DBRS Rating

Criteria for
Securitizations U.S. Residential
Dominion Mortgage-Backed
Bond Securities: Default
Rating
Ser vice

DECEMBER 2004

SUSAN KULAKOWSKI

MICHAEL NELSON

KEN HIGGINS

Q U I N C Y TA N G
 Table of Contents

Executive Summary 1

Primary Frequency Drivers: Credit Score and LTV 1

Base Frequencies for Various LTVs 2

Other Characteristics affecting Frequency 2

Mortgage Product 3
Amortization & Term to Maturity 3
Interest Resets 4
Interest-Only Features 5

Loan Purpose 5

Documentation 6

Grade 7

Occupancy 7

Property Type & Ownership Interest 8

Conclusion 8

Appendix 9
Payment Shock Comparison Table: Hybrids and IOs
EXECUTIVE SUMMARY
In this document, Dominion Bond Rating Service
(DBRS) analyzes mortgage default frequency as part of
its rating methodology for securitizations of U.S. residential
mortgages.
This methodology discusses how the characteristics a
borrower, a mortgage, and a property serve to increase or
decrease the likelihood of mortgagor default as devised and
employed by DBRS in its RMBS model.
PRIMARY FREQUENCY DRIVERS: CREDIT SCORE AND LTV
The combination of LTV and credit score is fundamental to
the analysis of risk in residential mortgage-backed
securities. This pair impacts both the frequency of default
and the severity of loss after default.
Both are strongly correlated with mortgage default rates.
LTV is positively correlated - the higher the LTV, the
greater the default rate. The credit score itself, however, is
negatively correlated - the lower the credit score, the greater
the default rate.
The higher the LTV, the greater the default risk. The
converse may provide a more satisfactory illustration of
why this is true. The lower the LTV, the greater the
borrowers investment in the property and the greater the
variety of refinance/resale opportunities available. Both
serve to lower the default rate. Essentially a larger down
payment is a larger financial (and emotional) commitment;
second, it serves to lower the monthly payment; and, finally,
it affords the borrower a greater opportunity to refinance or
sell the property, should the borrower run into financial
difficulties.
The lower the credit score, the greater the default risk.
Again, the converse may provide a more satisfactory insight
into the dynamics of this relationship. The higher the credit
score, the better the borrowers financial management skills.
Residential Mortgages
Information comes from sources believed to be reliable, but we cannot guarantee that it, or opinions in this Study, are complete or accurate. This Study is not to
be construed as an offering of any securities, and it may not be reproduced without our consent.
Credit score and loan-to-value ratio (LTV), as a pair,
are the primary drivers of mortgage default frequency.
A mortgage product is identified by its defining
components: term to maturity, amortization term,
interest-only features, and the nature of interest paid.
Loan purpose and documentation standards are handled
as continuous variables based on credit score.
Borrower grade, occupancy, and property type are
discrete variables that influence default frequency.
Better financial management skills suggest that the
borrower is not only financially savvy but also likely to
have more substantial savings on hand. Consequently, the
borrower will be able to make a larger down payment and
maintain a financial cushion of at least several months to
fall back upon should the borrower run into financial
difficulties.
In addition to having strong correlations with mortgage
default rates, LTV and credit score tend to move together
towards greater or lesser default risk. That is, a borrower
with a higher LTV, indicating a greater risk of default, is
more likely to have a lower credit score, also indicating a
greater risk of default. Similarly, a borrower with a lower
LTV, indicating a lesser risk of default, is more likely to
have a higher credit score, also indicating a lesser risk of
default.
The LTV ratio has historically been and remains an
important variable in estimating default risk. Credit score,
although brought into widespread use in the mortgage
lending industry only within the past eight years, has
become an equally important variable. These two variables
are used in tandem within the DBRS RMBS model: the
credit score provides the exponential shape of the default
curve while the LTV sets the level of the default curve for
each rating category.
DOMINION BOND RATING SERVICE
 DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page 2

BASE FREQUENCIES FOR VARIOUS LTVS

The following four charts present the base default During the past five to eight years, FICO has become
frequency risk for various combinations of LTVs and credit widely used in predicting default rates. It is also quite useful
scores. They assume that the mortgage is an otherwise in predicting defaults as it is a good indicator of a
vanilla mortgage, i.e., a 30-year fixed-rate, purchase borrowers general propensity to meet the obligations on a
money mortgage on an owner-occupied single family house, timely basis.
underwritten to a full doc standard.
The combination of LTV and FICO is more powerful than
Historically, LTV has been a popular and quite useful either individually.
measure of default risk because its inverse, home-owners
equity, represents the borrowers initial financial
commitment to the property.

