PRINTMarket Update -- In the Markets
March 6, 2007
Subprime mortgages have been the subject of countless news headlines in recent weeks. Delinquencies have soared amid slowing home price appreciation and lax underwriting. Many prominent subprime loan originators have filed for bankruptcy, exited the business, or reported large losses. Credit default swaps on the ABX indices, which are based on a basket of securities collateralized by pools of sub-prime mortgages, have witnessed unprecedented volatility, causing the cost of default protection on the lowest tier of the investment grade rated classes to rise to more than 15 cents per year on every dollar of principal.
More recently, US stock markets and parts of the investment-grade bond markets have reacted negatively to the deterioration of the sub-prime market. Volatility has risen and liquidity has fallen as rumors of significant losses among dealers have circulated through the markets. A few CDO warehouses have liquidated portions of their pipeline, and margin calls have already led to forced selling among leveraged accounts. While some market participants have viewed the recent weakness as a buying opportunity, many others have proceeded with greater caution. Complacency has not been rewarded, and some fear that the contagion from the subprime industry is only the start of a much broader re-pricing of risk in the financial markets.
Meanwhile, concerns are growing that a tightening of lending standards among mortgage originators today will further weaken the housing market and cause some spillover into other segments of the economy. If the tightening remains isolated to the subprime mortgage market, the overall economy may well weather this storm just as it has many others over the past few years. However, subprime losses have been impossible to ignore, and we’re already seeing evidence of spillover into other sectors of the financial markets.
We believe that further caution is warranted.
We have felt for quite some time now that risk premiums across many asset classes in the fixed income markets have declined to levels that no longer adequately compensate investors for all the risks. This view is not an opinion on subprime mortgages. It is an opinion on risk in the credit markets as a whole. It is also a large part of the reason that we have been overweight high-quality structured product, such as triple-A rated commercial mortgage backed securities (CMBS) and asset backed securities (ABS), including even the highest tier of the subprime ABS market (specifically, the senior-most triple-A rated classes of home equity loan-backed securities). Even amid the turmoil in the subprime mortgage industry we remain quite comfortable with our overweight to these bonds, and prefer them to many lower-rated segments of the credit markets.
Given the level of attention the subprime mortgage sector has received from the media in recent weeks, we have invited Peter Milne, our ABS sector specialist, and Janet Braggs, our ABS credit analyst, to provide some of their insight on the sector.
Home Equities and the Subprime Mortgage Market – It’s
Not All Bad
Despite recent originator closures and a seemingly endless barrage of negative
headlines about the subprime mortgage market, bonds backed by home equity
loans (HELs) still offer good relative value and solid liquidity at the top
of the capital structure. We have been vocal for quite some time now about
excess capacity, lax underwriting standards, and the fact that spreads on
lower rated bonds have been driven tighter by the infamous CDO machine. In
response to those concerns, we have maintained a major up-in-credit bias
for well over a year now. That said, given all the negative press, we feel
it is now an appropriate time to take a step back from the headlines and
take a closer look at the subprime borrower, as well as the underlying structure
and collateral characteristics that drive performance and allow those of
us who are invested at the top of the capital structure to sleep well at
night.
The subprime home equity borrower is one that has a blemished or less than perfect credit history. He or she may have a heavy debt load, may have missed a payment or two on another loan, or has a very limited credit history. One metric used to measure the credit worthiness of a borrower is the Fair Isaac & Co. credit score, otherwise known as a FICO score. FICO scores can range from 300 to 850, and borrowers with a score of 720 or higher are considered “prime” borrowers, while those with a score of less than 680 or so are generally considered “subprime.” In the current environment, bonds backed by HELs typically have a weighted average FICO score in the low 600s. The borrowers tend to have loan-to-value (LTV) ratios between 80%-100%, debt-to-income (DTI) ratios around 40%-43%, and an average loan of about $200,000.
The home equity market has experienced significant growth over the past five years. Fueled by record low interest rates, strong home price appreciation (HPA), low unemployment, increased consumer leverage, and a slew of new and innovative mortgage products, loan originations grew from less than $150 billion in 2000 to well over $600 billion in 2006.
