Bonds backed by the Federal Housing Administration and Veterans Affairs loans are beginning to show a few cracks, prompting Moody’s Investors Service to place $3.5 billion of residential mortgage-backed securities issued through 39 transactions on watch for a possible downgrade. Moody’s warning on FHA/VA RMBS arrives two days after Barclays Capital (BCS) issued a report saying investors should consider buying bonds backed by FHA/VA re-performing deals, which are essentially government-backed transactions where loans serving as collateral were cured after a default. “Senior bonds from FHA-VA re-performer deals provide a very stable yield profile even in dire economic scenarios and look very attractive with leverage,” according to Barclays. But Moody’s has a slightly different outlook when analyzing certain pools of FHA/VA RMBS. The advantage of investing in bonds backed by FHA/VA loans is the fact the Department of Housing and Urban Development agrees to pay claims on defaulted loans upfront, the ratings agency said. However, HUD also places stiff penalties on servicers if there are irregularities in the annual audits, including an inability to stay up-to-date with HUD’s loss-mitigation timelines. With servicers dealing with regulatory and judicial intrusions in the servicing process, they may be forced to avoid the time-sensitive HUD reimbursement requirements altogether, forcing them to pass some of the expenses on to the trustee holding the loans, Moody’s contends. “Servicers have recently come under a great deal of scrutiny due to staffing and process-related issues. In such a stressful environment, servicers may not always be able to follow the strict guidelines and time lines required by HUD,” according to Moody’s analysts. “As a result, we foresee an increase in self-curtailments, and any associated expenses that servicers pass through to the trusts will result in higher loss severities on defaulted loans.” Moody’s admits FHA/VA loan delinquency levels have been relatively stable, but analysts believe that could change with home prices still falling and unemployment consistently high. “FHA/VA borrowers are typically low-income borrowers with poor credit histories who have been affected by the weak economy and housing market,” Moody’s said. “Securitized FHA/VA pools typically have high delinquency levels at inception, with the majority of loans being 90-days late or more. Because of the insurance coverage loss severities and overall losses have been fairly low. Loss severities, which have been rising, are now currently around 12% on average.” Moody’s said because “the level of losses depends primarily on the level of self-curtailments by servicers, we expect losses to rise with any increased scrutiny. We currently project losses of 1.64% of the original balance of outstanding securitized loans and 3.7% of the loans’ outstanding balance.” Write to: Kerri Panchuk.