Base Default Frequency for Various LTVs Assuming FICO of 820 Base Default Frequency for Various LTVs Assuming FICO of 680

3.0% 14.0%

2.5% 12.0%
Base Default Frequency

Base Default Frequency

10.0%
2.0% AAA AAA
8.0%
AA AA
1.5%
A 6.0% A
1.0%
BBB 4.0% BBB

0.5% BB BB
2.0%
B B
0.0% 0.0%
100% LTV 90% LTV 80% LTV 70% LTV 60% LTV 100% LTV 90% LTV 80% LTV 70% LTV 60% LTV

Source: DBRS Source: DBRS

Base Default Frequency for Various LTVs Assuming FICO of 720 Base Default Frequency for Various LTVs Assuming FICO of 560

10.0% 30.0%

9.0%
25.0%
8.0%
Base Default Frequency

Base Default Frequency

7.0%
AAA 20.0% AAA
6.0%
AA AA
5.0% 15.0%

4.0% A A
10.0%
3.0% BBB BBB
2.0% BB BB
5.0%
1.0%
B B
0.0% 0.0%
100% LTV 90% LTV 80% LTV 70% LTV 60% LTV 100% LTV 90% LTV 80% LTV 70% LTV 60% LTV

Source: DBRS Source: DBRS

OTHER CHARACTERISTICS AFFECTING FREQUENCY

In addition to LTV and credit score, several additional The discussion that follows begins with mortgage product,
characteristics are important to assess default risk. These the most crucial characteristic after LTV and credit score.
include the mortgage product itself, loan purpose,
documentation standard, borrower grade, occupancy, and
property type.
DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page 3

MORTGAGE PRODUCT
To comprehensively estimate the default risk of any mortgage loans. The DBRS RMBS model provides a benefit
particular loan, the DBRS RMBS model estimates a default for shorter amortization periods. Regardless of credit sector,
risk for each component of a mortgage. These components a 15-year fully amortizing loan has about 80% of the default
include amortization, interest resets, and interest-only risk of a 30-year fully amortizing mortgage loan. While
periods. Once the default risk for each component is short amortization terms (12 years or less) are likely to
estimated, the RMBS model multiplies these together to perform well within securitized mortgage pools because
estimate the default risk for the entire mortgage. they amortize so quickly, DBRSs estimates of default
frequency do not provide for any reduction in default
Historically, mortgage lenders offered two basic types of expectation for these loans.
mortgage products - fixed rate mortgages (FRMs) and
adjustable rate mortgages (ARMs). FRMs are fully Three other amortization schedules are possible.
amortizing loans, offered with either a 15-year maturity or a Increasingly popular is an IO-type amortization. These
30-year maturity. Of these, 15-year FRMs have historically mortgages marry a short-lived interest-only mortgage to a
performed exceptionally well, with base default fully amortizing mortgage with a substantially longer life.
expectations of 1.25% or less for two reasons. Fifteen-year Most often, the initial interest-only period will be two to ten
FRM borrowers tend to be the most creditworthy borrowers years, while the subsequent fully amortizing period will
and 15-year FRMs tend to have lower LTVs. Alternatively, range from 28 to 20 years. For mortgage loans that include
a base default expectation of about 2.25% is reasonable for an initial IO period, the DBRS model does not extend any
30-year FRMs, which was the most commonly offered amortization benefit for subsequent, faster amortization.
mortgage product until recently. In contrast, traditional
ARMs with annual (or more frequent) resets have not The two other amortization schedules - balloons and
performed nearly as well, with base default expectations negative amortizing ARMs - are less common. Balloon
about two times as high. mortgages are one possibility with two variations: partially
amortizing or interest-only. The partially amortizing balloon
In recent years, mortgage lenders have expanded the is a mortgage loan that pays principal and interest like a
available options for adjustable rate mortgages to include long-term fully amortizing mortgage, but matures before the
longer initial fixed periods of two to ten years (hybrid amortization schedule would bring the outstanding principal
ARMs) and interest-only periods, which may or may not balance to zero.
coincide with the longer initial fixed period (IO hybrids).
Balloon loans, either partially amortizing or interest only, The most common partially amortizing balloon is a 15/30
and negatively amortizing ARMs are less common today. balloon, which pays monthly principal & interest (P&I) like
a 30-year fully amortizing loan but which requires a final
Amortization & Term to Maturity payment of all principal due at the end of 15 years. For the
purposes of mortgage-backed securities, any partially
amortizing balloon mortgage with an amortization schedule
Frequency Benefit for Fully Amortizing Mortgage Loans of 30 years and a term to maturity of ten years or longer will
behave like its fully amortizing cousin. Balloons with quick
1.00 amortization schedules will benefit from the rapid
0.95 amortization, although the amortization benefit will be
smaller than it would be otherwise for a fully amortizing
0.90
.

