The document summarizes recent changes to Moody's methodology for rating Australian residential mortgage-backed securities (RMBS). Key changes include:
1) Increasing assumptions in Moody's Individual Loan Analysis model around default probabilities and house price declines, leading to higher expected losses.
2) Reducing the benefits attributed to lenders mortgage insurance by taking into account mortgage insurers' financial strength ratings and risks of lenders not complying with insurance policies.
3) Introducing a new approach to address tail risks by assessing credit enhancement and liquidity support available to rated tranches to cover potential shortfalls.
1. SPECIAL COMMENT
RESIDENTIAL MBS
Table of Contents:
EXECUTIVE SUMMARY 1
MILAN 2
LENDERS MORTGAGE INSURANCE 5
TAIL RISK EXPOSURE 6
CHRONOLOGY OF CHANGES 8
MOODY’S RELATED RESEARCH 9
Analyst Contacts:
SYDNEY +612.9270.8117
Arthur Karabatsos +612.9270.8160
Vice President - Senior Analyst
arthur.karabatsos@moodys.com
Jennifer Wu +612.9270.8169
Vice President - Senior Credit Officer/Manager
jennifer.wu@moodys.com
TOKYO +81.3.5408.4100
Kei Kitayama +81.3.5408.4161
Managing Director - Asia Pac Structured Finance
kei.kitayama@moodys.com
MOODY'S CLIENT SERVICES:
New York: +1.212.553.1653
Tokyo: +81.3.5408.4100
London: +44.20.7772.5454
Hong Kong: +852.3551.3077
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Singapore: +65.6398.8308
ADDITIONAL CONTACTS:
Website: www.moodys.com
SEPTEMBER 11, 2013
SummarisingPastChangesinAustralian
RMBSMethodology
Executive Summary
We have made various changes to our rating methodology in relation to Australian
residential mortgage backed securities (RMBS) since 2012. This report provides a
summary of the changes, which include: 1) updating our assumptions used to assess the
credit risks of a portfolio of residential mortgage loans, 2) reducing the value of the
benefits attributed to lenders mortgage insurance (LMI), and 3) introducing a new
monitoring approach to address the tail risks applicable in existing transactions with pro-
rata principal payments, and assessing the sufficiency of the credit enhancement and
liquidity support available to the rated tranches to address tail risk at the end of a
transaction's term.
In terms of the model we use -- Moody’s Individual Loan Analysis (MILAN) -- to
analyze the credit quality of a portfolio of residential mortgages, in order to determine
the size of expected losses from defaulted loans in a severe economic shock, we have
increased our assumptions for mortgages with loan-to-value ratios (LTV) greater than
65% defaulting. We also changed our assessment of how far house prices1
will fall in a
severe economic shock. This change is reflected in our use of dynamic analysis as
opposed to the previous static analysis in determining house price stress rates (HPSR).
Consequently, HPSRs will increase if the increase in house prices is caused by a growing
imbalance between housing supply and demand. In situations where house prices have
either stayed the same or decreased, a minimum 25% is applied to HPSRs . We also
reduced the rate of interest accrued on delinquent loans to 10% from 12%.
We have reduced the value of the benefits attributed to LMI when taking into account
the mortgage insurers’ insurer’s financial strength rating (IFSR) and by assessing the risk
of individual lenders either not having originated or serviced a mortgage in accordance
with LMI policies. Any non-compliance with such policies would increase the risk of
mortgage insurers reducing or rejecting claims.
Under our new monitoring approach to addressing tail risks, in general, if mortgage
portfolios are covered by LMI and the senior and mezzanine tranches do not incur losses
under stress scenarios, the maximum ratings achievable on the senior and mezzanine
tranches are the relevant mortgage insurer's IFSR, if the transactions have sufficient
liquidity to cover shortfalls during the mortgage insurance claim period. By contrast, if
there is insufficient liquidity, the senior and mezzanine tranches would be rated one
notch below the relevant mortgage insurers’ IFSR. If, on the other hand, the tranches do
incur losses under stress scenarios, their ratings would reflect the losses.
1
In this report, house prices refer to the price of homes and apartments.
2. 2 SEPTEMBER 11, 2013 SPECIAL COMMENT: SUMMARY OF RECENT CHANGES IN AUSTRALIAN RMBS METHODOLOGY
RESIDENTIAL MBS
MILAN
We use MILAN to assess the credit quality of a portfolio of residential mortgage loans in order to
determine the size of expected losses from defaulted mortgage loans in a severe economic shock. We
calculate the loss on each loan by multiplying the loan’s probability of default (PD) by its loss given
default (LGD). This loss is known as the Base Benchmark Credit Enhancement (Base Benchmark CE).
