Mortgage Banking
October 2007
The subprime meltdown spilled over into other financial markets over the summer. Investors fled the private-label residential mortgage-backed securities market, shutting it down in early August. Facing margin calls, falling asset values, no buyers for non-agency bonds and no buyers for mortgages originated for the private-label market, mortgage companies large and small scrambled to survive.
By Robert Stowe England
"There's got to be a morning after," goes the theme song from the 1972 disaster flick The Poseidon Adventure. Many mortgage company executives had to share that sentiment as August 2007 finally drew to a close.
Like passengers on the Poseidon, a fictional luxury liner hit by a tidal wave triggered by an underwater earthquake, mortgage lenders and Wall Street mortgage financiers now know more than they would like to about being caught up in a disaster outside of their control.
The underwater earthquake that first rattled the foundations of the mortgage industry came in the form of sharply higher delinquencies and defaults from a book of poorly underwritten subprime loans from the fourth quarter of 2005 through the first quarter of 2007.
A liquidity squeeze by warehouse lenders imposed on subprime companies was the first visible shock wave from this earthquake. It toppled many independent subprime lenders earlier this year. Most of the survivors were acquired by major financial companies. By Aug. 31, the crisis prompted a response from President Bush, who unveiled a proposal to use the Federal Housing Administration (FHA) to rescue some stranded subprime borrowers facing higher mortgage payments due to resets.
Shock wave No. 2: Bear Stearns
Following the first shock wave from the subprime meltdown in late winter and early spring, a second-even more powerful-wave hit in June, upending two hedge funds invested in investment-grade tranches of subprime residential mortgage-backed securities (RMBS) managed by the investment arm of Bears Stearns & Co. Inc., New York. The trouble began after Bear Stearns' Enhanced Leveraged Fund, which had $638 million in investor capital and $11.15 billion in gross long positions, lost 23 percent of its value between January and April, with most of that in April. A chronology of the major events in the summer's market meltdown can be seen in the sidebar, "Timeline." which is reprinted at the end of this article.
Bear Stearns had earlier reported a much smaller loss in April of 6.5 percent, but restated the April loss to 19 percent on June 7 BusinessWeek reported that banks began marking down the value of the mortgage bonds held by the hedge fund, which required Bear Stearns to put up more collateral, which precipitated the crisis.
News of the sharp decline in the value of the hedge fund prompted a flurry of redemptions from investors and a series of margin calls from creditors. To meet the redemptions and margin calls, Bear Stearns sold $8 billion in assets from its less-leveraged High-Grade Fund to generate cash, according to The Wall Street Journal. The High-Grade Fund had $925 million in investor capital and $9.7 billion in gross long positions.
"The sheer size of the asset sales suggests investors or lenders have asked for some or all of their money back," reported Stephen Foley in the June 15 issue of London newspaper The Independent. The internal struggle to salvage the Enhanced Leveraged Fund went public when Bear Stearns suspended redemption payments to investors in the fund.
On June 15, a major creditor-New York-based Merrill Lynch & Co.-ran out of patience and said it would sell $400 million of its collateral held against the loans it had made to the Enhanced Leveraged Fund. Bear Stearns persuaded Merrill Lynch to wait until it had time to hear its proposal for recapitalizing the funds the following Monday, June 18. Bear Stearns told Merrill Lynch it was injecting $500 million of equity and providing $1.5 billion in credit from the parent company, according to The Wall Street Journal. Merrill Lynch was unimpressed, and decided to raise the ante by announcing it would sell at auction the next day at least $850 million worth of collateral assets, mostly mortgage-related securities.
On June 22, more than a week after the crisis went public, Bear Stearns released a statement announcing a $3.2 billion deal to rescue the less-leveraged High-Grade Fund. At the same time, the firm revealed it was in the process of de-leveraging the Enhanced Leveraged Fund, presumably to salvage it.
A hopeful Bear Stearns Chairman James E. Cayne seemed convinced the crisis was over. "By providing the secured financing facility, we believe we have helped stabilize and reduce uncertainty in the marketplace," Cayne said. "We believe the repurchase agreements are adequately collateralized, and we do not expect any material adverse effect on our business as a result of providing this secured financing."
Weakness across the mortgage markets
Bear Stearns' reassurances proved less than convincing to market observers. "The public unwillingness of the broker-dealer to assume the hedge funds' debts for . . . two weeks fueled lively speculation about the severity of the losses by them and the prospects that other hedge funds may have incurred similar losses," says Michael Youngblood, managing director of assetbacked securities (ABS) research at FBR Investment Management Inc., Arlington, Virginia. Market fears were enhanced June 25 when London-based Cheyne Capital Management (UK) LLP announced it was writing off 400 million euros from one of its hedge funds, Queen's Walk Investment Ltd., which had invested 4.2 percent of its portfolio in U.S. subprime RMBS. Events at Bear Stearns and Cheyne Capital raised more speculation that the U.S. subprime meltdown had "contaminated" the primary and secondary markets for subprime mortgage-backed securities (MBS).
Youngblood says that until the speculation is abated, to expect elevated volatility in the MBS market and related derivative instruments.
The slow-motion train wreck at Bear Stearns ultimately careened off the tracks, despite the best of intentions and the intense and costly efforts of the firm. In a July 17 "Dear Client" letter obtained by Mortgage Banking, Bear Stearns revealed that "preliminary estimates show there is effectively no value left for investors in the Enhanced [Leveraged] Fund and only 9 cents on the dollar for investors in the High-Grade Fund as of June 30, 2007."
The letter told investors the funds had lost value due to "unprecedented declines" in the valuations of a number of highly rated (AA and AAA) securities. "In light of these returns, we will seek the orderly wind-down of the funds over time," the letter stated.
The funds' losses were magnified due to their high leverage. The Enhanced Leveraged Fund, for example, borrowed nearly 20 times its $699 million investment capital. The woes for the High-Grade Fund, despite its lower leverage, were compounded when assets were sold off at fire-sale prices. On July 31, the two funds filed for bankruptcy protection.
