A number of market players are counting on newly issued subprime mortgages to perform better than those originated six months or even three months ago, as marginal issuers are weeded out along with the type of borrowers that they sought.
Some securities buyers say that mortgages purchased from the strongest lenders are bound to perform, as underwriting standards have become more stringent.
To this end, five-year floating home equity spreads tightened last week, with triple-B and triple-B- minus spreads each contracted by 100 basis points, at 400 and 700 basis points over one-month Libor, respectively, as of Tuesday, according to Credit Suisse.
But some say not so fast
But despite tighter spreads in new-issue HEL collateral, quality may not be improving, said Chris Flanagan, head of global structured finance research at JPMorgan Securities. He made these remarks at the bank's annual securities product group research conference held in New York on May 3.
For example, JPMorgan compared a handful of securitizations from Countrywide Home Loans, Wells Fargo and Accredited Home Lenders completed in the second half of 2006 with whole loan pools sold by the same issuers this year. Analysts found that the weighted average FICO actually declined, along with the percentage of borrowers who qualified for a mortgage using full documentation.
The percentage of full documentation mortgages across the 2007 whole loan pools sampled by JPMorgan fell to 60%, compared with 73% in the 2H06 securitizations. Meanwhile, the weighted average FICO score dropped to 613 from 623.
Home prices have yet to hit rock bottom in the current housing cycle. Therefore, borrowers who think the market has nowhere to go but up are likely to be sorely disappointed when their home equity decreases, according to Flanagan. "There really should be no natural buyer at this point," Flanagan said. "It is still people buying into an inflated market, so someone is still going to have to stretch in today's market."
Flanagan estimates the U.S. housing market will endure three to four more years of negative home price appreciation. Defaults within the HEL market are likely to increase in 2H07, as the "credit crunch" occurring in the subprime mortgage market intensifies, he said.
Mezz CDOs more lucrative than ever
Yet CDO managers, and Flanagan, point out that mezzanine ABS CDO equity returns are currently at all-time highs - making constructing such deals lucrative right now. "The animal spirits will certainly be alive and well in the CDO market," Flanagan said, although he pointed out that, judging by its ability to reel HEL spreads back in, the CDO bid does not seem as strong as it once was.
JPMorgan projects that mezz SF CDO equity would yield 4,611, 4,085 and 3,285 basis points over Libor, respectively, in three progressively sour U.S. housing market scenarios. Comparatively, triple-B notes in the worst scenario would lose 825 basis points, earn 13 in a moderate scenario and 488 in the best-case scenario. Triple-A notes would yield 35 basis points, nine basis points and negative 112 basis points in the three situations. The returns are based on an assumed collateral spread of 395 basis points and annual CDO fees of 70 basis points.
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