Last Updated: June 1, 2012

Housing Loans
1.

Risk of Mortgage Loan and Credit Enhancement
Credit enhancement for residential mortgage backed securities (RMBS) can be broken down into
four tranches: The first tranche in response to bad-loan risk; tranche in response to interest-rate risk;
tranche in response to commingling risk; and the final tranche in response to setoff risk. The rating of
RMBS is a process of calculating a required level of credit enhancement for RMBS in response to thesevarious risks.
Credit enhancement is embedded in the RMBS scheme either in the form of collateral in excess ofclaims or in the form of cash reserves (Figure 1). Some RMBS schemes deem the tranche of credit
enhancement and the tranche of liquidity enhancement as seller’s beneficiary rights.
Figure 1:Example of correspondence relationship between underlying assets and RMBS
(Underlying Assets)(RMBS)

Preferred beneficiary rights/
Senior corporate bonds
Mortgage loan claims

Cash reserves

Sales to investors(Rating: AAA)

Subordinated beneficiary rights/
Subordinated corporate bonds(Response to bad-loan risk)(Response to interest-rate risk)(Response to commingling risk)(Response to setoff risk)(Response to liquidity risk)

Tranche of credit
enhancement
Tranche of Liquidity
enhancement(1) Bad-loan risk
Credit enhancement in response to the bad loss risk is in preparation for losses arising from loan
defaults by debtors and their bankruptcy. The credit enhancement (in response to the bad-loan risk) is
calculated by an analysis of the trend of bad loans and in consideration of the delinquency percentage
and prepayment percentage before maturity based on historical data of the mortgage pool. The following
is cited as the feature of mortgage loan claims: With residential houses offered as collateral, debtors
have a strong will to repay their mortgage loans and they place a high priority on repayments of theirmortgage loans, so mortgages are the claims whose bad-loan percentage is relatively low in comparison
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with shopping credits and cashing advances.
Since the bad-loan percentage is apt to heavily hinge on debt to (yearly) income ratio(DTI), loan tovalue ratio(LTV), business categories of debtors, passed years of claims, and other attributions of themortgage pool, individual attributions should be analyzed in details. DTI is the ratio of the amount ofannual repayment by a mortgage debtor to its annual income. The higher the DTI ratio, the heavier is theburden of monthly repayments on the debtor. Generally speaking, it becomes difficult for the debtor tocope with decreases in its income, increases in its expenses, and other changes. Consequently, thebad-loan percentage and the delinquent-loan percentage tend to become higher. The LTV (loan to value
ratio) is the ratio of the amount of a mortgage claim to the price of collateral real estate. Generally
speaking, a mortgage loan shows in many cases the higher the LTV, the less amount of money to sparethe debtor has on hand. As a result, the bad-loan percentage and the delinquent-loan percentage tend to
become higher. Even when the full repayment of a mortgage loan becomes difficult in the future, thelower the initial LTV the higher is the possibility that the market price of the collateral property may
exceed the outstanding balance of the mortgage loan claim. In many cases, a mortgage loan with a low
LTV stops short of becoming a bad loan or a delinquent loan by loan refinancing or by the sale of thecollateral property at the discretion of the debtor.
Since mortgages are long-term claims, it is necessary to analyze their trend according to theirelapsed years. The base parameter is calculated in consideration of the average value, standard deviation,and trend of individual parameters. Chronological development of occurrences of losses in parent claims(loss curve) and chronological development of repayments before maturity are estimated using static
data, etc.
The table below shows standard stress magnifications of RMBS. In the case where only a shorttime has elapsed since the drawdown of a mortgage loan, the loan repayment percentage before maturity
is estimated to be low.
Stress Magnifications
Bad loan/Delinquent loan

