Rating Canadian Residential Mortgages HELOCs

Transcription

Methodology
Rating Canadian Residential Mortgages,
Home Equity Lines of Credit and
Reverse Mortgages
november 2014
CONTACT INFORMATION
Kevin Chiang
Senior Vice President
CDN ABS, RMBS & CBs, Global Structured Finance
Tel. +1 416 597 7583
[email protected]
Jamie Feehely
Managing Director
CDN Structured Finance, Global Structured Finance
Tel. +1 416 597 7312
[email protected]
DBRS is a full-service credit rating agency
established in 1976. Privately owned and operated
without affiliation to any financial institution,
DBRS is respected for its independent, third-party
evaluations of corporate and government issues,
spanning North America, Europe and Asia.
DBRS’s extensive coverage of securitizations
and structured finance transactions solidifies our
standing as a leading provider of comprehensive,
in-depth credit analysis.
All DBRS ratings and research are available in
hard-copy format and electronically on Bloomberg
and at DBRS.com, our lead delivery tool for
organized, Web-based, up-to-the-minute information. We remain committed to continuously
refining our expertise in the analysis of credit
quality and are dedicated to maintaining
objective and credible opinions within the global
financial marketplace.
Rating Canadian Residential Mortgages, Home Equity Lines of Credit and Reverse Mortgages
November 2014
Rating Canadian Residential Mortgages, Home Equity
Lines of Credit and Reverse Mortgages
TABLE OF CONTENTS
Scope and Limitations
Introduction
Application of Methodology
Loan-Level Analysis
Default Frequency (Probability of Default)
Key Factor: The Combination of Loan-to-Value (LTV) and Credit Score
Base-Case Mortgage and Base-Case Default Curve
Examples of Default Frequency Assumptions
Other Factors
Loss Severity (loss given default)
(1) Unpaid Principal Balance
(2) Accrued Interest
(3) Recovery on the Property
(4) Foreclosure Costs
(5) Other Recoveries
(6) Second-Lien Mortgages
Portfolio-Level Analysis
(1) Geographic Concentration
(2) Pool Size
Cash Flow and Structural Analysis
(1) Excess Spread and Cash Flow Analysis
(2) Other Structural Features
Analysis for Insured Mortgages/HELOCs and NHA-MBS
Legal Review
Notice and Perfection
Registration
Foreclosure and Recourse
Operational Review
HELOCs
Characteristics of a HELOC
Terms and Payments
Credit Limit
HELOCs in Canada and the United States
Transaction Structure
Trust Structure (Master Trust)
Co-Ownership Interest (Non-Discrete Purchase)
Seller’s Interest
Commingling
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Addition and Removal of Accounts
Revolving Period
Amortization Period
Controlled Accumulation and Controlled Amortization Periods
Early Amortization Period
Priority of Payments (Waterfalls)
Loan-Level and Cash Flow Analysis
(1) Loan-Level Analysis
ABCP liquidity
Reverse Mortgages
Expected Occupancy Term (EOT)
Property Value and Home Price Appreciation (HPA)
Mortgage Rates
Stress Testing and Cash Flow Analysis
EOT Assumption
Stressed Property Value and HPA
Excess Spread and Cash Flow Analysis
Accrual of Note Interest
Surveillance
Appendix 1: Glossary
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Scope and Limitations
DBRS evaluates both qualitative and quantitative factors when assigning ratings to a Canadian structured
finance transaction. This methodology represents the current DBRS approach for rating mortgage-related
securitizations issued in Canada with collateral originated in Canada. It describes the DBRS approach
to analysis, which includes (1) a focus on the quality of the originator/servicer, (2) evaluation of the collateral pool and (3) utilization of historically employed credit evaluation techniques. This report also
outlines the asset class and discusses the methods DBRS typically employs when assessing a transaction
and assigning a rating. It is important to note that the methods described herein may not be applicable
in all cases. Further, this methodology is meant to provide guidance regarding the DBRS methods used in
the sector and should not be interpreted with formulaic inflexibility, but understood in the context of the
dynamic environment in which it is intended to be applied.
Introduction
DBRS’s approach to rating Canadian residential mortgage-related transactions considers the key characteristics of residential mortgages and their corresponding risk metrics, together with the various structural
features. In addition, as market value declines from the Canadian RMBS Model (the RMBS Model) are
used for the analysis of reverse mortgages, DBRS incorporates in this methodology the approach to
rating Canadian reverse mortgages, which was previously a separate appendix in the Rating Canadian
Structured Finance Transactions methodology. The main body of this methodology continues to focus on
the discussion of regular residential mortgage securitization, with additional discussions of home equity
lines of credit (HELOCs) and reverse mortgages.
The fundamental approach used for Canadian residential mortgage transactions has remained consistent
since the first publication of the methodology in 2008. First, the RMBS Model assesses credit risk for an
individual mortgage relative to a base-case mortgage, which is a 30-year fixed-rate mortgage for purchase
of an owner-occupied single-family property underwritten to a full documentation standard. The expected
loss at each rating level is then increased or decreased by distinctive risk factors (risk layering) of the individual loan. Second, after the RMBS Model sums up the expected loss for each individual mortgage in a
pool through a risk-weighting formula, the RMBS Model adjusts the expected loss, if necessary, to reflect
the characteristics of the pool as a whole (namely, the size and the geographic concentrations of the asset
pool). Finally, DBRS uses the RMBS Model output to run the cash flow model. In addition, the quality
and experience of the mortgage originator and servicer and the legal and operational aspects of the transaction are examined to determine if any further adjustments are necessary.
APPLICATION OF METHODOLOGY
The following diagram describes the overall process for analyzing residential mortgage- and HELOCbacked transactions:
(1) DBRS conducts loan-level and portfolio-level analysis using the RMBS Model. The resulting output
of the model is the expected gross credit loss of the loan. The RMBS Model is a substantial component
of the DBRS rating process.
(2) DBRS performs a cash flow analysis based on the output from the RMBS Model by incorporating
assumptions regarding prepayment for residential mortgages or base-case principal payment rate and
stress multiples for HELOCs, timing of defaults and interest rates in order to estimate the excess spread
available over the life of the transaction and the appropriate credit support for each rating level.
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(3) The legal and operational aspects of the transaction are also reviewed with the understanding that the
adequacy of the credit enhancement available is also subject to the legal structure of the transaction and
the results of an operational review.
Loan-Level Analysis
Canadian
RMBS Model
+
Prepayment
Assumptions
Gross Credit Loss
Interest Rate
Assumptions
Cash Flow Analysis
Timing of Default
Assumptions
Base Case Principal
Payment Rate and
Stress Multiple
Assumptions
(HELOC)
Operational Review
Credit Enhancement/Ratings
Surveillance
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Legal Review
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Loan-Level Analysis
DEFAULT FREQUENCY (PROBABILITY OF DEFAULT)
Key Factor: The Combination of Loan-to-Value (LTV) and Credit Score
The combination of LTV and credit score (the most common credit score provided in Canada is the
BEACON score from Equifax Inc.) is the most important factor in determining the default risk of a
residential mortgage. LTV is positively correlated with mortgage defaults, which means the higher the
LTV, the greater the probability of default. Credit score, however, is negatively correlated with mortgage
defaults, which means the lower the credit score, the greater the probability of default. These two variables are used in tandem within the RMBS Model.
Base-Case Mortgage and Base-Case Default Curve
DBRS defines the base-case mortgage as a 30-year fixed-rate mortgage for purchase purposes, underwritten to a full documentation standard and assumed by an “A”-grade borrower who occupies the
single-family detached house as the primary residence. This base-case mortgage of 30 years is based
on the U.S. market where a large amount of mortgage data is available. When the characteristics of a
mortgage deviate from the base-case mortgage, the default risk associated with this mortgage changes
accordingly. For example, a 25-year mortgage with all other characteristics being the same has a lower
probability of default than a 30-year mortgage because if a borrower chooses a shorter amortization
period, it implies that the borrower is able to afford a larger monthly mortgage payment and is confident
in paying off the debt sooner. In other words, such a borrower is considered to have a stronger financial
ability and willingness to pay and, therefore, is less risky in terms of credit risk.
The default probability of a base-case mortgage can be estimated by the borrower’s credit score in combination with the LTV of the mortgage at origination. The base-case default curves are subsequently derived
from DBRS interpretation of the modified Fair Isaac Corporation (FICO) bad-rate table and the statistical
study of the historical mortgage performance data in the United States. DBRS internal analysis reveals
that, for the same credit scores between 510 and 680, Canadian borrowers tend to perform better, resulting in adjustments for Canadian loans with a slight credit lift embedded in the base-case default curve.
As credit score decreases, the ability or willingness to pay is considered to decrease exponentially, causing
the bad rate of mortgages 90-plus days in arrears or defaulted mortgages to increase at an exponential
rate. The RMBS Model allows for credit scores in the range of 440 and 880. Any score above or below
this range is considered statistically immaterial from the cut-off points and is replaced by the cap (880) or
floor (440) score. If a credit score is not available for any given mortgage, DBRS typically assigns a score
of 580 unless the historical performance or credit quality of the pool proves otherwise.
Examples of Default Frequency Assumptions
(1) The graph below illustrates a base-case mortgage with a BEACON score of 820 at different LTV levels
for rating categories from AAA (sf) to B (sf).
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820 BEACON Score by LTV
Base Default Frequency
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
60%
70%
80%
90%
100%
LTV
AAA (sf)
AA (sf)
A (sf)
BBB (sf)
BB (sf)
B (sf)
(2) The graph below shows a base-case mortgage with a BEACON score of 620 at different LTV levels
for rating categories from AAA (sf) to B (sf).
620 BEACON Score by LTV
18.0%
16.0%
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
60%
70%
80%
90%
100%
LTV
AAA (sf)
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AA (sf)
A (sf)
BBB (sf)
BB (sf)
B (sf)
November 2014
(3) The graph below shows a base-case mortgage of 90% LTV with different BEACON scores for rating
categories from AAA (sf) to B (sf).
90% LTV by BEACON Score
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
540
580
620
660
700
740
780
820
BEACON Score
AAA (sf)
AA (sf)
A (sf)
BBB (sf)
BB (sf)
B (sf)
(4) The graph below shows a base-case mortgage of 60% LTV with different BEACON scores for rating
categories from AAA (sf) to B (sf).
60% LTV by BEACON Score
8.0%
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
540
580
620
660
700
740
780
820
BEACON Score
AAA (sf)
AA (sf)
A (sf)
BBB (sf)
BB (sf)
B (sf)
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Other Factors
(1) Type of Mortgage Product
A mortgage product contains various characteristics such as mortgage rate, amortization period, term to
maturity and interest-only (IO) period (if applicable). The RMBS Model compares these characteristics
to the base-case mortgage, determines the deviation from the base-case mortgage and any related penalty
(or benefit) factor of each characteristic and multiplies these factors to obtain the overall assessment of
default risk of a particular mortgage product.
(a) Mortgage Rate: Fixed-rate mortgages (FRMs) are the most popular type of mortgage in Canada, while
the popularity of adjustable-rate mortgages (ARMs) depends on interest rate levels. ARMs are considered
riskier in the RMBS Model because the mortgage rate could potentially be reset to a higher level when the
Bank of Canada rate (and consequently the index rate, usually the lender’s prime rate) moves up and a
higher monthly payment will be required (the payment shock). DBRS uses FRMs as the base and applies
an ARM penalty factor, based on the reset frequency of the interest rate. A mortgage with interest rate
reset more frequently than two years (monthly, quarterly, semi-annually, annually or biennially) is considered most risky as the borrower is subject to more frequent potential payment shocks. A mortgage with a
three-year reset period is considered riskier than a five-year reset as historical experience in Canada shows
that the likelihood of default is highest within three years of loan origination. With a reset to a potentially
higher rate, the likelihood of default increases. In comparison, a common mortgage in Canada with a
fixed five-year term or longer (i.e., mortgage rate reset at the end of five years or later) is considered virtually the same as an FRM throughout the entire amortization period. See the Timing of Defaults section in
Cash Flow and Structural Analysis for more details.