The swift evaporation of $3 billion into the black hole of Bear Stearns' two hedge funds revealed to the markets the soft underbelly of private-label subprime mortgage bonds. Private-label residential mortgage-backed securities had since 2005 become the dominant source of funding for securitized mortgages, when private-label issuance rose to $1.19 trillion, or 55 percent of the $2.16 of total residential mortgage-backed securities, according to data collected by Inside Mortgage Finance.
Historically, mortgage issuance has been dominated by the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, and by Ginnie Mae. Prime agency conventional, conforming mortgages (with balances no higher than $417,000), however, have not been significantly affected by the subprime contagion during the market implosion.
It was soon clear the subprime contagion was far from over, as United Capital Markets Holdings Inc., San Francisco, announced July 3 it was temporarily suspending investor redemptions in four of its Horizon hedge funds tied to subprime mortgage-backed securities. The Horizon funds cut their leverage and sold "a large amount" of cash securities in the market, according to a company statement. United Capital suspended trading in the synthetic structured finance markets completely, due to high volatility in the markets, the company reported.
Shock wave No. 3: Credit agency downgrades
Downgrades of hundreds of classes of residential mortgagebacked securities by the credit-rating agencies became the third wave to hit the mortgage industry and the financial markets. The actions began when New York-based Moody's Investors Service announced it was downgrading 399 subprime RMBS and was placing an additional 32 on negative watch. Moody's also downgraded 52 subprime second-lien RMBS.
On July 11, Moody's placed 184 classes of collateralized debt obligations (CDOs) on negative review because of their exposure to the subprime RMBS the agency had downgraded the prior day. On July 10, New York-based Standard & Poor's (S&P) announced it had placed on watch 612 classes of subprime RMBS totaling $7.35 billion. Then, on July 12, S&P downgraded 498 classes of the 612 it had put on watch, and left 26 classes on negative watch. A few days later, New York-based Fitch Ratings Ltd. placed 170 subprime RMBS and 19 related CDOs on negative watch.
"These actions are unprecedented," stated the July 14 issue of FBR Investment Management's newsletter, Structured Finance Insights. "Never before has either S&P or Moody's downgraded or placed on watch so many classes of RMBS-a grand total of 1,095."
The newsletter further reported that S&P's and Moody's combined downgrades affected 652 subprime RMBS totaling $7.4 billion, or 1.03 percent of subprime RMBS outstanding as of April 2007, if one takes into account duplicates. According to FBR's analysis, issuers owned directly or indirectly by broker-dealers accounted for seven of the top 10 issuers with classes downgraded by the credit-rating agencies between July 10 and 12.
S&P, Moody's and Fitch all scheduled telephone conference calls to discuss the downgrades, which each of the rating agencies tied to higher-than-expected early delinquencies and defaults on subprime RMBS issued mostly in 2006.
"The losses continue to exceed historic[al] precedents," says Susan Barnes, managing director of S&P's rating services, during the conference call. Barnes reports that total aggregate losses for all subprime transactions issued since the fourth quarter of 2005 was 29 basis points, compared with 7 basis points for similar transactions at a similar point in seasoning in 2000-which previously had been the worst-performing vintage in this decade.
Losses are likely to continue to rise as the 2006 vintage ages and the housing recession continues. David Wyss, S&P's chief economist, says property values will decline 8 percent on average, nationally, between 2006 and 2008, reaching the bottom in the first quarter of 2008. Borrowers facing rate resets in the last half of 2007 and early 2008 will have fewer options, because lenders have tightened underwriting guidelines, according to S&P.
In explaining why there were higher losses than expected, S&P cited data from the Mortgage Asset Research Institute (MARI), Reston, Virginia, that show misrepresentations on credit reports were up significantly for 2006. MARI, commissioned by the Mortgage Bankers Association (MBA) to conduct a mortgage fraud study, found that the findings of fraud exceeded previous industry highs. S&P also reported that its analysis for the 2006 vintage found that previous indicators of performance, such as FICO® scores, loan-to-value (LTV) levels and ownership status, "are proving less predictive" of delinquencies and foreclosures.
S&P told investors it had modified its surveillance methodology for evaluating the creditworthiness of various classes of RMBS. Severity assumptions in stress-test scenarios have been raised, and the rating agency said it expected to downgrade the securities on credit watch based on the new assumptions.
Using its new stress test, S&P will write down to CCC any class that the test predicts may experience a principal writedown in the next 12 months. For 13 to 24 months, the writedown is to B; for 25 to 30 months it's to BB, and for 31 to 36 months it's to BBB.
S&P also modified its approach to reviewing the ratings on senior classes of RMBS in a transaction where the subordinate classes have been downgraded. In the past, S&P maintained a rating on any class that passed its stress test and which had the same level of credit enhancement it had when first issued. Going forward, however, S&P said, "There will be a higher degree of correlation" between classes. "A class will have to demonstrate a higher level of relative protection to maintain its rating when the class immediately subordinate to it is being downgraded," S&P stated.
S&P also announced it had revised its rating methodology for new issues closing on or after July 10. The ratings methodology will assume a faster combination of voluntary and default prepayments that will result in less credit to excess spread. Default expectations for 2/28 hybrid adjustable-rate mortgage (ARM) loans will increase by 21 percent, S&P stated.
Moody's new methodology
Moody's revamped its methodology for rating new securitizations of new residential subprime mortgage loans in mid-July, and released a summary of its "refinements" on Aug. 2. These refinements were based on the rating agency's analysis of the most significant factors that led to the higher delinquencies and defaults in the 2006 vintage, according to David Teicher, managing director at Moody's.
"The biggest driver continues to be the leverage of the borrowers," says Navneet Agarwal, vice president of U.S. RMBS at Moody's. Although greater leverage has always been seen as posing a higher risk, the rating agency found that the performance of loans where borrowers rely on a second-lien loan have suffered higher defaults in the current weak housing and mortgage market. In rating deals going forward, Moody's will assume that defaults from such loans will be up to 25 percent higher than it previously modeled for those loans.