Bad loan/Delinquent loan

Repayment before maturity

First five years

After the first five years

Entire period

AAA

3.5

3.5

0.5

A

2.5

2.5

0.5

BBB

2.0

1.5

0.75

Actually applicable stress magnifications are determined by individual RMBS projects inconsideration of the following factors.
■ DTI
■ LTV
■ Bank’s Screening and Collection Systems
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· Particularly, the quality of underlying claims, so to speak, the probability of bad loans anddelinquent loans increases and decreases depending upon the screening standard.
· A due diligence meeting pays attention to the screening standard at the time of drawdown of a
relevant loan and changes in the screening standard thereafter (when the loan balance has
sharply increased at one time because of a business strategic campaign conducted by the bank,the screening standard itself may possibly have been relaxed.)· For example, even in the case of the same DTI, the screening standard on business conditionsof a place of employment may possibly have been eased. Even in the case of the same LTV,
the evaluation method of collateral properties may possibly have been eased.
■ Regional economic trend (unemployment rate, land-price trend, etc.)■ Debtor’s employment conditions (salaried worker or self-employed worker)■ Age (age distribution at the time of full repayment)■ Use of funds (for one’s own residential house or for the purpose of asset management)■ Regional concentration to an extremely high degree (risk of earthquake)(2) Interest rate risk
Credit enhancement in response to interest rate risk is the subordination in preparation for anegative interest-rate spread that emerges when the interest rate of a mortgage loan differs from that of
RMBS. The amount of credit enhancement is determined by the corresponding degree of the risk of anegative interest-rate spread. When the base (interest) rate of RMBS is equal to that of the underlying(backing) claims or when the interest-rate risk of RMBS is hedged by swaps or any other means, thiscredit enhancement is unnecessary.
(a) Negative spread risk involved in an interest-rate type mismatch between a mortgage loan and
RMBS
If there is any interest-rate mismatch between a mortgage loan and RMBS, the mismatch posesa risk of a negative interest-rate spread. A fixed-interest-rate selective mortgage loan makes it
possible to fix the interest rate for a certain period. At the time of expiration of the period for the
fixed interest rate, the debtor can select either a fixed interest rate or a variable interest rate. It is also
possible to change from a variable interest rate to a fixed interest rate. The debtor has the freedom tochoose a fixed interest rate or a variable interest rate. In this context, the following cases pose therisk of a negative interest-rate spread: In a downward trend of interest rates, the debtor selects avariable interest rate, while RMBS applies a fixed interest rate; and in an upward trend of interest
rates, the debtor selects a fixed interest rate, while RMBS applies a variable interest rate.
(b) Basis risk
When the base (interest) rate of a mortgage loan is different from that of RMBS, the risk that
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the latter may become higher than the former is referred to as “basis risk”.
The interest rate of a mortgage loan is often linked with the long-term prime rate or the
short-term prime rate, while that of RMBS is often linked with “Libor” rate. In this context, when
the difference between Libor rate and the prime rate is little or when the Libor rate becomes higher
than the prime rate, a negative interest-rate spread emerges. The interest rate of a mortgage loan isusually reviewed twice a year. The path-through-type RMBS interest rate is usually reviewed on amonthly basis. Particularly in an upward trend of interest rates, the RMBS interest rate increases ahead of the mortgage loan interest rate and becomes higher than the latter, which may possibly giverise to a negative interest-rate spread.
When a fixed interest rate is applied to the full amount of RMBS, the potential of further
decreases in interest rates of underlying (backing) claims is extremely limited in the current
conditions of lower interest rates. The subordination in response to a negative interest-rate spreadnormally remains at a low level. In recent years, however, competition in providing mortgage loans
has been intensified with a preferential interest rate applied to them in many cases. In the case where
there is a negative interest-rate spread between the RMBS fixed rate and the mortgage loan interest(with the former being higher than the latter) as described immediately above, there is a possibility
that the credit enhancement in response to the interest rate risk may stay at a higher level.
(3) Commingling risk
The funds collected from the underlying debtors are pooled in the originator’s financial institution
and after a lapse of a certain period the collected funds will be remitted to the trust bank and the SPC(hereinafter called “SPV”). If the originator becomes bankrupt during the time before the remittance ofthe collected funds, there is a risk that the collected funds may be commingled with the originator’sother assets.
In a RMBS project which reserves receiving from the debtors their consent to the transfer of claims
and notifying them of the transfer of claims and does not make it apparent that the collected funds arecovered by the deposit insurance, it is generally required to set aside an estimated equivalent amount ofcollectible funds for one collection period as the credit enhancement in response to the commingling
risk, except in the case where the commingling risk is deemed to be small or low because the collected
funds stay only one day at the originator’s financial institution and due to other reasons.
When the rating of the servicer bank falls below “BBB Flat/Negative Direction”, however, it ispossible to set aside the initial reserve for the credit enhancement in response to the commingling riskby (a) additional cash in trust with the equivalent amount of the credit enhancement in response to thecommingling risk within 30 days; or by (b) advance payment of an estimated amount of collectible
funds.

