Biggest Risk for RMBS Investors? Strategic Defaults.

The credit performance of private-label residential mortgage-backed securities (RMBS) in the U.S. continues to face many challenges in 2012, with the biggest risk posed by strategic defaults, according to ""Moody's Investors Service"":http://www.moodys.com.

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Despite what's expected to be a year of anything but calm waters ahead, in its annual outlook released Thursday, Moody's says the performance of loan pools backing outstanding RMBS has begun to stabilize. As a result, Moody's 2012 loss expectations for U.S. RMBS are mostly unchanged.

""Although delays in loan liquidation timelines and an increase in distressed sales will continue to dampen housing prices and limit recoveries on delinquent loans, they will not have a material impact on RMBS recoveries, given our already high loss expectations on RMBS pools,"" explained Debash Chatterjee, a Moody's associate managing director.

Delinquency levels among loan pools have been flat or even dropping largely because of loan modifications, according to the ratings agency. Moody's notes that re-default rates on modified loans have also been declining, largely because payment reductions in the modifications have gotten larger.

Strategic defaults, however, will continue to pose a big risk for RMBS in 2012, as housing prices continue to decline, according to Moody's.

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The ratings agency perceives the risk as greatest in the prime jumbo sector, where more than half of the borrowers, who have so far been making their mortgage payments regularly, are now underwater on their mortgages. Moody's says negative equity among prime jumbo borrowers has ""risen significantly"" since late 2010.

The subprime sector, on the other hand, faces the lowest potential for significant performance deterioration in 2012, namely because more of its weaker borrowers have already defaulted, leaving less room for losses to increase substantially.

Moody's says the risk of performance deterioration in the Alt-A and option ARM sectors is less than that of the jumbo but greater than that of the subprime sectors, with option ARM loans facing the greater risk of strategic defaults.

""The practices of the servicers will continue to play a major role in determining loan performance,"" commented William Fricke, a Moody's VP and senior credit officer.

""Although modifications that include principal forgiveness are a key way to prevent strategic defaults, we continue to expect servicers to be reluctant to employ principal forgiveness, given that the GSEs do not permit it, and that many private label RMBS carry provisions limiting the practice.""

Servicing is undergoing a transformation, however, as servicers establish single points of contact for delinquent borrowers and increasingly transfer servicing to special servicers â€" both of which Moody's considers to be credit positives.

The ratings agency expects the issuance of private-label RMBS to be modest in 2012, owing to GSE dominance and regulatory uncertainty.

The deals that do take place, Moody's believes, will feature more comprehensive reviews of originators, better quality and more reliable loan level data, and strong mechanisms for enforcing breaches of representations and warranties (R&Ws). They will also better address legal issues relating to foreclosure challenges.