MaxedOutMama
Monday, December 11, 2006
RE: Is Subprime About To Go Splat?
I honestly cannot tell.
[Update: there is an excellent post at Calculated Risk that details characteristics of various recent mortgage vintages with commentary on Fitch's 2007 outlook. If you wil read it you will see why this is not sustainable. The only question is when and at what velocity we are going to hit the wall, not whether we will. Far too many loans originated now are degrading borrower's future economic prospects. TSHTF.]
It's true that a few subprime lenders have gone belly up, but the subprime market is growing rapidly. If you look on the origination side, it's booming due to immense demand from people who need subprime loans. Broker Outpost is a place for brokers to find someone to make a loan. I strongly suggest spending some time at this forum if you have "skin in this game". For those not in the industry, NOO= Non Owner Occupancy, OO=Owner Occupancy, LTV is Loan to Home Value ratio. It goes by state. When you see some of the dreck being underwritten....
From a thread at Broker Outpost:
The quality of subprime originations has dropped severely this year, but this is an extension of a three-year trend. Overall, almost 8% of subprime loans are 60 days or more delinquent. For 2006 subprimes, the 60 day rate is now close to 4%. According to this article, 2% of 2006 subs are already in foreclosure proceedings. That is sky-high.
Over at least the first 5 years, delinquency rates rise in all mortgage portfolios, and defaults are strongly correlated to whether the borrower is underwater (owes more than the value of his or her home). Expected principal losses from severe defaults are even more strongly related to how much the borrower is underwater. The lienholder may and usually will do a minor shortsale (allow the homeowner to sell for less than the total lien value to avoid having to foreclose), but will usually foreclose if the total loss will be much higher. The 2006 vintage of subs may well end up with five year default rates of 15% or so. The alternative is for lienholders to convert these loans to save payment, and when so many loans are written stated-income, the odds are high that at least half of the borrowers won't qualify for workouts or conversions.
This is why I predicted the "historically unprecedented" national drop in home values earlier this year - values in markets dominated by this type of lending cannot flatten. They can only take a minimum 10% drop once the music stops, because subprime borrowers in these types of loans default in large numbers if they don't have high home appreciation EACH YEAR, and once they start defaulting, a self-reinforcing cycle is set up.
Overall, over 10% of all mortgages out there are classified as subprime. I would say that it is going to reach 15% quite quickly due to the factors noted above (more and more primes being refied as subs). Worse, the subs are written for relatively low home equity transactions and relatively high dollar volumes. The expectation has always been that most sub borrowers will refi out relatively quickly, but the ability to do so is falling with home values. (See this pdf, which deals largely with 2004 stats, for a comparison between prime and subprime.)
The current mortgage market is dominated by sub or nonprime loans with risky charateristics. RGE has a useful compendium of 2005 stats (and 2006 is worse):
Portfolios of high interest mortgages and home equity loans have lethal aging characteristics. The underlying loan terms act like a giant sifter; within a few years, all the borrowers that have relatively good characteristics (some equity, or the ability to pay up to 0% equity, cash to pay refi costs, the ability to service the loan, a decent credit score) move out of the worst loans and into somewhat better ones. Year by year, the underlying credit quality of these portfolios drops. Fitch's warning on ACC (Ameriquest parent) clearly outlines these concerns:
Historically, mortgage originators and funders have faced these circumstances only as a result of economic downturns or a period of very high mortgage rates, and most of them tend to hold on until the economic conditions improve. What is unique about the current situation is that we reached this point in boom times, and that underlying economic conditions are going to continue to worsen, which will reinforce risks and place increasing pressure on rewards. One of the reasons that I am so negative on homebuilders is that I believe that they have constructed a similar (although less severe) dynamic for themselves with the types of incentives and loan assistance they have been offering over the last year.
The raging debate over the eventual effect on the broader economy continues (see Calculated Risk for a rather optimistic view from one analyst). But one thing is clear - the payout from the bottom half of the subprime originations must rise in order to make them a good investment, and that would indicate a creeping credit contraction from the bottom up, which will cut the effective demand for homes in high-priced markets, in turn forcing home prices downwards in these markets. Therefore I don't believe that the housing market will improve in 2007, although the local conditions in the housing market will vary widely. Instead, I expect the last few bright spots to come under increasing pressure as the fallout from the "hot" areas continues to spread.
Credit conditions, however, are national. I expect the rating agencies to next turn their concern to commercial paper, which is has been developing some interesting characteristics of its own.
