Insights
In the News - The Sub-Prime Market and its Impact on the Financial Markets
Sub-Prime Loans. These are first-lien mortgage loans that are made to borrowers who have less than perfect credit, usually with a FICO ( Fair Isaac and Company) score of between 500 and 680 on a scale that ranges from 300 to 850. The sub-prime average of roughly 600 compares to prime borrowers whose FICO scores are generally 700 and above. Sub-prime mortgages represented roughly 21% of the overall securitized mortgage market in the US between 2004 - 2006, up from approximately 9% from 1996-2004. While sub-prime debt issuance is prominent in southern and central California and much of the Southwestern region of the United States, it has also been over-represented in the Greater Miami FL, Richmond VA and Memphis TN metropolitan areas.
Mortgage Originations: Totaling $2.5 Trillion, 2006
Many of the sub-prime loans that have been issued to date are adjustable rate mortgages (ARMs) that carry a fixed rate for a specified period, generally 2-3 years, followed by an adjustable rate period for the remainder of the loan (usually 27-28 years). The rate on the mortgage is designed to adjust up or down at predetermined intervals based on the movement and direction of interest rates. These loans have typically been non-conforming loans, including those that offered 0% down payments as well as other creative financial strategies, where no proof of income or assets was required. This allowed for loans that in the past would never have been made, or given to individuals who couldn’t have afforded to pay off the loan even in the best of conditions.
Many of the more worrisome adjustable rate mortgage loans in today’s environment arose from teaser rates -- for example very low initial rates of 1%-3 ½%, which originated predominantly in 2005, are scheduled for their first reset in the upcoming November/January period, up to rates approaching 6 1/2%. The less contentious group ARMs with initial rates of between 4%-6% are expected to be reset at to rates of roughly 7%, though resets of as much as 8%-9% exist as well. The chart below illustrates that the amount of mortgage debt facing it’s first payment re-set will likely peak between September and November of this year, while a sizeable amount will also reset through most of 2008 as well.
U S Mortgage Debt Facing First Payment Re-Set
A March, 2007 study presented by First American CoreLogic, Inc., suggested that the impact of reset-based foreclosures will not be spread evenly, but will focus especially on teaser-rate and sub-prime mortgages originated in the past three years. Furthermore, the study projected that 32 percent of teaser loans, 7 percent of market-rate adjustable loans and 12 percent of sub-prime loans will likely default due to reset.
Bearing the Risk of Sub-Prime Loans. In the past, banks made loans to its customers and bore the risk associated with the loan. More recently, however, mortgage originators package these loans into securities (called securitization) in various forms including Collateralized Mortgage Obligations (CMOs), Asset Backs, etc., and ultimately into Collateralized Debt Obligations (CDOs). They are subsequently sold to a wide range of investors, including pension funds, hedge funds and other institutional and financial investors looking for higher relative returns.
The Backdrop for the Housing Crisis. At the start of the decade, the sub-prime market was very profitable, as profit margins were considerably higher than those in the prime mortgage market in order to compensate for the traditionally higher risk of default. Interest rates at that time were at historically low levels. The attraction of lower rates, coupled with an allocation shift from equities into real estate (resulting from the bust in the technology bubble in the equity markets), represented the backdrop for the dramatic appreciation in the housing market that was being fueled by more and more home sales. Housing prices rose, quite significantly in various parts of the country such as Florida, California, Nevada, and the southern states in the aftermath of Katrina. The risk of default, however, was ignored in that the loan to value ratios on existing loans increased overall. As such, if borrowers defaulted on their loans, they could have easily sold their house, paid off the mortgage and even had a profit as they walked away! As competition from the sub-prime lenders increased in this environment, margins on new fangled mortgage vehicles, including interest only, and other innovative hybrid and variable rate loans, narrowed. Originators turned a blind eye to the risk management aspects of their business and made loans with loosely defined and in many cases irresponsible credit standards.
The Housing Slowdown. In 2006, interest rates began to rise, which notably curtailed refinancings, loan originations slowed and home sales began to decline. This in turn increased the inventory of homes in the market and typical of a supply/demand imbalance, housing prices began to decline. As the first set of adjustable rate mortgages experience their first upward adjustment in the face of higher interest rates, borrowers began to default on mortgage loans they were barely able to afford at the lower rates. This time, however, housing prices had begun to decline and the ratio of a borrower’s loan to their home value rose considerably, reducing their real estate profits, or further deepening their loss. It was no secret that there was likely to be troubles ahead. However, the more noteworthy snowballing affect began to take place in 2006, after several rounds of interest rate hikes had taken place. Not surprisingly, many of the loans were ‘interest only’ and with no price appreciation, had little to no equity ownership built up. Therefore, because of the higher loan to value ratio, homeowners were not even allowed to re-finance, further worsening their plight! This scenario, combined with a tightening in the standards for new loan originations, and more homes for sale and increasingly fewer buyers, has largely been the cause for the spiral of higher delinquencies and subsequent foreclosures!
