Sentiment in the mortgage securitization market is improving, with pricing regaining momentum and talks of a new-issue RMBS pipeline rebuilding.
However, underlying this optimism are the same cracks that brought down the sector in the first place. Clearly the market still has to brace itself for the impact of the remaining several hundred billion dollars of option ARMs due to reset between now and the end of 2011.
Additionally, some $500 billion of the $2.4 trillion Alt-A adjustable-rate mortgage segment is due to reset between now and 2015.
"Many of those loans are underwater and barely affordable at current historically low interest rates," said Joseph Mason, a partner at Empiris. "If interest rates were to rise as a result of Federal Reserve tightening, those mortgages would be rendered even less affordable to borrowers."
Although the momentum generated by improving pricing might have roused some investor interest, it doesn't mean the securitization market is out of the woods yet.
The industry has not solved the subprime problem. This subsector of the mortgage market encompassed a larger universe that moved beyond loans underwritten for less creditworthy borrowers. The subprime classification was also designated for borrowers with incomplete or impaired credit.
In fact, securitizations must still filter through the impact of what is termed the non-prime universe, which includes the option ARM resets from late 2007 vintages, for example, and Alt-A mortgages.
Last month, Moody's Investors Service placed $330 billion of Alt-A loans on review for downgrade.The rating agency released updated loss projections for 2005 to 2007 vintage Alt-A RMBS and as a consequence, placed bonds totaling $330 billion in current face on review for downgrade.
The move is more significant for the 2005 vintage bonds than it is for those of 2006-07 since the vast majority of 2006-07 Alt-As have already been downgraded below investment grade by the rating agency.
However, roughly 30% of 2005 senior securities still maintain investment-grade ratings, although Moody's expects most of these to be downgraded below investment grade.
"The move reiterates our long-held opinion that earlier vintage bonds are the most susceptible to the impact from downgrades," said Barclays Capital analysts.
"The high incidence of defaults was not limited to subprime mortgages only; defaults have also risen rapidly in other segments of the mortgage market - for example, the market for Alt-A (or Alternative-A) mortgages," said Rajdeep Sengupta, economist at the St. Louis Federal Reserve. "But our knowledge of the Alt-A market is significantly less than our knowledge of subprime mortgages."
Many of these loans aren't eligible for modification, and in many cases the loans are simply poorly underwritten without enough documentation per the stated guidelines in the modification programs available today. A market source said he was currently dealing with a portfolio where 68% of these mortgages were underwritten with a material defect.
Consequently, Mason said, many of these loans are at an endgame when they hit trouble. With the national home prices expected to decline approximately another 10% this year, according to Fitch Ratings, it is likely that some of those borrowers who have still met monthly payments may fall underwater.
Fitch said that of the currently paying borrowers in pools issued from 2005 to 2008, approximately 50% owe more than their homes are worth.
"In 2010, the existing negative equity position of many performing borrowers combined with a further rise in unemployment is expected to prevent any material improvements in roll rates from performing to delinquent," Fitch analysts said.
Modifications also focus only on reducing monthly payments as opposed to addressing borrowers' negative equity position. As a result, the re-default rates after 12 months are ex pected to remain high. Based on re-default rates on similar modifications performed before the Home Affordable Modification Program (HAMP) was implemented, Fitch predicts that re-default rates will be around 50% for prime and 65% to 75% for Alt-A and subprime.
"You've got some people in the market who are buying into ABS value thinking they know all they need to know, but those in the know are still expecting more losses up ahead," Mason said.
However, even though the industry is still sorting out its issues, the market is already beginning to entertain the slow return to the securitization of residential whole loans.
"There has been interest in securitizing seasoned loan portfolios acquired through mergers or through the acquisition of a former lender," Fitch analysts said. "Additionally, in recent months, there have been increased inquiries from issuers interested in credit enhancement levels for potential transactions collateralized by newly originated jumbo prime fixed-rate loans with full income documentation."
The securitization market "for newly originated mortgage loans is getting closer to reopening," said Tom Deutsch, executive director of the American Securitization Forum. Market reports indicated that the first deals could total $250 million to $500 million and debut during the first quarter of this year.
However, Mason added that while some investors will be able to extract value from the marketplace, economic growth will drag overall as buying loans will remain cheaper than making loans. "Once the Federal Reserve begins tightening, a scramble for yield will ensue that will pressure lenders to create earnings to make up for lower values resulting from higher interest rates," he said. "Not until the entire dynamic plays out - when the profile of failed banks and assets in liquidation turns back down and retreats to manageable proportions - will economic growth return."
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