mortgage loan. Balloons that mature quickly increase

Frequency Factor

0.85
default risk, especially if the final payment comes due
0.80 during the peak default years (three to five). In general, the
0.75
longer the maturity and the longer the maturity in
relationship to the amortization, the less risky the mortgage.
0.70
The other type of balloon mortgage that is only rarely
0.65 offered as a first lien mortgage is the interest-only balloon.
10 12 14 16 18 20 22 24 26 28 30
Amortization Term in years
These mortgages pay only interest and require repayment of
Source: DBRS
the full principal balance at maturity. To the extent that
lenders offer interest-only mortgages, they direct these
Whether a mortgage loan fully or partially amortizes is key mortgages to the most creditworthy, who use these
to understanding default risk. A fully amortizing loan pays mortgages as financing tools.
both principal and interest with a monthly mortgage
payment calculated so that the loan amortizes completely The final possibility for amortization is negative
over its life (i.e., the amortization term is equal to the term amortization, which adds unpaid accrued interest to the
to maturity). It may pay either a fixed or an adjustable principal balance, causing the outstanding loan balance to
coupon. grow. Negatively amortizing mortgage loans performed
very badly during the 1990s and are infrequently offered
Fully amortizing loans with terms to maturity of less than today. Within the RMBS model, the frequency factor for
30-years have historically performed better than 30-year loans that permit negative amortization is 1.2 times.
 DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page 4

A variation occasionally seen is the mortgage that offers the payment or a smaller down payment and mortgage
borrower a choice of up to three different monthly insurance offering coverage down to 80% or less LTV.
payments. These are: (1) a fully amortizing payment; (2) an
interest-only payment that covers interest, but excludes any During the 1990s, adjustable-rate mortgages (ARMs) were
principal payment; or (3) a minimum payment that is less increasingly offered into the secondary market (although
than the interest-only payment, adding accrued interest to ARMs were available well before the 1990s, as indicated by
the unpaid principal balance and negatively amortizing the Freddie Macs decision to add the one-year ARM to its
mortgage balance. Primary Mortgage Market Survey in 1984). The willingness
of lenders to make ARMs available to borrowers increased
Most lenders that offer such choices to borrowers report that the base of mortgages because: (1) lenders were often
the vast majority of borrowers opt for the fully amortizing willing to qualify borrowers at exceptionally low teaser
or interest-only payment and not the negatively amortizing rates, which are good until the first interest rate reset, and
minimum payment. In practice, these mortgages have to (2) by generally lowering initial interest costs. Because the
date performed better than the negative amortizing ARMs interest costs for ARMs were (and remain) lower than the
of the 1990s, but some default risk remains. To the extent 30-year fixed rate mortgages (at least at the time of
that financially troubled borrowers opt for the minimum origination and ignoring the possibility of interest rate
payment and do negatively amortize a mortgage, negative increases), the borrowers taking these mortgages were
amortization can be disastrous if property values fall below generally those less able to qualify for 30-year fixed rate
the outstanding principal balance. mortgages, i.e., generally less creditworthy borrowers.

Interest Resets ARM borrowers, therefore, remain more likely to default

than their fixed rate borrower counterparts. This occurs for
three reasons. First, ARMs are initially cheaper than FRMs
Frequency Penalty for Adjustable Rate and Hybrid Mortgage Loans so less financially stable borrowers are more likely to
qualify for an ARM. Second, although the past 15 years
1.60 have witnessed exceptional declines in interest rates,
1.50
interest rates on ARMs sometimes do index upwards to
higher rates. Third, lenders in the past were particularly
.

1.40 generous in qualifying borrowers for ARMs, often offering

Frequency Factor

1.30
exceptionally low teaser rates through the first interest
rate reset and qualifying borrowers at the teaser rate rather
1.20 than the more costly fully-indexed rate.
1.10
These first two reasons combine to explain payment
1.00 shock, the rude awakening experienced by borrowers (and
12 22 32 42 52 62 72
Time to First Reset in months
lenders alike) when the borrowers monthly payment resets
Source: DBRS
beyond the borrowers ability to pay it. The third, qualifying
borrowers at even lower teaser rates, also explains poor
historical performance.
Frequency Penalty for Various Interest-Only Periods Hybrid ARMs, which combine fixed and adjustable interest
characteristics, have become common in securitizations
1.60
during the past five years. These adjustable rate mortgages
1.50 combine an initial fixed rate period of two years or more
(differing from the traditional ARM that generally resets
.

