Sunday, December 10, 2006

Housing Update: Mortgage Market Problems Increasing

Tuesday, Ownit Mortgage Solutions of California shut down, citing "the unfavorable conditions of the mortgage industry." That's a euphemism for subprime home borrowers getting into trouble and defaulting on loans at unprecedented speed.

Ownit would sell loans it originated to Wall Street, which repackaged them as mortgage-backed securities. But, as Dow Jones Newswires reports, the issuers of the MBS can force Ownit to take back loans that go into default. Ownit ran out of cash to repurchase the bad loans for the street, according to industry sources quoted by Dow Jones Newswires.

Here’s a brief overview of the mortgage market. When you get a home loan from a bank, the bank doesn’t keep the loan on its books. Instead, it sells the loan to a larger institution. These mortgages usually end up with Fannie Mae or Freddie Mac. Freddie and Fannie take similar mortgages (mortgages that have the same interest rate, maturity etc…) and “pool them”, or puts them together in one giant mortgage bond. Then, these institutions sell the mortgages to pension funds, mutual funds and other investment companies. When people state that Fannie and Freddie have added liquidity to the mortgage market, the above-mentioned process is what they are talking about.

Here’s more on Ownit from Bloomberg:

In 2003, Dallas and a group of investors including Chicago- based CIVC Partners bought Ownit. They expanded the company's annual mortgage issuance at least eight-fold to more than $8 billion last year.

Nonprime News, an industry newsletter, ranked Ownit as the 11th-largest U.S. issuer of so-called subprime mortgages, or home loans made to borrowers with low incomes, untested credit or a track record of default or delinquency. The company issued $5.46 billion of loans during the first half of the year, 44 percent more than a year earlier, according to the newsletter.

What’s important about this particular story is Ownit was a large company. They weren’t a fly-by-night organization; they were almost in the top ten of all US sub-prime mortgage lenders. That should indicate the sub-prime mortgage market is definitely showing signs of problems.

In addition, sub-prime mortgage bonds are beginning to experience problems:

The mortgage bond market is beginning to buckle under the weight of the worst U.S. housing slump in six years.

Yields on so-called sub-prime mortgage securities rated BBB have risen to 6.52 percent on average from 6.28 percent on Sept. 5, data compiled by Bank of America Corp. show. The yield premium, or spread above the one-month London interbank offered rate, a lending benchmark, rose to a seven-month high of 1.2 percentage points.

About 3.3 percent of the $160 billion in sub-prime loans made this year through July have payments that are more than two months late, the highest ever for mortgages in their first year, according to New York-based Fitch Ratings. Housing starts tumbled in October to an annual rate of 1.486 million, the lowest in more than six years. The economy grew at the slowest pace since 2005 during the third quarter.

The primary benefit of pooling mortgages as mentioned above is to diversify risk. If 1 mortgage among 100 goes bad, the pool is still in fine financial shape. However, the larger percentage that goes bad, the worse off it is for investors. The fact that mortgages are starting off with a high rate of defaults does not bode well for the future; it indicates that worse problems are probably further down the road.

Also from the Baron’s article above:

Grant's Interest Rate Observer has been among the first to pick up the warning signs of the trouble in the subprime mortgage market. The current issue, dated Dec. 1, points out that loans made in 2006 already are turning bad. In past cycles, it generally took a few years for borrowers to go bust.

Grant’s Interest Rate Observer is a must-read in the bond industry. The point is market watchers are picking-up on the early problems of the latest sub-prime market.

Finally, we have this:

The deteriorating conditions for subprime mortgages also have been evident in the relatively opaque market for credit derivatives. The benchmark for these loans is an index known as ABX, which are split into the various sub-indices of varying quality. According to Markit, an online source of valuation for derivatives, the lowest-quality indices, the ABX.HE 06-1 BBB and BBB-minus, recently suffered a "credit event." Two underlying bonds had interest shortfalls resulting in losses, according to a Nov. 27 release from Markit.

This week, the ABX has taken "a pounding," according to one mortgage professional, especially in the triple-B-minus indexes. Investors have been trying to get protection by selling this lowest tier of the ABX index. But, according to this pro, the value of the constituent credits in the index may be even lower than implied by the index's value -- because there's no market for credit protection for the individual names. So still more selling may be ahead.

Credit derivatives are a relatively new development in the mortgage market. Essentially, they are an insurance policy of sorts on mortgages. Remember those pools mentioned above? A person who holds one of those mortgage pools can buy a credit derivative as something like an insurance policy in case a mortgage in the pool goes bad. The fact that derivatives are increasing in price simply means the perceived risk is increasing. That’s not a good sign.

So – the 11th largest sub-prime lender goes bankrupt, recent sub-prime delinquencies are increasing at higher than expected rates and credit derivative prices are increasing. Adding these up and we get a pretty ugly picture for 2007.