S&P slashes second-lien mortgage bond ratings

NEW YORK (CNNMoney.com) -- Standard and Poor's Rating Services dropped the other shoe Thursday, announcing it would downgrade 418 classes of U.S. residential mortgage backed securities (RMBS) backed by second-lien collateral.

The action covered second-mortgage loans, such as home equity loans (HELs) and home equity lines of credit (HELOCs).

The rating agency said it acted because of the poor payment histories for these loans; recent data on late payments have been much higher than on similar loans in the past and S&P does not expect that performance to improve.

The original total balance of all the loans being downgraded came to about $3.8 billion. That represents 6.1 percent of the approximately $62 billion in U.S. RMBS backed by second-lien collateral that S&P rated from the beginning of January 2005 through the end of January 2007.

The dollar amount of all mortgages extended during that period came to about $2.5 trillion, but the downgrades are expected to have more of an impact than the numbers might indicate.

"It's going to be more severe [than last week's action]," said S&P's chief economist, David Wyss. On July 10, S&P placed 612 classes of subprime residential mortgage-backed securities (RMBS) on CreditWatch -negative.

One reason it's going to be worse, according to Wyss, is that RMBS's backed by subprime, second-lien mortgages expose lenders to a much higher chance of absorbing total write-offs than do first mortgages. Lenders don't receive anything back from borrowers until first liens are fully paid off.

Falling home prices, combined with very heavily leveraged borrowers, have made the risk of total losses from non-performing second-lien loans much more likely.

A borrower, for example, who financed a $200,000 home purchase two years ago with 20 percent down had home equity of $40,000 and debt of $160,000 originally.

Since then, however, the homeowner may have borrowed more, perhaps taking out a HEL of $20,000 to put in a new kitchen. This increased his loan-to-value ratio to a very high level.

Meanwhile, home prices in the community dropped, say 10 percent, making the property worth $180,000, equal to the current debt. The borrower can no longer refinance to pay bills, because there's no equity left.

Underwriting standards have tightened up, and lenders are less likely to approve a loan that increases the borrowers already heavily leveraged debt.

If the lender forecloses because of late payments, the first lien holder takes the entire $180,000, leaving the $20,000 HEL debt a total loss.

During the housing boom, that was a less likely scenario. Home prices were running up so quickly in so many communities that homeowners were soon priced out of danger.

But today, with housing market conditions poor in many areas and their near-term prospects iffy, S&P expects losses from these RMBS will significantly exceed historical norms, as well as the agency's original assumptions.

Default rates are already running far higher than predicted and, according to S&P, these loans will probably underperform throughout their lifetimes.

The agency is also sharpening its rating standards for second-lien loans being underwritten today, increasing default and loss assumptions for loans above 95 percent in loan-to-value ratio and for borrowers with FICO scores at or below 660.