1.40
every one, six, or 12 months) with usually annual rate and
Frequency Factor

1.30 payment resets thereafter. Borrowers who assume hybrid

ARMs tend to self-select much the way fixed rate and
1.20
adjustable rate borrowers self-select. Financially stronger
1.10 borrowers tend toward hybrids with longer initial fixed
periods, say five to seven or more years. Financially weaker
1.00
1 3 5 7 9 11 13 15
borrowers tend toward hybrids that reset at the two- or
Interest-Only Period in years three-year mark.
Source: DBRS

Overall, hybrid ARMs represent increasing segmentation

The nature of the mortgage coupon also reflects default within the mortgage market. With hybrid ARMs, lenders
propensity. The standard American mortgage that was can offer relatively cheaper rates to borrowers who prefer
securitized into the secondary market was, until the early- to longer periods of payment stability. At the same time, with
mid-1990s, a 30-year fully amortizing mortgage, either hybrid ARMs, lenders can offer relatively longer periods of
fixed rate or adjustable rate, with either a 20% down fixed interest costs to borrowers who would otherwise
prefer traditional ARMs.
DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page 5

The crucial feature in identifying the additional default risk the fact that amortization will be quick during the
represented by the mortgage coupon is the length of the subsequent fully amortizing period, the RMBS model
initial fixed period. A fixed rate mortgage, the least risky provides no amortization benefit to any loan that includes an
option, never resets. Because this borrower will never face initial interest-only period. (For more information, see
payment shock, the default frequency factor for fixed rate Appendix).
mortgages is 1.0 times. An ARM, on the other hand, may
experience its first reset anytime between one month after Within the RBMS model, interest-only mortgages have
origination and ten years out. Within the RMBS model, this different penalties depending on the term to maturity. IOs
risk is represented by an equation that starts at a factor of with a shorter 15-year maturity carry a larger frequency
1.5 times for any mortgage that resets within the first 12 factor than do loans with a 30-year maturity. This occurs
months, decreases as the initial fixed period lengthens, and, because the short term to maturity requires a relatively
by six years, falls to a factor of 1.0 times, representing a risk much larger principal payment, increasing the likelihood of
equivalent to the risk of a fixed rate mortgage. payment shock when principal first comes due.

Interest-Only Features Whether the term to maturity is 15 or 30 years, the risk of

During the past five years, mortgage lenders have offered payment shock is greatest for interest-only loans with short
30-year mortgages that begin with an interest-only period initial fixed rate periods (less than five years). Not only may
(typically two to ten years), followed by a fully amortizing interest rates reset upwards, increasing default risk, but for
loan for the remainder of the 30 years (i.e., the remaining 28 short IO periods, the first principal payments also come due
to 20 years). The interest-only period brings an additional during the period of greatest default risk (years three to
level of risk to the mortgage. Although the amount of five).
foregone principal amortization is minimal, the IO borrower For intermediate term interest-only loans, the default risk
faces twice as many payment shocks as faced by a fully lessens simply because the borrower has more opportunities
amortizing ARM borrower. during the intervening years to sell or refinance. In addition,
In addition to the risk of payment shock caused by increases although housing prices may fall after loan origination and
in interest rate - which the fully amortizing ARM borrower remain depressed for extended time frames, it is unlikely
must face - the IO borrower will face a large payment shock that a property ten years after it was originated would be
when principal first comes due. The payment shock will be worth less than it was at origination. For the longest term
large even if interest rates remain unchanged because the interest-only loans, information on historical performance is
principal payment required will be relatively large, given limited and increasing default frequency factors reflect a
that the amortization term is shorter than 30 years. Despite conservative bias.

LOAN PURPOSE
Borrowers historically assumed mortgages to purchase The base loan purpose is purchase, with a default
homes. However, the past 12 years have witnessed great frequency factor of 1.0 times. Purchases are the least risky
cycles of refinancings as mortgage interest rates fell from of all loan purposes, including rate/term refinances, for a
highs of more than 10% on 30-year FRMs in 1990 through variety of reasons. The primary reasons are solid property
the 40-year lows of mid-2003. These cycles of falling rates valuation, borrower equity, and motivation. One of the risks
(coupled with improved automated underwriting engines in originating mortgages is that a property may be
and low/no cost refinance opportunities) fostered large overvalued, i.e., in the event of liquidation, the servicer may
increases in the numbers of both rate/term refinances and not be able to sell the property in order to satisfy the
cash-out refinances. outstanding mortgage obligation.