The total expected loss is then calculated by adjusting the Base Benchmark CE through a comparison
with the benchmark loan.
We changed our PD and LGD assumptions, which we detail below and which were announced in our
report titled “Moody’s Updates Approach to Rating Australian RMBS,” published on 31 May 2012.
Changes to PD. Exhibit 1 illustrates our increased assumptions for the PD of loans with LTV ratios
greater than 65%. For example the PD of a loan with an LTV ratio of 75% has increased to 8% from
5%.
EXHIBIT 1
Probability of Default of Benchmark Loan
Source: Moody’s Investors Service
Changes to LGD. We changed two of our assumptions used in calculating the LGD of benchmark
loans. Firstly, we lowered the rate of interest accrued on delinquent loans, and secondly, we changed
our assessment of HPSRs to a dynamic from a static analysis.
We also incorporated the indexing of property values when calculating Base Benchmark CEs.
Reduced Accrued Interest. We reduced the rate of interest accrued on delinquent loans to 10% from
12%. Interest accrues on loans between the period when they first become delinquent and when the
security properties of the loans are foreclosed.
Dynamic HPSR. We changed the basis of our assessment of HPSRs to dynamic from static. HPSRs
are our assessment of how far house prices will fall in response to severe economic shocks. As Exhibit 2
illustrates, HPSRs are different for each of Australia’s states and territories.
EXHIBIT 2
HPSR across Australia
State or Territory Previous Static HPSR Dynamic HPSR as at March 2013
Australian Capital Territory 35% 40%
New South Wales 45% 37%
Northern Territory 35% 53%
Queensland 35% 42%
South Australia 35% 41%
Tasmania 30% 42%
Victoria 40% 42%
Western Australia 40% 47%
Source: Moody’s Investors Service
-%
5%
10%
15%
20%
25%
30%
35%
40%
30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100% 105% 110% 115% 120%
ProbabilityofDefault
Loan-to-Value Ratio (LTV)
Previous Current
3. 3 SEPTEMBER 11, 2013 SPECIAL COMMENT: SUMMARY OF RECENT CHANGES IN AUSTRALIAN RMBS METHODOLOGY
RESIDENTIAL MBS
Our current approach to HPSRs incorporate two components: 1) we measure every quarter, the
increase in house prices for each state over a period of time, typically the last 10 years. This is used as a
parameter to calculate by how much current house prices will fall in each state, where such increase in
house prices will be unsustainable owing to the imbalance between demand and supply, and 2) by
how much house prices will fall because of structural features in the Australian economy that will
affect all states equally. This second component is subject to a minimum decrease in prices of 25%.2
Exhibit 3 shows the HPSRs for a given percentage increase in house prices, assuming that half the
increase is unsustainable, and incorporating a fixed minimum decrease in prices of 25%. For example,
if the growth in house prices3
is either flat or negative, we apply an HPSR of 25%. The HPSR steadily
increases as house prices grow, if such increases are caused by the growing imbalance between housing
supply and demand.
EXHIBIT 3
House Price Stress Rates
Source: Moody’s Investors Service
Exhibit 4 shows how HPSRs for the more populous states have changed every quarter. The overall
decrease in HPSRs since December 2011 is due to the leveling off of house price increases.
EXHIBIT 4
Movements in House Price Stress Rates by State
Source: Moody’s Investors Service
2
For a detailed explanation of how we arrived at the market value decline in each state and the mathematical formulae used refer to House Price Stress Rates for
Australian RMBS, published on 29 May 2013.
3
In Australia the growth in house prices is measured over a period of 10 years.
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
-10%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
110%
120%
130%
140%
145%
150%
HousePriceStressRates
House Price Gains
35%
40%
45%
50%
55%
60%
01/12/2005
01/03/2006
01/06/2006
01/09/2006
01/12/2006
01/03/2007
01/06/2007
01/09/2007
01/12/2007
01/03/2008
01/06/2008
01/09/2008
01/12/2008
01/03/2009
01/06/2009
01/09/2009
01/12/2009
01/03/2010
01/06/2010
01/09/2010
01/12/2010
01/03/2011
01/06/2011
01/09/2011
01/12/2011
01/03/2012
01/06/2012
01/09/2012
01/12/2012
01/03/2013
HousePriceStrssRate
Date
NSW VIC QLD SA WA
4. 4 SEPTEMBER 11, 2013 SPECIAL COMMENT: SUMMARY OF RECENT CHANGES IN AUSTRALIAN RMBS METHODOLOGY
RESIDENTIAL MBS
Illustrative Example of LGD
A mortgage loan’s LGD is based on three drivers: 1) the loan amount and accrued interest, 2) the
foreclosure costs, and 3) the stressed property value, which is the indexed property price after taking
into account HPSR.