All other things being equal, the credit enhancement for any given rate tranche in deals with higher-LTV loans will be commensurately higher, according to the new methodology statement. The risk will be seen as especially high for loans with LTV or combined loan-to-value (CLTV) ratios above 90 percent-a risk that can be positively or negatively affected by FICO scores, geography, interest rate, documentation type and occupancy type.
Low or no documentation in the 2006 vintage represents the second-biggest factor leading to higher defaults, according to Moody's. "Loans where the borrower's income is not fully documented (especially where the borrower is a wage earner rather than self-employed) have, in general, a higher probability of default than fully documented loans," according to Moody's Aug. 2 statement on its revised methodology. This includes stated-income/stated-asset (SISA) loans and noincome/no-asset (NINA) loan programs. Moody's has further increased its risk assessment for low- and no-doc loans by 20 percent to 25 percent.
Teicher says that wage-earning borrowers who used stated income may have plausible reasons for choosing that loan option. "We've heard from originators that the rationale is that part of the income comes from a source where they are not a wage earner-such as a spouse who is self-employed or a wage-earner who has a second job as self-employed," Teicher explains. "That said, a stated-doc loan from a wage earner does raise additional questions."
Moody's also increased its risk assumption for selfemployed borrowers by 10 percent. Moody's now views the expected loss of a loan where income is not documented to be 40 percent higher for a salaried borrower compared with a self-employed borrower, according to Moody's Aug. 2 statement on its revised methodology.
The risk for first-time homebuyers was also seen as a significant factor, according to Teicher. Moody's new approach estimates that first-time homebuyers will have about 25 percent higher losses. Moody's also found added risks in newly originated loans that may be related to borrower, broker and appraisal misrepresentations in the origination process. To compensate for these potential misrepresentations, Moody's increased its loss expectation by 10 percent for loans that have not yet reached the first payment due date. Thus, all other things being equal, Moody's-rated tranches would have higher credit enhancement for a given rating level to compensate for this. The estimated loss increase of newly originated loans declines over time, however, as the borrower makes his or her payments, and there is no increase [in credit enhancement] after four months when no payments have been delinquent.
Moody's also increased its differentiation in losses based on originators. "As long as I can remember, we've seen different performance from different originators," says Teicher. However, the differences among originators widened with the 2006 vintage. As a result, Moody's increased the distinction it makes in loss estimates by as much as 20 percent higher than previously assumed.
When Moody's loss estimate for a pool increases, the loss coverage for any given rated tranche generally also increases. Where that loss coverage comes in the form of overcollateralization, the portion of the pool represented by rated tranches will decrease. Teicher gave as an example a pool of $100 million loans where securities were issued against only $95 million of loans. The additional loans represent "overcollateralization," he says. "It's not exactly a cash reserve, but a cushion against losses on the rated securities in the form of extra loans."
Mark Zandi, chief economist at West Chester, Pennsylvania-based Moody's Economy.com-whose views are independent of Moody's rating activities-says he expects average home prices to fall 10 percent, peak to trough, in the current housing recession, which began in late 2005. "The decline in credit quality that is occurring today is the worst the U.S. economy has seen since the mid-1990s in Texas, Louisiana and Oklahoma," he says.
The potential damage from deteriorating credit has been exacerbated because the subprime market had become so much larger, reaching 40 percent of all originations in 2006, according to Zandi. He predicts that 1.2 million first-mortgage loans will default in 2007 and another 1.3 million in 2008. This compares with about 900,000 in 2006 and 800,000 in 2005. While Federal Reserve Chairman Ben Bernanke had predicted in testimony in July that the higher defaults in the mortgage industry could lead to $50 billion to $100 billion in credit losses, Zandi predicts investors will lose $100 billion to $125 billion on their investments during 2007 and 2008.
Zandi is more pessimistic than the Fed because his analysis assumes a bigger decline in home prices, he explains. The decline in the housing sector will shave one-quarter of é percent off gross national product (GNP), Zandi predicts. "The economy will bend, but it will not break," he predicted in late July. Zandi, however, raises the potential that there could be a financial shock from the contagion effect of losses in the mortgage sector. "The risks are still low, but they are rising and they are rising measurably," he said in late July.
The hope for containment
During a brief interlude in mid-July, the financial markets in the United States rebounded as investors seemed to believe that the damage was being contained. Yet, despite the comforting notion of containment, as July moved toward a close, the contagion spread to more and more firms, and worries migrated from subprime to include prime second liens, alternative-A and even jumbo prime.
On July 24, for example, Countrywide Financial Corporation, Calabasas, California, reported unexpected losses in its prime home-equity business during the second quarter due to rising delinquencies in prime home-equity loans. Delinquencies rose from 1.77 percent in the second quarter of 2006 to 4.56 percent in the second quarter of 2007, the company stated. Countrywide took a $388 million charge in the second quarter on the impairment of residual securities collateralized by prime home-equity loans.
Angelo Mozilo, chairman and chief executive officer of Countrywide, attributed the rising delinquencies and foreclosures in part to "softening home prices" during a phone conference with investors. With many borrowers having little or no equity, "the borrower says 'I'll just walk away,'" he said.
Mozilo was downbeat about the timing for a recovery in the housing market, which he said would have to precede any recovery in the mortgage market. Mozilo told investors a recovery in the housing market will first require a clearing of the oversupply of homes, which will not happen until prices fall further. Once supply and demand for housing come back into balance, then home-price appreciation can resume, and with that, borrowers will change their psychology about walking away from their mortgages, he explained.
"My experience is that it just takes a long time to turn a battleship around," Mozilo said in the conference call to investors. "This is a huge battleship, and it is turning in the wrong direction. It's going to take 2007 to get this thing slowing down; 2008 to get it to stop; and 2009 to head in the other direction."
A big challenge will be the economy, according to Mozilo. "I do think that this ultimately has to have an effect on the economy. I just can't believe the economy is totally insulated from housing," he said.
American Home Mortgage Investment Corporation, Melville, New York, became the first major non-subprime mortgage company to fall victim to the contagion from the subprime mortgage meltdown, after warning at the end of June it would likely report a loss for the second quarter. American Home Mortgage's borrowers generally are considered prime or near-prime, and the company originated $59 billion in mortgages in 2006 and $3475 billion in the first half of 2007, making it the loth-largest originator in the first six months of the year, according to Inside Mortgage Finance.
