Consulting Corner

Forecasting Conditional Default Rates for Manufactured Housing ABS
By Anne Ching

2003 has been another dismal year for manufactured housing (MH) asset-backed securities (ABS). The downgrade of several Oakwood B-1 classes in the second week of October (1998-B, 1999-C, 2001-C, 2001-D and 2001-E) by S&P signals the likelihood that investors will not receive timely interest payments or the ultimate repayment of principal. The recent downgrade of Oakwood transactions is just another sign to investors of the weakening collateral backing these transactions. All of the major players in the sector continue to suffer from high default rates and high levels of repossession inventories.

The deteriorating performance of the MH sector underscores how important it is for investors to forecast accurate default rates for the specific issues they own. We have found from our extensive work in the MH sector that forecasting future losses based upon recent experience requires careful analysis. Two obvious methods of forecasting future losses won't work well.

First, forecasting that future losses will continue at the current rates will likely lead to overstating losses. During the past year, firms have altered their approaches to servicing and default management; the net result has been a surge in losses. These levels of losses are not likely to continue indefinitely. In some cases these losses represent the resolution of a surge of seriously delinquent loans reflecting the changed servicing practices and declining collateral value in the industry. Over time the crisis situation will pass. In addition, MH loans tend to have peak losses at about the three year point in a contract's life. Loans that survive beyond that point generally have an improving performance pattern.

On the other hand, forecasting based on cumulative losses and defaults to date may understate losses. While valuation models typically use forecasts of conditional default rates (CDR), true CDRs are not always reported for MH on remittance/trustee reports. From our experience, the convention in the MH sector is to report not defaults, but the principal amount of liquidated contracts, thereby excluding the current balance of seriously delinquent loans and repossession inventory. Reporting conventions will vary across deals depending on the definitions specified in the pooling and servicing agreements.

In order to improve the accuracy of forecasting CDRs, we utilize a method that takes into account the cumulative defaults as well as the large inventories of repossessions and seriously delinquent loans. >>>