Bloomberg Pronounces Hope for Subprimes Based on Single Deal

An article by John Berry at Bloomberg, “Fed Actions Defuse Subprime ARM Rate Reset Bomb,” is extraordinarily misleading, claiming that a Fed paper based on a single pool of MBS issued by New Century in 2006 shows that subprimes will work out much better than conventional wisdom says.

Let’ s start with Berry:

Many analysts and public officials have said that foreclosures of subprime adjustable-rate mortgages would soar this year as owners’ monthly payments jumped when interest rates reset to a higher level.

Not only is that unlikely to happen, this year’s resets of earlier vintages of subprime mortgages may even reduce some payments that increased in 2007.

The reason? The index to which many ARMs are tied is the six-month London inter-bank offered rate, or Libor, and that rate has fallen from more than 5.3 percent last fall to about half that level….

Unfortunately, most of the defaults and foreclosures that have wreaked havoc in financial markets haven’t been due to resets so far. Many borrowers simply bought a house or condo they couldn’t afford unless bailed out by rising prices, and lower rates alone won’t help them much.

Still, the big drop in Libor means there likely will be many fewer foreclosures than there would have been….

A new report, “Understanding the Securitization of Subprime Mortgage Credit,” by economists Adam B. Ashcraft and Til Schuermann of the New York Federal Reserve Bank, published this month, provides a wealth of detail about subprime mortgages. Much of its information is based on a pool of such mortgage-backed securities issued by New Century Financial in June 2006.

All but 12 percent of the loans in the pool were ARMs, either the so-called 2/28 or 3/27 variety. That is, they carried a fixed-initial rate for two or three years, respectively, so the former will first reset in June.

The average initial rate for the loans was 8.64 percent, set when the six-month Libor was 5.31 percent, according to the report. It was a teaser rate in the sense that once resets began, the interest rate would be based on Libor plus a spread of 6.22 percentage points.

Now the interesting thing is that the authors of the paper stress that they investigated only one pool used to illustrate how subprimes work and to try to understand how the product turned out to work so badly. The abstract and executive summary make no reference to the economics of subprimes. The abstract:

In this paper, we provide an overview of the subprime mortgage securitization process and the seven key informational frictions that arise. We discuss the ways that market participants work to minimize these frictions and speculate on how this process broke down. We continue with a complete picture of the subprime borrower and the subprime loan, discussing both predatory borrowing and predatory lending. We present the key structural features of a typical subprime securitization, document how rating agencies assign credit ratings to mortgage-backed securities, and outline how these agencies monitor the performance of mortgage pools over time. Throughout the paper, we draw upon the example of a mortgage pool securitized by New Century Financial during 2006

Fed economists no doubt would know better than to use on one pool of MBS issued by one issuer in one month for an economic when there are vastly more comprehensive data sources that are designed for precisely that sort of analysis. And a quick look at one suggests that Berry’s conclusions are quite a stretch.

The American CoreLogic databases as of March 2007 contained 38 million mortgages. Their extraordinarily detailed analysis of 8.4 million ARMS originated between 2004 and 2006 showed only 9.1 % with initial interest rates of 8.5% or higher (note that the paper claims an average of 8.64%)

There were more mortgages ate 2% and below (1,1 million) than above 8.5% (770 thousand). Without throwing in the intermediate levels, it’s obvious that the weighted average is well below 8.64% (the level in the New Century pool, which gave Berry the notion that there wouldn’t be much reset shock). Similarly, a March 2007 (admittedly now dated) paper by Chris Cagan deemed ARMs with initial rates of 6.5% or higher as not-very-vulnerable to reset shock.

ARMs with low introductory rates were never intended to reset; the assumption was that the would refinance. And recent pools are running at unheard-of rates before reset, with monthly default rates of 3.5%, which equates to a 34.8% cumulative default rate over three years. Thus the performance of later subprimes is horrendous independent of the issue of resets.