On July 27, the company announced it was suspending payment of its dividend to fund current operations. Trading in its shares was suspended July 30 as the company was swamped by margin calls on $4 billion in warehouse lines of credit from lenders. The next day, the company said it had already paid "very significant" margin calls in the prior three weeks, had "substantial" unpaid margin calls pending and had hired advisers to help in evaluating its options-including selling off its assets. Shares in the company fell 86 percent.
Without access to additional funds from its warehouse lines, American Home said it had failed to provide $300 million in mortgages to homebuyers scheduled to close on July 30 and did not expect to finance $450 million due July 31. On Aug. 3, American Home laid off all but 750 of its 7,047 workers. On Aug. 5, the company filed for bankruptcy.
Australian fallout
The subprime contagion soon showed its ability to leap continents as far away as Australia and hit several leveraged funds, including those with no ties to U.S. mortgages. Sydney, Australia-based Basis Capital Group, which was not invested in mortgage securities, announced in July it was defaulting on margin calls, and suspended redemptions on two hedge funds, valued at A$056 million. It appointed New York-based Blackstone Group LP as a financial adviser to avoid a fire sale of its assets, and told investors they could receive less than 50 cents on the dollar for their investments. At least four banks reported potential exposure to the funds: the Commonwealth Bank of Australia Ltd., Sydney; Westpac Banking Corporation, Sydney; Macquarie Bank Ltd., Sydney; and St. George Bank Ltd., Kogarah, New South Wales.
On July 25, another Australian hedge-fund company, Absolute Capital Group Ltd., Sydney, suspended withdrawals until October on two of its hedge funds valued at A$377 million. It had appointed Blackstone Group as a financial adviser to avoid a fire sale of its investors assets. The two funds invested in CDOs, and had less than 5 percent of assets invested in U.S. subprime securities. Unlike Basis Capital, Absolute did not have margin calls in place.
On Aug. 1, more shoes dropped in Australia as Macquarie Bank warned that two of its leveraged debt funds faced losses of up to 25 percent. The two Fortress funds invest in securitized loans and have no direct exposure to U.S. subprime mortgages. Trouble at the two hedge funds sent share prices falling at Commonwealth Bank of Australia Ltd.and Westpac Banking Corporation, whose investment management arms are invested in the hedge funds.
Macquarie saw its share price plummet the same day it warned that investors could lose up to 25 percent in two debt funds. The two Fortress funds, which are invested in securitized loans and had no exposure to American subprime mortgages, were valued at A$300 million.
'Shooting in the dark'
As contagion spread around the globe, nervous lenders monitored loans to leveraged funds, and investors clamored for more information on the value of their investments. It became clearer that no one knew the full extent of the potential problems within various funds and financial institutions that might be associated with subprime mortgages, mortgage-backed securities, collaterized debt obligations and other debt instruments.
Investors and market observers began to worry about the ability of some companies to obtain financing to convert from public to private equity, financed by debt issues, sometimes with high leverage. "We are to some degree shooting in the dark here," says Charles Dumas, chief economist for Lombard Street Research Ltd., London. "We haven't got real information. One of the reasons is, of course, people don't mark to market and people aren't on top of this in terms of how to handle it." Investments in CDOs and hedge funds, for example, are typically marked to model-not market, he explains.
Lombard Street had been predicting a global meltdown generated by defaults on subprime loans in the United States for more than a year as a delayed response to the end of house-price appreciation, which peaked in September 2005, Dumas says. The problem was compounded, he says, because "for much of the last year the mortgage industry, in ever-increasing desperation, pushed out less and less sound mortgages in order to keep business up. There's a deterioration of quality of actual business being done. That created the subprime crisis."
Dumas adds, "There comes a moment when the stone is lifted up and everyone rushes for their little holes in the ground. Then you ask yourself, 'What in that context is the value of all this paper?' Unfortunately, the paper has proliferated in such an extraordinary way on the back of all these various forms of asset-backed securities and collateralized stuff; we don't have the first idea of who owns this stuff, really, at this point. With whom rests the ultimate liability? No one's prepared to admit they own it, because at the moment, the value in the game is trying to muddle it out." Dumas believes markets work best in the long run if everyone marks to market. "Then you get adjustments rather more quickly, and you don't get so much unsound behavior in the first place," he says.
Dumas finds it ironic that the world markets were roiled by a liquidity crisis when, in fact, there is "a grotesque excess of liquidity, which to some extent is why this market has been created-because it is a means of parking excess appetite for investments out of range of scrutiny, really," he says.
Tracking the decline of mortgage and related assets
As defaults rose above expected losses and the subprime meltdown demonstrated it could be a contagion for other financial flare-ups, one previously obscure market indicator became the focus for measuring investor sentiment on subprime loans. That indicator is the ABX Index, which is a series of creditdefault swaps based on 20 bonds backed by subprime mortgages (see sidebar, "Snapshots of RMBS Summer 2007 Decline and Partial Rebound"). The ABX Index is published daily by Markit Group Ltd., London.
The ABX has been a window into investor sentiment about the unknown level of risk that lurks from higher defaults in bonds backed by subprime mortgages across all credit tranches. Currently there are four broad ABX indexes representing bonds from 80 different credit-market dealers, according to a June report by Felix Salmon in Condé Nast Inc.'s Portfolio.com. There are separate indexes for bonds from four different quarters: the first and second quarters of 2006 and the first and second quarters of 2007.
On July 2-after the Bear Stearns hedge fund blow-up and before the massive credit downgrades-the ABX-HE (ABX-home equity) Index for AAA-rated RMBS from the first quarter of 2007 stood at 99.48, meaning that investors thought such bonds were worth close to full value, reflecting great confidence in the highest-rated tranches of subprime RMBS deals. Similarly, AA tranches stood at 98.74 while single-A was somewhat weaker at 82.12. The lowest tranches, however, had already suffered enormous declines. The BBB tranches stood at 60.77 while BBB-minus stood at 54.06.