Frequency Adjustment for ARMs
Frequency Adjustment Factor
1.60
1.50
1.40
1.30
1.20
1.10
1.00
0.90
0.80
-
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2
3
4
5
6
7
8
ARM Reset in Years
(b) Amortization Period: In Canada, a common amortization term is 25 years. Using 30-year amortization as the base, DBRS applies a frequency (upward) adjustment for mortgages with longer amortization
terms and a frequency benefit factor for mortgages with shorter amortization terms. As discussed above,
if a borrower chooses a shorter amortization (all else being equal), it implies that the borrower is likely in
better financial condition or more committed to pay off the debt sooner and, therefore, the borrower is
less likely to default on the loan. On the other hand, if a borrower opts for a longer amortization, which
results in lower monthly payments and increases affordability, it could mean the borrower likely would
not otherwise qualify under the standard amortization term and is less creditworthy. The likelihood of
default is therefore assumed to be higher. Another feature of amortization is negative amortization, which
allows unpaid accrued interest to be added to the principal balance of the mortgage, causing the outstanding loan balance to grow instead of being paid down over time. Mortgages with negative amortization
features are considered risky since the effective interest rate is below the mortgage rate and the monthly
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payments are kept artificially low to stretch the affordability. These borrowers will face payment shocks
when the outstanding mortgage balance reaches a predetermined LTV limit and starts to amortize. To
properly assess this risk, the frequency penalty factor for negative amortization is 1.2 times (x) within the
RMBS Model.
Frequency Adjustment for Full Amortization Mortgages
Amortization Frequency Factor
1.40
1.30
1.20
1.10
1.00
0.90
0.80
0.70
0.60
0
5
10
15
20
25
30
35
40
45
50
Full Amortization in Years
(c) Term to Maturity: In Canada, a mortgage usually carries a term to maturity much shorter than
its amortization term, which means a mortgage is subject to a review (and renewal) at the end of the
mortgage term. Such partially amortizing mortgages (or balloon mortgages) carry additional default risk
as the mortgagor may not be able to arrange a new mortgage when the term of the mortgage ends and
the final payment (the balloon payment) becomes due. In general, the longer the term to maturity and the
closer its length to that of the amortization term, the less risky the mortgage is because a mortgage with
longer term to maturity will carry a smaller balloon when the mortgage matures and the LTV at maturity
is likely to be lower; therefore, it is considered easier for the borrower to obtain another mortgage at the
end of the mortgage term. The RMBS Model assigns a penalty factor for partially amortizing mortgages
if the term to maturity is less than five years as a five-year mortgage term is the norm and borrowers with
shorter loan terms are potentially perceived as less creditworthy by the lenders to assume their credit risk.
In addition, there is less time to pay down the mortgage balance for shorter term loans.
Changing market conditions, lender liquidity and refinancing criteria have caused some non-conventional
lenders to be unable or unwilling to refinance a mortgage at maturity, even if a borrower has been making
the mortgage payments on time during the entire mortgage term. This caused some borrowers to default
on the balloon payments as a result of their inability to renew the maturing mortgage, in spite of the borrowers’ clean payment history. On the other hand, with respect to prime mortgages, DBRS was not aware
of any conventional mortgage lender failing to renew performing loans during the recent financial crisis
and considers it highly unlikely that a prime borrower of conventional mortgages with a clean payment
history would be unable to obtain refinancing at loan maturity.
As the risk of defaulting on maturity (balloon risk) is different from the risk of defaulting on regular
mortgage payments (credit risk), it is additive to the default frequency generated from the RMBS Model.
The goal of balloon risk assessment is to determine a realistic probability of non-refinancing at loan
maturity.
Lender-specific liquidity lies at the heart of balloon risk; therefore, the higher the lender is rated, the
less likely a liquidity shortage would occur and the more likely maturing mortgages could be renewed.
DBRS attempts to assess the potential default concentration at the maturity of the loans by estimating the
lender’s liquidity (or lack thereof) at the end of the loan tenure and the percentage of loan defaults as a
result of non-renewal.
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For surveillance of existing transactions where the eligibility by mortgage insurers or lenders’ underwriting criteria may have changed since loan origination, DBRS may estimate future LTV and credit
scores at loan maturity. The estimated LTV takes into account the future scheduled mortgage payments,
potential prepayments and home price appreciation (HPA) since origination, based on publicly available
information such as Teranet-National Bank House Price Index (Teranet Index) or Canadian Real Estate
Association (CREA) data with DBRS adjustments.
When a non-conventional mortgage at maturity is considered to fall outside refinancing guidelines of
mortgage insurers or most lenders and a balloon risk exists, the loan is assigned a minimum default probability of 50% in the RMBS Model, based on the credit score of the borrower.
Partial Amortization Frequency Adjustment Factor
Partial Amortization Adjustment
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
Mortgage Term to Maturity (Years)
(d) IO Period: The IO mortgages offered in Canada are different than those offered in the United States.
As such, IO mortgages in Canada begin with an IO period (typically three years or five years) and end
with an obligation of full principal repayment at the end of the IO period; therefore, these mortgages are
IO balloon loans, while in the United States, IO mortgages begin with an IO period and at the end of the
IO period, principal amortization will occur for the remaining mortgage term. The IO feature brings an
additional layer of risk to the mortgage because these mortgages do not amortize during the IO period
and the borrower solely depends on the appreciation of the property to increase his/her equity by the
end of the IO period to refinance or fully repay the principal. There is a risk that the property value may
not increase during the IO period if there is a serious market downturn. In addition, borrowers face a
payment shock when the IO period ends as the mortgage payments start to include principal repayment
in addition to interest expenses. Within the RMBS Model, the penalty for the IO feature depends on the
term to maturity. For example, IO mortgages with a 15-year term to maturity are considered to have
a higher default probability than those with a 25-year term to maturity. This is because a shorter term
to maturity means a shorter period of time for full principal amortization after the IO period ends and
results in a larger principal repayment monthly, increasing the magnitude of payment shock when principal (re)payment is required. For loans with an IO period of between five years and ten years, the penalty is
relatively low because the borrower has a longer period for its property to appreciate and, therefore, more
opportunities during the ensuing years to sell or refinance the property. For an IO period of less than five
years, the risk of payment shock increases significantly as interest rates may move upward when the IO
period ends, increasing the payment obligations (both principal and interest) and the increased payment
also becomes effective during the period of greater credit risk (within five years of origination). For an IO
period greater than ten years, information on historical performance is limited and the increasing default
frequency penalty factors reflect a conservative bias. As such, the DBRS IO adjustment curve is U-shaped.
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IO Frequency Adjustment Factor
IO Frequency Adjustment Factor
1.8
1.7
1.6
1.5
1.4
1.3
1.2
1.1
1
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
IO Period in Years
IO (5-year Term to Maturity)
(2) Loan Purpose
The base-case loan purpose is to purchase. Purchase loans are the least risky of all loan purposes as no
borrower is willing to overpay for a property, especially when the borrower needs to provide a down
payment. Thus, the value of the property should be very close to the true market value, minimizing the
risk of an inflated property price and an underestimated LTV, which would result in lower credit risk.
Refinance mortgages are considered riskier than purchase mortgages, whether the refinance is a rate
refinance or a cash-out refinance. Refinance/cash-out mortgages are expected to have more aggressive
property appraisals than purchase mortgages as there is only appraised value without an actual sale and
the LTV may be underestimated because of an inflated assessment so that a larger equity takeout can be
obtained. Also, as no down payment is required for a rate refinance and only some costs are incurred
for a cash-out refinance, the refinance becomes more of a financial transaction, reducing the borrower’s
commitment to the property and turning the home into a financing vehicle using the equity in the house.
Nevertheless, there is generally no property reappraisal for a rate refinance transaction, reducing the
risk of inflated property valuation. In addition, rate refinancing is not common in Canada as there is
usually a substantial penalty on full prepayment, which discourages borrowers from seeking out the
lowest mortgage rates even when the interest rate drops.
The RMBS Model uses continuous equations based on borrowers’ credit scores to calculate default
penalty factors for both rate and cash-out refinances. The adjustment factors for rate refinance range
from 1.2x for borrowers with high credit scores to 1.5x for borrowers with weaker credit scores. This is
intuitively correct because the penalty is modest for strong credits and more substantial for weaker credits
as rate refinance is geared toward sophisticated borrowers.
The penalty factors for cash-out refinance range from more than 2.0x for borrowers with high credit
scores to 1.6x for borrowers with weak credit scores. That is, the stronger the borrower credit-wise, the
larger the penalty for a cash-out refinance as prime credit borrowers are assumed to have many means
of cost-effective borrowing rather than having to resort to cash-out refinance. If a prime credit borrower
chooses a cash-out refinance, it is likely that the borrower is running out of other financing options to
the point of being over-leveraged and, therefore, a larger penalty (up to 2.44x) is warranted than for a
non-prime borrower for whom cash-out refinance is probably the only financing option available. The
adjustment is relatively smaller at 1.6x for non-prime borrowers.
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Frequency Adjustment Factor - Loan Purpose
3.0
Frequency Factor
2.5
2.0
1.5
1.0
0.5
880
860
840
820
800
780
760
740
720
700
680
664
648
632
616
596
576
556
536
500
480
460
440
-
BEACON Score
Rate Refi Purpose Factor
Other Purpose (Cash Out, Debt Consolidation etc.)
(3) Documentation
The degree of documentation verification is important in the evaluation of mortgage default risks. DBRS
considers a mortgage to be one with full documentation if the mortgage meets the documentation requirements of uninsured mortgages at a traditional Canadian financial institution (e.g., a bank, credit union
or trust company). Full documentation usually includes the verification by the lender of the borrower’s
income, assets, employment and rental/mortgage payment history. DBRS assigns a penalty factor to mortgages with reduced or low documentation since those features introduce additional credit risks into the
mortgage. The less documentation verified as part of the mortgage application process, the greater the
uncertainty about the borrower’s financial ability and propensity to pay. Similar to loan purposes, the
frequency penalty for documentation is continuous based on the borrowers’ credit scores. The penalties
for reduced documentation increase as the borrower’s credit score improves, similar to the adjustment
for cash-out refinance loans. This may not be intuitively obvious: DBRS considers that prime borrowers
should have no problem providing full documentation and the use of low documentation in mortgage
applications implies non-standard practice, potential misrepresentation and adverse self-selection. There
is a disconnection between a prime credit and low documentation. As for non-prime borrowers, the use
of reduced or low documentation mortgages is considered part of their credit nature, meaning incomplete
or unverifiable credit documents contribute to weak credit. The penalty, then, is lower than for prime
borrowers with low documentation. If a low doc or no doc (Doc Code = 1 or 2) mortgage happens to
carry other layers of risk, such as having a high LTV (over 80%), being an investment property or having
junior liens, there is an additional frequency penalty of up to 3.0x on top of the documentation frequency
adjustment factor.
Mortgage Documentation Codes
Documentation Type
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Doc Code
A full doc loan with all verifications completed in a manner that satisfies usual Schedule I bank standards.
Four pieces of verification are completed: income, assets, employment and mortgage/rental history
4
Usually three verifications were performed or one verification less than a full doc
3
A stated income, stated assets loan with verification of mortgage/rental history and employment
2
Minimum document verification
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Frequency Adjustment for Various Documentation Standards
Frequency Factor
2.50
2.00
1.50
1.00
0.50
880
862
844
826
808
790
772
754
736
718
700
682
668
653
639
625
608
590
572
554
536
502
484
466
448
-
BEACON Score
Full Doc
2 Complete Verifications
3 Complete Verifications
1 Complete Verifications or None
(4) Borrower Credit Grade
DBRS base-case borrower credit grade is “A,” which means that the borrower has had no delinquencies
on his or her credit card or on other personal debts in the past seven years, according to the credit bureaus
in Canada. Mortgagors whose credit histories are not as good are subsequently classified as A-, B, C or
even D borrowers based on their credit scores or their delinquency/default history. DBRS assigns a frequency penalty factor for mortgages without an “A” credit grade. DBRS may examine the underwriting
standards, available performance data and the borrowers’ credit scores to assign a credit grade to each
mortgage. As the underwriting standards vary among different mortgage originators, DBRS typically uses
the more objective credit scores presented in the following table as general guidelines to determine the
credit grade for mortgages.