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(4) Setoff risk
When any underlying debtor has a deposit at the originator, the underlying depositor can set off thedeposit due from the originator against the mortgage loan at the time of the originator’s bankruptcy. The
deposit insurance covers a deposit to the extent of the deposit amount up to ¥10,000,000. When any
debtor has a deposit of no more than ¥10,000,000, there is no possibility that the debtor may take any
setoff risk. In case that any debtor’s deposit exceeds the benchmark of ¥10,000,000, there is a possibility
that the part of the deposit in excess of ¥10,000,000 may be set off against the mortgage loan (the part ofthe deposit beyond ¥10,000,000 is hereinafter called the “amount of money exposed to the setoff risk”).
For this risk, of the amount of each debtor’s deposit, the amount of money in excess of the deposit
insurance cap (¥10,000,000) in terms of customer protection is deemed to be the amount of money
exposed to the setoff risk. For each debtor that has a deposit in excess of the deposit insurance cap, thetotal amount obtained by subtracting ¥10,000,000 from the result of deducting the debtor’s outstanding
deposit from the outstanding claim is the credit enhancement in response to the set off risk).
(5) Liquidity risk
If the originator becomes bankrupt and the delivery to the trustee of collected funds from the
debtors falls into arrears, there is a possibility that payments of various charges and dividends on
preferred beneficiary rights may run short of resources. In response to this risk, the following measures
are taken: In the case where a fixed interest rate is applied to the relevant RMBS with a financial
institution as the servicer, an amount of money equivalent to one month’s dividends on preferredbeneficiary rights, trust fees and other various fees are set aside as cash reserves; and in the case where avariable interest rate is applied to the relevant RMBS with a financial institution as the servicer, anamount of money equivalent to three months’ dividends on preferred beneficiary rights, trust fees andother various fees are set aside as cash reserves.
2.

Transfer of a Mortgage Loan Claim, Right to Ask a Guarantor to Make Good on the Guarantee,
and Mortgage
A mortgage loan from a bank, etc. is often accompanied by a guarantee of the guarantee company
belonging to the bank to ensure that the bank secures complete performance of the mortgage loan due
from the debtor. In this case, a mortgage is placed on the real estate owned by the debtor with theguarantee company as the mortgagee and with the prior reimbursement claim as the secured claim. After
having made good on the guarantee to the bank, the guarantee company can collect the mortgage loan
claim by foreclosing the mortgage in the form of the reimbursement claim against the debtor. When thebank transfers the mortgage loan to the SPV, the right retained by the bank to ask the guarantee company
to make good on the guarantee will be transferred to the SPV due to the concomitant effect of theguarantee as a matter of course. Meanwhile, the mortgage will not be transferred to the SVP and theguarantee company will continue to hold the mortgage. It is the point of contention in the rating of a
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RMBS project how much the RMBS project can expect to collect the mortgage loan claim by asking theguarantee company to make good on the guarantee and by foreclosing the mortgage.
(1) Right to ask a guarantor to make good on the guarantee:
In the case where each mortgage loan is accompanied by a guarantee company’s guarantee, no loan
losses will emerge in the mortgage loan pool as has been transferred to the SPV provided that theguarantee company makes good on the guarantee. A guarantee contract concluded between a bank and aguarantee company includes the (exceptional) clause that exempts the guarantor from making good on
the guarantee. With the exempt events limited to the bank’s violation of the guarantee contract as well as
the bank’s intention and gross negligence, however, if either of the exempt events applies to the bank,the bank is obliged to repurchase the relevant claim (mortgage loan pool) due to the bank’s violation of
the representations and warrantees and the consigner’s violation of the commitments in the trust contract,etc. If any bad loan emerges, the bank may sometimes select the choice to hold discussions with therelevant debtor and ease the loan conditions (interest reduction and exemption, extension of the term,etc.) instead of applying the acceleration clause (event of default by the debtor) and asking the guarantor
to make good on the guarantee, taking into consideration the possibility to collect the claim and otherfactors. In the latter case, the bank is also obliged to repurchase the claim in question due to the bank’s
violation of the representations and warranties and the consignor’s violation of the commitments in thetrust contract, etc.