By July 16, the AAA tranches of first-quarter 2007 ABX-HE had fallen to 95.53, while the AA index was at 88.17 and the A at 69.35 percent, representing the fact that the credit-rating agencies' downgrades had been extended to some AA and A classes. The ABX for the BBB class for the first quarter of 2007 had fallen to 47.72 (from 60.77 on July 2) while BBB-minus fell to 45.28 (from 54.06). Thus, by mid-July all classes of RMBS for the first quarter of 2007 had declined appreciably, with only AAA-rated classes holding their own.
Similar changes in investor sentiment could be seen in the spreads of floating-rate mortgage bonds over one-month London interbank offered rate (LIBOR), a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market. In mid-June, one-year AAA-rated floating RMBS were 6 points over LIBOR, while AA stood at 29, single-A at 50, BBB at 200 and BBB-minus at 400, according to the FBR Investment Management's Subprime Weekly Comp Sheet for June 15.
A month later on July 14, spreads on the one-year AAA held up at 10 basis points. AA spreads were slightly higher at 37, while single-A spreads rose sharply to 110 (from 50). Spreads ballooned for BBB to 425 and BBB-minus at 700.
Default forecasts raised
With new default data for April and May confirming deteriorating credit performance, FBR Investment Management raised its forecasts for defaults on all types of mortgages somewhat in July and then raised them again slightly August.
Subprime defaults, which stood at 12.40 percent in May 2007, are expected to rise to 14.54 percent by May 2008, according to FBR. Alt-A defaults, which stood at 2.69 percent in May 2007, will rise to 3.92 percent by May 2008.
Prime loans, however, should hold closer to historical averages, rising from 0.37 percent in May 2007 to 0.53 percent in May 2008, FBR projects. "This outlook is based on the assumption the Fed does not tighten credit and the economy continues to expand at its current pace," FBR Investment Management's Youngblood says. "We do not expect Depression-era levels of defaults," he adds. "We do expect, however, the worst losses of the decade."
A summer of scary earnings calls
Investor sentiment on all mortgages began to fall sharply after July 24, when the nation's largest mortgage lender, Country-wide Financial Corporation, reported a 33 percent drop in second-quarter earnings due to losses on prime home-equity loans. The company took an impairment charge of $417 million for its investments in credit-sensitive retained interest, including $388 million in impairment on residual securities collateralized by prime home-equity loans.
"The impairment on these residuals [was] attributable to accelerated increases in delinquency levels and increase in the estimates for future defaults and the loss severities on the underlying loans," according to a company statement. The company also set aside $293 million for held-for-investment loans, including a loan-loss provision of $181 million on prime home-equity loans in the banking segment of the company. Shares in Countrywide fell 10 percent.
In a telephone conference call, Angelo Mozilo told investors that Countrywide has "excess capital in the near term-the next quarter or so" that it intends to put to use by investing in the balance sheet until market conditions normalize. John McMurry, Countrywide's chief risk officer, reported that Countrywide had been actively modifying loans for resetting mortgages where appropriate, in order to keep homeowners in their homes and thereby reduce the potential level of defaults.
As July came to a close, more and more lenders announced sharp declines in earnings and cutbacks in mortgage product offerings. Countrywide said it would no longer offer 2/28 and 3/27 subprime mortgages-the type of mortgage that has been posing such a challenge currently as those loans reset in a weak housing market.
GMAC Financial Services, Detroit, reported that its Minneapolis-based Residential Capital LLC (ResCap) subsidiary had been sharply reducing both originations and holdings of subprime mortgages since the end of the first quarter, when it reported a $910 million loss. In the second quarter, ResCap pared its losses to $254 million, and GMAC injected $500 million in new capital. ResCap reduced subprime originations from $3.3 billion in the first quarter to $700 million in the second quarter. The company also reduced its subprime portfolio of $5.4 billion at year-end 2006 to $1.9 billion at the end of the second quarter. GMAC reported that ResCap had reduced its exposure to the subprime market through asset sales in its held-for-sale portfolio and a steady asset run-off in its held-for-investment portfolio, plus loan restructuring and sales in its warehouse lending receivables.
Private-label MBS market freezes
By the end of July, mortgage lenders were finding it increasingly difficult to sell into the private-label secondary market other mortgage products beyond subprime, such as alt-A and even jumbo prime. In fact, the private-label secondary market was freezing up as bids on assets came in "significantly lower" on securities for new deals, making them unattractive to mortgage lenders, according to an industry observer.
On Aug. 2, Mike Perry, Pasadena, California-based Indymac Bank's chairman and chief executive officer, gave a window into the dilemmas facing companies that rely on the private-label secondary market for a significant share of their originations. Perry followed up the company's earnings announcement (a 50 percent decline in income) with e-mail commentary to explain to investors how Indymac planned to cope with the difficulties it faced.
"Unfortunately, the private secondary markets (excluding the GSEs and Ginne Mae) continue to remain very panicked and illiquid," he wrote in the e-mail, which was published on the company blog at www.theimbreport.com.
"By way of example, it is currently difficult, at present, to trade even the AAA bond on any private MBS transaction," Perry wrote. He indicated that the disruptions apparent in the secondary market appeared likely to last longer than those in the past, which had gone on for only a few weeks. Perry warned that Indymac would not to be able to continue funding $80 billion to $100 billion of loans a year with a $33 billion balance sheet, "unless we know we can sell a significant portion of these loans into the secondary market . . . and right now, other than the GSEs and Ginnie Mae, . . . the private secondary market is not functioning."
In response to the collapsing private-label secondary market, Perry wrote that Indymac "will continue to widen its pricing and tighten product and underwriting guidelines to ensure that a much greater percentage of production qualifies for sale to the GSEs or through GNMA security." He told investors that Indymac had sold 40 percent of its second-quarter originations to the GSEs, up from 30 percent in the first quarter and 19 percent in 2006. Perry further wrote that it was Indymac's goal to increase the portion of loans sold to the GSEs "up to at least 60 percent, ASAP [as soon as possible]." In a postscript, he wrote: "We will still originate product that cannot be sold to the GSEs . . . just less of it; and we will have to assume we retain it in portfolio [until the AAA private MBS market recovers]."