Consequently, LGD is calculated as follows:
LGD=
(𝐿𝑜𝑎𝑛 𝐴𝑚𝑜𝑢𝑛𝑡 + 𝐴𝑐𝑐𝑟𝑢𝑒𝑑 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝐹𝑜𝑟𝑒𝑐𝑙𝑜𝑠𝑢𝑟𝑒 𝐶𝑜𝑠𝑡𝑠) - Stressed Property Value
𝐿𝑜𝑎𝑛 𝐴𝑚𝑜𝑢𝑛𝑡
where Stressed Property Value = Current Indexed Property x (1 – HPSR).
Exhibit 5 illustrates the LGD of a mortgage loan totaling $225,000, with a security property valued at
$300,000 at origination and located in the state of Queensland.
EXHIBIT 5
Illustrative Example: Calculating LGD for a Property in Queensland
Current Indexed Property Value $336,550 (The last property value, $300,000, is updated using house price indices)
Stressed Property Value: $195,200 ($336,550 x (1 –HPSR) = $336,550 x (1 – 42%))
Accrued Interest $45,000 ($225,000 x 10% x 24/12)
Foreclosure Costs $11,712 ($195,200 x 6%)
Loss $86,512($225,000 + $45,000 + $11,712 - $195,200)
LGD ≈38% ($86,512 / $225,000)
The difference between the current indexed property value and the last property value represents the
time between loan origination and securitization. In this example, the value of the property at
origination is $300,000, and the current or indexed value of the property is $336,550 based on
information on house prices in Queensland, as provided by the provider of property information,
currently being RP Data.
Based on the HPSR for Queensland of 42%, the stressed property value is $195,200.
Exhibit 6 further illustrates how the current indexed property value in the example above is combined
with the HPSR to determine the stressed value of the property in Queensland.
EXHIBIT 6
Determining the Stressed Property Value
Source: Moody’s Investors Service
Impact of HPSR on the Base Benchmark CE
Increases in Base Benchmark CEs are higher in times of heightened credit risk, when the growth in
house prices is more dramatic, as HPSR is used to calculate Base Benchmark CEs.
Original Property Value ($300,000)
Current Property Value ($336,550)
Stressed Property Value ($195,200)
(HPSR)
5. 5 SEPTEMBER 11, 2013 SPECIAL COMMENT: SUMMARY OF RECENT CHANGES IN AUSTRALIAN RMBS METHODOLOGY
RESIDENTIAL MBS
Lenders Mortgage Insurance
Most loans in Australian RMBS have LMI, which effectively covers investors if there is any unpaid
principal or interest owing after security properties are sold in response to borrowers defaulting.
Consequently, the presence of LMI serves to mitigate credit risk and reduce expected losses from
residential loans. However, we explain below and in our methodology report titled “Approach for
Evaluating Lender’s Mortgage Insurance in Australian RMBS,” published on 19 October 2012, why
we have reduced the value of the benefits attributed to LMI.
Re-assessment of LMI benefit: The three changes to the benefits of LMI are:
(1) A reduction in the LMI benefit, based on our assessment of the lower ability of mortgage insurers
to pay on claims, and as reflected in their IFSRs (Exhibit 7).
For instance, if the expected loss on a portfolio as calculated by our MILAN model is 8% and
every loan in the portfolio is covered by a mortgage insurer rated at A3, the expected loss would
be higher, at 5.6% (8% - (8% x 30%)) versus the 4.8% (8% - (8% x 40%)) that we would have
calculated prior to our reduction of LMI benefit.
EXHIBIT 7
Benefit of LMI
Mortgage Insurer’s IFSR Previous LMI benefit Current LMI Benefit
Aa1 90% 70%
Aa2 80% 60%
Aa3 70% 50%
A1 60% 40%
A2 50% 35%
A3 40% 30%
Baa1 30% 20%
Baa2 20% 10%
Baa3 10% 5%
The reduction in LMI benefit is because of the high correlation between the mortgage market,
RMBS, the mortgage insurers’ financial strength and the risk posed by the difference in timing of
losses experienced by the mortgage portfolios of mortgage insurers and specific RMBS underlying
mortgages.
(2) Further reducing the LMI benefit is our assessment of the risk that individual lenders have either
not originated or serviced a mortgage in accordance with LMI policies. Such breaches raise the
risk of mortgage insurers reducing or rejecting claims. To capture this risk we have introduced the
concept of a loss adjustment rate (LAR) for each originator. The LAR is between 10% and 25%.
