Though delinquency rates for mortgage loans rose for the second quarter report (after three consecutive quarterly declines) and are expected to show a slight uptick in the third quarter report, Jay Brinkmann, vice president of research and economics at the Mortgage Bankers Association (MBA), said that the national delinquency rate would start to trend downward as the economy starts
to improve. The results were reported in the MBA's National Delinquency Survey.
This optimistic outlook is echoed by Freddie Mac economist Frank Nothaft. He said that this year has probably seen the peak for mortgage delinquencies, but as the economy recovers and the employment picture improves, the delinquency rate will drop gradually.
Borrowers are also not over-leveraged even with many homeowners taking advantage of the cashout refinancing option and home prices growing at a more moderate pace. Nothaft predicts home price appreciation slowing down to 5% for the remainder of the year and 4.5% in 2004, which is still a relatively healthy pace. He explained that borrowers usually exercise the refinancing option responsibly, not moving above the 80% LTV mark. Also, homeowners usually use the money they get from their home equity for home improvement purposes, which increases the value of their homes.
Deteriorating credit fundamentals, according to Fitch
In the most recent edition of its RMBS newsletter Mortgage Principles and Interest, Fitch Ratings looked at the deteriorating credit quality in the mortgage sector, specifically focusing on subprime as mortgage underwriters have had to lower their standards to attract more borrowers in this sector.
In an article called The Economics of RMBS Collateral, Fitch noted the poor household credit conditions, including the record high rate of personal bankruptcies (1.6 million households filing over the past year through the second quarter of 2003) as well as the high number of auto loan repossession and manufactured housing delinquencies.
This worsening credit is reflected in the performance of different vintages of RMBS collateral. Fitch said that the 2000 and 2001 vintages have performed considerably worse compared to prior vintages. This trend applies to the prime, Alt-A and subprime sectors in most delinquency statuses and foreclosure rate statistics. The rating agency said that the 2002 vintage has had some improvement in performance through seasoning. However, since the vintage is less than two years old, there isn't sufficient history to be more than suggestive.
Fitch said that borrowers leveraging up by utilizing mortgage debt adds to mortgage credit problems. Analysts stated that mortgagors have been aggressive in pulling cash from their homes. Almost $800 billion (annualized rate) has been taken out so far this year. This compares with roughly $700 billion in 2002 and $500 billion in 2001.
"While this extra cash has been instrumental in supporting consumer spending and thus the broader economy, it also has resulted in significant leveraging," Fitch analysts wrote. The aggregate mortgage LTV - measured by the value of all mortgage debt outstanding divided by the value of all housing (this comprises even homeowners without mortgage debt) - is now almost 42%, which increased from just over 38% in late 2001. Aside from this, the mortgage debt service burden - this measuring the proportion of after-tax income reserved for mortgage debt - has been increasing rapidly and is at a record high when mortgage rates are at a record low.
Fitch also analyzed how the different sectors - prime, Alt-A and subprime - utilize mortgage debt differently. Analysts said that Alt-A mortgagors are most reflective of the overall market. As of the beginning of this year, 60% of all refinances were cash-outs from this sector. As interest rates dropped, Alt-A borrowers were more likely to take out cash-out refinance loans. In contrast, prime borrowers had less of a tendency to do a cash-out refinance when interest rates fall.
Subprime borrowers tended to do cash-out refinancings as interest rates increased. This type of refinancing accounted for roughly 80% of all subprime refinancings in 2000, when the benchmark one-year ARM rate was round 7%. However, this number stayed at merely 52% when the benchmark rate fell to less than 4% in 2003. Fitch says that this trend was due to subprime borrowers consolidating nonmortgage debt as their other debt became much more expensive in a rising rate environment. Refinancing through a cash-out mortgage became a more attractive option and offered the lowest cost of funds.
Also, current LTVs in the subprime part of the market have stabilized at about 80%, which rose by roughly 10% from levels in the mid-1990s. In contrast, the LTVs of prime borrowers dropped to 60% from mid-70% in the same period.
Fitch said that overall mortgage credit quality should erode further through 2005 despite forecasts of a better economy. If the job market and the economy improve in the coming months, the Federal Reserve is probably going to tighten monetary policy and cause interest rates to rise sometime late next year, hitting the housing market hard. The significant drop in interest rates in recent years has been capitalized by house prices.
Analysts said that any small rise in interest rates might negate the effect and cause house prices to weaken significantly, particularly in markets where housing price growth has been strong and mortgage credit quality has remained good, such as California and Florida. When interest rates increase, the rating agency thinks housing prices will be weakest in these markets.
"Weak house prices, combined with the aggressive mortgage lending of recent years, will lead to worsening credit performance in these markets, reflected in a rise in delinquencies and foreclosure rates," wrote analysts.
Also, the fact that rates have backed up is a sign that the economy is improving. But this does not mean that credit quality will improve, specifically in the subprime sector. This is because underwriters usually change their guidelines to attract more borrowers, as these originators have ramped up their capacity to deal with the considerably high volume during the refinancing wave. They also generally do not lay off workers right away as volume drops. Originators thus become more aggressive in offering mortgages with higher loan-to-value ratios to borrowers with higher debt-to-income ratios and lower FICOs. Analysts said that these loans have been given out to people who are leveraged out already.
Sarbashi Ghosh, senior director at Fitch, said that in the last couple of years, borrowers were able to refinance out of their debt when it got to a point where loan payments were already proving difficult to maintain. However, previously, they had the benefit of lower rates so that gave them the ability to refinance and reduce their payments. But as rates start backing up, these borrowers won't have this escape hatch. This is why mortgage quality post-refi wave usually suffers.
"After coming out of a great refinancing boom, the credit quality of the following year's vintage usually suffers," said Ghosh.