Perry reported in his e-mail that he had been in contact with Fannie Mae and Freddie Mac about market conditions, and that he had also received a call from Sen. Chris Dodd (D-Connecticut), chairman of the Senate Committee on Banking, Housing and Urban Affairs.
Shock wave No. 4
The sinking RMBS market for new issues in the United States was accompanied by growing concern by investors around the globe that they may be invested in a fund that held U.S. securities tied to subprime mortgages somewhere in the world. On Aug. 8, those fears sparked a new wave of selling in world bond and stock markets, when French bank BNP Paribas, Paris, announced it was suspending redemptions in some of its funds with ties to U.S. subprime mortgages, after having publicly stated it did not have problems in its holdings the week before.
A week earlier, 1KB Deutsche Industriebank AG, Dusseldorf, Germany, said it would be hurt by losses on U.S. subprime loans. On Aug. 8, WestLB Mellon Asset Management, also based in Dusseldorf, suspended redemptions in its fund, which was heavily invested in mortgage securities. The fund blow-ups at two of the biggest banks in Dusseldorf were enough to be an embarrassment for the city's mayor, Joachim Erwin, who has been trying to lure overseas banks to the city. "I'm appalled by both banks," he told the International Herald Tribune. "WestLB was acting like a gambler, and 1KB is a boring old bank that has no business investing in subprime. It's bizarre."
A torrent of de-leveraging
The panic selling around the globe that began Aug. 9 in response to the blow-up at BNP Paribas was rumored to come from hedge funds and other leveraged funds. For hedge funds, the risks of higher leverage were made painfully clear by the growing number of fund freezes, rescues and meltdowns.
Higher leverage meant greater profitability in good times. However, the flip side of the coin is that higher leverage leads to greater losses when markets turn. If the leverage is very high, losses can exceed the capital in the fund, wiping out investors and threatening creditors and corporate affiliates.
As hedge funds moved to de-leverage, many sought to do so in a steady way so as not to send asset values plummeting. But as fear rose and a drumbeat of negative news hit the markets on a daily basis, hedge funds stepped up the pace of selling, dumping any assets they held that they felt they could dispose of to raise cash and reduce leverage-including U.S. agency RMBS and highly rated shares of companies that were performing well in the current economy.
The irrationality of the sell-off could be seen in some of the anomalies, such as the fact that the spreads of Ginnie Maes over Treasuries at one point were higher than the spread for corporate AAA bonds, in spite of the government guarantee behind Ginnie Mae securities.
On Aug. 9, shares plunged first in Europe and then in the United States-where the Dow Jones Industrial Average fell 385 points on the news from Europe, but also from more bad news from two major mortgage companies in the United States. Countrywide warned in its 10-Q filing: "We have significant financing needs that we meet through the capital markets, including the debt and secondary mortgage markets. These markets are currently experiencing unprecedented disruptions, which could have an adverse impact on thef company's earnings and financial condition, particularly in the short term."
Seattle-based Washington Mutual Inc. ( WaMu), the nation's largest savings-and-loan association, gave a similar warning. WaMu's 10-Q stated: "While these market conditions persist, the company's ability to raise liquidity through the sale of mortgage loans in the secondary market will be adversely affected."
The European Central Bank (ECB), Frankfurt, Germany, moved quickly to settle the markets there, injecting $131 billion (nearly 95 billion euros)-the most the bank has ever provided in a single day's injections, according to MarketWatch Inc.'s London bureau. ECB also said it was prepared to meet all the requests for funds from banks.
"The ECB move shows that interbank financing is drying up. The banks don't trust each other anymore," commented Heino Ruland, a strategist at Stebing AG, Frankfurt, Germany, as reported in MarketWatch. On the same day, Aug. 9, the Federal Reserve Bank injected $12 billion in one-day repurchase agreements, and then followed up the next day, Friday, with three injections-all three-day repos over the weekend: $19 billion before the markets opened, $16 billion in the morning and $3 billion in the early afternoon, for a total of $38 billion, made up largely of mortgage-backed securities.
Mortgage lending capacity severely squeezed
The bad news pouring out of mortgage companies on Aug. 9 brought the private-label RMBS market to a complete halt. "Essentially no trades are taking place" in the private-label market since noon of Aug. 9, said Douglas Duncan, MBA's chief economist, a week later. There two things that were functioning: the agency part of the market-Fannie Mae, Freddie Mac and Ginnie Mae-and lending by companies that can hold the loans in their own portfolio, Duncan said.
There are two limitations, however, to the ability of portfolio lenders to lend, he added. "One of them is that they have to hold capital for it, so they don't have infinite amounts of capital-so they do have some concern about exhausting their flexibility," he said. "The second one is that if they take a loan and hold it in the portfolio in the held-for-sale category, and if a trade takes place in the market that's below that value, then they have to mark to market and take a hit to earnings."
Because of the increased costs associated with asset mark-downs, the mortgage lenders "have raised rates significantly in the nonconforming part of the marketplace," Duncan said. "They would love to make the loans, but as long as all the non-agency securitization market remains frozen, that's what they will have to do to protect balance-sheet capacity and earnings."
Not surprisingly, the spreads among conforming loans and jumbos, alt-As and subprime loans widened considerably after late July. Even as rates were falling for conventional, conforming loans, rates went up for jumbo prime.
On Aug. 20, for example, North Palm Beach, Florida-based Bankrate.com reported the average rate for a 30-year, fixed-rate mortgage (FRM) at 6.24 percent, while the rate for a 30-year, fixed jumbo mortgage was 7.08 percent-a spread of 84 basis points. The spread had been closer to 40 basis points at the end of July, and even lower in June.
