Digital Risk In The News

On Wall Street, Consistency Breeds Confidence

Volume 6, Issue 152
August 7, 2007
Michael Murray

Moving forward, quality and consistency become even more important to investors and ratings agencies as they attempt to rebound from fallout in the subprime market.

“Any correction period exaggerates to the other way to start with; then it comes back to the middle ground,” said Jeffrey Taylor, managing director at Digital Risk LLC, Dallas, a risk mitigation firm working with Wall Street investors. “But we don’t really know what the middle ground is yet. How far back is it going back? I think it is obviously overreacting.”

Taylor said the move back to the middle will require ratings agencies to determine strong criteria where investors can feel confident with performance in the structured finance market. Right now, investors-residential, commercial and corporate-are standing on the sidelines as funds to underwrite securities are tightening up, he said.

“There is a credit dry up right now,” Taylor said. “Not so much for the mortgage loans but for other traditional types of debt financing right now. As an economy, we have enjoyed unlimited liquidity for the past five or six years, which has fueled the growth of a lot of the hedge funds and the private equity funds -all sorts of investment grade debt—and the subprime mortgage bonds.”

Fitch Ratings, New York, said its fundamental methodology on the hedge fund counterparty will remain similar to its 2004 original criteria, but with formalizing the criteria to other hedge instruments, such as interest rate caps and collars; revising volatility cushions and advance rates for collateral; and simplifying the approach to minimum counterparty rating.

Based on less liquidity, some lenders are no longer providing 100 percent loan-to-value, no-down payment loans while other lenders will charge a slightly higher interest rate to pay closing costs. “Piggyback” loans are tightening as well because second trusts bring more risk through adjustable rate mortgages that balloon after 10 to 15 years.

In Countrywide Financial's second quarter report, chairman and CEO Angelo Mozilo noted that the Calabasas, California based company incurred increased credit related costs in the second quarter, based primarily on its investments in prime home equity loans, which could be second trusts or “piggyback” loans.

Rating agencies released more reports in the past two weeks on different credit methodologies to add investor confidence to loan performance. Moody's Investors Service, New York, adjusted credit methodologies on RMBS to address the negative effect of "piggybacked" or "closed-end second" loans, the poor performance of no- and low-documentation loans, early and first payment defaults and the impending effect of loan modifications in subprime pools.

"We believe that this will help to address the uncertainty in the performance of unseasoned loans, especially in light of market reports that part of this phenomenon may be related to borrower, broker and appraiser misrepresentations in the origination process," said the Moody’s report, "U.S. Subprime-Overview of Recent Refinements to Moody's Methodology: July 2007.”

In May, the home equity sector performance deteriorated, according to Moody's Home Equity Index Composite. The 60-plus delinquency rate based on current balance rose to 12.35 percent from 11.63 percent in April, while the foreclosure and REO rate indexes reached 4.89 percent and 2.38 percent, respectively. During the same month, the performance of securitized prime jumbo mortgage loans weakened slightly, according to Moody's Jumbo Mortgage Credit Indexes. The May 60-plus day delinquency rate was 0.422 percent, increasing from 0.397 percent in April and from 0.268 percent one year prior in May 2006.

Industry experts, however, said the Countrywide Home Loans announcement did not reflect the entire country because a large part of Countrywide’s market sare is in California. But Taylor said Countrywide’s market share expands beyond its own state. “The reality is it is not all in California,” Taylor said. “Countrywide lost a lot of the market share in last few years to the New Centurys, the WMCs /and the subprime that was in California. [Mozilo]was saying this was not in any particular part of the country—it was over the whole country.”

“Softening home prices continued to affect many areas of the country and delinquencies and defaults continued to rise across all mortgage product categories as a result,” Mozilo said.

First American Core Logic, Santa Ana, Calif., said risks from fallout of high delinquency rates in the subprime and Alt-A markets were spread unequally and concentrated in certain markets across the country. The First American Core Mortgage Risk Index said fraud and collateral risk increased in markets with “cooling housing prices,” which increased foreclosure stocks.

The third quarter report said 10 Florida markets and 14 California markets depreciated, but the “declines reflect isolated house price corrections, since the fundamental economic climate in the states is sound."

The report showed house pricing trends reaching the bottom on a national level. Eight of the 10 highest risk markets are in Ohio and Michigan, manufacturing states which had high levels of unemployment in the manufacturing sectors.

Taylor expects the commercial securitization mortgage market to return before residential and subprime mortgage-backed securities, but he also forecasts liquidity becoming tighter rather than looser before the end of this year and that more mortgage industry players will leave the market before it “settles down.”

First American Core Logic forecasts upward pressure from higher delinquency rates in the subprime market-created by adjustable rate mortgage payment reset terms and fundamental economic factors on the Fraud and Collateral Risk Index to continue into 2008 as markets work through the resulting foreclosures. The company said the last time home appreciation rates were as low as they are now was in 1998, the same time the subprime market experienced a liquidity crunch.

Whether the market has overreacted or not, questions still remain as to the length of time for a market correction and the damage to take place waiting for the market to correct itself.

Last week, American Home Mortgage Investment Corp., Melville, N.Y., announced closing most operations with more than 6,000 layoffs. At Accredited Home Lenders, San Diego, stock fell 46 percent.

“I would like to say we have seen the worst. Unfortunately, I think the worst is still in front of us,” Taylor said. “I am not trying to be ‘gloom and doom.’ I am just trying to be very factual.”