Subordinate home equity spreads widened this week, as some speculated that investors began to grow nervous of risk involved in the deals, and a number of analysts released sour outlooks on residential mortgage performance, particularly in the subprime market. Some deals in secondary trading are trading south of where they've been in recent months, on the anticipation that the price buyers are willing to pay is headed further in the same direction, according to industry sources.
The widening did not come as a surprise to distressed debt buyers that have been waiting for such an opportunity, such as United Capital Markets, whose traders pointed to wider spreads on home equities in secondary trading last month. The question is if the spreads will continue to widen. And if so, by how much?
Subordinate home equity spreads widened from five to 25 basis points last week, from double-A down to double-B plus, according to JPMorgan Securities. Analysts at the bank anticipate what could be a slow widening in spreads as a compliment to continual Federal Reserve tightening wringing some of the excess liquidity from the market. On Thursday, the Fed raised the federal funds target rate another quarter point, to 3.25%, bringing it to the highest level since August 2001. "While spread widening may well prove to be relatively contained over the near term, a result of the ever-present CDO bid, we think the event highlights the fundamental overvaluation of the sector and the risks for which investors remain largely uncompensated," JPMorgan analysts stated.
JPMorgan analysts did warn of widening home equity ABS spreads highlighting the risk of the structured finance CDOs they back. "Ultimately, that interconnectedness could cause spreads in both the ABS and CDO sectors to move potentially sharply wider, most likely when there is a clear and present danger from the housing market, but for now it simply represents a risk to be aware of." JPMorgan downgraded the sector to underweight on double As through triple Bs for CDOs and structured finance CDOs, citing that its immediate CDO concern lies with cash CDOs of mezzanine ABS because of the abundance of home equity ABS in the deals.
A majority of the data pushing investors to exercise more caution in the market is cited by Nomura Securities in the company's mid-year report, released last week. Of the homes purchased in 2004, 23% were purchased for investment purposes; 14% were second homes; 42% first-time purchases and 25% of all homebuyers made no down-payment on their home purchases in 2004; more than 60% of new mortgage loans in California are either IO loans or include negative amortization features; and adjustable-rate mortgages account for 50% of new-loan production in the states with the highest level of home price appreciation. Nomura got those figures from the June 18 issue of the Economist.
Echoing much of the sentiment in the industry, Mark Adelson, head of structured finance research at Nomura, said he has more of a pessimistic outlook on collateral quality in the next 12 to 24 months, but not as much so over the next six months. For the second half of the year, Nomura is predicting spreads on triple-A rated home-equity ABS to continue to widen, but they will not reach the widest levels of 2004.
Lehman Brothers reported similar findings, and in addition to that, in recent originations, close to 30% of loan-to-value ratios are north of 80%. According to the investment bank, around 15% of recent loans are made to borrowers who would not have qualified if it weren't for "affordable" products offered by lenders. "Layer in the potential payment shocks down the road, and the picture for consumer balance sheets and mortgage credit looks quite bleak."
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