Home equity loan downgrades could increase by three to four times this year compared with the second half of 2006, Lehman Brothers said last week in a report. Such an increase would mean as many as 1,500 bonds could be at risk for a downgrade, given a 0% to 5% national rate of home price appreciation.
The activity is widely anticipated to stretch HEL spreads further, both in cash and synthetic markets. Rising delinquencies could be enough to abate what has been an insatiable hunger by CDOs for the securities because of mark-to-market and structural issues - a trend that is likely to give way to either new or lesser-utilized asset classes for the sectors to feed on, such as trust-preferred securities or commercial real estate.
Actual downgrades to CDOs holding the bonds are likely several years out, most sources said, although the speed and degree to which downgrades occur depend largely on whether HEL delinquencies pile up quickly, as in the case of 2006 deals, or lag behind, as is the case of later vintages.
Outstanding subprime loans were defaulting at a rate of 9.08% as of the end of October, according to Friedman Billings Ramsey, up from 6.16% a year earlier. A combination of thinly enhanced subordinate securities in deals originated in 2003 and 2004, along with a continuance of the widespread trend of poor credit performance early on for loans originated last year and in 2005, are expected to be the main drivers of upcoming downgrade activity this year, according to Lehman.
While the number of relatively new deals piling up on rating agency watch lists is unprecedented - and there seems to be a consensus that the 2006 vintage is, in fact, the worst ever - a number of sources are expecting the number of downgrades of 2003 and 2004 vintages to take the market by surprise. In fact, 50% of triple-B securities closed during those years are due for a downgrade, given a 5% national HPA scenario, Lehman wrote. Problems are arising in 2003 and 2004 deals due to a combination of low excess spread, embedded basis risk and weak triggers.
Moving up the capital structure, Lehman estimated that 30% of double-A rated HEL deals from 2003 would be subject to a downgrade by year end, as would 38% of single-A and 40% of Baa'-rated bonds, given a 0%, or flat, HPA scenario. The scenario eased with more recent vintages, but still affected bonds rated as high as double-A, with 2% of double-A tranches issued just last year subject for a downgrade by year end. It would appear as though rating agencies are being more proactive on downgrading 2005 and 2006 deals at the gate, Lehman wrote. Forty-six bonds across 13 deals from 2005 and 2006 were on negative ratings watch as of Jan. 16 - compared with no downgrades on previous vintages at the same level of seasoning, according to the report. Of course, deals issued in the last two years have not experienced anything near the level of HPA enjoyed by 2003 and 2004 deals, a big driver in the front-ended losses.
Barclays takes on HPA
Going forward, employment and home price appreciation will be the key drivers of HEL performance. Cumulative losses for loans originated in 2002, for example, had a 77% correlation to home price appreciation, according to Inna Koren, head of U.S. securitization research at Barclays Capital, in a conference call on U.S. residential real estate earlier this month. Barclays is predicting national HPA this year in a range of 1% to 3%. Koren said she expects 2007 to be a better vintage than 2006, as underwriting standards have tightened. The proliferation of 40- and 50-year loans, which are indicating worse performance than the interest-only loans they replaced, along with limited or no documentation loans, purchase mortgages and piggy back seconds, are expected to be the poorest performers among the 2006 vintage.
The extent to which trouble in the housing market will spill over into the broader economy is unclear, although Barclays presented a positive outlook. "The story is simply not holding at this point that housing is going to drag the rest of the economy down," said Dean Maki, chief U.S. economist at Barclays.
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