Nationally, according to MarketPulse, a loan performance data compiler, Ohio (14.1%), Louisianna (12.6%) and Mississippi (12.6%) appear to have the highest levels of serious subprime mortgage delinquencies (greater than 60 days) as of March 2007. On a more local level Barnstable-Yarmouth (11.2%) and Pittsfield, MA (9.6%) were among the top 25 cities with the highest delinquencies in 2006, with California and Florida cities prevalent on the list. The 2006 national delinquency rate of 6.8% rose to 8.3% in March, 2007. While delinquencies don’t automatically default to foreclosures, it is currently estimated that areas that are expected to be most hardest hit with foreclosures this year include Atlanta, Indianapolis, Denver, Dallas and Detroit.
Seriously Delinquent US Mortgage Distribution
Source: LoanPerformance
The Affect on the Financial Markets. Interestingly, the housing slowdown and increase in delinquencies in the sub-prime markets is old news. However, as the markets do not like surprises, the fact that Firms who assured Wall Street investors that there was little or at least well contained exposure from sub-prime mortgages have changed their story almost overnight, creating a crisis of confidence on a global basis. It now appears that the ramifications from sub-prime delinquencies have begun to spill over in the Alt-A and prime mortgage portfolios, leading mortgage originators to notably tighten their credit standards, locking many home buyers out of the market and further lowering the prices of mortgage related investment vehicles. For example, pools of sub-prime mortgages used to create Collateralized Mortgage Obligations (CMOs) were in turn were packaged into Collateralized Debt Obligations (CDOs) . The mezzanine traunches of these CDOs, and other of the more risky, higher yielding components, were then sold to investors. Hence in the massive “flight to quality” in today’s environment, the current risks are now being priced into the valuation of these issues.
Recent Developments. On August 9th, BNP Paribus, one of France’s largest banks, froze the assets of three Funds that were tied to US mortgage securities. Because both the liquidity and marketability in mortgage securities had virtually ceased, and because the underlying securities of the assets held were not widely traded, investors were unable to provide a viable market price for the assets of the securities held in these Funds. Given this loss of confidence in Europe’s financial arena, the European Central Bank (ECB) abruptly injected roughly €95 billion Euros equivalent to $130 billion (surpassing the nearly €70 billion Euro loan made after 9/11) into its financial system. The intent was to increase liquidity in the marketplace, in the largest single loan ever made by the ECB. The US followed suit adding over $36 billion dollars of liquidity into the US financial system during the following two days as the Federal Reserve was quick to maintain order and assure investors that the situation was under control.
The Bottom Line. It’s too soon to tell…but balance sheets are strong and asset quality is high on average compared to the last real estate crisis of October 1990. The current crisis, while far reaching, does not appear to have permeated other sectors of the real estate industry, including Real Estate Investment Trusts (REITs). Furthermore, in some of the areas in California, Arizona and Florida, where property had appreciated dramatically since the beginning of the decade, the imbedded gains have provided a cushion for many investors. This has helped many homeowners with considerable equity in their homes to take other measures to stay out of foreclosure, or give up considerable profits by selling their homes at extremely attractive prices to new buyers. As this trend continues, the likelihood is that the market will stay soft for a longer period than usual because of the current/projected buildup in unsold inventory and/or the movement towards a spiral of price reductions.
It will undoubtedly become more difficult for high-risk borrowers to get mortgage loans in the foreseeable future, hence prolonging the housing slump. Thus may also have a moderating effect on the economy overall. While many of the larger banks claim to have sufficient capital to remain solvent and viable, there are smaller, less well capitalized firms that will likely fall victim to the crisis, or take years to recover. In the current environment, with online trading and live communications feeds, the swiftness of the market moves is unlike anything most of us have experienced in the past…so it is imperative that investors keep a cool head during what will surely be a very volatile environment for the foreseeable future. As many institutions are still uncertain as to the depth and breadth of losses stemming from the sub-prime vehicles (obvious or surreptitiously entrenched in their various portfolios), it may be fair to say that the next 6 months in the financial markets may be volatile at best.
The good news is that US economic fundamentals appear to remain strong, with unemployment rates at record or near-record lows in most parts of the country. Furthermore, improving company fundamentals and continued corporate profit growth should bode well for the equity markets overall while the housing dilemma runs its course. What’s interesting is that there appears to be sufficient liquidity in the system, and that much of the tribulation in the markets appear to be due less to investors selling than from the lack of buying. It seems that many investors are resigned to sit on the sidelines until order has been restored, while those who have a greater penchant for taking risk, are poised, ready to take advantage of oversold conditions and bargain basement prices in the housing market and related industries. However, as caution continues to be advisable in the current market environment, once again, we advise that a well diversified portfolio remains a highly prudent strategy, particularly in these difficult times.
