Hoisted from comments by a helpful anonymous reader was a revealing post yesterday at FT Alphaville that we somehow missed. It’s a important addition to the discussion over the stress in the US housing and mortgage-backed securities markets.
CreditSights, an award-winning provider of credit research, disputes the commonly held view that the sharp falloff in the mortgage debt market is due to a bit of fundamental deterioration compounded by considerable, and somewhat unwarranted, panic. According to Alphaville (sadly, the research is restricted; we’d love to read it ourselves), CreditSights believes that the current pricing of MBS is in line with fundamentals. The big reason for their harsh view is what they call the “severity loss ratio” which I assume is roughly equivalent to recovery net of expenses. They inspected a series of deals and found the loss ratio to be weighted average of 35%, which is truly horrid. Historically, recoveries on mortgage foreclosures are more like 70% (I believe that is pre-expenses), and it’s a certainty that levels like that were used in structuring these deals.
And in a related development, Fitch released a report that reaches the not-surprising conclusion: deterioration in US subprime RMBS will lead to rising risk of events of default for collateralized debt obligations.
From FT Alphaville:
But, said CreditSights, in a note to clients on Wednesday, current pricing levels reflect fundamentals, even for the most highly-rated debt. Mortgage securities across the board are overrated and overvalued:
The harsh truth about the outlook for the AAA tranches – necessary downgrades, if not defaults – should put the lie to the argument that current low prices in AAA RMBS tranches – let alone AAA tranches of mezzanine RMBS CDOs – are somehow the victim of poor liquidity conditions, and do not reflect the true fundamentals of the situation.
CreditSights publish the results of a survey they have conducted on “188 individual relatively large RMBS deals”. The outlook, by all accounts, is grim.
At root, CreditSights calculate a severity loss ratio for lenders on individual defaulting subprime mortgages based on mortgage market data collected over the past few weeks. The survey results indicate that such loss severity rates on mortgages are “painfully high”. They range from 24 per cent to 55 per cent – with a weighted average at 35 per cent. And they’re expected to rise. For second-lien mortgages – that is, second mortgages on a property, the loss severity rates average 94 per cent.
So how do those figures translate into the capital structure of structured mortgage-backed debt? Foreclosure rates are rising higher and higher – which means the number of occasions when the above loss severity ratios have to be applied are increasing.
And it doesn’t look like the blame can be pinned on any particular vintages of MBS. Here’s a graph of foreclosures on vintages since 2004:
According to CreditSights, that should “up-end the idea that the 2004 vintage was perhaps sufficiently seasoned and composed of loans that had enjoyed enough home price appreciation since 2000, to avoid any further erosion.”
As it is, foreclosure rates are hovering at around 13 per cent on 2005 and 2006 mortgage debt. But CreditSights say there is “no end in sight” when it comes to that figure rising.
Consider then the outlook for delinquancy rates – a measure of mortgage loans not yet in foreclosure, but in trouble:
How then does that translate into the world of structured finance, and those RMBS tranches?
To trigger a default on the most secure subprime RMBS debt – rated AAA, and structured with a typical 18 per cent attachment rate – foreclosure rates would have to reach the 30 per cent.
As can be seen from the results of CreditSights’ survey, that scenario is indeed becoming “less and less unthinkable”. Adding the foreclosure and delinquancy rates takes us close to 20 per cent. Both are set to increase. Then there’s those painfully low severity loss ratios. Add it all together and that AAA debt is far, far, far from safe.
And we haven’t even mentioned prime tranches lower down the structure.
Far from mispricing RMBS, CreditSights even go so far as to suggest that actually, the ABX indices (which list AAA RMBS debt at around 80 cents in the dollar) are throwing up some pretty appropriate figures.
This 20% default figure is no surprise; in fact it is likely to be low due to vagaries in loan classification. We featured this quote from IndyMac Bancorp CEO Michael Perry back in May:
On subprime loans, one of the things that I think people aren’t aware of is that the Mortgage Bankers Association basically classifies the lender as a prime lender or a subprime lender. So for example, they classify IndyMac and Countrywide as prime lenders, and they classify New Century or whoever as a subprime lender. And all of their servicing portfolio is considered prime or subprime for the MBA. Ok? And so when you see that delinquency number in the press of 13% subprime delinquencies, it’s hugely understated. It is absolutely hugely understated. And the prime delinquencies are overstated.The subprime delinquencies are more like 18, 20, 22% delinquencies and that’s where I think you’re going to see the problems.