The higher the LAR, the smaller the total LMI benefit. The majority of originators in Australia
have LARs of between 15% and 20%.4
Exhibit 8 illustrates the total LMI benefit for an
originator we assess as having a 20% LAR for the various mortgage insurer rating categories.
4
For full details refer to Approach for Evaluating Lender’s Mortgage Insurance in Australian RMBS, published in October 2012.
6. 6 SEPTEMBER 11, 2013 SPECIAL COMMENT: SUMMARY OF RECENT CHANGES IN AUSTRALIAN RMBS METHODOLOGY
RESIDENTIAL MBS
EXHIBIT 8
LMI Benefit for Aaa Notes
Mortgage Insurer’s IFSR LMI Benefit (Reduction in Aaa CE)
Total LMI Benefit = LMI Benefit - (LMI Benefit x LAR))
(assuming LAR = 20%)
Aa1 70% 56% (70% - (70% x 20%))
Aa2 60% 48%
Aa3 50% 40%
A1 40% 32%
A2 35% 28%
A3 30% 24%
Baa1 20% 16%
Baa2 10% 8%
Baa3 5% 4%
Exhibit 9 is an example of how LMI reduces – to 3.4% from 5% -- the subordination required for a
senior note to achieve Aaa rating. The example is for illustrative purposes only and is based on a
sequential principal allocation between senior and junior notes. It does not take into account any
structural features such as negative carry, excess spread and principal draws to cover interest.
EXHIBIT 9
Working Example of Impact of LMI on Capital Structure
Comment
Senior note target rating Aaa
Minimum subordination required pre-LMI benefit (A) 5.0% Aaa CE output from MILAN model
Mortgage Insurer’s IFSR (B) 40% LMI Benefit from Exhibit 5
IFSR Benefit (C) 20%
Total LMI Benefit (D) 32% =B X (1 – C)
Minimum subordination required post-LMI benefit 3.4% = A x (1 – D)
(3) Relying LAR in the rating of the junior notes. This methodology invariably results in junior notes
being rated sub-investment grade. Under our previous methodology the rating we assigned to the
junior note was the same as the IFSR we assigned to the mortgage insurer, resulting in investment
grade ratings. However, under our current methodology, the rating of the junior note will reflect
the high probability of the junior notes incurring losses in the absence of other credit mitigating
factors such as a reserve fund, the rating would be in the Caa range (non-investment grade).
Tail Risk Exposure
In June 2013, we introduced a monitoring approach to address tail risks5
in Australian RMBS. Such
risks relate to the disproportionately large losses on underlying pools at the end of a transaction’s term,
when few loans remain in the pool and credit enhancement although high in percentage terms, is low
in dollar terms.
The approach applies to transactions that pay principal to the tranches on a pro-rata basis. These
transactions have no or insufficient credit enhancement or liquidity floors. At the end of the
transaction, when only a small number of loans remain outstanding, losses or delinquencies from a
few loans can deplete the available credit enhancement or liquidity.
5
For full details refer to Moody's Approach to Addressing Tail Risk in Australian RMBS that Pay Principal Pro-rata, published in June 2013.
7. 7 SEPTEMBER 11, 2013 SPECIAL COMMENT: SUMMARY OF RECENT CHANGES IN AUSTRALIAN RMBS METHODOLOGY
RESIDENTIAL MBS
For such transactions, we increase the pool’s base case expected loss by a stress factor of 1.5 to 2.0.
This stressed loss will not be less than the loss arising from the default of the five largest loans in the
pool. We also significantly delay the timing of future defaults.
Under the approach, in general, if the securitized pools are covered by LMI and the senior and
mezzanine tranches do not incur losses under the stress scenario, the maximum ratings achievable on
the tranches are: 1) the relevant mortgage insurer's rating, if liquidity is sufficient to cover the
collection shortfall during the mortgage insurance claim period, and 2) one notch below the relevant
mortgage insurer's rating, if liquidity is insufficient. If the tranches do incur losses under the stress
scenario, their ratings will be commensurate with the losses under that scenario.
Deals that pay principal on a pro-rata basis without effective triggers that switch the transaction to
paying principal amounts on a sequential basis, are uncommon. Instead, Australian RMBS
transactions begin by making sequential principal payments to the most senior tranche. Upon the
occurrence of certain triggers (e.g. where the subordination to the senior note is doubled from when
the transaction began), the principal distributions switch to pro-rata, such that they are made to all
tranches in proportion to their size. Principal distributions will switch back to sequential upon the
occurrence of another set of triggers (e.g. if the portfolio’s size is reduced to 10% of the original size)
to allow the buildup of credit enhancement.
