The subprime RMBS from the 2005 vintage are turning into a puzzle for market professionals, because although the adjustable-rate loans are experiencing significant default rates, the fixed-rate deals have performed well. Out of all this confusion, however, lenders and issuers say the big picture offers ample opportunity for them to sustain business growth.

Based on an analysis of default rates of 18 subprime issuers as of April, defaults on adjustable-rate subprime RMBS stood at 2.73% in April, a 55% increase, said Michael Youngblood, managing director of ABS research for Friedman Billings Ramsey & Co. Meanwhile, the default rate on fixed-rate subprime RMBS was at 5.92% in April. Compared to prior years, the default rate dropped by 58 basis points, or 13%.

Even so, the increase in the default rate from 2004 to 2005 is absolutely small, less than one percent, Youngblood wrote in a report last week. What's more, at 2.69%, the default rate for securities issued in 2005 is no different in statistical or absolute terms from the weighted-average default rate of all the securities originated from 2000 to 2005, and at similar ages.

The difference in default rates cannot be explained simply by looking at the loans' debt-to-income ratios and credit scores, Youngblood said. For one, a vast majority of adjustable-rate subprime loans originated in 2005 were hybrid ARMs, and of those, only 3.9% adjust at one-year or shorter intervals.

"We can fully explain the higher default rates by reference of weak economic conditions of certain cities," he said, during a conference call last week. "Sixty-three MSAs are experiencing persistently high rates of default [that] reflect weak economic conditions."

Default rates bear a strong correlation to employment conditions especially in the New England and the Gulf Coast regions, he said. There are 18 MSAs with weak employment conditions in New England, where default rates increased by 3,766 basis points in the latest month from the prior year, a 74% year-on-year increase. Hurricanes Katrina and Rita disrupted labor markets in 12 metropolitan areas in Louisiana, Mississippi and Texas. At the same time, default rates increased by nearly 1,300 basis points, Youngblood said.

Mortgage lenders react

A couple of mortgage lenders and insurers who were part of the conference call took the bad news in stride. They said they have little exposure to the loans that are coming under such pressure, and added that it would not adversely affect their businesses.

The defaults on the adjustable-rate RMBS were highly concentrated in investor properties and mortgages on condominiums, said Curt Culver, CEO of MGIC Investment Corp., parent company of mortgage insurance provider Mortgage Guaranty Insurance Corp. Also, much of his firm's core operations are in fixed-rate mortgages, which have not experienced the high default rates. At any rate, said Culver, employment is the real driving force behind MGIC Investment's business, and that mortgage defaults are typically a result of unemployment, death or illness, rather than increasing interest rates that might make mortgage payments less affordable, or higher housing prices.

"If they have a job, they make their payments," he said of mortgage holders, especially those with loans on owner-occupied, single-family houses.

While agreeing with Culver that employment is the biggest driver in determining mortgage default rates, Accredited Home Lenders COO Joe Lydon, acknowledged that affordability also plays a part. Lydon said that for the past three years, the company had no mortgages lapse into real estate-owned (REO) status, but they have seen 12 REOs come about in the last six months. Six of those loans were originated in San Diego County, and the rest were dispersed throughout the state. Such anecdotal evidence suggests that San Diego County has some issues.

"What concerns me most is the affordability question," said Lydon. "It's just expensive to buy houses. I'm seeing more loans with option ARMs and interest-only."

Changes to lender products

Accredited Home Lenders is not overly concerned with the quality of the credit behind its underlying loans, but Lydon said the company is beginning to make some changes to its mortgage product offerings. For one, it has stopped offering second mortgages to borrowers with unsatisfactory FICO scores. The company will also offer financial incentives to loan originators to encourage production of more resilient loans, said Lydon.

"We want more of a focus on credit quality," he said. "We want to move repurchases down or defaults down."

Still, said Lydon, only about 15% of loan production comes from California. The company is not being aggressive, from an underwriting standpoint, but is taking what they want at pricing levels that they dictate.

Another explanation is that subprime mortgages from 2002 through 2004 were so low that some lenders might have felt more comfortable taking on a little more risk in 2005, Lydon said.

At any rate, the problems with higher default rates might sort themselves out on the secondary market, said Lydon, because there are certain products for which demand is slacking off, such as second mortgages.

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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