S&P Viewpoint

Unfortunately for the MH production industry, interest rates fell earlier this decade, and with them so did Treasury yields and mortgage rates for site-built homes. Lending rates for commercial projects, such as apartment buildings, also declined. Hence, some MH borrowers faced attractive housing opportunities and alternatives.

MH borrowers typically compare monthly housing payment obligations of site-built homes, MH units, and apartments when contemplating their housing decisions. As interest and mortgage rates began to fall in 2001, MH borrowers who could purchase site-built homes with similar monthly payment terms began to do so, leading to adverse selection of the remaining borrowers in the outstanding MH securitizations. For borrowers who had little to no equity in their MH units, apartment rentals also became attractive alternatives as vacancies rose in certain markets where renters had purchased site-built homes. The shift away from MH units to site-built housing and apartment rentals exacerbated the inventory overhang that the MH production industry experienced, as the used MH units competed with new MH units for a dwindling buyer pool.

This shift away from MH and into other alternatives was significant. Although the MH and site-built housing markets are typically countercyclical, the MH industry downturn earlier this decade was more pronounced than in previous cycles. In the mid-to-late 1990s, the MH industry produced and shipped over 300,000 units per year, while in 2003 and 2004, it shipped slightly over 130,000 units annually (data sources include the Manufactured Housing Institute, the Institute for Building Technology and Safety, the U.S. Department of Commerce, and the U.S. Census Bureau). These numbers show that a marked shift in demand occurred. Ultimate recoveries on repossessed units of MH also foretold the shift in demand, as some units yielded 10% to 15% of their outstanding balance following liquidation. The U.S. site-built housing market is not expected to, nor has it ever suffered, such widescale loss severities on first-lien mortgages.

The U.S. RMBS industry may take heed, however, as more site-built home borrowers have less equity in their homes today than in the past. Should financial hardship strike, some may opt for other housing alternatives. Many MH borrowers and subprime mortgage borrowers focus more on their monthly housing payments than the interest rates being charged. As adjustable-rate mortgage (ARM) rates reset and monthly housing payments increase, site-built home borrowers may opt to reduce their payment obligations by moving to apartments that carry similar monthly rent payments.

Manufacturers took their cues from certain originators that were entering the MH lending sector and loosening underwriting standards (as MH loans typically carried higher coupons than did mortgages for site-built homes), as well as from various dealers, some of whom received incentives to sell the most units. Looser underwriting standards allowed borrowers who may not have otherwise qualified to purchase MH, which helped stimulate production demand. In the mid-to-late 1990s, the MH industry produced and shipped over 300,000 units per year, which was up from the historical average of 235,000. The demand proved transitory, however, lasting until underwriting guidelines were tightened.

Had the dealer incentives differed, excessive lending may have been partially curbed, thereby depressing the demand for new units and limiting production. Some dealers and lenders sold borrowers homes and loans they could ill afford, and, not surprisingly, delinquencies and defaults increased (many of these loans had been packaged into MH ABS transactions).

Beginning in 2001, when mortgage rates began their decline to 40-year lows, a refinance boom began in the mortgage market. Industry participants, including lenders and brokers, expanded their operations and staffs to handle the increased volume and larger market. As volume, revenue, and market share grew, the participants began to rely on new products to remain competitive. By expanding the universe of borrowers to whom they would lend and introducing affordability products, while remaining competitive on pricing, lenders began to trade volume and revenues for performance and profitability. Both subprime RMBS borrowers and nonprime MH borrowers rely heavily on their continued employment to meet their monthly housing payments, as they typically have fewer reserves. So long as home price appreciation remained robust, borrowers could stave off default when faced with unemployment or other financial difficulties by refinancing the existing loan or selling the property. But as home price appreciation began to wane, exit opportunities began to diminish, and delinquencies and defaults started to rise.

While delinquencies are trending higher for the 2006 RMBS vintage than for previous vintages, slowing home price appreciation and higher mortgage rates may be more responsible for the increase than overproduction of new site-built homes. As the RMBS market contains a greater percentage of rate/term and cash-out refinancings than did the MH market, the run-up in home prices during the past few years may have contributed to the demand for new affordability products.

MH manufacturers took several years to recognize the artificial run-up in demand, and they and the dealers were left with unsold inventory of new homes, which depressed both retail and resale prices. Rising inventories of used homes also contributed to the decline in sales prices. As borrowers defaulted on their loans, their homes were repossessed and at times transported back to dealer locations. As defaults mounted, some servicers began to sell the units at auction—in bulk, at wholesale prices—depressing recoveries.

The MH industry tracks the number of units produced by manufacturers and shipped to dealers, but it does not necessarily focus on the number of units placed onto sites. Hence, a lag occurs between declines in demand and curbs on supply. This delayed reaction contributed to the inventory overhang that plagued the MH industry between 2002 and 2005, and depressed resale and recovery values nationally.

