distribution made before the
loan closing may be used for a down payment and/or settlement costs as long as it is
verified by a copy of the check or the trustee’s letter that shows the distributed amount.
Rental Income—Income on rental properties may be included in qualifying income,
depending on the type of property generating the rental income. Rental income
received from a non-owner occupied property will be evaluated according to the
following considerations:
I Leases are acceptable. Seventy-five percent of rental income can be considered.

I Tax returns are required. Lease agreements cannot be used in lieu of tax returns

  and are not required to be submitted.
I For rental income to be included in qualifying ratios, take an average of two year’s

  net rental income (or loss), with depreciation added back; 100% of this calculated
  rental income can be used.
I Payments on the underlying mortgage should not be included in the debt ratios,

  since mortgage payments have already been deducted from the rental income on
  Schedule E of the U.S. federal income tax return.
For rental income received from 2-4 family owner-occupied property,
the following apply:
I Lease agreements or tax returns must be provided to verify income.

I For rental income to be included in qualifying ratios, use 75% of the gross monthly

  rent figure on a lease, or 100% of net rental income from tax returns (after
  adding back depreciation, mortgage interest, taxes and insurance).
I Mortgage payments (PITI) on the subject property are used in the calculation of

  the housing expense ratio.
Retirement Income—Borrowers who receive retirement income can submit letters
from the organization providing the income, copies of retirement awards and letters,
tax returns, W-2’s or copies of bank statements to confirm regular deposits of payment
of proof of receipt.



 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   186
      Social Security Income—Income received from the Social Security Administration is
      an acceptable source of income. Acceptable evidence is:
      I Copy of Social Security Administration awards letter, or

      I Copy of borrowers last 12 months bank statements to confirm regular deposits

        of payment.
      Income is derived by calculating the amount stated on the award letter times (x)
      125% to achieve a gross amount of Social Security income.
      Veterans Benefits—Borrowers receiving VA benefits can use the income with proof
      of benefits documented by a letter or distribution forms from the Veterans
      Administration. The benefits must continue for a least three years from the date of
      mortgage application. Education benefits are not acceptable income because they are
      offset by educational expenses.
      Military Income—Military personnel often receive supplemental pay in addition
      to their base pay. Provided the pay is verifiable by the military and not subject to
      termination in the next three years. The following supplements are accepted:
      I Flight or hazard pay,

      I Ratios,

      I Clothing allowance,

      I Quarters allowance, and

      I Proficiency.


      Foster Care Income—Borrowers may receive income from a state or country sponsored
      organization for the temporary care of one or more children. This income can be
      considered as long as the borrower has a two year history of providing foster care
      services under a recognized program and is likely to continue to provide such services.
      The income may be verified by letters from the organization providing the income,
      tax returns or copies of the borrowers deposit slips or bank statements that confirm
      the regular deposit of the payments.

      Self-Employed Income
      Income from self-employment often requires special attention due to the documentation
      required. Any individual who has a 25% or greater ownership in a partnership or
      corporation, or who is a sole proprietor, is considered self-employed. Income can
      be considered if the borrower has been self-employed for two years or more and if
      documentation indicates that income will support the loan and other expenses and
      can be expected to continue. The ability of the self employed borrower to repay a
      mortgage loan cannot be verified by a third party; therefore, the borrowers personal
      tax returns and a year to date profit and loss statements are the only means of
      verifying the borrowers income. The percent of ownership is indicated on the
      K-1 attachments.



187
                                                                         Income Calculations




Expense items included on the Federal income tax returns may be added to the total
income if these adjustments do not result in a qualifying income that exceeds the
borrowers actual earnings. Adjustments that may be included are:
I Depreciation on real or personal property,

I IRA/Keogh contributions,

I Interest income exclusions,

I Dividend exclusions,

I Non-Taxable pension income,

I Non-Cash losses, and

I Alimony and child support.


