Subprime Trends

The report, Trends in U.S. Residential Mortgage Products — Subprime Sector Fourth-Quarter 2004, was prepared by Standard and Poor’s credit analysts Scott Mason and David Glehan. Included in the discussion was data from 35 companies whose residential mortgage backed securities are rated by S&P.

The subprime market ended 2004 with total subprime issuances of $401.5 billion — almost doubling that of 2003, the report said. Mortgage brokers accounted for about 52% of all subprime originations.

While issuances of subprime RMBS have ballooned, potential changes such as finance legislation for Fannie Mae and Freddie Mac could heavily impact their results this year. And, in the midst of a possible production decline, the popularity of interest-only loans and 40-year mortgages may rise, according to S&P.

The government-sponsored enterprises together purchased 43.7% of the total subprime issuance last year, but “the growing political storm swirling around Freddie and Fannie” may prompt legislation requiring the agencies gain better control of their finances, which if implemented, will most likely decrease their hunger for subprime issuance, S&P said.

“A dramatic impact on the subprime mortgage market” could result if legislation is passed forcing a downsize in the GSE’s portfolios to $200 billion from a combined $1.7 trillion. That possibility was recently disclosed by Federal Reserve Chairman Alan Greenspan, but there are no indications that such legislation will be passed, according to the report.

Also, because the market for subprime mortgage securities is experiencing significantly more demand than availability for many issuances, if the GSEs decrease their purchases of subprime mortgage-backed securities, the other active subprime investors would more than cover this void, S&P said.

In an effort to hedge such risks, originators may reportedly look to offering more loan programs with reduced-document or streamlined-documentation loans, 40-year mortgages, negative-amortization loans, and interest only loans.

An increase in IO loans may increase overall originations, but could potentially decrease retention rates for some lenders (IO loans accounted for approximately 10.90% of all subprime originations in 2004, and the relatively small percentage of IO loan originations versus total originations may represent a growth opportunity for many lenders). Also, S&P cautioned about offering IO to lower credit grades.

Adjustable-rate mortgages comprised 67.1% of subprime loan production, the report said, and any rate hikes could considerably decrease overall originations or cause a shift in adjustable-rate loans to fixed-rate loans.

Another area that might affect subprime volume is the Alt-A market — which experienced “explosive growth” with total issuance of $158.6 billion. As lenders expand their definitions of borrowers considered Alt-A, they could potentially compete for the higher-quality subprime borrowers, which could result in reduced originations as well as the securitization of lower-quality loans, S&P said.

In an attempt to maintain retention rates and increase overall originations, S&P noted that some lenders have tried making loans more affordable with 40-year mortgages and programs such as outplacement services for borrowers that lose their jobs.

Subprime lenders with the highest average loan-to-value were Merrill Lynch Mortgage Investors Inc. with 85.33% (fixed only); Deutsche Bank AG with 85.52% (fixed only); and EquiFirst Corp. with 89.07% (fixed and ARM).

When it came to credit scores, the lowest averages were Option One Mortgage with 605.66; Chase Funding Inc. with 604.77; and Countrywide affiliate CWABS Inc. with 602.74.