Frequency Factors
Credit Grade
Credit Score
Frequency Factor
A
Greater than 679
1.0x
A-
640 to 679
1.2x
B
580 to 639
1.35x
Less than 580
1.5x
C/D
(5) Occupancy
As mentioned above, a base-case mortgage is secured by a property occupied by the owner as the primary
residence. Non-owner-occupied properties, such as second homes and investment properties, are considered riskier since the borrower is more likely to default on a non-owner-occupied property when financial
resources are constrained. For example, a second home is not a necessity to satisfy an immediate, basic
need for housing and represents additional commitment (a luxury) on the part of a mortgagor. Given the
choice between making the mortgage payments on a primary residence and on a second home, most borrowers would be expected to maintain their primary residences if their ability to pay is diminished. The
penalty factor for second homes is 1.2x. For an investment property, the investor is dependent on rental
income to cover the mortgage payments and other expenses and rental income is subject to changes in
the rental market. In addition, renters are generally not as financially or emotionally committed to the
property and if the investor-owner is more distant from the property’s maintenance needs, an investorowned property is more likely to be poorly maintained than a primary residence or a second home. As
it is by nature an investment, subject to investment return goals and reflecting a certain appetite for risk,
vacancy and/or rental market risk may alter the likely investment outcome, property value and borrower’s
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interest. The frequency factor for investor-owned properties is 1.7x, harsher than for second homes,
which typically have a strong commitment from the owners.
Frequency Adjustment for Different Occupancy Types
Frequency Factor
1.8
1.7
1.6
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
Primary
2nd Home
Investor
(6) Property Type
Detached single-family homes, the most common and preferred property type in Canada, are the basecase property type. Semi-detached houses, row houses and freehold townhouses are also considered the
same as detached single-family properties. The default penalty factor increases when the property houses
more than one family (e.g., a duplex) or ownership is somehow shared and an individual mortgagor is
closely tied to neighbouring properties (e.g., condominiums and co-operatives). Historically, non-singlefamily properties tend to have less market liquidity than single-family properties, take longer to sell and
are, therefore, considered riskier in a market downturn, although the popularity of multi-unit residential
dwellings such as condominiums has increased over the past decade. Specifically, condominiums and
co-operatives, even though they are intended as single-family housing, are different in the sense that a
mortgagor owning a condominium or co-operative unit is tied to the neighbouring units for the financial and physical maintenance of the entire building in which the unit exists. This codependency creates
additional risk, which is especially apparent in circumstances where the building association is financially
troubled, even though the individual unit owners are not. To account for this increased risk, the DBRS
penalty factor for both condominiums (including condominium townhouses) and co-operatives is 1.5x.
Property Frequency Adjustment Factor
Frequency Adjustment Factor for Various Property Types
16
1.6
1.5
1.4
1.3
1.2
1.1
1
0.9
0.8
Single-family
Townhouse
Duplex
Condo
November 2014
(7) Location
(a) Provinces/Territories: Each province/territory in Canada has its own distinct real estate laws and
some provinces/territories are more creditor friendly than others. DBRS assigns an adjustment factor
to account for the impact of different legislation. For example, in Alberta, property foreclosures occur
under judicial sale so that when a lender obtains a court order for foreclosure on a property, the mortgage
debt is entirely extinguished and the lender can no longer pursue the borrower for any deficiency if the
foreclosure proceeds do not fully satisfy the debt. In other words, the lender has no recourse back to the
borrower (except for insured mortgages). Therefore, DBRS applies a penalty factor for mortgages with
high LTVs in Alberta as a distressed borrower will likely be better off surrendering the property to the
lender and walking away than trying to sell the property, paying off the loan and realizing the equity (if
any) in the property. The likelihood of default in this scenario is considered high. Some provinces/territories have less creditor-friendly legislation, which complicates the delinquency management process and
increases the default risk.
(b) Market Liquidity: According to Statistics Canada, more than half of Canadians live in a municipality with a population of 100,000 or more and more than two thirds of Canadians live in a municipality
with a population of 20,000 or more. Properties located in the less populated areas are considered riskier
because the liquidity of the local real estate market is limited and there is a higher dependence on one
industry. To assess the risk related to the reduced market liquidity, DBRS uses population cut-offs to
classify mortgages into the following categories and assigns a penalty factor to mortgages located in nonurban locations.
Location Adjustment Factors
Category
Population Range
Frequency Adjustment Factor
Urban
100,000 and over
1.0x
Suburban
45,000 to 99,999
1.05x
Tertiary
20,000 to 44,999
1.2x
Rural
Less than 20,000
1.25x
(8) Loan Size
Large mortgages (usually associated with expensive properties) exhibit higher default propensities because
expensive properties have limited market liquidity and take longer to sell during a market downturn.
DBRS classifies mortgages according to their sizes and locations and assigns adjustment factors as follows:
a penalty factor of 1.15x to loans with sizes above the large loan limit and 1.1x to loans within the size
limit. DBRS also reviews the concentration of large loans from a portfolio perspective and may adjust the
expected loss levels if necessary.
Mortgage Size Restrictions by Location
Large Mortgage Limit
Locations
$600,000 to $1,000,000
• Toronto and Vancouver (city proper)
$600,000 to $800,000
•
•
•
•
$400,000 to $600,000
• Rest of Canada
Oakville, Thornhill and Unionville (Ontario)
Victoria, West Vancouver, North Vancouver, Richmond and Burnaby (British Columbia)
Calgary (inner city only)
Montréal
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November 2014
(9) Seasoning
Seasoned loans are considered less likely to default than newly originated loans with similar features
because, for a seasoned loan, the borrower has already demonstrated his/her ability to pay. DBRS review
of historical mortgage performance data indicates that, in general, mortgage defaults tend to be front-end
loaded; therefore, there is no credit given for loans with less than two years of seasoning as these loans
are not considered to be over the default peak. DBRS gives credit to loans with more than two years of
seasoning (up to 60% frequency reduction).
DBRS expects loans to have an updated property value at renewal, as indicated in the Office of the
Superintendent of Financial Institutions Canada (OSFI) Guideline B-20, and the origination date to be
reset to the renewal date, essentially considering it a new loan, in the data provided to DBRS. For a very
seasoned portfolio without updated property values or renewal dates such as the portfolios of mortgage
insurers, DBRS may mark to market the property value for HPA since the last appraisal date or the
origination date based on Teranet Index or CREA data with DBRS HPA adjustments and prepayment
assumptions to assess the appropriate LTV. If the property value or the origination date is not updated
at renewal, the loan is subject to seasoning benefit since the last appraisal date, which is generally less
beneficial than HPA benefit depending on price appreciation over the assessment period.
(10) Delinquency Status
The default frequency for loans that are over 30 days delinquent is equal to the greater of (1) the default
estimate based on the credit attributes of the loan (without considering delinquency status) and (2) the
default estimate indicated in the table below (regardless of rating category):
Default Frequency Estimate for Delinquent Loans
Delinquency Status
Credit Score ≤ 680
Credit Score ≤ 740
Credit Score > 740
2nd Lien
30-59 days
60%
50%
40%
60%
60-89 days
75%
70%
50%
90%
90 days and over
90%
80%
60%
100%
Bankruptcy
90%
90%
90%
100%
Foreclosure
95%
95%
90%
100%
100%
100%
100%
100%
Real Estate Owned
LOSS SEVERITY (LOSS GIVEN DEFAULT)
Loss severity is defined as the mortgage loss divided by the unpaid principal balance. The mortgage loss
is the sum of unpaid principal balance and accrued interest, net of recovery on the property after adjustments for foreclosure costs or any other recoveries.
(1) Unpaid Principal Balance
Unpaid principal balance is the loan amount at the time of securitization. To be conservative, DBRS
assumes an immediate default on the original securitized amount without making any assumption for the
timing of default or amortization.
(2) Accrued Interest
The total amount of interest accrued during the mortgage arrears and subsequent property foreclosure
periods depends on the length of the liquidation period and the level of the interest rate on the mortgage.
The total liquidation period includes a delinquency period, a property marketing period and a foreclosure
period, with the length of each period varying among the provinces/territories because of different provincial/territorial regulations. For mortgage rates used in the calculation of the carrying costs during the
liquidation period, DBRS uses the maximum of the current rate, the initial rate plus 4% and the life cap
minus 2% for ARMs and the current mortgage rate for FRMs.
18
November 2014
Foreclosure Process in Canada
In Canada, judicial sale and power of sale are two main ways a lender recovers mortgage debt when
a borrower defaults. Judicial sale is a sale conducted under the supervision and authority of the court,
where a lender must apply to the court to get the court’s permission to sell the property. On the other
hand, power of sale allows a lender to sell the property without the involvement of the court. The lender
has the right to sell the property according to the mortgage documents and/or the provincial/territorial
legislation that allows power of sale in that province/territory.
Power of sale is mainly used in Ontario, Newfoundland and Labrador, New Brunswick and Prince
Edward Island. Judicial sale has been adopted in British Columbia, Alberta, Saskatchewan, Manitoba,
Nova Scotia and Québec. In addition to legislative guidelines, the actual length of foreclosure (either for
judicial sale or power of sale) varies in each province/territory. During normal or good economic periods,
it can range from days to several months, but during economic downturns, it can be stretched to up to a
full year, with some smaller communities experiencing even longer time frames.
The following table shows the DBRS assumptions on the liquidation period for each province/territory.
Liquidation Period by Province/Territory
Province/Territory
Foreclosure Period (Months)
Total Liquidation Period (Months)
Alberta
4
14
British Columbia
8
18
Manitoba
1
11
New Brunswick
2
12
Newfoundland and Labrador
6
16
Nova Scotia
3
13
Northwest Territories
10
20
Nunavut
10
20
Prince Edward Island
2
12
Ontario
4
14
Québec
9
19
Saskatchewan
4
14
Yukon
4
14
(3) Recovery on the Property
Market value decline (MVD) is important in determining loss severity when the mortgage defaults. Loss
severity, similar to default frequency, is correlated to the borrower’s credit quality. Losses are likely smaller
for borrowers with better credit quality and vice versa as borrowers of good credit quality are assumed to
pay more attention to and take better care of the property than those with poor credit, resulting in lower
losses upon recovery. Accordingly, the borrower’s credit score is used as a proxy for the condition of real
estate collateral during the repossession of property and recovery process. In the RMBS Model, MVD is
a continuous function of borrower credit scores by the rating categories as follows.
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November 2014
Market Value Decline by Rating Categories
55%
50%
45%
MVD %
40%
35%
30%
25%
20%
15%
10%
440
480
520
AAA (sf)
560
600
AA (sf)
640
680
BEACON Score
A (sf)
720
BBB (sf)
760
800
BB (sf)
840
880
B (sf)
As shown above, DBRS base MVD (B rating) represents a quick-sale or distressed-sale discount on the
property, with a minimal level of stress beyond the individual property’s distressed state. The base MVD
for borrowers with credit scores greater than 700 is approximately 20% and rises steadily to 30% as credit
scores decrease. At the AAA (sf) level, the RMBS Model assumes that the collateral will lose its value at
origination from approximately 38% to 51%, depending on the borrower’s credit score. Such stress levels
are consistent with the worst historical home price declines observed in the United States (financial crisis
of 2008–2009, California in the early 1990s, oil bust in Texas) and certain market segments in Canada.
Delinquency Status
If the delinquency status of the loan is either 90 days and over, bankruptcy, foreclosure or real estate
owned (REO), the RMBS Model changes the credit score of the loan to 580 or keeps the original credit
score if it is lower so that the MVD calculation reflects the possible rundown condition of the property.
Further Adjustments on MVD
Property Type
DBRS base-case property is a single-family detached home (including freehold townhouses). Multifamily
buildings, such as a duplex or condominium (including condominium townhouses), are considered riskier
as they appeal to a more limited buyer population and tend to exhibit more price volatility historically.
As a result, they tend to take longer to sell, especially during a market downturn. Condominiums and
co-operatives carry additional risks because the ownership of a common property means (1) escalating
association or maintenance fees may push levered borrowers beyond their means and (2) the borrower
partially depends on the neighbours in maintaining the property value. The following graph shows the
penalty factors for different property types.
20
November 2014
MVD Adjustment Factor by Property Type
MVD Adjustment Factor
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
Townhouse
Single-family
Duplex
Condo
Relative Price Level (Dearness)
Affordability and desirability are relative measures in the RMBS Model and may be perceived differently
when different market conditions exist. DBRS has incorporated three levels (provincial/territorial, municipal and forward sortation area (FSA, the first three characters of a Canadian postal code) of housing
price indices based on 2006/2007 resale transaction data as a benchmark to gauge the relative dearness
(or cheapness) of a collateral property. Extremely expensive or cheap properties are modelled at a higher
loss at foreclosure as expensive properties have a limited resale market and very cheap properties will
incur a higher percentage of foreclosure costs because of some fixed foreclosing costs, regardless of the
property value. Properties with a price closer to the benchmark index (i.e., cookie cutters) are assumed to
experience less severe value declines thanks to their broader appeal in resale markets.