Since MH is constructed to federal standards outlined in the HUD code, the units can be transported and situated anywhere in the U.S. However, given the costs involved with transportation and potential for damage while in transit, units are not typically moved great distances from the regional manufacturing plants. Site-built housing is built to state and local building codes and is typically not moved after construction is complete.

Sales prices for site-built homes may be more stable, as the homes are available in more areas than MH (in terms of zoning ordinances) and land is almost always included. Hence, although bulk sales may occur in the site-built market, the recoveries in many regions should be greater than what MH realized. In addition, the market value of site-built housing is more transparent, given the national real property listings found in the Multiple Listing Service database. Although the MH industry now benefits from similar services, they were not as widely available or extensively used during the most recent MH downturn. The recent run-up in site-built home prices in some regions, however, may make certain home prices more volatile in the near future. MH is an affordable housing option, and its price range is thus typically narrower than that of site-built housing.

With U.S. RMBS, fewer site-built homes are constructed on speculation, so overproduction should be more limited than with MH. However, the total number of unsold homes in inventory will be higher because the site-built market is considerably larger.

As delinquencies, defaults, and losses mounted, some lenders and servicers exited the MH industry. Two of the largest MH securitizers (originators and servicers), Conseco Finance Corp. and Oakwood Homes Inc., filed for bankruptcy protection during the fourth quarter of 2002. A consortium of buyers, including Fortress Investment Group LLC and Cerberus Capital Management L.P., bought Conseco's MH lending and servicing operations in 2003, while Clayton Homes Inc., which Berkshire Hathaway acquired in 2003, purchased Oakwood shortly thereafter.

Prudent underwriting standards allowed disciplined MH lenders to survive despite dismal market conditions. These MH lenders focused on two key areas: verification of income and employment, and providing value to the borrowers. Some lenders began to move away from low-documentation loans and required greater equity in the units through larger down payments. As MH is typically a depreciating asset when real property isn't attached, equity at the onset is critical to maintaining borrowers' willingness to meet their monthly payment obligations.

Gain-on-sale accounting may have contributed to the decline in MH lenders' financial health, as they wrote down the values of their transaction residuals when defaults and losses increased. Access to funding became more expensive and difficult as a result, sending some MH lenders into a downward spiral.

Consolidation has begun in the U.S. subprime mortgage sector, as investment banks and other parties have been acquiring mortgage originators and servicers, while other lenders have exited the subprime origination business. Subprime mortgage lenders that continue to originate have indicated that they are tightening underwriting guidelines, including requiring more income, employment, and asset verification and greater equity in the properties. We expect further consolidation and exits throughout 2007.

Although the current RMBS environment resembles that of the MH industry in several respects, important differences remain. These differences will most likely have positive implications for outstanding RMBS performance, and the magnitude of downgrades and defaults should be less pronounced for this asset type. Here's where MH and RMBS part ways:

Securitization was the preferred exit strategy for some MH lenders, who were unable to raise financing when defaults and losses grew, rating agencies required additional credit enhancement, and investors demanded higher margins to assume the associated risks. Without additional financing, lenders couldn't originate new loans, which contributed to bankruptcy filings and exits from the industry.

Some diversified residential mortgage lenders have a variety of financing alternatives, including warehouse facilities, lines of credit, loans from other parties, covered bonds, disparate revenue streams, and strong balance sheets, and they may not be as reliant on securitization for continued operations. In addition, investment banks, hedge funds, and other parties have been acquiring or providing working capital and financing to specialty finance mortgage lenders and servicers, providing them with additional funding and liquidity.

Because many MH ABS transactions were issued off the originator's shelves, the MH lenders that securitized directly (as opposed to through banker conduits or shelves) didn't face the volume of loan repurchase requests that some subprime RMBS originators, particularly specialty finance companies, are currently experiencing. Many banker conduits have been enforcing remedies against first payment and early payment defaults by putting back the affected loans to the related mortgage originators. Although loan repurchase requirements may reduce a mortgage lender's cash reserves and working capital, such repurchases would flow through as prepayments to the related RMBS banker conduit transactions, partially mitigating losses on such loans. Repurchase requirements have so adversely affected some specialty finance companies that they have filed for bankruptcy protection. This differs from the MH lending industry, which was hobbled by a decline in investor demand for securitized MH ABS products.

Although MH servicers employed a host of loss mitigation strategies, including offering extensions, transfers of equity/loan assumptions, and loan modifications, they had limited opportunities to refinance MH borrowers into new loans. Aggressive use of MH loss mitigation strategies may have masked poor loan performance, and the depreciating nature of the collateral may have reduced the number of available refinancing alternatives, as borrowers had little equity that could be restructured.