Mortgage Interest Rate Environment Frequency Penalty for Loan Purpose

10.0% 2.6

9.0% 2.4

2.2
.

8.0%
.

Frequency Factor

2.0
Interest Rate

7.0%
1.8
6.0%
1.6
5.0%
1.4
4.0%
1.2

3.0% 1.0
Sep-93

Sep-94

Sep-95

Sep-96

Sep-97

Sep-98

Sep-99

Sep-00

Sep-01

Sep-02

Sep-03

Sep-04

560 580 600 620 640 660 680 700 720 740 760 780 800 820 840
Credit Score
30PMMS 10yrCMT Rate/Term Refinance Cash-out Refinance Purchase
Source: DBRS Source: DBRS
 DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page 6
First, with an arms length transaction between an
independent buyer and seller, there is little uncertainty as to
the value of the property, which should be very close to
true market value, minimizing the risk of overvaluation.
Second, while the down payment made by the borrower
may be large or small, at the time of origination, an active
cash investment is being made in the property by the
borrower. If the borrower either makes no down payment
(100 LTV at origination) or borrows more than the value of
the property through a high LTV program, this advantage
for purchase money mortgages disappears.
Refinance mortgages are riskier than purchase money
mortgages, whether the refinance is a rate/term refinance or
a cash-out refinance. That is because refinance mortgages
share none of the advantages of purchase money mortgages.
First, because there is no sale, there is no true property
value, i.e., no value that satisfies buyer, seller, and
appraiser. Second, no down payment is required (and, in
fact, with a cash-out mortgage, the property provides cash to
the borrower), making the refinance process more of a
financial transaction and less of an active commitment to
the property, essentially turning the home into a financing
vehicle.
Although refinancings are in general riskier than purchase
money mortgages, the risk varies by credit sector. In the
prime sector, purchase money mortgages and rate/term
refinances are the two most common loan purposes and
perform similarly. In contrast, sub-prime borrowers are
more likely to assume cash-out refinances, which do not
perform as well as purchase money mortgages. The DBRS
model uses continuous equations based on borrower credit
score to calculate default factors for both rate/term and
cash-out refinances.
The frequency factors for rate/term refinances range from
1.2 times for borrowers with high credit scores to 1.5 times
for borrowers with weak credit scores. Intuitively, this is
DOCUMENTATION
A lender may require four types of verifications:
verification of mortgage (or rental) payment (VOM),
employment (VOE), income (VOI), and deposits and/or
assets (VOD/VOA). Twenty years ago, a lender collected
these using standard government-sponsored enterprise
(GSE) forms from mortgagee, employer, and depository.
Today lenders accept alternate forms provided by the
borrower or other sources. Existing mortgage obligations
generally appear on the borrowers credit report. The lender
phones the employer near closing to verify employment
while the borrower submits pay stubs, W2s, and tax returns
to verify current and annual income. Borrowers can submit
two bank statements to verify deposits.
Verifications vary across the credit spectrum. While prime
borrowers generally obtain full doc mortgages - especially
for purchase money mortgages - lenders offer pre-
screened programs, with very minimal requirements, to
borrowers with strong credit on low risk transactions.
Except for these lender-offered programs, less-than-full-doc
appealing because the penalty is modest for strong credits
and more substantial for weaker credits, although rate/term
refinances may be slightly riskier overall.
In direct contrast, the frequency factors for cash-out
refinances range from more than two times for borrowers
with high credit scores, to 1.6 times for borrowers with
weak credit scores. That is, the stronger the borrower, the
larger the penalty for a cash-out refinance. Two points of
the analysis warrant discussion: the similarity between the
two refinance purposes for sub-prime borrowers and the
dissimilarity between the two for prime borrowers.
Firstly, for the weakest borrowers, the difference between a
rate/term refinance (1.5 times factor) and a cash-out
refinance (1.6 times factor) is slim. This occurs because,
given the fundamentally high credit risk in sub-prime, there
is little additional deterioration in performance for cash-
outs. Even when a mortgage loan made to a sub-prime
borrower is labeled rate/term refinance, it is more likely
to be a refinance of an existing cash-out mortgage than of a
purchase money mortgage. In addition, because property
valuations are more likely to be pushed for sub-prime
mortgages, and especially for higher LTV sub-prime
mortgages, substantial uncertainty about the actual
homeowners equity remains, whether the mortgage is a
rate/term or cash-out refinance.
Secondly, the substantially higher cash-out penalty for the
strongest credit borrowers applies not only for discussion of
loan purpose, but also for documentation standards. Prime
borrowers have the ability to cost effectively borrow
without having to assume a larger, long-term mortgage
burden, so prime cash-out refinances are relatively rare. To
the extent that prime borrowers re-mortgage into cash-out
refinances, it seems that these prime borrowers are
adversely self-selecting, extracting equity from their homes.
The default performance of these mortgages is worse than
for any other purpose, indicating a larger penalty is
warranted.
prime mortgages are relatively rare. The Alt-A channel
includes prime borrowers unwilling or unable to meet full
doc requirements (less-than-full is a distinguishing
characteristic of Alt-A). A sub-prime borrower has a wide
range of programs to choose from, some of which require
very minimal documentation (although at a higher price to
compensate the lender for the increased risk).
If a verification is completed in a manner that meets the
GSE full doc standard, that verification is met. A full
doc or an alt doc, then, would have all four verifications
(VOM, VOE, VOI, and VOA/VOD) completed in a way
that meets the full standard of the GSEs for manually
underwritten mortgage loans. For programs with less
stringent requirements, DBRS evaluates the verifications
separately. For example, a stated income, stated assets
program, while not authenticating income or assets, will still
require VOM and VOE.
DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page 7