The benchmark indices used in the RMBS Model were based on the market values in 2006/2007. Given
the over 30% positive HPA in the national housing index since 2006/2007 to date, collateral properties
for mortgages originated or renewed in recent years are more likely to be considered dear or expensive
compared with the benchmark index and are therefore more likely to have less benefit or even be subject
to penalty. To be conservative, DBRS has not updated the benchmark index to reflect positive HPA.
Should there be a housing price correction up to 30% in the future, the benchmark index used in the
RMBS Model would still be considered appropriate to measure a property collateral’s dearness.
MVD Adjustment Factor by Relative Dearness
MVD Adjustment Factor
1.7
1.6
1.5
1.4
1.3
1.2
1.1
1.0
0.9
0.8
0.1
0.6
1.1
1.6
2.1
2.6
3.1
3.6
4.1
4.6
5.1
Relative Dearness Ratio (Property Value/Property Index)
21
November 2014
The RMBS Model incorporates benchmark indices based on average resale prices at the (i) FSA level (with
86, 21, 196 and 185 benchmark indices for the Greater Toronto Area, Greater Montréal Area, Calgary
and the entire province of British Columbia, respectively); (ii) municipality level (142 benchmark indices);
and (iii) provincial/territorial level (13 benchmark indices). The property value is compared with the most
granular corresponding benchmark index available to calculate the dearness ratio of the property. An
adjustment factor based on the dearness ratio is a continuous function implemented in the RMBS Model
as illustrated in the chart above. Properties too cheap or too expensive relative to the index are penalized
up to 1.65x, while property prices close to the index receive a benefit of up to 15%.
(4) Foreclosure Costs
There are additional costs incurred in the foreclosure and liquidation processes. These include legal fees,
real estate broker fees, property taxes, hazard insurance premiums (if applicable), eviction and routine
maintenance. The RMBS Model assumes foreclosure and liquidation costs are equal to 10% of the
stressed property value with a minimum of $5,000.
(5) Other Recoveries
Aside from property sale, recoveries may occur from pledged accounts, mortgage insurance or other
arrangements that provide potential cash flows to offset losses on the property value. The analysis of
insured mortgages is discussed in the Analysis for Insured Mortgages section.
(6) Second-Lien Mortgages
As a result of the increased sensitivity of second mortgages to property value declines, the impact of additional costs, the involvement of additional stakeholders and the subordinated access to recovery proceeds,
a 100% loss is assumed for second-lien mortgages plus disposal costs. This may result in a loss severity
of more than 100%. In addition, the RMBS Model usually assigns a punitive default frequency close to
100% on second-lien loans because of the high combined LTV of the first- and second-lien loans and the
adverse selection nature of second-lien loans (i.e., over-leverage). Depending on the combined LTV limit
(for example, up to 65% or 80% with a second-lien HELOC), DBRS may adjust the default frequency
downward to address the benefit of at least 20% equity in the property.
(1) Geographic Concentration
Geographic concentration increases the risk of a mortgage pool as the concentration increases the dependence on local economies and reduces the benefits of diversification compared with a geographically
diversified pool. A geographically concentrated pool is also more likely to be subject to other shocks such
as environmental issues and natural disasters, which can depress housing prices in the affected areas.
DBRS assumes that the base-case pool is geographically diversified according to the actual population
distribution in Canada. Expected loss for a pool with substantial geographic concentration is adjusted
based on the following two factors: province/territory and city.
(a) Province/Territory
If the concentration of one province/territory (in terms of mortgage values) is more than 2.0x that of the
province/territory’s actual population distribution, the excess portion is subject to a 20% penalty. The
threshold of 2.0x is considered sufficient to account for property value differences in each province/territory across Canada. The following table shows the population distribution of each province/territory and
the maximum concentration without penalty. For example, a pool can contain almost 80% of loans in
Ontario without being penalized for any provincial/territorial-level concentration.
22
November 2014
Concentration Levels by Province/Territory
Province/Territory
Population Percentage1
Maximum Concentration without Penalty
Ontario
38.9%
77.7%
Québec
23.4%
46.9%
British Columbia
13.2%
26.4%
Alberta
10.4%
20.9%
Manitoba
3.6%
7.2%
Saskatchewan
3.0%
6.0%
Nova Scotia
2.9%
5.7%
New Brunswick
2.3%
4.6%
Newfoundland and Labrador
1.6%
3.1%
Prince Edward Island
0.4%
0.8%
Northwest Territories
0.1%
0.3%
Yukon
0.1%
0.2%
Nunavut
0.1%
0.2%
1. According to a Statistics Canada 2006 survey.
The three largest provinces/territories in the pool (in terms of mortgage values) are evaluated according
to the maximum concentration allowed listed above and the penalty factor is the sum of the three provincial/territorial concentration factors, if any. A pool with 60% of its loan balances in Québec results in
a 2.64% relative increase in the expected loss figure, assuming the other two largest provinces/territories
do not incur concentration penalties. If the original expected loss is 15% prior to the provincial/territorial
concentration assessment, the final expected loss after such adjustment is 15.4% (15% * (1+2.64%)).
Sample Provincial/Territorial Population Concentration Calculation
A
B
Provincial/territorial %
Provincial/territorial
in the Pool
population % in Canada
60%
23.4%
C
D
E
Threshold (2.0 x B)
Excess (A – C)
Provincial/Territorial
Concentration Factor
2.0 * 23.4%
= 46.8%
60% - 46.8%
= 13.2%
13.2% * 20%
= 2.64%
(b) City
If the concentration of a city (in terms of mortgage values) is greater than 2.5x the city’s population distribution, the excess portion is subject to a 20% penalty. Similarly, the threshold of 2.5x is considered
sufficient to account for the property value differences in municipalities across Canada. The ten largest
cities in the pool (in terms of mortgage values) are evaluated and the total city concentration adjustment
factor is the sum of the ten city concentration factors, if any. Consider a pool with 40% of its loans in
Toronto. Such concentration in Toronto results in a relative 4.05% increase in the expected loss, assuming
the other nine largest cities do not incur concentration penalties. If the level of expected loss is 15% prior
to the city concentration assessment, the final level after such adjustment is 15.6% (15% * (1 + 4.05%)).
Sample City Population Concentration Calculation
A
B
C
D
E
City % in the Pool
City Population % in
Canada
Threshold (2.5 x B)
Excess (A – C)
City Concentration
Factor
40%
7.9%
2.5 * 7.9% = 19.75%
40% - 19.75% =
20.25%
20.25% * 20% =
4.05%
23
November 2014
A regionally concentrated mortgage pool is subject to both provincial/territorial and city concentration
penalties as these two factors are independently assessed and applied cumulatively.
(2) Pool Size
DBRS considers a mortgage pool size of $250 million to be large enough for meaningful diversification in
terms of loan counts and geography and is used as the base case. Up to 10% credit is given when the pool
size is greater than $250 million and up to 20% penalty is applied if the pool size is less than $250 million.
Pool Size Factor
1.3
Pool Size Factor
1.2
1.1
1
0.9
1,100
1,050
1,000
950
900
850
800
750
700
650
600
550
500
450
400
350
300
250
200
150
100
50
10
1
0.8
Pool Size ($million)
A small, geographically concentrated mortgage pool (in terms of province/territory and city) is subject
to three different penalties at the pool level as these factors are assessed independently and applied
cumulatively.
Cash Flow and Structural Analysis
In residential mortgage transactions, DBRS uses the pool-wide weighted-average default frequency and
loss severity results from the RMBS Model, in addition to other conservative assumptions, to assess the
adequacy of cash flow generated by the underlying mortgages and the credit protection available for rated
debts.
Excess spread is typically available as internal credit protection to cover losses if no margin-related securities are issued to strip out excess spread. It is crucial to appropriately value the amount of potential excess
spread because it affects the sufficiency of credit enhancement proposed. DBRS considers numerous risk
factors when evaluating a transaction’s excess spread, including the following:
• Timing of defaults.
• Interest rate mismatches.
• Prepayment speeds.
(a) Timing of Defaults
DBRS base assumption of timing of defaults is derived from historical experience in the United States and
spans ten years. DBRS also assumes that there is a recovery time period before the liquidation proceeds
of a defaulted mortgage can be received. DBRS uses two typical default curves for cash flow analysis:
front-end-loaded and back-end-loaded curves. The shape of the curves may be different for the types of
24
November 2014
mortgages. For example, the default curve for sub-prime mortgages tends to be more front-end loaded
than for prime mortgages as a sub-prime borrower is considered more likely to default earlier than a
prime borrower, everything else being equal. The back-end-loaded curve can be further adjusted by the
seasoning of the mortgages if necessary. To address the balloon risk, DBRS also modifies the default
timing curves to better simulate the possible concentration of defaults at the tail end.
(b) Interest Rate Mismatch
Interest rate mismatch risk occurs when the interest rate on the underlying mortgage collateral (i.e., asset
yield) is different from the interest coupon on the notes (i.e., cost of funds). For example, mortgages
can have fixed rates or adjustable rates based on the prime rate while being funded by floating-rate debt
in asset-backed commercial paper (ABCP) or indexed to the Canadian Dealer Offered Rate (CDOR).
This creates a mismatch between the fixed and floating rates or a mismatch between the prime rate and
CDOR (a basis risk). When CDOR rises, the spread between CDOR-based liabilities and fixed-rate assets
decreases. Interest rate mismatch also exists between prime rate and CDOR and between CDOR and the
ABCP rate. To quantify the effect of these interest rate mismatch scenarios, DBRS uses a dual approach
in stressing interest rates upward. First, it applies stress multiples to the base-forward curve of one-month
CDOR by rating category. The stresses are capped when the CDOR increase reaches 500 basis points
(bps) for AAA (sf); however, the forward curve does not always slope upward. To account for a flat or
downward-sloping forward curve environment, DBRS also incorporates a stressed linear increase over 36
months. The linear increase is intended to offset the risk that the forward curve would not apply significant stress in certain interest rate environments. DBRS then uses the more conservative value of the two
stresses in every month. In addition to an upward interest rate stress, DBRS applies a downward stress,
which, for a AAA (sf) rating, represents a 300 bps linear decrease over 12 months. The stress multiples to
the base-forward curve, the corresponding caps and the linear increases and decreases are commensurate
with the rating categories. The differential between the prime rate and CDOR can also be stressed to
assess the potential spread compression as the prime rate may not necessarily change in the same quantum
or with the same frequency as CDOR. The results from the more conservative of the two stress scenarios
(upward and downward) are then used to determine the adequacy of credit support.
Interest Rate Stress by Rating Category
Forward Stress
Rating Category
AAA (sf)
AA (sf)
A (sf)
BBB (sf)
Multiples
1.40x
1.30x
1.25x
1.15x
Cap (Basis Points)
+500
+470
+440
+410
AAA (sf)
AA (sf)
A (sf)
BBB (sf)
+400
+350
+300
+250
AAA (sf)
AA (sf)
A (sf)
BBB (sf)
-300
-230
-170
-100
Linear Increases in 36 Months
Rating Category
Linear Increases (Basis Points)
Linear Decreases in 12 Months
Rating Category
Linear Increases (Basis Points)
(c) Prepayment Speeds
Prepayment speed measures the rate at which borrowers make their principal repayments above the
required amounts prior to the scheduled maturity date. Prepayments reduce the outstanding principal
balance of a mortgage, thereby reducing excess spread but also reducing possible defaults in the future.
The faster the prepayment speed, the quicker excess spread is depleted and the lower the number of
cumulative defaults. As prepayments shorten the average life of securitized assets, they reduce the period
of time over which stressed assumptions can affect the portfolio. Most residential mortgages are prepayable in Canada to some extent. Generally, 10% to 20% of the original principal may be prepaid in any
one year (as of each anniversary date) without penalty. Furthermore, if a property is sold (i.e., the whole
mortgage amount is repaid), most lenders do not impose a prepayment penalty as long as a new mortgage
25
November 2014
is placed with the same lender. Notwithstanding no penalty imposition, the securitization documents
usually state that a make-whole payment will be made to the special-purpose vehicle (SPV) issuing the
notes to compensate for the lost future excess spread.