Finally, while Libor was a popular index for setting the reset rate, it’s far from the only benchmark. Others include the 11th District Cost of Funds rate, the Prime rate, the Monthly Treasury Average rate, the Constant Maturity Treasury rate. And some of these have not been affected by the Fed’s cuts:

Note that while prime has fallen, its level is not much below what it was in 2005 and 2006, which were the heaviest years for origination of dubious subprimes (while the 2007 vintage is worse in terms of quality, the volume issues was lower than in the two preceding years):

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  1. Anonymous

    I didn’t have time to read the paper yet but it seems like the authors got the facts right but interpreted them wrong. Lower Libor certainly does reduce payment shock but as you noted “the performance of later subprimes is horrendous independent of the issue of resets.”. The default rate will be lower than if Libor were still >5% but still at a ridiculously high level.

    I think you make the same mistake as the authors in picking a sample, they only look at one bond but you reference the entire universe of ARMs between 04-06. That’s a valid set of loans to analyze but you are including a lot of high credit loans along with the bad ones when doing so. I have a couple of fantastic graphs from BoA’s latest research paper I wish I could post. They show ARM reset shock as a function of Libor for only Subprime loans resetting in 2008. At 5.4% 6M Libor ~ 5% of loans would have a rate shock of 1% or less, at 3% 6M L its ~65%, at 2% 6M L its ~ 90%. At 2.5% 6M Libor ~40% of loans will have their rate reset down.

    Again I think you hit the nail on the head in pointing out that defaults aren’t being driven by rates. A small fraction of borrowers who would have been hurt by resets are getting relief from lower Libor. Unfortunately those people are a very small fraction of subprime borrowers, not enough to get excited about.

  2. gaius marius

    i think one of the most important aspects of this is left unsaid — something WSJ mentioned back in october.

    subprime 2/28s from 2005 and 2006 are rolling off now, and that’s contributing to default problems. and a lot of loans are going bad without ever even getting to the reset. but looking forward a huge aspect of resets is not only rate raises but full amortization of pay-option ARMs (OAs). the journal:

    The deteriorating performance of option ARMs is evidence that lax underwriting that led to problems in subprime loans is showing up in the prime market, where defaults typically are minimal. Challenges could grow, as from 2009 to 2011, monthly payments on some $229 billion of option ARMs will be adjusted to include market-rate interest and principal, according to Moody’s

    It now appears that many borrowers who moved into option ARMs were attracted by the low payments and may have been staving off other financial problems. More than 80% of borrowers who are current on these loans make only the minimum payment, according to UBS.

    $230bn, of which 4 in 5 are negatively amortizing. that’s a massive blast of foreclosures coming — and it’s being pushed closer in time as many OAs revert to full amortization early if LTV rises to 110-115%. most of these loans will reset well before their 2009-2011 schedule — and static rates won’t help any of them.

  3. Anonymous

    The reduction in short term rates is actually helping the OA situation massively too. As rates fall so does spread between the minimum payment and the full interest amount reducing negative amoritization. 12 Month MTA has already fallen 100 bps in the past year and will drop another 200 bps in the next 8 months. That is a huge amount of negam taken off the table, pushing the recast back quite a bit.

    As with Subprime loans though a large part of the defaults have nothing to do with the payment level.

  4. Anonymous

    Even if Berry were right, any relief from lower interest rates would be temporary. Unless incomes increase significantly or housing prices rebound to their previous highs, these loans will default once interest rates rise. It’s hard to see where there is an escape.

    Incidentally, Mike Shedlock had a post yesterday about some interest rates that are going to reset lower. If his reporting is accurate, some lenders may be trying to convert borrowers into fixed-rate loans that are higher than the reset rates.

  5. eh

    Again I think you hit the nail on the head in pointing out that defaults aren’t being driven by rates.

    Several articles a while ago showed convincingly that negative equity was the single biggest factor in defaults (‘walkaways’), e.g. even bigger than ability to pay (loan reset).

    So if lowering rates does not really help all that many people keep their homes, and in a climate of falling prices cannot really stimulate enough people to buy in order to reverse that trend, how stupid does Bernanke look for hollowing out the dollar and kicking responsible savers in the teeth (inflation meaning most savings and/or money market accounts have a negative return)?