High housing affordability over much of the past ten years has led to a substantial increase in home ownership, and with HPA rising in the double digits the housing market also became a very alluring investment for speculators. During the housing boom originators unveiled a number of innovative mortgage products aimed at reducing payments during the first few months or years of a loan. Offerings included adjustable-rate mortgages with very low teaser rates, negative amortization loans, loans with 40 and even 50 year amortization schedules, as well as interest-only loans. Individuals were able to purchase homes with very little or no money down and later refinance their loans (often taking equity out in the process) at attractive rates before their adjustable payments reset to higher levels.
Unfortunately, in late 2005 and throughout 2006, competition among originators became fierce and underwriting standards suffered as a result. Lenders were extending credit to individuals with no money down and little or no documentation to prove their income. Low documentation loans like the “stated income” loan, where the borrower would more or less tell the lender how much money he made and the lender would take his word for it, became more prevalent. As home prices began to plateau in late 2006, poorly underwritten loans began to experience a spike in delinquencies and early payment defaults (defaults that occur within the first few months after origination). Borrowers were no longer able to count on price appreciation to bail them out of a financial pinch, and rising loan defaults are now putting originators under financial pressure, even causing some to file for bankruptcy.
Source: Office of Federal Housing Enterprise and Oversight
Given the decline in loan quality and the turmoil in the industry, why would anyone want to own subprime mortgage exposure in their investment-grade bond portfolio? The answer lies in the structure of the transaction.
A typical HEL securitization is a senior/subordinated structure that employs several measures of credit protection within the transaction, namely excess spread, over-collateralization, and subordination. Excess spread is the difference between the weighted average interest rate on the underlying mortgages and the weighted average cost of liabilities in the transaction (primarily coupons on the issued securities plus servicing costs and trust expenses). The excess spread provides a cushion that can help absorb losses. Over-collateralization (O/C) is the practice whereby the balance of mortgage loans deposited into the issuance vehicle exceeds the total principal balance of the bonds issued. O/C can be pre-funded at the start of a deal or can build over time. A deal that is over-collateralized can sustain losses up to the amount of O/C and excess spread before realizing any principal writedowns.
If collateral losses exceed both excess spread and O/C amounts in a senior/subordinated deal, principal writedowns will then occur in the lowest rated classes first, and then gradually work their way up the waterfall structure. With the amount of credit support mandated by the credit rating agencies for each rating level, a deal would have to sustain extremely high losses before ever threatening the principal in the senior-most triple-A rated classes. HEL securitizations typically have close to 20% subordination at the triple-A level, meaning that nearly half of the loans in a deal could default and suffer 40% losses upon liquidation before the triple-As suffered any hit to their principal. It seems needless to say that it would be difficult to imagine a scenario under which almost half the borrowers in a deal default on their mortgages.
It is also worth pointing out that as these transactions season, they can de-lever, causing credit enhancement to actually increase. As loans prepay and retire the principal of the senior classes of the securitization, the credit enhancement available to the remaining bonds increases proportionally. Under a fairly typical prepayment scenario, an HEL securitization with 20% credit support at issuance can see its credit support double within three years.
We don’t think we’ve seen the end of the shakeout in the subprime mortgage industry yet. Excess capacity will continue to be worked off, more poorly capitalized originators will likely close or be acquired, and underwriting standards will tighten. Marginal borrowers will find it more difficult to refinance their mortgages, loan defaults will run higher than historical norms, and risk-based pricing will return to the marketplace. Our concerns about the lower-end of the sub-prime credit spectrum notwithstanding, credit enhancement available to the senior classes of HEL-backed securities remains more than sufficient to weather the current downturn. We will maintain our high quality bias, focusing our investments in the highest levels of the capital structure and favoring more conservatively underwritten loans originated by well capitalized mortgage companies. Further, we will view any significant widening of spreads in the high-grade structured products market as a buying opportunity.
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