DBRS assumes at least three different prepayment speeds (generally at 5%, 10% and 15% per year) to
assess the impact introduced by the prepayments of mortgages for adequate levels of protection.
After consideration for prepayments, potential interest rate mismatches and mortgage default timing and
recovery as well as servicer fees, transaction-specific triggers and waterfall structure, at least 12 scenarios
of cash flow results are generated. The proposed enhancement must pass all scenarios without incurring
any loss on the notes.
(2) Other Structural Features
In addition to excess spread, which can be available to the transaction depending on the structure, there
are other structural features and forms of credit enhancement generally employed, such as interest rate
swaps, overcollateralization (OC), subordination, cash and liquidity support in ABCP.
(a) Interest Rate Swaps
To fund fixed-rate mortgages, it is common for the SPV to agree to pay the swap counterparty a specified
fixed rate (fixed swap rate) in exchange for CDOR or cost of funds based on a predetermined amortizing
notional schedule. The fixed swap rate is usually lower than the fixed mortgage yield, thereby creating
a certain amount of spread for the SPV. The DBRS methodology Derivatives Criteria for Canadian
Structured Finance expects that, for AAA (sf)/R-1 (high) (sf) transactions, all hedge counterparties have a
minimum rating of A (high) or R-1 (middle) and the relevant downgrade provisions are incorporated in
the transaction documents.
(b) OC, subordination and cash
OC and subordination are similar in that they both allow holders of the senior notes to access cash flows
relating to assets with a value of more than the face amount of the senior notes. Cash is usually necessary to maintain minimum amounts of liquidity in a typical ABCP transaction unless other satisfactory
arrangements are in place. The use of cash introduces negative carry as cash must be invested in highly
liquid investments, often yielding less than the coupon rate on the notes or than the mortgage rate if the
cash were invested in additional mortgages. On the other hand, there are also disadvantages associated
with OC or subordination. While OC can generate a higher yield than cash at the mortgage rate, any
default will reduce the yield and interest payment on subordinated notes, which creates some cash drain
from collections.
(c) ABCP liquidity
The liquidity available to the ABCP conduits may provide extra protection against losses (including the
balloon risk) for residential mortgages funded in ABCP, when the recovery rates in the liquidity agreement
for residential mortgages, if applicable, are set at levels higher than DBRS assumptions used for credit
enhancement and transaction assessments.
There are other less popular forms of credit enhancement such as bond insurance, letters of credit and
third-party guarantees. In each case, the rating of the security may be affected by the credit rating of the
enhancement provider.
26
November 2014
Analysis for Insured Mortgages/HELOCs and NHA-MBS
The credit loss of insured mortgages is considered to be negligible as insurers guarantee the full payments
of principal and accrued interest when a borrower defaults on the mortgage. For AAA (sf)/R-1 (high)
(sf) transactions, DBRS criterion for minimum acceptable mortgage insurer’s rating is AA (low). Insured
HELOCs and National Housing Act Mortgage-Backed Securities (NHA-MBS), a form of sovereign-guaranteed securitization, are subject to the same analysis as insured residential mortgages. DBRS expects
the issuers to review the insurers’ ratings and the credit scores of underlying portfolios and to propose
adequate credit enhancement in the form of cash, in addition to excess spread, to mitigate potential
negative carry from the time of mortgage default until full repayment by the insurers.
Legal Review
DBRS reviews the legal structure and transaction documents to ensure that they comply with DBRS Legal
Criteria for Canadian Structured Finance. More specifically, DBRS expects to be provided with legal
assurances (by way of legal opinions, with DBRS as an addressee) that the sale of the receivables from the
originator/seller to the special-purpose vehicle (the SPV or the Trust) issuing the notes constitutes a “true
sale” and that the subsequent grant by the Trust of a security interest in the receivables to the indenture
trustee (on behalf of the noteholders) has been perfected in all applicable jurisdictions. DBRS reviews
legal opinions to determine whether the transfer of the receivables to the Trust (the Transfer) constitutes
a true sale such that the assets of the Trust would not be consolidated with those of the seller in the event
of the seller’s bankruptcy (i.e., it is bankruptcy remote from the claims of the seller’s creditors) and also
to ensure that the indenture trustee has a perfected security interest in the purchased assets that secure the
Trust’s obligations to the noteholders.
NOTICE AND PERFECTION
Except for in Québec, Personal Property Security Act (PPSA) legislation in Canada does not cover interests in the real properties that support mortgage loans. Instead, a mortgage filing in the local land title
registry office is required in order for the Transfer to be considered a legal assignment and enforceable
against third parties. This could be impractical with large or revolving receivables pools. For this reason,
an irrevocable power of attorney that is in registrable form (i.e., it is capable of being registered in the
related land registry or land titles office, as supported by a legal opinion with DBRS as an addressee)
should be granted by the originator/seller in favour of the SPV in securitizations that involve real property.
The power of attorney will allow the SPV to effect a transfer of legal title to the mortgage in the related
registry or land titles office without the cooperation of the originator/seller. If the originator has an
investment-grade credit rating, re-registration of title in the related land registry or land titles office is not
required on closing of the securitization transaction. If the originator has insufficient credit strength, does
not have the equivalent of an investment-grade rating or falls below investment grade, DBRS expects that
mortgages be retitled in the name of a nominee or third-party custodian at the closing of the securitization transaction. This protects the SPV against the risk of seller’s bankruptcy proceedings or a stay of
proceedings in the event that the originator/seller goes bankrupt while legal title to the mortgages is still
in the name of the originator/seller.
In Québec, in the absence of a universality of claims (a legal concept under the Québec Civic Code),
perfection of a security interest usually requires notification to the individual obligors in addition to the
mortgage re-registration of title in the relevant land registry or land titles office. The perfection by notification requirement is usually triggered when the originator/seller is downgraded below investment grade.
Please refer to Legal Criteria for Canadian Structured Finance at www.dbrs.com for more details.
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REGISTRATION
Because land has a title registry in all jurisdictions in Canada, all mortgages are registered in the land
registry system. Usually the mortgages sold in a securitization transaction are registered in the name of
the originator/seller and continue to be registered in that name, even when sold to an SPV (i.e., legal title
to the mortgages remains in the name of the originator/seller, even though the beneficial interest in the
mortgage receivables has been sold to the SPV by way of a true sale, supported by legal opinions). In
some instances, the originator or seller registers legal title to the mortgages in the name of a third-party
custodian, an entity that is remote from the originator or seller, upon inception of the mortgage. If that
is the case, the mortgages should not be subject to stay-of-court proceedings upon a bankruptcy of the
seller (in which case there would be no need to request that a court declare that the mortgage receivables
officially belong to the SPV and to release them from the seller’s estate) as legal title to the mortgages is
already registered in a name other than that of the originator/seller. As mentioned above, DBRS expects
that a legal opinion be delivered on closing of the securitization transaction (with DBRS as an addressee)
that indicates that the sale of the interest in the mortgages to the SPV is bankruptcy remote and that the
creditors of the seller would have no right to claim against the mortgages. In all provinces, there is an
additional step that is required to allow the SPV to enforce the mortgages. That step is a registration of
legal title to the mortgages in the relevant land registry or land titles office to evidence the legal transfer
of the mortgages to the SPV. This step will be required where the underlying obligor of the mortgage
has defaulted on its monthly payments and the owner of the mortgage (the SPV) intends to enforce the
security against the mortgaged property to be repaid the outstanding mortgage amounts, which may not
be possible if legal title to the mortgage remains in the name of the seller (even if it is servicing the mortgages on behalf of the Trust).
The securitization documentation usually provides for an irrevocable power of attorney in registrable
form to be delivered on closing (supported by a legal opinion, with DBRS as an addressee) so that the
particular mortgage can be re-registered and/or enforced by the SPV without requiring the cooperation of
the originator/seller. In the event of a bankruptcy of the originator/seller, if the registration of legal title to
the mortgages in the relevant land registry or land titles offices has not been updated to reflect a transfer to
the SPV, the ability of the SPV to enforce against a defaulted mortgage (or any mortgage, for that matter)
may be subject to stay-of-court proceedings, in which case, no steps can be taken until a court allows it;
however, assuming the elements of a true sale are present (as evidenced by the legal opinion mentioned
above) and perfection has been achieved on behalf of the noteholders, that stay should eventually be
lifted by a court to allow the SPV to effect both re-registration of legal title to the mortgages and, accordingly, enforcement of the mortgaged properties. If a registration of legal title is made at the relevant land
registry or land titles office reflecting the transfer of the mortgage to the SPV prior to a bankruptcy of the
originator/seller, enforcement against that property should not be subject to stay-of-court proceedings in
the event of the bankruptcy of the originator/seller. Similarly, the collections or regular payments made
by an obligor should not be subject to a stay of proceedings if the SPV’s (and ultimately, the noteholders’)
interests in the mortgage receivables have been perfected as required under the laws of the relevant jurisdiction and provided that no commingling of the mortgage payments with other assets of the originator/
seller occurs.
To address the risk when legal title remains in the name of the originator/seller and is not re-registered
upon the sale of the mortgages to the SPV, DBRS generally expects the completion of re-registration of
title within 30 to 60 days once the seller falls below investment grade. If the seller does not have a credit
rating, there must be other measures taken to mitigate the above risks, such as having financial strength
tests or a sufficient reserve to cover stay risk.
Please refer to Legal Criteria for Canadian Structured Finance at www.dbrs.com for more details.
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FORECLOSURE AND RECOURSE
Loans that remain delinquent for more than 90 days are considered to be in default. At this point, the
servicer could recover outstanding debt by starting legal proceedings of foreclosure through either power
of sale or judicial sale. Power of sale allows a lender to sell the property without the involvement of the
court. The lender has the right to sell the property according to the mortgage document and/or provincial/
territorial legislation that authorizes power of sale in that province/territory. DBRS understands that this
is the lender’s primary recovery method for mortgages in Newfoundland, New Brunswick, Prince Edward
Island and Ontario and it is usually faster and less costly than a judicial sale. A judicial sale is a sale conducted under the supervision and authority of the court, where the court is extensively involved and a
lender must apply to the court to get the court’s permission to sell the property. DBRS understands that
this is the primary debt recovery approach for mortgages in British Columbia, Alberta, Saskatchewan,
Manitoba and Québec. The actual judicial sale procedures vary by province/territory. DBRS understands
that, in Nova Scotia, the primary recovery process for mortgages is a mix of the two practices but is considered judicial as the court is involved.
It is DBRS’s understanding that, except for in Alberta and Saskatchewan where legislation dictates that
under certain conditions a borrower is not personally liable for any deficiency amount on a secured loan
(a non-recourse loan), lenders in all other jurisdictions in Canada can pursue creditor-friendly options
(such as wage garnishment) for any loan deficiency remaining after the mortgage is enforced, thanks to
the personal covenants to pay provided by the borrowers in the documentation at loan origination. DBRS
understands that in provinces/territories that have power-of-sale legislation, a lender seeking a deficiency
judgment must start an action against the borrower after the property has been sold, but in provinces/
territories that use the judicial sale procedures, the deficiency judgment is part of the foreclosure proceedings against the borrower. It is DBRS’s understanding that loss mitigation techniques, such as short sales
or non-recourse loans with higher rates, are rarely used in Canada.
Operational Review
Notwithstanding all the quantitative analysis above, the adequacy of available credit enhancement levels
is always subject to the assessment of the operational review. An operational review is an important
element when making comparisons among lenders and their respective underwriting criteria. This is
particularly true for new originators without performance data that extends back to the last recessionary
period. A review of the underwriting process, philosophy and system provides insight into the operations
and the approach that might be taken in dealing with defaults if the originator also serves as servicer and
is a practical way of determining if performance is likely to track other players in the marketplace.
DBRS places emphasis on the review of servicers because the efficiency and effectiveness of collection
systems have a significant impact on the performance of loans. Technology plays a crucial role in servicing and can be a major competitive advantage given the large number of loans to be serviced. Similar
to loan origination, many servicers now use behavioural scoring models and other analytics to evaluate
delinquent accounts in order to optimize collection efforts. Servicers who can efficiently deploy resources
for collections will ultimately reduce the losses.