Rates also varied widely among lenders, with rates exceeding 9 percent for some jumbos and higher than 10 percent for subprime. Mortgage brokers were scrambling to provide mortgages, especially to the jumbo prime market-sometimes combining a conforming mortgage for $417,000 and either a home-equity line of credit (HELOC) or fixed 3o-year second for the remaining balance up to the full loan amount, according to a mortgage broker in Pompano Beach, Florida.
In response to global market declines spawned by the troubles at BNP Paribas and among U.S. mortgage companies, the subprime ABX indexes, already low, sank further. On Aug. 10, the ABX index for AAA tranches of subprime mortgages originated in the first quarter of 2007 stood at 89.78 percent, AA at 69.56 and single-A 48.25. The BBB tranches stood at 37.58, with BBB-minus slightly lower at 36.69.
Turmoil intensifies
During the week of Aug. 13, markets were hit daily in response to a steady diet of bad news. Despite the injection of funds in the markets on Monday by the European Central Bank and the Federal Reserve Bank, values sank and spreads widened on most debt instruments, as a flight to quality lifted U.S. Treasuries. Troubles emerged in the commercial paper market, especially asset-backed commercial paper, and there were even worries about a few money market funds. New York-based Goldman Sachs & Co.announced an injection of $3 billion into the Global Equity Opportunities Fund (GEO), a quantitative hedge fund that had lost 30 percent of its value in the previous week. On Tuesday, Aug. 14, the president of the ECB, Jean-Claude Trichet, said the recent financial turmoil was largely over-which proved to be unfortunate timing, as the U.S. markets fell sharply later that day on more worries about mortgages.
Also on Tuesday, Aug. 14, Thornburg Mortgage Inc., a Santa Fe, New Mexico-based real estate investment trust (REIT) that invests in prime jumbo mortgages, announced it was postponing its dividend after worries about its liquidity led to a 47 percent drop in its share price.
On Thursday, Aug. 16, the Federal Reserve injected $17 billion into the markets and issued a statement that it stood ready to inject funds as needed. Yet, the Dow Jones Average sank 300 points on news that Countrywide announced it had drawn down its entire $11.5 billion bank credit line as the global credit squeeze hit the commercial paper market and limited Countrywide's access to short-term cash. Investors breathed a sigh of relief, however, as the market surged back to close near where it had opened.
The roller-coaster markets in the first two weeks of August were enough to confound pundits and observers, but perhaps no one captured it better than Lyle Gramley, former Fed governor and senior economic adviser at the Stanford Group, Washington, D.C. Gramley blasted the irrationality of mortgage bond investors in an interview on CNBC on Aug. 17. "A year ago they were buying garbage, and buying it avidly," he said. "Mortgage products that are being churned out by the mortgage market today are of much better quality. And investors don't want to have any part of them, because they are scared," he added.
"Now, if we can get the panic situation turned around, and if investors will begin to think more rationally about their decisions, we'll come through this," Gramley said.
A surprise discount rate cut
As the trading day began on Friday, Aug. 17, Asian stocks began to plummet as investors sold shares to unwind their yen carry trades. At trading day's end, the Nikkei was down a sharp 5.4 percent. Worried investors in the United States who rose early Friday and tuned in to their favorite radio or television financial news were pleasantly surprised to hear that the Federal Reserve had unexpectedly announced a 50-basis-point cut in its discount rate, from 6.25 percent to 5.75 percent. The higher rate had acted as a penalty and kept potential borrowers who needed to shore up liquidity away from the window.
The Federal Reserve also said it would continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets. Further, the Fed would allow loans up to 30 days to be renewable at the discretion of the borrower. This decision, in effect, allows mortgage lenders that are also depository institutions-such as Countrywide, Washington Mutual and Indymac-to borrow for short-term liquidity.
There was more good news in a separate statement from the Fed, which reported that as a result of financial market turmoil, tighter credit and uncertainty, the Federal Open Market Committee (FOMC) "judges the downside risks to growth to have increased appreciably." In a separate statement, the Fed sought to further reassure the markets: "The committee is monitoring the situation, and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in the financial markets." This statement led many market observers to increase their expectations of one or more Federal Funds Rate cuts during the remainder of 2007.
The U.S. stock markets gave a resounding seal of approval to the Fed's move and its statements, with the Dow Jones rising 225 points. It was the first real break in the ongoing deterioration of the markets, and gave hope that moves could begin to take place to bring about a recovery in the debt markets-especially the private-label RMBS markets.
While most observers expected the markets to continue to be unsettled in the coming weeks and perhaps months, the situation seemed poised for a recovery. "We moved from a situation where source of funding was opaque. Now the banking system has to replace that, and that requires more discipline and credit standards. It's a process that has started and has to go on, and that's a good thing," said David Kotok, president and chief investment officer of Cumberland Advisors Inc., Vineland, New Jersey, in an Aug. 20 interview on CNBC.
The way forward
As the markets' deterioration accelerated in late July, Washington policy-makers sought ways to help the mortgage markets recover. Fannie Mae and Freddie Mac asked their regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), for permission to raise the caps on the total amount of portfolio lending they could do, and even sought to raise the loan limit above $417,000. OFHEO, however, said on Aug. 10 that it would not raise the caps-and it also declined to raise the loan limit.
OFHEO Director James B. Lockhart set caps on Fannie Mac's portfolio at $727 billion and caps on Freddie Mac at $724 billion last year, arguing the risk of allowing the GSEs to take on more debt was too great. "Their safety and soundness is of paramount importance," Lockhart said, although he also said he would reconsider the decision later. Before reaching their caps, Fannie Mae and Freddie Mac were able to buy private-label RMBS and, thus, help provide a market for them.
The recovery, then, will rest on the resurrection of the private-label RMBS market. MBA's Duncan believes investors will have to regain confidence in the ability of the credit-rating agencies to rate bonds.
"There has been a complete flight of investors from the market, with the exception of the agencies, Freddie, Fannie and Ginnie," Duncan says. "They've lost confidence in the rating agencies and their ability to accurately assess the collateral," he adds.
"There is a fundamental question in the mind of investors about the value of mortgage-backed securities: How can they be certain about the value? Because they are uncertain, they've simply left the market." Duncan believes investor confidence in the private-label RMBS market can begin its recovery when a few large investors move in and snap up some of the bargains in the RMBS market.