For transactions that do not switch back to sequential principal distributions, our approach to
addressing tail risks in Australian RMBS transactions, based on the pay principal pro-rata
methodology, would apply.
8. 8 SEPTEMBER 11, 2013 SPECIAL COMMENT: SUMMARY OF RECENT CHANGES IN AUSTRALIAN RMBS METHODOLOGY
RESIDENTIAL MBS
Chronology of Changes
Exhibit 10 shows our various methodology announcements and rating actions, due to the rating
downgrades of LMI providers.
EXHIBIT 10
Chronology of Announcements
Date of
Announcement
Summary of
Announcement Rating Actions Taken Explanation of Announcement
19 June 2013 Moody's approach to
addressing tail risks in
Australian RMBS that
pay principal on a pro-
rata basis.
30 senior Aaa (sf),
two senior A1 (sf),
three mezzanine Aa3 (sf),
six mezzanine A1 (sf) placed
on review for downgrade.
This announcement provides details on the
monitoring approach to addressing tail risks.
We have up to 6 months to conclude the
review.
29 May 2013 House price stress rates
for Australian RMBS.
No impact. This announcement is not on a change in
methodology. It is a special comment
explaining how house price stress rates used in
the MILAN model were derived.
28 May 2013 Moody’s approach to
rating RMBS using the
MILAN framework.
No impact. This announcement is not on a change in
methodology. Instead, it is a global
consolidation of the MILAN framework.
28 May 2013 RMBS rating
methodology
supplement – Australia.
No impact. This announcement is not on a change in
methodology. It is a supplementary
spreadsheet listing all the risk factors and
adjustments used in the existing MILAN
methodology.
6 February 2013 Moody’s concludes
review of Australian
RMBS.
Downgraded 1 senior, 13
mezzanine and 71 junior
notes.
No more notes remain on
review.
The rating downgrades are the result of a
completed review of the impact of LMI and the
impact of the new methodology announced on
19 October 2012.
The LMIs downgraded are as follows:
Genworth Australia to A3 from A1.
Genworth Indemnity to A3 from A2.
QBE to A2 from Aa3.
19 October 2012 Moody’s updates
approach in evaluating
LMI in Australian RMBS.
1 mezzanine note placed on
review for downgrade.
This announcement provides details on the
new LMI methodology. This is not a new
methodology. It is an updated approach to
evaluating LMI for RMBS
1 senior, 7 mezzanine and
12 junior notes from 31 May
2012 remain on review.
89 tranches remain on
review for downgrade from
28 April 2012.
Genworth, QBE and Westpac LMI review not
yet completed.
31 May 2012 a) Moody’s updates
approach to rating
Australian RMBS.
b) Moody’s reviews
ratings of Australian
mortgage insurers for
possible downgrade.
1 senior, 7 mezzanine and 12
junior notes placed on
review for downgrade due
to a combination of a) and
b).
a) This is not a new methodology, but an
update on certain aspects of our MILAN
model, such as the default frequency curve.
b) QBE and Westpac’s LMI placed on review
for downgrade.
89 tranches remain on
review for downgrade from
28 April 2012.
Genworth review not yet completed.
28 April 2012 Moody’s reviews
Australian RMBS
tranches for
downgrade, following
Genworth review.
89 tranches placed on
review for downgrade.
Genworth Financial Mortgage Insurance Pty
Ltd's A1 insurance financial strength rating is
placed on review for downgrade.
9. 9 SEPTEMBER 11, 2013 SPECIAL COMMENT: SUMMARY OF RECENT CHANGES IN AUSTRALIAN RMBS METHODOLOGY
RESIDENTIAL MBS
Moody’s Related Research
For a more detailed explanation of Moody’s approach to this type of transaction as well as similar
transactions please refer to the following reports:
Rating Methodologies:
» Moody's Approach to Addressing Tail Risk in Australian RMBS that Pay Principal Pro-rata, June
2013 (SF331786)
» Moody’s Approach to Rating RMBS Using the MILAN Framework, May 2013 (SF274702)
» RMBS Rating Methodology Supplement - Australia, May 2013 (SF318067)
» Approach for Evaluating Lender’s Mortgage Insurance in Australian RMBS, October 2012
(SF303936)
» Moody’s Approach to Rating Australian Asset-Backed Securities, July 2009 (SF174008)
Special Comment:
» House Price Stress Rates for Australian RMBS, May 2013 (SF326290)
To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of
this report and that more recent reports may be available. All research may not be available to all clients.
Moody’s publishes a weekly summary of structured finance credit, ratings and methodologies,
available to all registered users of our website, at www.moodys.com/SFQuickCheck.