Everyone is going to have to make their own decisions about this situation. The risks in the marketplace are high, and current pricing levels don't reflect these risks. Yields don't reflect the appropriate risk pricing either. This will change more rapidly than most analysts expect, IMO. Mortgage News releases are well worth your time and effort at this juncture. One bright spot over the last few months has been lower mortgage rates; I expect that we have just about reached the end of that cycle and that they are about to turn and head upwards for some months. Money is going for a premium (see CD rates), and the spread between rates offered for deposits and lending yields must rise.
If you are still reading and don't grasp what I am trying to convey, consider this. Home prices are sure to take at least a 5% drop, and lending standards must tighten, and will probably effectively tighten along the lines of lower LTV ratios. If average home prices drop 5%, and if the average LTV drops 5%, the pool of effective home equity borrowing power is slated to drop about 10%. With housing stock value reported to be about 22.5 trillion, that translates to over 2 trillion less potential borrowing power.
We have not seen this type of reckless risk acquistion since the run-up to the Great Depression. However, our economy is very diversified in comparison to that period, and one of the points of difference is that we have a large cohort of older individuals with high skills, education and relatively high economic resources. This demographic segment seems to have cushioned the 2001 recession by going into private consulting or contracting when large corporate employment dropped.
However, the basic funding mechanism for this type of business is based on home equity, and if this tightens, the vibrant and extraordinarily flexible small business sector will be constrained. Extremely high household debt levels suggest that this will be a major factor in the next two years. The major pressure on this group is insurance costs, ensuring that they will be in the marketplace as long as they can recover at least $15,000-$20,000 gross return a year. It's called "scratching a living". But they will not be spending on consumer goods if they cannot draw on credit lines; they will be banking their money for future costs. They also may be forced to draw on 401K/IRA funds, which would indicate selling pressures on equities above and beyond those projected by analysts. The rise in UI state employment versus survey employment surely must mean that small contractors and servicers are picking up the employment slack.
We appear to be set for a trickle-up recession of no mean proportions. The gap in most analyses I see is that it ignores demographics (which are clearly a major input in housing), and that it greatly underestimates the radiative effect of a nationwide drop in home prices. One cannot borrow against 401K or IRA funds; doing so is treated as a withdrawal. This means that home equity has become the primary bank for pressed consumers, and credit constraints on home equity will exert a much stronger net effect on the overall economy than most analysts seem to think.
[Update: there is an excellent post at Calculated Risk that details characteristics of various recent mortgage vintages with commentary on Fitch's 2007 outlook. If you wil read it you will see why this is not sustainable. The only question is when and at what velocity we are going to hit the wall, not whether we will. Far too many loans originated now are degrading borrower's future economic prospects. TSHTF.]
It's true that a few subprime lenders have gone belly up, but the subprime market is growing rapidly. If you look on the origination side, it's booming due to immense demand from people who need subprime loans. Broker Outpost is a place for brokers to find someone to make a loan. I strongly suggest spending some time at this forum if you have "skin in this game". For those not in the industry, NOO= Non Owner Occupancy, OO=Owner Occupancy, LTV is Loan to Home Value ratio. It goes by state. When you see some of the dreck being underwritten....
From a thread at Broker Outpost:
It is amazing what kind of mood one is in on a Saturday morning after a week with 4 closings. One more later today, and 2 next week. We hired an extra processor about 3 weeks ago and loans are just flying out here with Superman speed!Now there is growing concern on the broker byways and highways about the subprime shops. See this thread.
...
Bleak future?!?!?!? HARDLY!
There are so many loans setting to adjust in the next couple of years, I am not sweating it. You just change your target audience from A paper to Alt-A and sub-prime.
I know that we are not the only ones seeing this, but so many borrowers that were A paper, have now run up debt, pushed down their scores, and their income has not kept pace.
Bring 'em on!
...
Doing loans? I thought the industry was about to collapse. Well, at least that's what everyone has been saying. My office for one has not slowed down one bit (well, with the exception of one LO that has preached on how slow this fall and winter is going to be - she has 1 loan in her pipeline). As a matter of fact, this MAY be the best month since July...
The quality of subprime originations has dropped severely this year, but this is an extension of a three-year trend. Overall, almost 8% of subprime loans are 60 days or more delinquent. For 2006 subprimes, the 60 day rate is now close to 4%. According to this article, 2% of 2006 subs are already in foreclosure proceedings. That is sky-high.