Servicers also manage the recovery process of the defaulted accounts. Most servicers rely on a combination of internal collections, outside collection agencies and legal channels (including foreclosure) in their
collection work. The timeline of the foreclosure process varies depending on the province/territory and
is affected by two main factors: the provincial/territorial legislation (judicial sale or power of sale) and
the strength of the housing resale market. The foreclosure of a property requires the servicer to manage
different legal approaches in various jurisdictions and the servicers may have no control over the ultimate
timelines. For example, during good or normal economic periods, the timeline can range from a few days
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to several months, but during economic downturns, it can be stretched to a full year, with properties in
some smaller communities experiencing even longer time frames.
The DBRS methodology Canadian Residential Mortgage Servicer Evaluations provides details and guidelines DBRS uses to assess the servicer’s ability to deal with significant increases in delinquencies and
defaults. If there are inherent limitations, it represents a significant concern should portfolio performance
deteriorate. The ability of a servicer to produce reasonably detailed historical data with respect to default
rates, foreclosure frequency and recoveries is viewed positively as an indication that the originator/servicer
is capable of tracking problem loans efficiently. Where historical data is not sufficiently detailed, tighter
triggers to protect the investors may be deemed necessary.
HELOCs
Consumer lines of credit can be classified as secured or unsecured, depending on whether a security is
pledged to the lender to obtain the credit. Credit cards are a common example of an unsecured line of
credit. For secured lines of credit, commonly accepted collateral includes personal property, investments,
bank account holdings, insurance policies and real estate. The most common secured line of credit is a
HELOC, which has a residential property as underlying security to the lender.
As DBRS’s approach to rating HELOC and residential mortgage transactions is similar, the sections below
focus on the differences in analysis for HELOC transactions.
CHARACTERISTICS OF A HELOC
A HELOC is essentially a hybrid of a mortgage credit and a revolving consumer credit. To be more
precise, it is a line of credit secured by the equity in the underlying residential property to mitigate the
losses should the borrower default.
Terms and Payments
HELOC products can be categorized according to their terms of maturity: definite or indefinite.
Definite Term
This type of HELOC has a predetermined maturity date (full repayment date) that is preceded by two
periods: the draw period followed by the amortization period. During the draw period, borrowers can
increase their indebtedness by drawing up to the credit limit or decrease their indebtedness by repaying
the principal at any time. The draw period can vary, during which time the minimum payment requirement is IO and no repayment of the principal is required. Once the amortization period begins, the
borrower is no longer permitted to make draws on the HELOC and the outstanding amount drawn is
required to be amortized and fully repaid at the end of the term.
The structure of a HELOC with a definite term is similar to an IO principal mortgage (or an IOP mortgage),
which, after the IO period expires, obligates the borrower to pay down the outstanding principal by the
end of the mortgage term. Because of the non-amortizing nature of the mortgage principal during the IO
period, borrowers with IOP mortgages largely rely on rising home values or the equity buildup over the
loan principal amount in this period to assist in the repayment of the loan, likely through a refinancing,
when the amortization period begins.
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Indefinite Term
A HELOC without a predetermined amortization period is payable on demand. Generally, the contractual terms allow the borrowers to draw and repay an amount for an indefinite period (the revolving
period) as long as the account is in good standing and the outstanding balance is within the credit limit.
The revolving and payable-on-demand nature is similar to the features of credit cards.
November 2014
This type of HELOC usually has a floating interest rate that is charged daily on the outstanding balance,
based on the lender’s prime rate with or without a premium, and provides borrowers the flexibility of
making monthly payments as low as the interest amount and/or principal repayments without penalties.
A HELOC with an indefinite term also permits frequent draws up to a pre-determined credit limit.
Most HELOC products offered in Canada fall into this category. They are underwritten by traditional
financial institutions as a substitute for regular amortizing mortgages to prime borrowers with high credit
scores. This allows the borrowers to reduce monthly payments, increase affordability and/or extract the
equity embedded in the underlying properties; therefore, HELOCs in Canada generally have higher credit
limits, more flexible payment terms and more favourable borrowing rates than other kinds of revolving
consumer credit.
Credit Limit
The credit limit on a HELOC is set according to the property value and the LTV of the property at origination, which takes into account the lien of the HELOC lender and any other liens with priority on the
property. Because of the large value of a real estate property, HELOCs often have larger credit limits
than other secured or unsecured lines of credit. Consequently, the potential loss to the lender could be
significant upon the borrower’s default if there has been a decline in the value of the secured property.
To manage such risk, the lenders periodically reassess borrowers’ property values and risk profiles. As
home equity mitigates the loss to the lender, prudent property value assessment is crucial in determining a
HELOC credit limit. A HELOC credit limit is expressed as a dollar amount, which cannot exceed 65% of
the appraised property value for newly originated accounts. The LTV limit is reduced from 80% by OSFI
B-20 guidelines effective August 9, 2012. The combined LTV of HELOCs and amortizing mortgages at
origination cannot be more than 80% without mortgage insurance. Mortgage insurance on HELOC
loans, however, is no longer available in Canada after April 18, 2011, regardless of the LTV or credit
limits.
HELOCs in Canada and the United States
As discussed above, HELOC products in Canada offer flexibility to borrowers because the required
monthly payments can be as low as IO (payment holidays may be allowed in limited circumstances)
without any principal repayments as long as the amount drawn is within the authorized limit and the
account is in good standing. Borrowers are also permitted to repay any amount drawn at any time without
any prepayment penalties. This flexibility allows borrowers to manage their cash flows better, reduces the
likelihood of a borrower default and makes HELOCs an appealing alternative to conventional mortgage
lending. HELOC products also have higher interest rates and are therefore more profitable for the lenders
than regular floating-rate mortgages.
The LTV limit, the mostly first-lien borrowing, the payment flexibility and the floating interest rates result
in HELOC products in Canada typically only being offered to prime borrowers as cash management
tools. Because of these characteristics, HELOC products in Canada are comparable with payment-option
adjustable-rate mortgage (option ARM) products in the United States, which were initially intended for
and marketed to well-heeled, financially sophisticated homeowners before they morphed into affordability products for non-prime borrowers.
As mortgage interest is tax deductible in the United States, the higher the mortgage amount, the more
deductions the borrower can use, reducing incentive for the borrower to accumulate and retain equity
in the property; therefore, until recently, HELOC products in the United States were mostly underwritten either as refinancing substitutes for first-lien mortgages to maximize the borrowed amounts or as
second-lien piggyback loans with definite amortizing terms and a combined LTV greater than 80% in
lieu of obtaining mortgage insurance. These second-lien HELOCs usually have higher interest rates than
the first-lien mortgages, with a premium that is similar to the mortgage insurance premiums, which, until
recently, were not tax deductible.
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TRANSACTION STRUCTURE
Trust Structure (Master Trust)
Most HELOC securitizations in Canada use a master trust structure, which provides the flexibility of
issuing multiple series of notes all secured by the same collateral pool or the ability to purchase discrete
collateral pools (silos) associated with a separate series of notes. This is achieved by the conveyance of
a pool of eligible HELOC accounts to a custodian to be held as assets backing any subsequent sale of
co-ownership interests in the conveyed pool (a co-ownership) or by the sale and transfer of a discrete
pool of HELOC loans to the Trust (a discrete purchase). The co-ownership structure, similar to that
used in credit card securitizations, is generally used for HELOC products with indefinite terms as it suits
the revolving nature of the underlying accounts. A discrete purchase, on the other hand, is mostly used
for HELOC products with definite terms as they are similar to regular mortgages with definite maturity
dates. Consequently, investors can be exposed to the seller’s entire managed receivables portfolio or only
to discrete asset pools, depending on the trust structure.
In Canada, master trust structures typically issue senior and subordinated classes of notes simultaneously
(vertical classes) to achieve desired levels of credit enhancement. The credit support for vertical classes
needs to be reassessed and can be adjusted for each new issuance, regardless of whether it is a co-ownership or a discrete purchase structure. The maturity date of subordinated notes in vertical classes is the
same as the senior notes.
Co-Ownership Interest (Non-Discrete Purchase)
As most HELOC products in Canada are underwritten with indefinite terms and allow the borrowers
to make frequent draws and repayments like credit cards, the co-ownership structure is used for related
securitization transactions. The seller is typically also the servicer in a co-ownership structure.
DBRS believes that this provides skin in the game as the seller/servicer’s interest is aligned with the
investors’ interests. For example, the seller maintains investments in the receivables through the seller’s
co-ownership interest and the receivables that are not conveyed to the Trust but remain on the seller’s
balance sheet. The seller/servicer also expends considerable resources to actively manage the accounts
(and the corresponding receivables) in order to promote consistent and robust levels of profitability as
excess spread is returned to the seller/servicer after the payment obligations for the investors are met. Such
interest alignment may be weakened in a discrete purchase structure if the seller is not the servicer and
excess spread, instead of being released back to the seller, is securitized and sold to investors.
Seller’s Interest
Separate co-ownership interests are established for each series of notes issued by the Trust, with the seller
retaining a co-ownership interest (Seller’s Interest) in the balance of receivables that are not offered to
the investors. Thus, there are at least two co-ownership interests in a master trust structure: the Seller’s
Interest and the Trust’s interest. The latter is represented by the outstanding notes issued by the Trust.
There could be more than one co-owner in addition to the Trust. The Seller’s Interest is the difference
between the balance of the receivables in the conveyed pool and the Trust’s interest plus any other coowner’s interests.
Generally, in Canada, HELOC securitizations require a minimum Seller’s Interest based on the notes
outstanding. The minimum Seller’s Interest exists to mitigate potential fluctuations in the balance of the
receivables supporting the notes. These fluctuations occur because of repayments and/or draws by the
borrowers. Except for the minimum Seller’s Interest described above, whose related cash flows are allocated to the Trust first, the Seller’s Interest in excess of the minimum required amount ranks pari passu
with the Trust’s interest in terms of monthly cash flow allocations, thereby aligning the interests of the
seller and the Trust.
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When the Seller’s Interest falls below the minimum required level, the seller must provide the Trust with
additional receivables to restore the required Seller’s Interest amount. If the minimum level is not restored
or maintained, an early amortization event will be triggered and the notes will begin amortizing. Although
the required minimum Seller’s Interest is generally not considered part of credit enhancement, the related
cash flows are available to the Trust for credit support.
Commingling
The payment flexibility of HELOCs poses additional challenges for servicers as cash flows are difficult
to predict. For instance, the amount of collections could potentially change significantly each month,
ranging from the minimum payments of IO to substantial principal repayments. The commingling of
funds occurs when the seller, acting as servicer, blends receivables collections for a particular securitization transaction with its general funds that are not related to the securitization. Commingling allows
remittance to investors to be carried out on a monthly or even less frequent basis rather than daily. DBRS
generally considers the commingling of funds by the seller until the next settlement date of the transaction
acceptable as long as the seller maintains an investment-grade rating, consistent with the expectations for
residential mortgage transactions. Should the seller be removed as servicer or the seller’s rating fall below
investment grade, DBRS expects the allowable commingling period to be reduced to two business days or
less or a third-party servicer to handle the collections.
Addition and Removal of Accounts
A co-ownership structure typically permits the addition and/or removal of certain accounts to and from
the pool of receivables conveyed to the Trust, subject to certain conditions. Additional accounts might
be added to meet the minimum Seller’s Interest requirement or to provide for additional issuance of
notes. The addition of accounts to the Trust’s portfolio is usually subject to a cap or limit and may have
other conditions that must be satisfied. The caps or limits are generally measured over three-month and
12-month periods in terms of both the number of accounts and the dollar value of the receivables added.
Similarly, account removals are permitted as long as an early amortization event does not occur as a result
of the account removal. These measures are meant to protect against adverse selection, which might materially alter the credit quality or composition of the Trust’s portfolio of assets.
Revolving Period
To maintain a bullet payment at note maturity without gradual amortization over time, the co-ownership
structure uses a revolving period, during which interest is paid to investors while principal payments
received on the collateral are used to purchase new receivables instead of paying down the notes. This
ongoing purchase mechanism serves to reduce prepayment of principal to investors and enables the use
of long-term financing for revolving receivables. The revolving period has a definite term and may be
prematurely discontinued by an early amortization event. Similar to credit card transactions, the principal
collections that may otherwise be allocated to a series in the revolving period may be re-allocated to other
series of notes that are in an accumulation period.
Amortization Period
The notes can be repaid through gradual amortization during the ordinary course or with one bullet
payment on the expected maturity date. For the latter, a soft bullet structure will allow an amortization
period to begin if the notes are not fully repaid on the expected maturity date. At this point, collections
are used to pay down the notes monthly until the earlier of the full repayment of the notes or the legal
final maturity date. The soft bullet mechanism may also affect other series of notes with respect to cash
flow allocations if a co-ownership structure is in place.
