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Advantus Predicts More Subprime Downgrades on the Way
By Alton Gary Simpson
ST. PAUL, MN -- According to Advantus Capital Management Inc., an asset management firm with its headquarters here, based on the sub-par performance of the 2006 vintage of subprime loans and the lack of a material difference between the 2006 vintage and first quarter 2007 vintage, "there are more rating reviews on the horizon and significantly more downgrades to come." In a report titled, "Subprime Strikeout: Assessing the Subprime Mortgage Market," Advantus attempts to explain the deterioration of the subprime mortgage market. The report by James Kragenbring, vice president and senior investment officer, Jon Thompson, investment officer and Lena Harhaj, investment analyst -- all from Advantus' Capital Finance division -- starts with a brief recap of subprime financing this decade, moves on to an examination of the cracks in the market's foundation that began appearing about 18 months ago and provides a review of the current state of the market, with predictions for the future.
"The period from 2000 to 2006 was a golden age for U.S. real estate," said the report, which detailed the factors that set the stage for the housing boom. These factors included global demand for U.S. real estate assets, the effect of tax law changes made in the 1990s, memories of the risk of stock market investment during the 'tech bubble,' a reduction in leisure travel after the Sept. 11, 2001 attacks and historically low interest rates. "As a result, record numbers of Americans became homeowners and U.S. housing values soared," noted Subprime Strikeout. "Housing was the rage and Americans got richer for simply sleeping under their own roofs.""
After the poor performance of the 2000 vintage of subprime loans, loan originators concentrated on increasing the quality of borrowers by focusing on FICO scores. The report suggests that the over-reliance by loan originators on using FICO scores to measure borrower quality missed the deterioration of other borrower risk metrics including:
• The dramatic increase in second mortgages taken simultaneously with first mortgages to provide purchase money. Simultaneous seconds existed on only 3% of subprime mortgages in 2000. By 2006 they accounted for 29%. CLTV rose from 80% to 85%;
•·The appearance of interest-only loans, which peaked at 28% of the market in 2005. The report stated that underwriters were also qualifying borrowers only on their ability to make the initial interest-only payments and not the fully amortized payments;
•·The decline in the percentage of loans for which borrowers fully documented their income and assets from 73% to 57%. This increased the risk of fraud and misrepresentation; and
•·The increase of borrower DTI from 39% to 42% between 2000 and 2006. According to the report, the DTI would be even higher if DTI were calculated on the basis of a fully amortizing payment and took into account the uncertainty caused by reduced borrower income documentation.
Advantus' report noted that the rating agencies, such as Standards & Poor's, Moody's, Fitch and Dominion Bond Rating Service, seemed to take the non-FICO risk metrics into account in their loan performance models. "While rising FICO scored could have led to decreasing credit enhancement levels, enhancement was largely static between 2000 and 2005. What became troubling was that credit enhancement levels declined in 2005 and 2006 when significant credit problems began to appear in the subprime market."
While delinquency reports and early payment default rates were rising in 2006, the credit default-swap market in subprime RMBS was also on the rise. The development of ABX allowed the hedging of subprime positions and speculation on their future. It wasn't until this year that the performance of the 2006 vintage significantly impacted trading levels.
"By the end of February, ABX spreads reflected that high delinquencies were not simply the result of transient early payment defaults," said the report. "They also indicated broader collateral quality deficiencies that will plague the 2006 vintage for the indefinite future."
It was already July before the rating agencies took action, affecting 3,174 individual classes across 424 transactions. The value of securities downgraded or placed under review totaled more than $138 billion.
According to the report, "We believe there are more rating reviews on the horizon and significantly more downgrades to come." The reasons for the firm's pessimistic outlook are:
•·The performance of the 2006 vintage will show little improvement before rate resets kick in;
•·The collateral characteristics of the 2007 vintage deals issued to date aren't materially different from the 2006 vintage; and
•·The most significant catalyst for downgrades lays in the reset risk on short-dated hybrid ARMs.
The report concludes, "In this environment, it is impossible to make investment conclusions on the basis of credit ratings."
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