A lenders documentation code is open to interpretation. It
condenses a complex set of rules into a single statistic used
outside of the lending institution by users without first-hand
knowledge of the rules by which it was evaluated and the
credit culture under which it was determined. The
following table presents three common doc programs and
DBRS codes. Informed judgment will at times be required
to map an originators doc codes into a standardized form,
as is also true for borrower grades. A preponderance of
exceptions across the verifications will lead to a code that is
lower, even if each verification is marginally satisfied.
increasing doc penalty occurs because the less
documentation completed as part of the mortgage
application process, the greater the uncertainty about the
borrowers financial stability and the propensity to pay.
Although documentation mainly serves to establish the
borrowers current financial and employment circumstances
and does not necessarily predict the borrowers future
circumstances, a borrower with a generally stable income
stream historically, employment record, and ability to save
is likely to continue to demonstrate these characteristics in
the future.

"No
"Stated
Program "No Ratio" Income, Frequency Penalty for Various Documentation Standards
Income"
No Assets"
DBRS Code 3 2 or 3 2 2.2

Mortgage GSE GSE GSE 2.0

.
Employment GSE GSE GSE 1.8

Frequency Factor
Not
Income Not Verified Not Verified 1.6
Verified
Assets/ 1 or 2 bank Not 1.4
GSE
Deposits statements Verified 1.2

As with loan purpose, the frequency penalty for 1.0

560 580 600 620 640 660 680 700 720 740 760 780 800 820 840
documentation programs is continuous based on borrower Credit Score

credit score. Importantly, the frequency penalties for Full Doc 3 Complete Verifications 2 Complete Verifications 1 Verification or None

reduced documentation increase as the borrower credit score Source: DBRS

improves, as does the penalty for cash-out refinances. The

GRADE
DBRSs analysts generally use the following guidelines to
standardize borrower grades. An A borrower has been not
more than 1 x 30 days delinquent within the past year and
has no bankruptcy or foreclosure within the past seven
years. An A- borrower has been perhaps as much as
2 x 30 days delinquent, but not 60 days delinquent and has
no bankruptcy or foreclosure within five years. A B-grade
borrower may have been 1 x 60 days delinquent and has no
bankruptcy or foreclosure within two years. A C-grade
borrower is a borrower who may have been 1 x 90 days
delinquent (or worse) or who may have declared bankruptcy
or suffered a foreclosure within the past year.
A grade of A is the base borrower grade. Its factor is
1.0 times. The DBRS frequency factor for a grade of A-
increases to 1.2 times, 1.35 times for a B-grade, and
1.5 times for a C-grade.
To the extent that guidelines offer different mixes of
allowable delinquencies, recency of bankruptcy, or other
features, an analyst must review available performance data
or, if there is no reliable data, make a thoughtful judgment
based on known performance.