The following define the types of self-employed businesses encountered and the
income documentation required.
Sole Proprietorship—A sole proprietorship is 100% owned by an individual and is
small in nature, with generally only a few employees. It may operate out of a house,
or in a small office or store. Since there is only the sole proprietor who owns the
business, the income earned by the business is the borrower’s personal income. The
borrower pays individual income taxes based on those earnings. The income is
reported on Schedule C of the tax return, and represents the income for both the
business and the borrower.
The documentation required for the sole proprietorship is:
I Individual Federal income tax returns, with original signatures and all applicable

  schedules, for the most recent two years;
I A year-to-date profit and loss statement and balance sheet prepared by an

  accountant; and
I IRS Form 4506—Request for Copy of Tax Form, signed by the borrower, giving

  the bank permission to obtain copies of his or her federal tax returns from the IRS
  for the past two years
Corporation/Sub Chapter S Corporation—A corporation is a legal tax paying entity
with its own rights, privileges and liabilities separate from those of its owners. A
Sub-chapter S corporation is a small version of a full corporation which passes all of
its taxable income or loss through to the shareholders. It has no more than 35 owners
who pay income taxes on their portion of the taxable income.
   The documentation required for a Sub-chapter S corporation is:
I Individual federal income tax returns, with original signatures and all applicable

   schedules, including the borrower’s K-1’s, for the most recent two years;
I Corporate income tax returns signed by the borrower for the most recent two year

   period. If the past year return is unavailable, obtain a year end fiscal statement
   signed by the borrower;
I A year-to-date profit and loss statement and balance sheet prepared by an accountant;




 Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   188
      I   A Dun & Bradstreet Corp.’s report; and
      I   IRS Form 4506—Request for Copy of Tax Form, signed by the borrower giving
          the bank permission to obtain copies of his or her federal tax returns from the IRS
          for the past two years.
      Partnership—A partnership is the association of two or more people joined by contract
      to contact a business. Profits and losses are passed through to the partners. Income
      taxes are paid by the individuals, since the partnership itself is not required to pay
      taxes. The documentation required is:
      I Individual federal income tax returns, with original signatures and all applicable

        schedules, for the most recent two years;
      I A year-to-date profit and loss statement and balance sheet prepared by an

        accountant; and
      I IRS Form 4506—Request for Copy of Tax Form, signed by the borrower, giving

        the bank permission to obtain copies of his or her federal tax returns from the IRS
        for the past two years.
      For income qualification purpose, use the average of two years’ income if the most
      recent year’s income is higher than the previous year. If the most recent year’s
      income is lower than previous year’s income, use the most recent two years. The
      Self-Employed Income Analysis form is completed to calculate the gross monthly
      income for all types of self-employment income.




189
Appendix E

Liabilities and Other Debt
The calculation of liabilities and other debt are as follows:
I Installment Debt. Any outstanding installment debt with more than 10 months

  remaining is considered in the total debt. If the credit report does not contain a
  reference for open debt listed on the application, a loan verification must be
  obtained or 12 months of canceled checks may be submitted.
I Alimony/Child Support. Payments with more than 10 months must be included in

  the total debt. Verification which clearly defines the borrower’s obligation must be
  provided. A copy of the divorce decree, property settlement or statement from the
  attorney is acceptable verification.
I Business Debts. If a borrower is self employed and discloses a business debt on the

  application, it must be evidenced on a tax return and financial statement that this
  debt is a business expense. Canceled checks showing a debt is paid out of the
  business account is acceptable too.
I Co-Signed Debts. When the borrower has co-signed a loan for another party (i.e.,

  car loan for son or daughter), the monthly payment is not included in the total
  debt as long as the borrower can verify a history of documentation payment paid
  by the debtor and the current borrower. If payment documentation is not
  obtained, then the monthly payment is calculated into the total monthly debt.
I Revolving Debt. When revolving debt with outstanding balances do not have

  minimum required payments, payments should be the greater of 5% of outstanding
  balance or $10 per month.
I Other Real Estate Debts. Comprises the total monthly PITI payments for all

  properties other than the subject property.




  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   190
Appendix F

Criteria for FICO Scores
S    tandard & Poor’s has approved criteria for the use and selection of FICO scores
     and the selection of those scores.
   A newly originated loan requires a “representative” consumer credit score that
will be used in Standard & Poor’s rating’s process. The score for each borrower
is collected from each of the three credit repositories. The middle score is then
selected for both the primary and secondary borrower. The lower of the two
middle scores is the representative score used in the automated underwriting or
mortgage score algorithm.
   If one borrower has only two scores and the other borrower has three, then the
middle score of the three should be selected. The lower of the two should then be
selected. Then the lowest score of the remaining pair would be the representative
score and is used.
   Likewise, if one of the borrowers has only one score available from the three re-
positories that score would be used. For the other borrower the rules above
would apply.




  Standard & Poor’s Structured Finance   I   U.S. Residential Subprime Mortgage Criteria   192

								
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