Falling Mortgage Dominos

Like its subprime sibling, the Alt-A mortgage mart sees rise in late payments and defaults

Investment Dealers Digest
January 28, 2008
BYLINE: Aleksandrs Rozens

The Alt-A mortgage market, which once accounted for 1%-2% of the MBS market but now makes up as much as 20% of the securitized mortgage universe, has seen a rise in late payments and defaults, spurring warnings by credit rating agencies.

While the problems with Alt-A home loans have been ascribed to poor underwriting standards among mortgage lenders, what may be worrisome to investors is that credit scores for many of these borrowers are what would be considered prime or credit-worthy.

"The Alt-A market is displaying the same symptoms as the subprime market," says Thomas Zimmerman, head of asset-backed and mortgage credit research at UBS in New York. "2006 and 2007 loans were as weakly underwritten as subprime loans."

"These are issues we're seeing in all mortgages. We are in a housing correction so all mortgages are seeing an increase in delinquencies off of what were record lows," says Karen Weaver, global head of securitization research at Deutsche Bank. Alt-A "is in some ways a sister product to subprime. Some Alt-A pools are very, very close to subprime quality. There is a pretty big divergence (among loan underwriting practices and standards)."

Alt-A loans have been around since at least the 1990s when they were introduced as a mortgage product designed for small business owners whose income patterns were different from that of a typical borrower.

This meant that borrowers could offer less documentation detailing their earnings. In recent years, these loans were more broadly adopted, particularly among borrowers who used these loans to buy investment properties. In some cases, borrowers who did not qualify for a regular mortgage product because they did not earn enough opted for Alt-A loans where they could "state" their income even though they paid a slightly higher rate.

"[Real estate] investors wanted it done rapidly. They wanted to capture price gains. They didn't want to provide much documentation. The idea was to sell the property or refi the loan," says Douglas Duncan, chief economist at the Mortgage Bankers Association.

In recent weeks, credit rating agencies have downgraded several securities backed by Alt-A loans, including deals with fixed and floating rate mortgages from Indymac, Countrywide, Goldman Sachs, Citigroup and American Home. All of the transactions subject to downgrades in recent weeks have been 2007 deals, but the problems may also crop up in transactions from 2006.

The underlying reason for the downgrades or warnings of bonds being put on review for a downgrade is the higher-than-anticipated rates of delinquency, foreclosure and real estate-owned properties.

"The Alt-A market is a little better than subprime. People were focused on subprime as the most extreme, but some Alt-A is almost as bad as subprime," says Zimmerman. "We're seeing an increase in delinquencies. It is well beyond normal levels."

According to Deutsche Bank's Weaver, Alt-A delinquency rates rose to 6.2% in December 2007 from 1.4% in December 2006. That magnitude of change was greater than that seen in subprime loan delinquencies.

Understanding the loans backing the bonds

The Alt-A mortgages backing the bonds include floating rate and fixed rate mortgages. The loans are first-lien mortgages and their credit scores can run over 700, a level comparable to prime mortgages guaranteed by Freddie Mac and Fannie Mae. (You can get a 95% LTV agency loan with a 660 credit score).

What makes Alt-A paper different is that their loan documentation is not as thorough and Alt-A mortgages have increasingly become the loan of choice for borrowers looking to buy investment properties. Housing finance professionals generally believe that a borrower who lives in a home will be less likely to default than the borrower who sees the property as merely an investment. According to MBA's Duncan, Alt-A mortgages have been very popular in states that saw the biggest run-up in prices and speculation: California, Arizona, Nevada and Florida. "The Alt-A was very popular in the same areas where there was speculative buying," says Duncan.

Nevada and Florida are two states which have seen a marked rise in problem loans.

Realtytrac, a firm that keeps tabs on foreclosure activity, reported last month that Nevada was the leading state in terms of foreclosure activity where one household out of every 152 had a property foreclosure. Florida had a rate of one foreclosure per every 282 households, while Ohio had one foreclosure for every 307 households. Foreclosures in November 2007 were up 68% from a year ago.

