The subprime RMBS market in 2006 arguably boiled down to a game of tug-of-war. On one side, hedge funds were eager to capitalize on a perceived gloom-and-doom scenario fraught with a busted housing bubble and empty-pocketed subprime borrowers. CDO managers, ever the real estate bulls, were on the other. And while these two sides are expected to continue their dance of supply and demand through yearend, a crop of subprime lenders - no longer able to carry the weight of investor buy-back requests - appeared to become the losers, at least for now.
Ownit Mortgage Solutions and Sebring Capital Partners recently closed their doors, and a host of subprime lenders leftover from the wave of investment bank acquisitions that took place this year are still seeking the refuge found in richer parent companies. A particular surprise for some market participants, Ameriquest Mortgage, a subprime lending arm of ACC Capital Corp., appears to be among them.
The news helped to spin HEL spreads into "wild gyrations," according to a JPMorgan Securities depiction. ABX.HE 06-2 spreads gapped out by 65 basis points to 269 basis points at the triple-B level, and about 90 basis points, to 397 basis points at the triple-B minus level. Continued spread volatility, along with more pronounced tiering by issuer, underwriter and vintage are widely expected to carry on as main themes in 2007, as headline risk and lender consolidation continue.
"Borrowers who had stretched to afford higher home prices really started to show some strain [this year]," said Grant Bailey, a director at Fitch Ratings, during a Dec. 14 conference call on the matter. The rating agency is anticipating a total of roughly 300 downgrades for subprime securitizations at yearend, and is expecting more downgrades next year.
2006: Worst vintage ever?
Tremendous demand on behalf of borrowers and secondary market investors grew the subprime lending industry to an unsustainable size, market participants said, leading to cut-throat competition to maintain volume and a semblance of profitability. While lenders began to curb underwriting standards in response to rising delinquency rates and regulatory scrutiny, the number of borrowers defaulting on their mortgage loans early on became a relatively widespread trend this year.
What seemed to be the ever-worsening performance of 2006 subprime mortgage loans led some to question whether it might be the "worst vintage ever." In an unusual move, rating agencies put on watch for downgrade several securitizations issued just this year.
Moody's Investors Service on Nov. 10 put on watch for downgrade the two lowest rated tranches of SG Mortgage Securities Trust 2006-FRE1, a securitization backed by Fremont Investment & Loan collateral and the first 2006 deal to be watchlisted for a downgrade. Standard & Poor's followed suit shortly after, and in the early days of the following week, Moody's watch listed yet another tranche from a 2006 deal backed by Fremont collateral - MASTR Asset Backed Securities Trust 2006-FRE2.
Expectations for 2007
As it is difficult for anyone to calculate the future performance of securitizations backed by subprime loans - an intricate balance of a number of elements including bond structure, the level of truth contained in mortgage applications, home price appreciation and overall economic health - a majority of market participants appear to be taking a "wait and see" approach.
The advent of the derivatives market, and especially its boom in 2006, has allowed all parties in the residential mortgage market to express their divergent opinions over trading desks, and it has changed the RMBS world 100% since the summer, one hedge fund portfolio manager said. For instance, a bond at the bottom of the credit stack that priced at Libor plus 200 in the summer was recently priced to sell at 390 basis points over. Aside from last week being the busiest the CDO market had been for two weeks prior, certain dealers were floating a transaction that referenced 40 securities in two indices. Investors could simply buy a tranche off of that, allowing them to go long in the equal weight of their static portfolio.
With so many market players putting in bids on deals and chasing arbitrage, the question for 2007 becomes: will credit dry up? "That is the multi-billion-dollar question," one market source said. "The 2006-2 vintage is shaping up to be as bad as any since 2000. Some would argue that it will be worse than [the] 2000 [vintage]."
Most RMBS market players are calling for cumulative losses in the 5% or 6% range, while more bearish observers say losses will be the double digits. Although the Federal Reserve held its fire last week on the Federal Funds Rate, market players note that the subprime housing market is not getting any buoyancy from the macroeconomic markets. Normally, said one professional, mortgage rates of 6% and a 4.5% unemployment rate would be cause for cheer. Current GDP growth, however, has slowed, affecting subprime consumers. "That is why there is more stress on subprime deals now," he said.
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