Loan Losses to Reach Record

Last year, over 55 percent of all mortgage originations were packaged and sold as residential mortgage-backed securities into the capital markets, according to a written transcript of testimony before Congress by Standard and Poor’s Ratings Services Managing Director Susan Barnes. She spoke about the performance of subprime transactions.

“The securitization process allows subprime lenders access to liquidity to fund their mortgage originations,” the report stated. “Furthermore, since most of the credit risk associated with mortgage lending gets transferred or sold through the securitization process, from the lender to the security-holder, securitization is not only a source of diversified collateralized funding, but also a critical risk management tool.”

Lenders used to self-fund mortgages through their own capital funds or proceeds from unsecured borrowing and hold the mortgages on their balance sheets — bearing all of the credit and interest rate risk of the mortgage for the entire term of the loan as well as the funding risk, which magnifies in times of volatile interest rates and is the risk of mismatch between the maturity of the mortgage and maturity of its unsecured borrowing.

Bearing credit, interest rate, and funding risk contributed significantly to the banking system stress in the early 1980s and led to the development of the mortgage finance market. While lenders can still hold mortgages and bear both the credit and interest rate risk, they can also now sell the mortgage to another financial institution as a whole loan sale; sell the mortgage directly into a securitization; or sell it to a mortgage conduit or loan aggregator who may securitize it.

Investors or holders of mortgage-backed securities receive the principal and interest borrowers repay on the underlying loans each month and have the right to receive future cashflows generated by the repayment of principal and interest. The cashflows are distributed based on the predetermined structure and payment priorities agreed upon at the closing of the MBS transaction. With mortgage originators as intermediaries, the issuance of MBS channels funds from investors in the capital market directly to mortgage borrowers.

In the past two years, subprime mortgages accounted for about 20 percent of all mortgage loans. In 2006 alone, subprime loans represented about 40 percent of all adjustable-rate and interest-only mortgages.

The increased availability of mortgage credit to subprime borrowers contributed higher home ownership rates and occurred simultaneously with a rise in originators loosening their underwriting guidelines, which included low equity and little to no income verification loans to first time borrowers with weak credit histories.

“The poor performance of subprime mortgage loans originated in 2006 has dampened investor appetite for subprime mortgage bonds,” Barnes said in the testimony. “Accordingly, the interest rate sought by investors, given their risk appetite for mortgage bonds, has increased as compared to mortgage-backed bonds issued in prior years. Therefore, the securitization of subprime loans has become less economical, resulting in fewer subprime mortgage loan originations in 2007.”

In addition to lenders overtly stretching underwriting guidelines, factors that are contributing to subprime transactions rated in 2006 performing worse than in recent vintages are slowing home price appreciation rates and heightened risk created by ARM loans possibly being unaffordable when they reset in the rising interest rate environment.

While S&P sees the 2006 vintage to be the worst performing in recent history, it said delinquencies for the vintage are “not atypical with past long-term performance of the RMBS market.” For example, 2006 serious delinquencies, which include loans 90-plus days overdue, in foreclosure, and REO, are nearly equal to delinquencies reported for the 2000 vintage.

Overall, the agency forecasts losses of 5.25 percent to 7.75 percent for subprime loans in RMBS transactions rated in 2006, which is slightly above losses of about 5 percent incurred in the previous worst performing year, 2000.

“Due to minor home price declines in 2007, we expect losses, and consequently negative rating actions, to keep increasing in the near-term relative to previous years,” S&P said in a written statement. “However, as long as interest rates and unemployment remain at historical lows, and income growth continues to be positive, there is sufficient protection for the majority of investment grade bonds.”

As of April 12, 2007, S&P has downgraded 30 tranches of various 2006 subprime, Alt-A, and second-lien transactions, and placed 64 classes on CreditWatch Negative. This translates to 32 subprime transactions currently affected out of the 1,025 rated from 2006, or that “only 0.3% of the outstanding ratings in the subprime area have been downgraded or placed on CreditWatch,” the ratings agency said.

S&P believes that “if a large percentage of mortgage loans go into default and foreclosure, the principal amount of losses may be greater than the losses that would result from forbearance or restructuring the mortgage loans.” However, it believes a majority of transactions allow servicers to forbear or restructure mortgage loans within generally accepted servicer and industry standards. And, “so long as forbearance and restructuring of the subprime mortgage loans is consistent with industry standards, S&P believes that the ratings on the RMBS will not be negatively affected.”

Furthermore, the ratings agency does not anticipate pervasive negative rating actions on financial institutions due to rising credit stresses in the subprime mortgage sector. Those that have felt the effects of current subprime credit stresses are specialty finance companies that focus solely on the subprime market, as these do not have the protection provided by the diversification of loan portfolios and origination sources of larger financial institutions.

After concluding that “securitization has proved to be both a source of increased liquidity in the mortgage market and a viable risk mitigation mechanism in periods of credit and market stress,” Barnes urged Congress “to exercise care in crafting a response to the current credit stresses in the subprime market, as there is the potential for unintended consequences that could lead to further deterioration of the market and restrict liquidity in the subprime sector.”