Controlled Accumulation and Controlled Amortization Periods
To facilitate predictable principal repayments to investors, a co-ownership structure generally has a
controlled accumulation and/or controlled amortization period after the revolving period ends. During
these periods, principal collections from the receivables are either distributed to the investors in agreed33
November 2014
upon amounts (controlled amortization period) or are accumulated in a trust account until the expected
maturity date (controlled accumulation period) and used to repay the notes with a hard bullet payment.
The length of these periods depends on the principal payment rate of the receivables. Subject to the provisions of transaction documents, the length of the accumulation period can be reduced if it is determined
that sufficient principal collections can be collected in less time than initially expected for a hard bullet
payment on the maturity date.
Early Amortization Period
Some transactions include covenants in the structures, referred to as early amortization triggers, to protect
investors. Breaches of these triggers (if not cured within any applicable grace period) would result in the
onset of the amortization period earlier than scheduled or expected. These triggers include, but are not
limited to, the following:
• Insolvency of the seller.
• Failure of the seller to perform or observe covenants, breaches of representations and warranties or
other default of the seller.
• Failure to pay timely interest or principal on any series of notes when due.
• The occurrence of a servicer termination event.
• Breach of a performance or minimum required pool amount trigger.
Priority of Payments (Waterfalls)
Collections from the receivables are identified as either principal or finance charges. The finance charge
component is used to cover the expenses of the Trust, interest on the notes and written-off receivables.
The principal component is reinvested in new receivables, paid to the investors or accumulated for a
bullet payment, depending on the status of the transactions.
Finance charges, principal collections and receivables write-offs are allocated pro rata between the
Seller’s Interest and the Trust’s interest. The pro rata share of the Trust’s interest is determined by the
aggregate amount of notes outstanding divided by the balance of the receivables conveyed to the Trust.
Subsequently, the Trust’s share of collections is divided among each series of notes issued by the Trust.
In general, finance charges and principal collections can be shared and re-allocated among each series of
notes. For example, excess finance charges not needed by one series may be re-allocated to another series
for any shortfalls in interest on the notes, excess write-offs or restoration of any previous writedowns of
note principal.
LOAN-LEVEL AND CASH FLOW ANALYSIS
(1) Loan-Level Analysis
Before performing cash flow analysis, DBRS uses the RMBS Model to conduct a quantitative evaluation
of the HELOC loans. As borrowers are allowed to draw to the maximum credit permitted under the
HELOC contractual terms while making the minimum required payments to keep the accounts current,
several sets of assumptions are made in respect of the term to maturity, payment requirement and current
balance and may include a scenario where all borrowers encounter financial stress and all accounts are
drawn to the limit with IO payment requirement.
Additionally, static pool analysis can be used to evaluate the consistency of the seller’s origination over
time through the normalized performance of seasoned accounts. Specifically, static default rates, cure
rates and recovery rates over time can help with the estimates of future asset performance.
The most conservative outcome of default probability and loss severity from the RMBS Model, along
with static pool analysis, if available, is used as input for cash flow analysis.
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DBRS cash flow analysis incorporates the structural elements of the transaction, including any triggers
or covenants that may affect cash flows. Excess spread is the amount of net asset yield after deduction of
funding costs, credit losses, servicing expenses (if applicable) and other fees. Servicing fees, which are calculated based on the outstanding balance of the total receivables and allocated pro rata between the seller
and the Trust in a co-ownership structure, reduce the amount of excess spread available. If the receivables
are sold on a fully serviced basis by the seller, the seller will service the loans and does not receive explicit
servicing fees in the payment waterfalls. Instead, the seller receives excess spread after all expenses and
costs are paid at the bottom of the waterfalls as servicing compensation. When replacement servicers are
in place, they are entitled to servicing fees which DBRS stresses in the transaction waterfalls.
When positive excess spread occurs at the bottom of the waterfall, it can either be retained in the transaction or be released back to the seller, depending on the transaction structure and/or asset performance.
Excess spread may be shared and re-allocated among each series in a co-ownership structure or be only
available to a specific series of notes.
Excess spread could be compressed without any deterioration in portfolio quality. For example, the portfolio’s yield, which is usually based on the lender’s prime rate, could be decreasing as interest rates decline
and at the same time coupon rates on the notes remain fixed, causing excess spread to decrease if there
is no proper mitigant in place; therefore, a mechanism is usually employed to ensure that, at a minimum,
excess spread could not be negative during the life of the transaction. DBRS notes that all HELOC
transactions rated in Canada so far have used swaps to create a positive excess spread for additional
enhancement support.
From a modelling perspective, transactions enter an early amortization period for all rating levels because
of a breach of a performance trigger. During the amortization period, cash flows and excess spread are
generally designated to repay the outstanding notes rather than being reinvested in additional receivables.
The notes must be able to withstand a combination of stress scenarios commensurate with the rating
category without any loss of principal or interest.
(a) Principal Payment Rate
The principal payment rate is equal to the total monthly principal collections received divided by the total
receivables balance. As a Canadian HELOC loan is usually structured as a revolving credit line, monthly
principal repayments are generally not required. This contributes to a lower payment rate for HELOCs
than other consumer credits with amortization schedules or with higher minimum payment requirements.
DBRS requests extensive portfolio performance data from the originator, specifically monthly principal
payment rates. The history of this variable is analyzed and other factors that may affect the transaction
may be considered as well, such as the credit quality of the obligors, contract terms, general economic
conditions, consumer spending and borrowing patterns and the availability of other financing or credit
options. Such analysis provides DBRS with a base-case assumption of principal payment rate that is
then used in the cash flow model with stress ranges commensurate with the rating categories. HELOC
payment rates may fluctuate significantly month to month as there are no penalties or limits on repayments of amounts drawn. Under a DBRS stress scenario, it is assumed that the payment rate will drop
precipitously.
Sellers may report payment rates on a total basis (finance charges and principal) and/or on a principalcollected basis. If only total payment rates are reported, DBRS estimates finance charge components to
determine an appropriate base-case principal payment rate. Principal payment rates affect the adequacy
of credit enhancement as higher payment rates indicate a faster liquidation of the receivables pool and
more funds will be available to repay the investors during the (controlled) accumulation or amortization
periods.
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After a base case for principal payment rates is set, the base case is evaluated under various stress ranges,
based on the desired rating of each class, to assess the sufficiency of the credit enhancement level (as summarized in Table 1 below).
Table 1: Principal Payment Rate Stress Ranges by Rating Category
Reduction of base case
AAA (sf)
AA (sf)
A (sf)
BBB (sf)
BB (sf)
35% to 50%
35% to 45%
30% to 40%
25% to 35%
10% to 20%
The actual stress used in the analysis depends on several factors, such as the volatility and trends of the
performance history and the credit quality of the borrowers. At each rating category, DBRS performs
various scenarios to evaluate the commensurate credit enhancement level. This is particularly useful for a
base case that may be considered too high or too low or for issuing entities that have significant franchise
value.
Time frames to stress the base case are compressed in the DBRS scenarios. The stress usually begins with
base case in a normal period for the first five months, followed by a deterioration of payment rates commensurate with the rating category, beginning in the sixth month. The deterioration is assumed to be
linear over 12 months for a AAA (sf) rating and may take longer for lower rating categories.
(b) Timing of Defaults
In addition to front-end-loaded and back-end-loaded default curves used in the analysis of residential
mortgage transactions, DBRS also uses a straight, evenly distributed default curve for HELOC transactions.
DBRS tests the viability of each transaction’s proposed capital structure and the adequacy of credit
enhancement levels at each proposed rating level through a combination of loan-level and cash flow
analysis. Specifically, cash flow modelling techniques evaluate the performance of the collateral (including
gross yield, payment rate, estimated default probability and loss severity) and soundness of the structure,
including proposed capital structure, priority of payments, trust expenses, cost of funds, swaps, interest
rate risk and basis risk. Scenarios are tested for each class of debt with commensurate assumptions for
the rating levels.
ABCP LIQUIDITY
The liquidity available to the ABCP conduits may provide extra protection against losses for HELOC
loans funded in ABCP when the recovery rates in the liquidity agreement for HELOCs, if applicable, are
set at levels higher than DBRS assumptions used for credit enhancement and transaction assessments.
Reverse Mortgages
36
A reverse mortgage is a mortgage loan offered to elderly individuals or couples without recourse to the
borrower. The advance of cash is usually obtained by the borrowers as a lump sum payment in return
for a first-ranking security interest in their residential property, thereby providing a way for the borrower
to monetize equity in the property without actually selling the property. A reverse mortgage contains
standard contractual mortgage terms and conditions; however, no interest or principal payments are
required during the borrower’s occupancy while interest accrues on the mortgage. This means that the
loan balance is accreted until the termination of the occupancy (which might be the death of the borrowers or, more often, a move of the borrowers to assisted care facilities or other retirement accommodation).
At that point, the property would be sold and proceeds would be used to repay the loan balance and any
accrued interest. A contractual breach occurs if the borrower fails to pay property taxes, maintain home
insurance, occupy the property and keep the property in good repair, at which time the lender would be
entitled to enforce its security interest over the property.
November 2014
As the reverse mortgage is secured solely by the property, should the total sale proceeds be insufficient to
repay the reverse mortgage balance, there would be no recourse to the borrowers or the estate and the
borrower (or the estate) is not required to make the lender whole on the mortgage. On the other hand, if
the value of the reverse mortgage is less than the proceeds from the sale of the property, any excess funds
would be returned to the borrower or the borrower’s estate.
Servicing of reverse mortgages is generally simpler than traditional mortgages as there is no collection of
monthly payments. In addition to monitoring the property taxes and insurance, the main task is sale of
the property when the property is vacated. To avoid a property tax lien senior to the lender, the lender in
practice usually pays delinquent property tax amounts on behalf of the borrower and adds the advanced
payment to the outstanding mortgage balance.
Reverse mortgage lenders typically pay little attention to the credit quality of the borrower as reverse
mortgages do not depend on a borrower’s ability to pay, unlike the case in a traditional mortgage. Instead,
the underwriting is asset based and centred upon property value estimation at occupancy termination.
Expected Occupancy Term (EOT)
The EOT plays a fundamental role in predicting the timing of property vacancy and is an estimation of
the time period between the origination of the reverse mortgage and the date the occupancy is terminated and the reverse mortgage comes due. The EOT is then used to determine the liquidation value on
the property at sale to pay off the reverse mortgage loan balance. The EOT is based on age, gender and
marital status of the borrower(s) and is determined by a combination of actuarial tables for life expectancy (mortality) and the lender’s experience of early move-out prior to the borrower’s death, including
contractual breaches (mobility). For married couples that are living together, it is prudent that both
spouses are required to sign the mortgage documents and mortgage repayment is not required until the
property is vacated by both spouses.
The risk of EOT extension occurs if borrowers remain in their homes longer than expected at loan
origination, which increases the probability that the accreted reverse mortgage amount at the time the
borrower eventually vacates the property will exceed the net sales proceeds of the property, thus resulting in a loss to the lender. In general, the older the homeowner is, the shorter the EOT. This may allow
a lender to advance a higher amount as the interest on the loan has less time to accrue and the property
value has a shorter time frame to encounter potential negative HPA by the property vacancy.
Property Value and Home Price Appreciation (HPA)
As the only source of reverse mortgage repayment is the cash flow received from the sale of the property,
the future property price change after loan origination is a key determinant to any potential loss on the
loan.
Collateral risk occurs when actual HPA is below expectations. To mitigate the collateral risk, the lender’s
forecast of property appreciation is generally set below long-term appreciation rates. In addition, to
determine the initial advance amount, the appraised value of property is further adjusted and discounted
by location and property type, among other things. This initial loan amount, therefore, establishes a conservative LTV ratio to minimize the risk that accreting interest exceeds future HPA and that at the actual
property vacancy the property value (net of sales costs) is insufficient to repay the mortgage balance at
that time. Furthermore, an LTV cap may be set for a single reverse mortgage such that the value of the
reverse mortgage is no longer permitted to accrete beyond this limit.
Mortgage Rates
Reverse mortgage rates are usually higher than the rates for traditional mortgages because of the nonrecourse nature to the borrower. The higher the reverse mortgage rate, the lower the amount a lender will
advance to a borrower at origination on a discounted basis as the loan balance will accrue faster and is
more likely to exceed the property value of the home at vacancy.
