A Massive Second Wave?

Author: Eric Uhlfelder

30 January 2009, Financial Times Fund Management

Expect a new round of defaults in the US housing market comparable in magnitude to subprime to smack the economy, reports Eric Uhlfelder.

The US economy is poised to be smacked by another wave of mortgage defaults that could cause as much damage as the subprime meltdown.

According to Credit Suisse, $1 trillion of Alt-A and Option ARM mortgages–the dubious loans used to propel home sales through the final years of the housing bubble–are scheduled to have their interest rates reset from now through the summer 2011. [See graph below.]

Many industry observers expect higher monthly payments to send defaults soaring-a process that’s actually under way as recession, escalating job losses, and a collapsing home market have sent borrowers fleeing their mortgages. Over the next four years, Rod Dubitsky, head of asset-backed securities research at Credit Suisse, projects foreclosures to reach 9 million, or nearly 18 percent of all mortgages.

“The greatest asset bubble in history is bursting,” explains Whitney Tilson, managing partner of the New York-based asset manager T2 Partners, “and the single biggest piece is the US mortgage market, and we’re probably only about halfway through the crisis in terms of write downs and recognized losses.”

The scale of the problem is massive. There are approximately 3 million Alt-A loans totaling $1 trillion outstanding, according to Inside Mortgage Finance, a trade publication in Bethesda, Maryland. Alt-A loans, made to borrowers who fell between subprime and prime status, represent 20 percent of the current mortgage market.

The US mortgage agency Fannie Mae, which owns or guarantees about one-third of Alt-A mortgages, presciently defined them as “loans underwritten with lower or alternative documentation than a full documentation mortgage loan. As a result, they generally have a higher risk of default than non-Alt-A mortgage loans.”

Option ARM [adjustable rate mortgages] loans, a form of Alt-A loans, were sold primarily to prime and near-prime borrowers between 2004 and 2007. Written based on borrowers’ safer credit scores, many loans involved little or no documentation and low introductory teaser rates, typically under 3 percent. That means that during the first five years of these loans, the vast majority are negatively amortizing, i.e., the amount owed is actually increasing as home prices are falling sharply.

Sue Troll, credit analyst at T. Rowe Price, who in 2006 forecast the subprime meltdown, describes Option ARM mortgages as “subprime on steroids with their underlying quality in many instances having been worse than subprime, despite involving higher quality borrowers.” She says approximately 80 percent were low- or no-documentation [twice subprime’s rate], with significantly greater concentrations in states experiencing the sharpest home price declines [California and Florida], longer maturities [up to 40 years], and with lower teaser rates [initially as low as 1 percent].

Tilson expects resetting Alt-A and Option ARM loans to push default rates even higher, further flooding the housing market, and putting further downward pressure on housing prices. This prevents a floor from being established, which everyone pretty much agrees, says Tilson, is critical for stabilizing the economic crisis.

Most disturbing, Tilson sees little way we can avoid this scenario. “All you need to do,” he explains, “is look back at what was written between 2005 and 2007, see the reset dates, and the current default rates and it’s pretty clear what’s going to happen.” In a typical securitized trust of 2007 Alt-A mortgages assembled by Lehman Brothers, Tilson found 43 percent of the underlying loans had defaulted just 17 months after the security was issued.

Extrapolating from current nonperformance figures, he thinks that more than 50 percent-maybe even as much as 70 percent-of Option ARM mortgages are likely to default, with the balance of Alt-A loans comparably failing. Tilson fears that the current equity and debt markets are not reflecting the potential impact this will have on the economy going into 2010 and 2011

Then there is the multiplicative impact caused by the failure of securitizations comprised of these mortgages. T. Rowe Price’s Troll says there around $800 billion worth of securities backed by Alt-A mortgages. She believes their eventual worth will be only cents on the dollar.

In the mean time, she expects the credit quality of 70 to 80 percent of the Alt-A and Option ARMs will be downgraded, which is how the broader economy gets hit.

“There’s a direct correlation between rating agency downgrades on securities and rising banks’ risk-weighted capital requirements,” observes Oppenheimer equity research analyst Meredith Whitney. When this trend is combined with collapsing housing values, this produces huge capital voids. “As fundamentals continue to devolve,” concludes Whitney, “more voids will be created in core capital positions of banks [and other financials holding these securities].” As a result, lending becomes more and more restricted, further strangling the prospects for growth and recovery.

But not everyone thinks resets will trigger a blowout in mortgages. “Certainly if companies continue to lay off workers at the current rate they’ve been doing,” says Michael Youngblood, principal of Five Bridges Capital, an asset manager who tracks and invests in mortgage securities, “then I don’t see what could halt the slide in mortgage failures.”

However, Youngblood doesn’t believe resets will necessarily translate into higher payments. “With aggressive government intervention to lower interest rates and with LIBOR falling,” he says, “adjustable rate mortgage rates may not be heading higher.”

Eric Pellicciaro, managing director and lead mortgage investor at BlackRock, thinks the markets may have already discounted the impact of resets. Moreover, he believes government policy to keep rates low and to infuse liquidity into the markets to help offset financial pressures may mitigate default rates.

Accordingly, he surmises the US debt market could be nearing a bottom. But that’s conditional on government intervention containing the fallout and stabilizing mortgage markets and housing prices.

Even if Pellicciaro is right, Dan Schwartz, senior economist at the New York hedge fund Argonaut Aggressive Global Partnership Fund, thinks the economy could be blindsided from commercial mortgage defaults. This risk is just beginning to show up on analysts’ radar screens, says Schwartz, but few realize the scale of commercial mortgage resets: $300 billion this year, soaring to a total of $1.5 trillion by 2013.

Given that commercial property debt was securitized just like subprime, Schwartz fears the potential fallout from huge defaults if government intervention doesn’t gain much traction and if refinancing remains elusive.

So for managers who think that the unwinding of subprime may be marking the end of the economic crisis, Whitney Tilson warns that “we are only about one-third way through the bursting of an asset bubble that took years to inflate.”


Data as of Nov 2008


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