OCCUPANCY
Owner-occupancy is the base occupancy status. Its default
factor, like the factors for all other base statuses, is 1.0
times. An owner who lives in the mortgaged property is
more likely to be financially committed to the property and
more likely to be attentive to the maintenance needs of the
property. Both investor-owned properties and second homes
are, all else equal, more likely to experience a default. In
practice, however, because investor properties and second
homes are subject to more stringent lending guidelines and
additional underwriting scrutiny during the application
process, their historical performance has been good for
carefully underwritten programs.
For an individual who buys a property as an investment, the
financial commitment to the property may be as strong as an
owner-occupiers commitment. However, the property itself
does not fulfil the investors/borrowers immediate, basic
need for housing and the investor may be dependent on
rental income to cover the mortgage and other payments. In
addition, to the extent that renters are not as financially or
emotionally committed to the property and given the
investors more distant contact with the propertys
maintenance needs, an investor-owned property is more
likely to be poorly maintained. 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 the borrowers interest. The frequency factor for
investor-owned properties is 1.7 times.
Similarly, a second home represents a secondary
commitment on the part of a mortgagor. Although the
 DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page 8
borrower may make a strong commitment to a second
home, it again does not satisfy an immediate, basic need for
housing. Given the choice between making the mortgage
payments on a primary residence and a second home,
PROPERTY TYPE & OWNERSHIP INTEREST
The final characteristic evaluated for default frequency is
property type and ownership. Detached single-family
homes, the most common property type in the U.S. housing
market, form the base property type. Its default factor is 1.0
times. The default factor increases to the extent that the
property houses more than one family (multi-family
properties) or that ownership is somehow shared and an
individual mortgagor is financially tied to neighboring
properties (condominiums, co-operatives). Increased
frequency factors also apply to manufactured housing units.
Within the DBRS model, all property types that house a
single family and are fee simple ownership have a default
factor of 1.0 times. Property types that qualify include
planned unit developments (PUDs), diminimus planned unit
developments (dPUDs), and townhouses.
A condo or co-op, although intended as single-family
housing, differs in that a mortgagor buying a condominium
or co-operative is tied to the neighboring units for the
financial and physical maintenance of the larger building in
which the unit resides. This co-dependency creates
CONCLUSION
The default risk of a 30-year fixed-rate purchase money
mortgage, underwritten to a full doc standard, assumed by
an A mortgagor who will occupy the single-family
detached house as the primary residence may be simply
estimated by evaluating the borrowers credit score in
combination with the original LTV of the mortgage.
As the characteristics of the mortgage move away from that
base mortgage, default risk changes.
Where possible, the DBRS model estimates the default risk
for a continuous variable as a continuous function. To
estimate the default risk of the various components of
mortgage product, for example, the DBRS model uses
equations to gauge the reduction in default risk as
amortization term decreases, initial fixed hybrid period
lengthens, or interest-only period extends.
almost all borrowers would choose to maintain their
primary residences. The frequency factor for second homes
is 1.2 times.
additional default risk, which is especially apparent in
circumstances where the larger building association is
financially troubled even though the individual unit owners
are not. To account for this increased risk, the DBRS factor
for both condominiums and co-operatives is 1.5 times.
Small multi-family buildings of four or fewer housing units
represent somewhat greater default risk. These buildings are
frequently purchased by individuals who occupy one unit as
a primary residence and rent the remaining units. As the
number of units increases, the mortgage burden rises,
increasing the owner-occupiers dependence on rental
income to cover mortgage and other building payments. The
DBRS default factor for two-family buildings is 1.15 times,
for three-family buildings is 1.375 times, and for four-
family buildings is 1.5 times.
Finally, of all property types, manufactured housing (MH)
carries the greatest default risk. The DBRS model
distinguishes between single-wide MH, with a default factor
of 2 times, and double-wide MH, with a default factor of
1.8 times.
Similarly, variables with default risk that changes by credit
score are evaluated by credit score. The primary driver of
default frequency - the combination of credit score and
original LTV - is built in this way. In addition, the default
penalties for loan purpose and documentation also vary by
credit score. Discrete characteristics, such as borrower
grade, occupancy, and property/ownership type, are
evaluated independently.
This model is a tool used to evaluate the overall risk of a
pool of mortgages destined for the secondary market based
on the historical performance of similar pools. As such, it
does not seek to capture qualitative differences in
origination or servicing practices, nuances of the structural
features of an MBS, or legal issues such as predatory
lending requirements. For thoughtful analysis of issues like
these and judgments regarding future performance, the
rating process additionally includes the judgment and
experience of the rating analysts and the rating committee.
DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page 9

APPENDIX
Payment Shock Comparison Table: Hybrids and IOs
The table below sets out four mortgage loans for
comparison purposes. These are a 30-year fixed-rate
mortgage, the base loan; plus a 5/1 IO hybrid, which
carries an initial fixed rate for the first five years and pays
interest only during that time; a 5/1 hybrid, which also
carries an initial fixed rate for the first five years, but
which is fully amortizing; and a 3/1 IO hybrid, which
carries an initial fixed rate for the first three years and
pays interest only during that time. The mortgage rates
used were current at the end of September 2004. The
end-of-September forward curve for six-month LIBOR
was used to adjust the interest rates for the hybrid
adjustable mortgages. For the purposes of this
comparison, all hybrids were assumed to reset annually
to the lesser of the prior rate plus 2% (i.e., a 2% annual
interest rate cap) or the projected LIBOR rate plus a gross
margin of 2.75%.
While the overall cost of these mortgages after ten years
of payments are not significantly different, at the reset
dates, borrowers with adjustable rate mortgages can face
significant payment shock in a rising interest rate
environment. In addition, unless interest rates have fallen
enough to offset the new principal payment, the IO
borrower can experience payment shock when the first
principal payments come due. All mortgage loans carry a
term to maturity of 30 years and an original loan amount
of $350,000. In addition, after the first reset, all hybrids
reset annually.