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Figure 2: Right to Ask a Guarantor to Make Good on the Guarantee, Mortgage, and Group Credit Life Insurance<Before Securitization>
Life Insurance Company
Group Credit Life Insurance Contract
Mortgage Claims
Underlying Debtors

Non-life Insurance Policy
Non-life Insurance
Company

Originator(Bank)
Mortgage

Right to Ask a Guarantor
to Make Good on the Guarantee
Guarantee Company

Pledge<After Securitization>
Memorandum of the Guarantee

Life Insurance Company

Group Credit Life Insurance Contract

Trust Bank

Originator

Mortgage Claims
Underlying Debtors(Bank)
Mortgage

Non-life Insurance Contract
Non-life Insurance
Company

PledgeGuarantee Company

Right to Ask a Guarantor to Make Good on the Guarantee

In this context, with the following as the requirements, JCR considers it possible to give a rating to
the tranche of credit enhancement in response to the bad-loan risk in such a manner that the ratingreflects the ability of a guarantee company to make good on the guarantee.
■ All mortgage loans from a bank are accompanied by a joint and several guarantee of the guarantee
company affiliated with the bank.
■ As a general rule, the bank has been receiving from JCR a rating at a certain level or even higher as
required.
■ The business unity of the bank and the guarantee company affiliated with the bank is strong.
■ With the guarantee contract limiting the exempt events (to the bank’s violation of the guarantee
contract as well as the bank’s intention and gross negligence, as an example), if either of the
exempt events applies to the bank, the guarantee contract obliges the bank to repurchase therelevant claim (pool of the mortgage loans) due to the bank’s violation of the representations andwarrantees and the consigner’s violation of the commitments.
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In the case where the exempt event is not limited (for example, buildings are damaged by anearthquake), the RMBS scheme ensures that responses will be taken to the emergence of the
exempt event.
■ If the bank eases the loan conditions (interest reduction and exemption, extension of the term, etc.),
the guarantee contract obliges the bank to repurchase the claim in question due to the bank’s
violation of the representations and warranties and the consignor’s violation of the commitments.
■ A legal opinion to the effect that the transfer of the claim is a true purchase and sale is to besubmitted.
■ Credit enhancement measures in response to various risks including interest rate risk, setoff risk,
etc. that cannot be covered by the guarantee contract are separately taken in the form ofsubordinated beneficiary rights and cash reserves.
* When the guarantee company is a subsidiary of the originator, the originator’s bank takes the credit
enhancement measures for a RMBS project on behalf of the group. Even in this case, the following
items explain the reasons that the true purchase and sale is not impaired.
(a) The parent company’s equity share of its subsidiary is a problem having a different nature from thatof a transaction between the parent company and its subsidiary.
(b) Each mortgage loan is not accompanied by the subsidiary company’s guarantee on the occasion ofits securitization. Instead, the guarantee has been provided at the time of drawdown of the mortgage
loan regardless of the securitization. Any parties involved in the securitization are aware that therelevant claim is accompanied by a guarantee of the assignor’s subsidiary and conduct buying andselling transactions of the relevant claim with the pricing based on that premise.
(2) Judgment of whether or not the claim can be collected by foreclosing the mortgage:
If the guarantee company becomes bankrupt, its mortgage right will not be transferred to the SPV
as a matter of course. As the guaranteed debts are cut in the process of the insolvency proceedings, thereimbursement claim acquired by the guarantor as the result of making good on the guarantee also
decreases in the amount and the collection of the claim by foreclosing the mortgage is deemed to belimited to the extent of the residual claim. In a RMBS scheme where the guarantee company transfers
the mortgage to the SPV (or the guarantee company places the transferred mortgage for the SPV) at thetime of the closing and the necessary conditions for opposing any debtors can be fulfilled with the eventof the guarantee company’s credit uncertainty as the trigger, the possibility remains that the originator’sreceiver/administrator may disapprove the fulfillment of the necessary conditions for opposing the
debtors at the time of emergence of the guarantee company’s credit uncertainty. If the guarantee
company is subject to the corporate rehabilitation proceedings, the mortgage or the transferred mortgage
will be the rehabilitation security rights. Accordingly, no voluntary repayments can be received beyond
the scope of the rehabilitation proceedings. Unless these legal restrictions are avoided, cautious
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judgment of whether the collection of the claim by foreclosing the mortgage is to be embedded in therating will be exercised except for the tranches with a rating equal to or higher than that of the guarantee
company.
(3) Group credit life insurance
Each mortgage loan is often covered by a group credit life insurance. However, any change of thebeneficiary of insurance money requires the debtor’s consent. Since the originator receives the insurancemoney, it is impossible to expect the positive effect of the coverage by a group credit life insurance after
the originator’s insolvency. For this reason, JCR takes no effect of a group credit life insurance into
consideration when assigning a rating to any RMBS project.
3.