Standard & Poor's recently noted that severe delinquencies among Alt-A loans from 2006 - that is 90-days or more, including loans in real estate owned or foreclosure - have seen two times the number of delinquencies of mortgages underwritten in 2005. The number of delinquencies for those 2006 mortgages is more than four times the number seen among loans created in 2003 and 2004.

"The 2006 and 2007 vintages are problematic, but the [borrowers] from 2004 and 2005 still have positive home price growth. The 2006 and 2007 buyers have seen a drop in their home values," says Fitch's Glenn Costello, a managing director at the credit rating agency and co-head of its residential mortgage backed securities group.

Market watchers believe that borrowers who have seen their property retain more of its value are less likely to default, while those who purchased homes in 2006 and 2007 did so at the very peak of the housing boon and may be more apt to fall behind on payments or simply abandon the property.

According to S&P, Nomura Securities was the issuer with the most severe delinquencies, but others with problem loans in their securities included Bear Stearns, Goldman, Impac, Credit Suisse and Morgan Stanley.

ARMs can hurt investors The Alt-A universe includes largely three types of loans: payment option ARMs, hybrid ARMs and fixed-rate loans. Fixed-rate borrowers have been the least problematic because these have not seen the payment shock associated with adjustable rate loans. When it comes to hybrid ARM loans, a rise in borrowing costs often trips up homeowners.

"A hybrid ARM homeowner is presumably more financially stretched than a fixed-rate homeowner and ... is more likely to be falling behind on his or her mortgage payments," according to S&P, which noted that payment option ARMs are the riskiest because the pay shock for these loans is much more dramatic.

"While in the past POA (payment option ARM) borrowers have been afforded ample opportunity to refinance, in the current market environment, troubled POA borrowers no longer have abundant liquidity available to them," S&P warned in its report, adding that "many borrowers in the future may find it difficult to avoid foreclosure."

Declines in home prices have made things even tougher for the Alt-A market because some borrowers purchased their homes with little or no down payment with the help of piggy-back mortgages, says Fitch's Costello. As a result, these borrowers will have little or no equity, hurting their chances of qualifying for a refinance.

While there are parallels to the subprime situation, market observers believe the problems in the Alt-A market likely took longer to surface because these homeowners are of better quality.

Their ability to readily refinance from one Alt-A loan to another was hindered by last summer's credit storm that claimed a well known Alt-A lender - American Home Mortgage. Problems in subprime were first beginning to be felt in late 2006, and were very evident by April 2007 when New Century, a leading subprime mortgage lender, filed for bankruptcy.

American Home filed for bankruptcy on Aug. 6 because it was unable to readily resell mortgage loans into securities. The bankruptcy added to concerns about mortgage credit risk and likely prompted many lenders to hold off from underwriting more Alt-A home loans.

For now, holders of highly-rated securities, AAA paper, backed by Alt-A loans have not experienced massive downgrades. But investors ought to remember that 90-95% of an Alt-A bond transaction - these deals typically total $500 million - is AAA. So, if and when losses pick up and eat through the support classes that higher rated paper could be impacted.

"It could be possible that AAA paper could be downgraded," says Fitch's Costello.

Meanwhile, some participants may have been cheered by the Federal Reserve's dramatic rate cut last week. The easier money likely will aid the economy, but many borrowers with little or no equity in their homes will continue to have a tough time refinancing their mortgage.

Additionally, the problems within the Alt-A mortgage market promise to seep into other areas of the credit markets, notably the collateralized debt obligations (CDO) that bundled low rated classes of various types of mortgage debt. Downgrades of subprime mortgage-backed securities last year led to downgrades of some CDO transactions.

"Yes, we may see some downgrades in CDOs," that included low-rated classes of Alt-A mortgage backed securities, says Deutsche Bank's Weaver.