  6. Anonymous

    Rates will be lowered another 1/5% in a month in classic supply side retardation, versus allowing the market to correct on its own:

    Even if this “trap” does not exist, there is a fourth element to Keynes’s critique (perhaps the most important part). Saving involves not spending all of one’s income. It thus means insufficient demand for business output, unless it is balanced by other sources of demand, such as fixed investment. Thus, excessive saving corresponds to an unwanted accumulation of inventories, or what classical economists called a general glut[2]. This pile-up of unsold goods and materials encourages businesses to decrease both production and employment. This in turn lowers people’s incomes—and saving, causing a leftward shift in the S line in the diagram (step B). For Keynes, the fall in income did most of the job ending excessive saving and allowing the loanable funds market to attain equilibrium. Instead of interest-rate adjustment solving the problem, a recession does so.

  7. Anonymous

    “Incidentally, Mike Shedlock had a post yesterday about some interest rates that are going to reset lower. If his reporting is accurate, some lenders may be trying to convert borrowers into fixed-rate loans that are higher than the reset rates.”

    I’ve wondered about this myself alot. Given how ignorant many borrowers are I can see them modifying their mortgages into fixed rate loans with rates higher than their floating rate for the foreseeable future.

  8. Anonymous

    When I refinanced my 7.25% fixed motgage to a 3/5 ARM several years ago, I specified a 6 Mo T-bill benchmark.

    Several days before closing, I was presented with a LIbor reset benchmark. I looked at the corelation and went ahead.

    Of course. The Libor is corrupted, like everything in the financial universe. The warning signals went off.

    It’s still okay. The reset bit me in the ass this year but should be better next year, unless I refi when the fixed rates reflect the unstoppable deflation.

  9. Anonymous

    The FirstAmerican databases you are referring to are the entire universe of mortgages, not just subprime ARMs. Almost all of the subprime hybrid ARMs do indeed have high starter rates (I would use 7.5 percent rather than 8.5 percent though). You are mixing this up with high-FICO option ARMs (dangerous, but in a different way) and other prime ARMs. These are not the ARMs that have been defaulting in such high quantities. Note that Berry is only talking about subprime mortgage resets (at least in the piece you excerpted) and therefore is correct in his statement.

  10. Yves Smith

    Berry did not do any analysis; he drew conclusions from a paper that analyzed a single deal in 2006 and made NO claims that its findings regarding the economics could be generalized to subprimes as a whole.

    Second, you evidently did not go to look at the paper I referenced to check how Cagan chose his 8+ million ARM mortgages and exactly what they consisted of.

    Third, your argument re option ARMS is incorrect. A post at Calculated Risk shows an IMF chart that arrays mortgage resets by volume by month through 2016. Option ARM resets don’t even register on the chart, and then only in a small amount, until 2009 and kick in in big numbers in 2010 and 2011. By contrast, the Cagan analysis of 8 million mortgages had a table (page 29) that arrayed initial interest rates by year of first reset. Eyeballing it, it is very clear that the loans with initial rates of 6.5% or higher reset in 2006 or 2007. For instance, loans initially at 6.5% to 7% has 52% reset in 2006, 31.2% reset in 2007, and only 2.2% in 2008. From 7% to 7.5% had 60.6% reset in 2006 and 51.4% reset in 2007, and only 1.8% reset in 2008. For every rate initial rate higher that 7.5%, the resets in each year 2008 or later are no higher than 1.9% and in most cases below 1%.

    Thus the claim that Berry’s so-called analysis is meaningful is utter baloney. Only a very small proportion of higher initial interest rate ARMs reset in 2008 or 2009, counter to his claim.

    Finally, I note that Andrew Leonard at Salon deems Berry’s argument to be irrelevant, since negative equity is proving to be a bigger driver of defaults than resets. And as I noted in the post, subprimes are showing unprecedented default prior to reset.

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