Points of Contentions in the case of Mortgage Loans from a Regional Financial Institution(1) Regional concentration
For mortgage loans from a regional financial institution, it is impossible to avoid the fact that
regional concentration of debtors becomes relatively high. The points of contention in the regional
concentration of debtors are the reflection of the regional economic impacts including economic growth
rates, income levels, etc. as well as earthquake risks. For earthquake risks, in the case of an extreme
regional concentration of debtors, for example, when debtors are extremely concentrated on a region
where earthquakes take place frequently and on the same apartment block, it is necessary to make stressadjustments and to take credit enhancement measures. JCR considers it possible to take sufficient
responses to a regional concentration by implementing measures to disperse debtors, for example, bymeans of preventing the debtors from their concentration in the same community, etc.
Concerning regional economic impacts, it is necessary to conduct a survey of unemployment rates
and other economic indices, research of the land price trends, and so on and to take into consideration
their impact on the extracted mortgage loan pool.
For a RMBS scheme that avoids the risk of regional concentration of debtors, the following
securitization efforts should be seriously taken into consideration: For example, mortgage loans frommultiple regional institutions that are regionally dispersed are collectively securitized.
(2) Subordination in response to setoff risk (setoff subordination)
A regional financial institution having a few or little competitors is often deemed to function as themain bank where consumers in the region maintain their payroll accounts. Besides, in comparison tourban areas, debtors of mortgage loans are often expected to hold their savings accounts there.
Concerning a RMBS project with a regional financial institution as the originator, JCR believes that it isa problem to be carefully investigated how much the RMBS Project should take credit enhancement
measures for the setoff subordination.

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Because of the possibility of human or mechanical error as well as other factors in the information herein, JCR makes no representation or
warranty, express or implied, as to accuracy, results, adequacy, timeliness, completeness or merchantability, or fitness for any particular purpose,with respect to any such information, and is not responsible for any errors or omissions, or for results obtained from the use of such information.
Under no circumstances will JCR be liable for any special, indirect, incidental or consequential damages of any kind caused by the use of any suchinformation, including but not limited to, lost opportunity or lost money, whether in contract, tort, strict liability or otherwise, and whether suchdamages are foreseeable or unforeseeable. Information herein is statements of opinion, and not statements of fact as to credit risk decisions or
recommendations regarding decisions to purchase, sell or hold any securities such as individual bonds or commercial paper. JCR retains all rights
pertaining to this document. Any reproduction, adaptation, alteration, etc. of this document, is prohibited, whether or not wholly or partly, without
prior consent of JCR.

Japan Credit Rating Agency, Ltd.
Jiji Press Building, 5-15-8 Ginza,
Chuo-ku, Tokyo 104-0061, Japan
Tel. +81 3 3544 7013, Fax. +81 3 3544 7026

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