Small Pools a Growing Risk for RMBS

by: Research Recap

Increasing numbers of U.S. RMBS are being exposed to ‘tail risk’, a growing concern that stands to adversely affect existing U.S. RMBS and needs to be addressed in new transactions that come to market, according to Fitch Ratings.

With call-options not being exercised as frequently as in the past, existing RMBS are increasingly being left with outstanding small pools. While not a new phenomenon, ‘tail risk’ leads to more volatile collateral performance and higher credit risk. ‘Most existing RMBS transactions are not structured to protect against the potential for increased performance volatility as the pool size declines,’ said Managing Director Grant Bailey.

In a reflection of its more stringent credit enhancement on mortgage loans containing small pools, Fitch placed 1,810 U.S. RMBS classes on Rating Watch Negative.

In response, Fitch is raising credit enhancement rating thresholds and incorporating rating ceilings on outstanding RMBS that are collateralized with a small number of remaining mortgages and lack any structural mitigant to protect against tail-risk. Structural features which mitigate tail-risk may include a subordination floor, which is determined as a percentage of the original pool balance that provides for a minimum amount of credit support for rated classes throughout the life of the deal. Other possible structural mitigants may include a feature that converts class principal distribution from pro-rata to sequential once the pool balance declines below a pre-determined threshold.