RMBS servicers may have additional loss mitigation tools available, as well as federal and/or state support for working with borrowers to minimize the risk of foreclosure. Many RMBS servicers are expanding their staffs and proactively contacting borrowers prior to the reset dates on ARMs (for more information regarding RMBS servicers' loss mitigation efforts, see " Subprime Loan Servicers Step Up Loss Mitigation Efforts to Avoid Foreclosures," published March 14, 2007, on RatingsDirect).

Residential mortgage originators continue to develop new loan products for borrowers who are approaching ARM resets. Fannie Mae and Freddie Mac recently announced that they are developing new loan products, which may contain reduced margins and longer fixed-rate periods for hybrid ARMs, to provide subprime mortgage borrowers with refinance opportunities. Longer-term loans and interest-only products remain popular, and market participants continue to ask Standard & Poor's about credit enhancement requirements for potential new products.

By offering rate/term refinancing or cash-out opportunities to borrowers who will prepay their existing mortgages, originators and servicers may be able to lower ultimate defaults and losses on outstanding RMBS transactions. In addition, by refinancing site-built home borrowers into mortgage products that contain affordable monthly housing payment provisions, lenders and servicers can reduce the potential for foreclosure.

The MH industry remains a small portion of the total U.S. housing industry (approximately 8% in 2005, according to the Manufactured Housing Institute). Hence, borrowers for site-built homes have more mortgage loan options, and originators and investors have more servicers from which to choose. Servicing transfers may occur prior to securitization, and the universe of available RMBS servicers remains larger.

Given the larger group of players and available capacity, RMBS performance shouldn't be as adversely affected as that of MH ABS, which suffered when the two largest originators/servicers filed for bankruptcy protection. Servicing capacity remains a critical distinction, as few, if any, MH servicers had available capacity to assume Conseco Finance's entire servicing portfolio. The mortgage servicing industry appears to have sufficient capacity to assume servicing transfers, as well as demand by third parties for acquisitions of servicing platforms.

Servicing is more difficult to transfer once an originator/servicer has filed for bankruptcy, as the court may determine that the servicing assets are vital to attracting potential buyers for the servicing platform or for the entity to emerge from bankruptcy.

Given that fewer homes are built on speculation and fewer "fire sales" (bulk sales at low prices) occur in the site-built market, recoveries on outstanding RMBS transactions should be higher than what MH ABS experienced. Many of the MH ABS loans were chattel and didn't include the land (and thus were more likely to decline in value), and some were located in remote areas with less consumer demand, which also contributed to the lower recovery rates. In addition, MH units are sometimes damaged during transit and/or installation, which may further reduce recovery values.

Certain regions of the U.S. have experienced home price declines. However, the fall in MH unit prices, which were less regional and more national, as well as more rapid and more dramatic, contributed to the greater-than-anticipated losses on the defaulted loans in MH ABS transactions. Although some site-built mortgage borrowers may have less equity in their homes than borrowers in previous cycles, the impact on losses may be limited based on regional home price trends.

Certain MH ABS transactions contained subordinated or below-market servicing fees, which were designed to increase the excess spread available to cover losses and maintain overcollateralization. As performance declined and servicing costs increased, however, some originator/servicers that used such structures may not have been able to cover their costs to service from the fees in the transactions. If they relied mostly on the securitization market for financing, they may have been left with few funding alternatives.

Currently, RMBS servicing fees are senior in the waterfall and market-rate, which should provide sufficient funding for servicers to continue following accepted servicing practices and minimize losses to the outstanding transactions.

RMBS performance will most likely remain a function of loosened underwriting and slowing home price appreciation, whereas MH performance was affected by aggressive underwriting, depressed recoveries, the bankruptcy filings of two of the largest originator/servicers (in a smaller universe of available originators and/or servicers), and greatly reduced industry demand.

Recoveries may be the distinguishing characteristic between subprime RMBS and MH ABS performance. Recoveries plummeted for MH units and, in certain instances, losses to the securitized transaction exceeded 100% of the outstanding loan balance when principal and interest advances and servicing advances for taxes and insurance were included. We expect RMBS recoveries to be generally higher than what the MH industry experienced.

While early payment defaults and rising delinquencies remain a concern for RMBS investors, lenders have indicated that they're tightening underwriting guidelines. Although refinancing existing borrowers out of securitizations may decrease ultimate defaults and losses, the timing may be affected, as these transactions may potentially suffer back-ended defaults and losses resulting from adverse selection. However, cumulative RMBS defaults and losses should remain lower, and recoveries should be higher, than those associated with outstanding MH ABS from the 1995 to 2002 vintages. Consequently, the magnitude of rating actions for investment-grade RMBS should be less severe than the MH ABS market recently experienced.