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Amid stalled activity on Capitol Hill, a number of investors and analysts are anticipating subprime defaults will rise, as options to refinance remain highly limited. And though credit unions and other portfolio lenders are doling out a greater number of mortgages, the portion of the subprime borrower base they’re willing to lend to excludes those at the greatest risk of default, said three buysiders and an analyst.
The dwindling refinance opportunities for borrowers approaching rate resets are prompting some analysts to reintroduce short recommendations on higher-rated pieces of the ABX index. Many of the mortgages underlying the indices were lent to borrowers that won’t be able to refinance their debt, one of the buysiders said.
While some subprime lending survived the recent meltdown, volume is likely to decline by 30%-50% this year compared to last, said Doug Duncan, chief economist of the Mortgage Banker’s Association. “You can go down the list of the top 10 banks and you will see most of them are making subprime loans,” Duncan said. But, he added, “the banks are moving up the credit spectrum. The whole risk profile of mortgage lending has become more risk-averse, so underwriting criteria have tightened.”
Those borrowers with loan-to-value ratios above 90%, a FICO score below 650 and limited or no income documentation, for example, will face a much greater challenge obtaining a new mortgage, said Duncan and one of the buysiders.
“If you financed with a 100% LTV mortgage, you do not own a home, you own a call option on the value of the home and a put option for the value of the mortgage,” wrote Andrew Lahde, managing partner at hedge fund Lahde Capital Management in a 10 October letter to investors.
The average original FICO scores across the ABX indices range from 620, for the 06-1 and 06-2, to 624 and 629 for the 07-1 and 07-2 series, according to Lehman Brothers. The cumulative LTV of the indices is 88%, 87%, 88% and 86%, respectively in the same order. About half of all the underlying loans are limited documentation – at 48%, 48%, 53% and 47%, respectively, according to Lehman.
Some borrowers are turning to lenders such as credit unions with hopes of refinancing. In the 12 months ending in August, credit union mortgage lending grew by USD 18.6bn (11.5%). But the cooperatives are relatively risk averse and favor their membership over other applicants.
“We are hearing stories about credit union members who took some of these subprime loans out at other lenders and now are in dire financial straits,” said Mike Schenk, vice president of economics and statistics at the Credit Union National Association. “To the extent we can, we are helping those folks out.”
However, credit unions typically sell only one-third of their mortgage originations to secondary market investors, Schenk said, making the amount of risk they are willing to accept relatively low. Credit unions typically do not lend to borrowers below a 650 Fico score, Duncan said.
Those waiting for a near-term governmental bailout are likely to be disappointed, according to analysts at JPMorgan who described the inaction on Capitol Hill as “Nero fiddles while Rome burns,” in a recent report. While members of Congress quarrel over various bills – ranging from a modification of Chapter 13 bankruptcy to a substantial increase in Fannie Mae and Freddie Mac portfolio limits – buyers are backing away from the US housing market, fearful of further price declines. Favorable changes to monetary policy seem equally unlikely, JPMorgan wrote, as a better-than-expected jobs number released last week lessens the odds of an additional cut in the Federal Funds rate.
“FHASecure, higher conforming loan limits, aggressive loan modifications, etc., are not getting the necessary traction to stop the collapse in homebuyer expectations,” the analysts wrote.
JPMorgan cut its outlook for home price growth to a national average 10%-20% decline in the next 1-2 years. The analysts recommended ABX shorts high in the capital structure, including A and AA in 07-1 and A in the 06-1 series.
While investors have largely locked in expectations for the lowest and highest rated pieces of the ABX, the middle ground - particularly the As - remain volatile.
The ABX 07-1 A tranche closed at 47.34 yesterday from a weekly high of 51.5. The 07-1 A bottomed out at 42.39 in early August but hit nearly 60 in early September, according to Markit Group. The AA piece of the 07-1 series closed at 80.50, down from a weekly high of 82.72; the AA fell to 63.19 in early August before rebounding to 86 in early September. The 06-1 A closed at 85.89 yesterday, down 2.09 points on the week, according to Markit. The 06-1 A peaked at nearly 90 in early September after falling to a low of 51.92 in August.
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