The adoption of new rating methodologies at the credit agencies for both subprime and alt-A, once in place, is "the essential catalyst for the recovery of the primary and secondary non-agency mortgage markets," says FBR Investment Management's Youngblood. Even after the revised methodology is issued by the rating agencies, it may take until January 2008 for mortgage underwriters to fully implement it in their underwriting and originations process and for all mortgage originators, including brokers, to become sufficiently familiar with it in order to offer it to consumers.
The heightened levels of fear in the financial market were further reduced Aug. 31 when President Bush indicated he would like the FHA to provide relief to potentially 80,000 subprime borrowers.
Members of Congress are likely to seek to expand that level of relief. The same day, Aug. 31, Fed Chairman Bernanke, speaking at a Fed conference in Jackson Hole, Wyoming, said the Fed would be prepared to act if the turmoil in the financial markets were to hurt the economy. Members of Congress have also supported efforts to grant additional authority to Fannie Mae and Freddie Mac to fund mortgages above their investment caps and above the conventional conforming loan limit of $417,000 to compensate for the collapse of the private-label RMBS market.
The Fed surprised financial markets Sept. 18 with both a 50-basis-point reduction in the Federal Funds Rate, lowering it to 4.75 percent, and a 5o-basis-point reduction in the discount rate, lowered to 5.25 percent. The Dow Jones Industrials Average roared its approval with a 330-point gain, the biggest one-day boost since Oct. 15, 2002, when the Dow rose 387 points. Also, by the second week of September, new deals for the best of credit quality, mostly jumbo prime, were successfully securitized "on a very limited basis," indicating that "things had stopped getting worse," says the Stanford Group's Gramley.
While market turmoil subsided, the toll on the mortgage industry continues to mount. On Sept. 7, Countrywide announced plans to cut as many as 12,000 jobs and said it expected originations to be 25 percent lower in 2008. On Sept. 10, Washington Mutual said it would set aside $500 million more than it previously forecast for loan losses in 2007, in what Washington Mutual Chairman and Chief Executive Officer Kerry Killinger called "a new perfect storm" in the housing market.
Subprime, once an obscure term, has become a household word synonymous with global financial meltdown. Meanwhile, the markets around the world continue to remain vulnerable to adverse news involving financial institutions and funds with any ties to U.S. subprime mortgages, and the mortgage industry struggles to fill the void caused by secondary market turmoil.
"Now, if we can get the panic situation turned around, and if investors will begin to think more rationally about their decisions, we'll come through this," Gramley said.
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Timeline
June 7, 2007: In a letter to investors, New York–based BearStearns & Co. Inc. restated May losses on its Enhanced Leverage Fund,from 6.5 percent to 18.97 percent. The hedge fund had invested in subprimemortgage bonds.
June 20, 2007: New York–based Merrill Lynch & Co. Inc. sells$850 million of collateral held against a credit line to Bear Stearns’Enhanced Leveraged Fund.
June 22, 2007: Bear Stearns announces a $3.2 billion bail-out of itsEnhanced Leverage Fund—the biggest Wall Street bail-out since therescue of Long Term Capital Management (LTCM) in 1998.
July 10, 2007: New York–based Standard & Poor’s (S&P) puts 612classes of subprime residential mortgage-backed securities (RMBS) onwatch, while New York–based Moody’s Investors Service downgrades399 subprime RMBS and puts an additional 32 on watch.
July 17, 2007: Bear Stearns tells investors in a letter that theEnhanced Leveraged Fund is worthless and that another hedge fund,the High-Grade Fund, was worth only 9 cents on the dollar.
July 24, 2007: Calabasas, California–based Countrywide FinancialCorporation announces a $388 million charge to second-quarter earningsfrom losses on residual securities collateralized by prime homeequityloans. The company also set aside a loan-loss provision of $181million on prime home-equity loans held for investment in the bankingsegment of the company.
July 31, 2007: Bear Stearns’ Enhanced Leveraged Fund and High-Grade Fund file for bankruptcy.
Aug. 9, 2007: BNP Paribas, Paris, freezes $2.2 billion in three fundsthat have investments in U.S. subprime mortgage bond assets.
Aug. 9, 2007: Countrywide and Seattle-based Washington MutualInc. warn in 10-Q filings of an adverse impact on their business operationsof ongoing disruptions in financial markets.
Aug. 9, 2007: The European Central Bank (ECB), Frankfurt, Germany,injects $131 billion to provide liquidity to banks.
Aug. 10, 2007: The Federal Reserve injects $38 billion in repurchaseagreements to provide additional liquidity to banks, accepting mortgage-backed securities as collateral.
Aug. 16, 2007: Countrywide announces it has exhausted its entire$11.5 billion bank credit line, as some investors flee the commercialpaper market.
Aug. 17, 2007: The Federal Reserve Board announces a surprise 50-basis-point cut in the discount rate, from 6.25 percent to 5.75 percent,ahead of the opening of the financial markets. Separately, the Fedannounces the Federal Open Market Committee (FOMC) “is preparedto act as needed to mitigate the adverse effects on the economy arisingfrom the disruptions in the financial markets.”
Aug. 24, 2007: Charlotte, North Carolina–based Bank of Americainvests $2 billion in Countrywide preferred stock, strengthening thecompany’s balance sheet.
Aug. 31, 2007: President Bush, recognizing the seriousness of thesubprime meltdown, proposes a new program called FHA Secure, whichwill allow the Federal Housing Administration (FHA) to refinance loansof some distressed borrowers who hold adjustable-rate mortgages(ARMs) that are resetting to higher monthly payments, where the borrowerwas not delinquent before the loan reset.
Sept. 18, 2007: In a surprise move, the Federal Reserve lowers theFederal Funds Rate 50 basis points to 4.75 percent and lowers the discountrate 50 basis points to 5.25 percent. The Dow Jones Industrials have the largest single-day gain since Oct. 15, 2002.
© 2007 Mortgage Banking. All Rights Reserved. Reprinted With Permission.