30-yr FRM 5/1 IO Hybrid 5/1 Hybrid 3/1 IO Hybrid

IO Period (months) none 60 none 36
1st Reset (months) fixed rate 60 60 36
Amortization Term 360 300 360 324
(months)
Initial Interest Rate 5.28% 4.44% 4.30% 4.00%

30-yr FRM 5/1 IO Hybrid 5/1 Hybrid 3/1 IO Hybrid

Interest Rate 5.28% 4.44% 4.30% 4.00%

First Payment
New Monthly Payment $1,939 $1,295 $1,732 $1,167
2.17% 6-mos.
LIBOR forward
Increase over 30-yr FRM Payment $0 ($644) ($207) ($773)
curve
As % 30-yr FRM Payment 100% 67% 89% 60%

Interest Rate 5.28% 4.44% 4.30% reset to 6.00%

Monthly Payment $1,939 $1,295 $1,732 $2,184

Starting 4th year
Increase over 30-yr FRM Payment $0 ($644) ($207) $245
4.21% LIBOR
As % 30-yr FRM Payment 100% 67% 89% 113%

As % Original Payment 100% 100% 100% 187%

Interest Rate 5.28% 4.44% 4.30% reset to 7.35%

Monthly Payment $1,939 $1,295 $1,732 $2,480

Starting 5th year
Increase over 30-yr FRM Payment $0 ($644) ($207) $541
4.60% LIBOR
As % 30-yr FRM Payment 100% 67% 89% 128%

As % Original Payment 100% 100% 100% 213%

Interest Rate 5.28% reset to 6.44% reset to 6.30% reset to 7.63%

Monthly Payment $1,939 $2,350 $2,108 $2,541

Starting 6th year
Increase over 30-yr FRM Payment $0 $411 $169 $602
4.88% LIBOR
As % 30-yr FRM Payment 100% 121% 109% 131%

As % Original Payment 100% 181% 122% 218%

 DBRS Rating Criteria for U.S. Residential Mortgage-Backed Transactions - Page 10

30-yr FRM 5/1 IO Hybrid 5/1 Hybrid 3/1 IO Hybrid

Interest Rate 5.28% reset to 7.92% reset to 7.92% reset to 7.92%

Monthly Payment $1,939 $2,674 $2,429 $2,606

Starting 7th year
Increase over 30-yr FRM Payment $0 $735 $490 $667
5.17% LIBOR
As % 30-yr FRM Payment 100% 138% 125% 134%

As % Original Payment 100% 207% 140% 223%

Interest Rate 5.28% reset to 8.09% reset to 8.09% reset to 8.09%

Monthly Payment $1,939 $2,710 $2,462 $2,640

Starting 8th year
Increase over 30-yr FRM Payment $0 $771 $523 $701
5.34% LIBOR
As % 30-yr FRM Payment 100% 140% 127% 136%

As % Original Payment 100% 209% 142% 226%

Interest Rate 5.28% reset to 8.30% reset to 8.30% reset to 8.30%

Monthly Payment $1,939 $2,756 $2,503 $2,685

Starting 9th year
Increase over 30-yr FRM Payment $0 $817 $564 $746
5.55% LIBOR
As % 30-yr FRM Payment 100% 142% 129% 138%

As % Original Payment 100% 213% 145% 230%

Interest Rate 5.28% reset to 8.34% reset to 8.34% reset to 8.34%

Monthly Payment $1,939 $2,765 $2,512 $2,694

Starting 10th year
Increase over 30-yr FRM Payment $0 $826 $573 $755
5.59% LIBOR
As % 30-yr FRM Payment 100% 143% 130% 139%

As % Original Payment 100% 214% 145% 231%

Cum. Principal Payments $62,930 $27,707 $57,211 $35,969

Cum. Interest Payments $169,777 $209,055 $190,890 $219,997

At the end of ten
years
Inc. over 30-yr FRM Cum. Payment $0 $4,055 $15,394 $23,259

As % 30-yr FRM Cum. Payment 100% 102% 107% 110%