Over at least the first 5 years, delinquency rates rise in all mortgage portfolios, and defaults are strongly correlated to whether the borrower is underwater (owes more than the value of his or her home). Expected principal losses from severe defaults are even more strongly related to how much the borrower is underwater. The lienholder may and usually will do a minor shortsale (allow the homeowner to sell for less than the total lien value to avoid having to foreclose), but will usually foreclose if the total loss will be much higher. The 2006 vintage of subs may well end up with five year default rates of 15% or so. The alternative is for lienholders to convert these loans to save payment, and when so many loans are written stated-income, the odds are high that at least half of the borrowers won't qualify for workouts or conversions.
This is why I predicted the "historically unprecedented" national drop in home values earlier this year - values in markets dominated by this type of lending cannot flatten. They can only take a minimum 10% drop once the music stops, because subprime borrowers in these types of loans default in large numbers if they don't have high home appreciation EACH YEAR, and once they start defaulting, a self-reinforcing cycle is set up.
Overall, over 10% of all mortgages out there are classified as subprime. I would say that it is going to reach 15% quite quickly due to the factors noted above (more and more primes being refied as subs). Worse, the subs are written for relatively low home equity transactions and relatively high dollar volumes. The expectation has always been that most sub borrowers will refi out relatively quickly, but the ability to do so is falling with home values. (See this pdf, which deals largely with 2004 stats, for a comparison between prime and subprime.)
The current mortgage market is dominated by sub or nonprime loans with risky charateristics. RGE has a useful compendium of 2005 stats (and 2006 is worse):
...in 2005 a good third of all new mortgages and home equity loans became interest rate only; over 40% of all first-time home buyer were putting no money down; at least 15% of buyers had negative equity; and an increasing fraction of mortgage came with negative amortization (i.e. debt service payments were not covering interest charges, so the shortfall was added to principal in a Ponzi game of accumulating debt).Because the areas where these loans predominate are in the "hot" areas, the dollar volume is higher for subs and nons than for primes. When I look at the default figures, I feel sure that the underlying funders are going to start pulling funding for the bottom 50% of these originations, one right after another. However, I may be wrong - because it is almost impossible to stop writing subprime once you are stuck with a certain amount of it. Seriously, you cannot get off this bucking bronco without recognizing huge losses. The originators and the funders have to buyback early defaults or scratch-and-dents, and so they must keep writing in order to have the money to do this. It looks like Own It folded when their buybacks exceeded their ability to pay for those, and so their funder pulled funding because they didn't want to end up stuck holding the bag. (The funder usually packages these up for resale as securitized obligations. The funder will have to take the rejects back, and then will return them to the originator. This can be a three or even four step process, and it usually drops down to the firm that has the least ability to pay for losses without continuing to write new loans.)
Portfolios of high interest mortgages and home equity loans have lethal aging characteristics. The underlying loan terms act like a giant sifter; within a few years, all the borrowers that have relatively good characteristics (some equity, or the ability to pay up to 0% equity, cash to pay refi costs, the ability to service the loan, a decent credit score) move out of the worst loans and into somewhat better ones. Year by year, the underlying credit quality of these portfolios drops. Fitch's warning on ACC (Ameriquest parent) clearly outlines these concerns:
Fitch believes that ACH's financial flexibility is constrained by significant settlement and restructuring charges taken in recent quarters as well as the increasingly challenging operating environment in the subprime mortgage market. While other originators and servicers face these challenges as well, AMC's sharp decline in origination volume has caused considerable seasoning of the servicing portfolio which is resulting in increasing delinquency levels and contributing to a cost of servicing that is significantly higher than the industry average. This rating action reflects Fitch's concern that unless this trend is reversed in a reasonable timeframe, AMC may face difficulty maintaining servicing qualityWhen I think about this reality, I think that the whole thing will go on for much longer than anyone now believes to be possible, because otherwise firms are abruptly going to have take large losses. ACC is selling both Ameriquest & Argent (mortgage originations) and Long Beach (auto loans), but keeping AMC (mortgage servicing). Fieldstone is now on the block:
Fieldstone joins a slew of subprime lenders that are up for grabs including industry volume leaders Argent Mortgage and its retail affiliate, Ameriquest, and Option One Mortgage Corp.Stock prices for firms in these areas seem to have tracked homebuilders in a reckless rise. I think that the Street has not recognized risk, which raises a number of questions about overall risk valuations. An example of a firm that is cutting its losses is Fifth Third, which announced at the end of November that it was selling out at a loss:
A month ago Fieldstone - a publicly traded REIT - posted a $45 million loss in the third quarter, citing an increase in reserves due to 'accelerated delinquencies.'
