PHOENIX - While subprime lenders try to recoup losses from declining mortgage origination volume, corporate belt tightening and industry consolidation could impact loan performance, according to attendees at last week's ABS West 2006 conference here.
The subprime lending industry - fueled by years of low interest rates and an accelerated pace of home price appreciation - has an infrastructure that most say is unsustainable during an environment that includes a rising federal funds borrowing rate, slowing home price appreciation and increased regulatory scrutiny. Investors need to keep an eye on underwriting, due diligence and servicing quality, conference speakers said.
"Most [lenders] you will talk to will be beginning to whack their bottom line," said Charles Freeman, chief credit officer at HomeBanc Corp.
Freeman said staff cutbacks could result in an increased burden regarding such tasks as information verification - such as borrower income and employment - with fewer employees. As mortgage brokers strive to maintain their own books of business, the temptation to push unqualified borrowers into an application could lead to a rise in mortgage fraud, he said. The prevalence of fraud increases when mortgage volume begins to fall, according to such research firms as the Mortgage Asset Research Institute Inc.
Originators may relax underwriting guidelines, usher in new affordability products or lower interest rates to maintain origination volume.
Originating loans at or below cost before selling them at a discount in the secondary market is not a viable business model, attendees said. Quincy Tang, a senior vice president at Canadian rating agency Dominion Bond Rating Service, said regardless of a drop in volume, originators that maintain strong mortgage underwriting guidelines will come out of the downside of the mortgage boom cycle "in tact."
For existing loans, the ability of mortgage originators to continue providing quality in-house or independent loan servicing is crucial toward performance, panelists said, especially during a time when a vast number of subprime mortgage borrowers will face higher payments after low initial payment terms have expired. Freeman is surprised more potential home equity ABS investors don't ask about how much loan volume a servicer is able to handle at a given time.
"That is where you are going to get hit in any economic shock - on the capacity and capacity planning side," he said.
Cutbacks at the mortgage servicing level could mean there are too few people to handle an influx of mortgage servicing needs should a downturn in subprime loan performance occur.
"You're going to have major headaches if a very, very large servicer has problems," said Jeffrey Nabi, a managing director at Ambac Financial Group Inc.
How much of a burden subprime loan servicers could have is unclear. Modeling the chance that subprime loans originated over the last several years will follow default and delinquency patterns of past years is not an accurate formula because of the changing face of loan products in the sector and a different economic environment than in previous post-housing boom periods, panelists said. The newest breed of affordability products in the subprime space, such as interest-only loans and 40-year loans, haven't been around long enough to derive any telling performance data, according to Tang. However, she said it was, "pretty safe to assume that 2005 and 2006 vintages will have higher default and delinquency rates."
Tang added that some subprime deals could see base cumulative losses of 5% to 6%. Mortgage borrowers last year and this year are thought to have a higher chance of defaulting on their loans because they are not likely to be cushioned by high home price appreciation levels, and the chance that they were pushed into loans they did not qualify for is greater.
Some criticized new mortgage products as an attempt by issuers to solely gain market share in the highly competitive space. Ownit Mortgage Solutions recently rolled out a 45-year mortgage - the longest amortizing loan after the 40-year amortizing product, thought to be a pseudo-replacement for the interest-only mortgage product in the subprime arena.
"Why are products changing the way they're changing, and why are borrowers being put into these loans?" Nabi asked. "They are in a 40-year loan because they could not get into a 30-year."
Former Fitch Ratings analyst Scott Seewald, now a senior vice president at AMC Mortgage Services (the formal name of Ameriquest Capital Corp.), said in general he's not worried about the array of new mortgage products available for subprime borrowers. Seewald said that IO loans, for example, perform better than non-IO loans because the loans require a higher quality borrower. In Ameriquest's loan portfolio, IO loan borrowers have higher credit scores, lower loan-to-value ratios and debt-to-income ratios compared with other loans. They also have a longer window available for home price appreciation to occur, he said. An unknown factor is what happens when current subprime IO borrowers need to refinance their loans when the interest-only period ends. If those borrowers could no longer qualify because of increased regulatory scrutiny, among myriad other reasons, "underperformance could be caused under that scenario," he said.
Seewald added that the extent lenders are discounting initial interest rates on loans will result in a higher shock to borrowers when they receive their first monthly mortgage bill under the new interest rate. He said within Ameriquest's loan portfolio, the average borrower will receive a payment increase of $170 when initially low interest rates change.
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