37
November 2014
STRESS TESTING AND CASH FLOW ANALYSIS
Timely and full payment of interest and principal of the notes by the legal final maturity date supported
by reverse mortgages depends primarily upon:
The accuracy of the EOT assumption;
The property value and HPA; and
The spread between the reverse mortgage rate and the coupon rate on the notes.
As there is currently only one lender of reverse mortgages in Canada, DBRS relies on the lender’s proprietary information to formulate its rating methodology. Accordingly, DBRS does not use a generic
cash flow model to stress test each transaction. Instead, a cash flow model incorporating the specific
transaction structure, asset tests and triggers is developed for this lender’s securitization program. In the
future, should new originators and sources of performance data become available, such new data shall be
assessed and potentially incorporated into the rating methodology, if applicable, by DBRS.
EOT Assumption
As there is no regular payment schedule, the actual cash flow generated by a reverse mortgage occurs only
at loan maturity; therefore, forecasting an accurate enough EOT for each mortgage is a critical component in predicting future cash flows. Underwriting EOT at the 50th percentile (i.e., a 50% EOT) means
that there is a 50% probability that the borrower will vacate the property or repayment of the mortgage
will occur by that specific EOT. A higher EOT percentage assumption at origination is more conservative as it corresponds to a longer EOT and a lower probability of actual occupancy term exceeding EOT.
It also leads to a lower advance amount, so that the loan amount is less likely to be above the property
value at property vacancy. DBRS reviews the lender’s underwriting guidelines and EOT assumption at
origination. In addition, DBRS may review actuarial mortality rates and/or move-out probabilities used
in origination in relation to the industry standard, when applicable.
The risk that the reverse mortgage value exceeds the property value at vacancy is known as crossover risk,
which results in losses on the mortgages and is a function of EOT, HPA and interest rates. As shown in the
diagram below, a 75% EOT, for example, is more conservative than a 50% EOT with a smaller loss area.
To assess crossover risk, DBRS does not stress historical losses of reverse mortgages as historical losses for
this asset class in Canada are nominal and there are no corresponding stress multiples.
Reverse Mortgage (RM) and Property Value Relationship
RM Value
(50% EOT)
RM Value
(75% EOT)
$
Loss Area
(50% EOT)
75% EOT
50% EOT
EOT
38
Loss Area
(75% EOT)
Property
Value
November 2014
Stressed Property Value and HPA
When calculating the maximum advance amount, the lender typically adjusts the property value downward
to reflect risks associated with the property such as location and property type. Additionally, the loan
advance is subject to a maximum LTV limit by the lender.
Before applying any stress, the property value is updated from the latest appraisal value provided by the
lender up to the date of note issuance with commonly used market indices. As EOT can be interpreted as
the estimated timing of loan maturity, an annual HPA from the issuance of the notes to the EOT of each
individual loan at origination is considered. To be conservative, DBRS generally assumes an annual HPA
rate around 2%, below the average inflation rate of 3.8% between 1950 and 2013. In comparison, the
average annual HPA rate experienced was 5.4% between 1980 and 2013.
DBRS then stresses property values by applying MVDs commensurate with rating levels at the time the
property is vacated and repossessed for resale. As there is no credit score available of reverse mortgage
borrowers, DBRS assumes that it is close to the Canadian average of 700. Consistent with the RMBS
model, then, a 38.5% MVD at the repayment of the mortgage is assumed for the AAA (sf) rating level.
MVD stresses commensurate with the rating categories are listed in the table below.
Excess Spread and Cash Flow Analysis
Excess spread refers to the difference between the reverse mortgage interest rate and the costs of the
notes. The variability of spread between these two rates may cause shortfalls in the cash flow required
to pay the notes. While reverse mortgages tend to be priced off fixed or floating benchmarks of shorter
tenors (such as one-year Government of Canada securities or prime rate) and reset frequently, the coupon
rates on the notes can be at fixed or floating rates but for longer tenors. In order to mitigate any interest
rate mismatch, hedging arrangements may be entered into with various counterparties; however, as these
hedges are based on anticipated repayments of the reverse mortgages, actual experience may differ and
cause some mismatches to arise, which DBRS takes into consideration in assessing the structure.
Based on the desired ratings, DBRS cash flow analysis assumes different MVDs shown below, in addition
to interest rate and prepayment assumptions. The interest rate assumptions are the same as those used for
residential mortgage transactions. DBRS notes that, historically, the percentage of borrowers that prepay
is low because of the nature of reverse mortgages. DBRS analysis shows that higher prepayments result in
lower enhancement as the crossover risk is lower, which more than offsets the reduction in excess spread.
Prepayment of reverse mortgages may also incur a penalty on the borrowers to allow the lender to recoup
the lost excess spread.
Market Value Decline by Rating Category
Rating Category
Market Value Decline
AAA (sf)
AA (sf)
A (sf)
BBB (sf)
38.5%
33.5%
29.5%
25.5%
Accrual of Note Interest
As the cash flows of reverse mortgages tend to come in much later after origination than regular mortgages, DBRS expects transactions to allow the accrual of interest shortfall so that if the scheduled interest
on the notes is not paid on time, no payment default on the notes is triggered. A cash account may also
be available to provide liquidity to mitigate this risk. Interest accrual on the subordinated notes may be
structured as part of subordination support for the senior notes.
39
November 2014
Surveillance
After a transaction closes, DBRS monitors the performance to ensure that DBRS ratings continue to
reflect the relevant information received by DBRS relating to that particular transaction. The maintenance
of each rating is dependent on the timely receipt of monthly performance information and data from the
servicer. The performance information and data for each outstanding transaction is reviewed by DBRS
analysts to identify variations between actual and expected performance levels assumed by DBRS. DBRS
also monitors changes in macroeconomic conditions and the associated effects on the consumer, industry
dynamics and other exogenous events that may affect the credit quality of outstanding transactions.
DBRS provides monthly surveillance information for all public ratings on our website, www.dbrs.com.
Appendix 1: Glossary
40
2-4 Family Unit
A single residential structure that is divided into two to four separate living units but
owned under a single title.
Adjustable-Rate Mortgage (ARM)
A mortgage with variable monthly payments that adjust based on changes to an
interest rate index such as the Canadian prime rate.
Adverse Selection
The concept that mortgages with better quality are more likely to prepay, leaving
lower-quality mortgages in the pool.
Amortization
The scheduled repayment of principal and interest on a mortgage, based on a set
period of time.
Appraisal
A valuation of the property securing a mortgage.
Balloon Mortgage
A mortgage that does not amortize to zero by the end of the mortgage term, leaving
a large payment (balloon payment) of the remaining principal balance to be paid at
maturity.
Cash-Out Refinancing
The refinancing of a mortgage in which the mortgagor borrows more than the outstanding balance of the prior mortgage, thereby taking cash out of the mortgagor’s
equity in the property.
Condominium
A housing unit representing a fractional interest in a larger property, part of which is
owned separately by each owner and part of which is held in general by all owners.
Credit Enhancement
The credit protection against losses on the notes backed by the assets.
Default
A term most often used to refer to a mortgage that has become so delinquent that
the mortgage is likely to be foreclosed upon and liquidated.
Delinquent
The condition of a mortgage when the borrower has failed to make one or more
scheduled monthly payments.
Equity Take-Out Refinancing
The refinancing of a mortgage in which the mortgagor borrows more than the outstanding balance of the prior mortgage, thereby taking equity out of the property as
cash (identical to a cash-out refinancing).
Fixed-Rate Mortgage (FRM)
A mortgage with a constant interest rate and level monthly payments through its
term to maturity.
Foreclosure
The process by which a mortgage lender takes title to the property underlying a
delinquent mortgage. The process is determined by provincial/territorial law.
Interest-Only Mortgage (IO)
A mortgage in which, for a set term, the borrower pays only the interest on the
principal balance, with the principal balance unchanged. At the end of the IO term,
the borrower may pay off the principal or convert the loan to a principal and interest
payment (P&I) loan at his/her option.
Letter of Credit (LOC)
A contractual promise issued by a bank or a financial institution to cover mortgage
losses or other contingencies up to a specific amount.
November 2014
Loan-to-Value Ratio (LTV)
The ratio of mortgage amount to the value of the mortgaged property. Original LTV
is the original mortgage amount divided by the original property value. Current LTV
is the current mortgage amount divided by the original property value and adjusted
LTV is the current mortgage amount divided by the current property value.
Loss Severity
The mortgage loss on a liquidated property divided by the original balance of the
mortgage.
Market Value Decline (MVD)
A decrease in the value of a property, the MVD is a significant component in the
determination of loss severity.
Mortgage-Backed Security (MBS)
A debt security collateralized by a pool of mortgage loans.
Piggyback
A piggyback mortgage is a second mortgage taken out by a borrower at the same
time as the first mortgage is started or refinanced.
Principal and Interest (P&I)
Refers to monthly principal and interest payments on a mortgage
Payment Shock
The destabilizing effect of increases in the mortgagor’s monthly payments associated with ARMs.
Prepayment
An unscheduled payment of principal in excess of the scheduled monthly P&I payment. Prepayments result from the sale of a home or the refinancing of an existing
mortgage or a partial paydown of the principal of an existing mortgage.
Seasoning
The length of time since a mortgage was originated or that a transaction has been
outstanding.
Second-Lien Mortgage
A mortgage that is in a secondary position to another mortgage (i.e., the first-lien
mortgage).
Senior-Subordinate Structure
A credit enhancement structure that includes at least two classes, with one class
(i.e., the subordinate class) providing credit enhancement to the other class (i.e.,
the senior class) by absorbing mortgage losses prior to the senior class.
Special-Purpose Vehicle (SPV)
Also referred to as a bankruptcy-remote entity whose operations are limited to the
acquisition and financing of specific assets. The SPV is usually a subsidiary company/trust/partnership with an asset/liability structure and legal status that makes
its obligations secure even if the parent company goes bankrupt.
41
Copyright © 2014, DBRS Limited, DBRS, Inc. and DBRS Ratings Limited (collectively, DBRS). All rights reserved. The information upon which DBRS ratings and reports are based is
obtained by DBRS from sources DBRS believes to be accurate and reliable. DBRS does not audit the information it receives in connection with the rating process, and it does not and
cannot independently verify that information in every instance. The extent of any factual investigation or independent verification depends on facts and circumstances. DBRS ratings,
reports and any other information provided by DBRS are provided “as is” and without representation or warranty of any kind. DBRS hereby disclaims any representation or warranty,
express or implied, as to the accuracy, timeliness, completeness, merchantability, fitness for any particular purpose or non-infringement of any of such information. In no event shall
DBRS or its directors, officers, employees, independent contractors, agents and representatives (collectively, DBRS Representatives) be liable (1) for any inaccuracy, delay, loss of data,
interruption in service, error or omission or for any damages resulting therefrom, or (2) for any direct, indirect, incidental, special, compensatory or consequential damages arising
from any use of ratings and rating reports or arising from any error (negligent or otherwise) or other circumstance or contingency within or outside the control of DBRS or any DBRS
Representative, in connection with or related to obtaining, collecting, compiling, analyzing, interpreting, communicating, publishing or delivering any such information. Ratings and
other opinions issued by DBRS are, and must be construed solely as, statements of opinion and not statements of fact as to credit worthiness or recommendations to purchase, sell
or hold any securities. A report providing a DBRS rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and
its agents in connection with the sale of the securities. DBRS receives compensation for its rating activities from issuers, insurers, guarantors and/or underwriters of debt securities
for assigning ratings and from subscribers to its website. DBRS is not responsible for the content or operation of third party websites accessed through hypertext or other computer
links and DBRS shall have no liability to any person or entity for the use of such third party websites. This publication may not be reproduced, retransmitted or distributed in any form
without the prior written consent of DBRS. ALL DBRS RATINGS ARE SUBJECT TO DISCLAIMERS AND CERTAIN LIMITATIONS. PLEASE READ THESE DISCLAIMERS AND LIMITATIONS AT
http://www.dbrs.com/about/disclaimer. ADDITIONAL INFORMATION REGARDING DBRS RATINGS, INCLUDING DEFINITIONS, POLICIES AND METHODOLOGIES, ARE AVAILABLE ON
http://www.dbrs.com.
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Rating Canadian Residential Mortgages HELOCs

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