...
In one other recent deal, a private-equity fund - through an asset sale - purchased, for an undisclosed sum, Millennium Funding of Washington state. The private equity fund, said a source, also owns Ace Mortgage Funding of Indiana.
'Fifth Third Bank has announced they are selling $11.4 billion in securities (all or almost all MBS, mostly short collateralized mortgage obligations, we suspect) before year-end 2006 and [is] taking a loss of approximately $500 million. This is the next move in the bank de-levering arena,' said Alec Crawford, head of agency MBS strategy at RBS Greenwich Capital in a Nov. 21 report.However, the only firms that can afford to make these shifts are the ones that are not concentrated in this area.
'Banks bought a lot of MBS over the past few years, and now some of them are realizing they don't have the retail deposits to support such a large securities portfolio. With cheap (transaction) deposit growth slowing at the banks, some have no option but to sell their securities and take a loss, otherwise, suffer through large negative net interest margins,' he said.
Historically, mortgage originators and funders have faced these circumstances only as a result of economic downturns or a period of very high mortgage rates, and most of them tend to hold on until the economic conditions improve. What is unique about the current situation is that we reached this point in boom times, and that underlying economic conditions are going to continue to worsen, which will reinforce risks and place increasing pressure on rewards. One of the reasons that I am so negative on homebuilders is that I believe that they have constructed a similar (although less severe) dynamic for themselves with the types of incentives and loan assistance they have been offering over the last year.
The raging debate over the eventual effect on the broader economy continues (see Calculated Risk for a rather optimistic view from one analyst). But one thing is clear - the payout from the bottom half of the subprime originations must rise in order to make them a good investment, and that would indicate a creeping credit contraction from the bottom up, which will cut the effective demand for homes in high-priced markets, in turn forcing home prices downwards in these markets. Therefore I don't believe that the housing market will improve in 2007, although the local conditions in the housing market will vary widely. Instead, I expect the last few bright spots to come under increasing pressure as the fallout from the "hot" areas continues to spread.
Credit conditions, however, are national. I expect the rating agencies to next turn their concern to commercial paper, which is has been developing some interesting characteristics of its own.
Everyone is going to have to make their own decisions about this situation. The risks in the marketplace are high, and current pricing levels don't reflect these risks. Yields don't reflect the appropriate risk pricing either. This will change more rapidly than most analysts expect, IMO. Mortgage News releases are well worth your time and effort at this juncture. One bright spot over the last few months has been lower mortgage rates; I expect that we have just about reached the end of that cycle and that they are about to turn and head upwards for some months. Money is going for a premium (see CD rates), and the spread between rates offered for deposits and lending yields must rise.
If you are still reading and don't grasp what I am trying to convey, consider this. Home prices are sure to take at least a 5% drop, and lending standards must tighten, and will probably effectively tighten along the lines of lower LTV ratios. If average home prices drop 5%, and if the average LTV drops 5%, the pool of effective home equity borrowing power is slated to drop about 10%. With housing stock value reported to be about 22.5 trillion, that translates to over 2 trillion less potential borrowing power.
We have not seen this type of reckless risk acquistion since the run-up to the Great Depression. However, our economy is very diversified in comparison to that period, and one of the points of difference is that we have a large cohort of older individuals with high skills, education and relatively high economic resources. This demographic segment seems to have cushioned the 2001 recession by going into private consulting or contracting when large corporate employment dropped.
However, the basic funding mechanism for this type of business is based on home equity, and if this tightens, the vibrant and extraordinarily flexible small business sector will be constrained. Extremely high household debt levels suggest that this will be a major factor in the next two years. The major pressure on this group is insurance costs, ensuring that they will be in the marketplace as long as they can recover at least $15,000-$20,000 gross return a year. It's called "scratching a living". But they will not be spending on consumer goods if they cannot draw on credit lines; they will be banking their money for future costs. They also may be forced to draw on 401K/IRA funds, which would indicate selling pressures on equities above and beyond those projected by analysts. The rise in UI state employment versus survey employment surely must mean that small contractors and servicers are picking up the employment slack.
We appear to be set for a trickle-up recession of no mean proportions. The gap in most analyses I see is that it ignores demographics (which are clearly a major input in housing), and that it greatly underestimates the radiative effect of a nationwide drop in home prices. One cannot borrow against 401K or IRA funds; doing so is treated as a withdrawal. This means that home equity has become the primary bank for pressed consumers, and credit constraints on home equity will exert a much stronger net effect on the overall economy than most analysts seem to think.
