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Alt-A Rumblings

UBS warns on layered risk Alt-A

March 14, 2007


Delinquency on Alt-A loans with layered risk is reaching the highest level on record, according a study released Tuesday. And based on current trends, most of the credit support for BBB- rated bonds back by Alt-A hybrids could be wiped out.

The Alt-A mortgage sector, "the poster child of the past decade's tremendous growth and drastic evolution in the mortgage market," is showing an increase in delinquency rates comparable to that in the subprime sector, according to the report by UBS.

"Delinquency rates of prime mortgages are at or below their 3-year ago levels," notes the study done by David Liu, head of mortgage credit research at the global financial firm. "By comparison, delinquency rates on subprime and Alt-A mortgages have roughly doubled within the past year and show no signs of moderation."

In fact, he pointed out, Alt-A mortgages that were originated last year are "on track to be one of the worse vintages in recent years, alongside the 2000 and 2001 vintage."

However, the credit deterioration of Alt-A mortgages is not evenly distributed in the Alt-A market, he said.

First off, Alt-A ARMs tend to produce higher losses than comparable fixed-rate mortgage products, he said, and then, among Alt-A ARMs, IOs are performing worse than other Alt-A ARMs, including Option ARMs.

Alt-A ARM IOs that were originated last year are, he said, "running neck to neck with some of the worse Alt-A credit performance we have on record. At comparable seasoning, the 2006 Alt-A ARM IO produced default rates that are as high as those on the worst performing of the 2000 and 2001 vintages."

And the 60+-day delinquency rate of 2006 Alt-A ARM IOs is running at an "alarming" four times the level of 2003-04 vintages, he added.

The default rates of Alt-A ARM IOs, according to Liu, are about two times as high as fixed-rate mortgages and five times as high as Option ARMs. In fact, Option ARMs originated last year, he added, are producing delinquencies at half the levels of non-option ARM Alt-A at the same seasoning.

But this poor performance of Alt-A ARM IOs is not unexpected, he maintained, because these loans have the highest percentage of silent seconds (57%), the highest combined loan-to-value (86%) and the second highest low doc percentage (76%) of all Alt-A loans.

Declining prepayment speeds for Alt-A IO hybrids also signal higher default rates in the future, he warned, pointing out that "non-agency Alt-A borrowers in general and hybrid IO borrowers in particular" are more leveraged due to their weaker credit profiles.

These borrowers will have high prepayment speeds in a robust home price appreciation environment because they are then more likely to take equity out of their properties, he said. "But when the housing market softens, borrowers with weaker credit respond less strongly to refinance incentive."

And when they cannot refinance, they are more likely to default on their mortgages, he said. Thus, mortgages with single-digit home price appreciation show the highest default rates. And a projected slowdown in ARM IO prepayment speeds from the high 20 percentile range Consumer Price Index in 2003-05 to the low 20s CPR in 2007 "could result in an increase of 25-30% in cumulative defaults," Liu cautioned.

And such defaults also would be more costly, he added, noting that, while in high appreciation areas, roughly 20% of defaults produced positive losses, in single-digit appreciation areas, the losses rose to the 30-40% range. Further, recovery rates in single-digit appreciation areas tend to be only half that of recovery rates in high appreciation areas.

"Putting the two sides together," he pointed out, "we arrive at roughly 5% loss severity for all defaulted Alt-A loans and 15% for low appreciation areas."

Projecting baseline prepayment speeds in the low 20 percentile CPR, Liu said his team foresees cumulative default rates of 12-13%.

Applying a loss severity of 15% on all defaulted loans, he concluded, "would result in a cumulative loss of -200 bps, which could potentially wipe out most of the credit support BBB- rated bonds back by Alt-A hybrids. And yet," he added, "we have not seen any spread movements that suggest investors are taking this into consideration."

Jerry DeMuth is an award winning journalist who has been reporting for four decades.

e-mail Jerry at [email protected]
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