Reflecting the state of the whole U.S. mortgage market, scratch and dent loans are feeling the pressure of the lack of new issuance and dips in pricing. And with continued subprime deterioration, a pickup in the sector is not likely, market participants said.
The virtual lockdown on U.S. mortgage market issuance has affected all levels of the credit spectrum. "Most of the mortgage market has seized up as far as new issuance and it is affecting every sector as far up as prime loans," said Bernard Maas, vice president at DBRS.
Scratch and dent includes, among others things, loans made outside of a lender's credit guidelines, mortgages with a previous history of defaults and loans with documentation or regulatory compliance errors.
Some participants had expected the volume in the sector to increase as a result of the troubles in the subprime market.
"We had actually predicted that the scratch and dent market was going to blossom this year," said Quincy Tang, senior vice president at DBRS. Because of the poor performance in subprime, Tang had thought that there would be a lot more early payment defaults or due diligence kickouts from subprime deals that could have potentially ended up as scratch and dent. In recent pools, probably 80% to 90% of the collateral came from subprime due diligence kickouts, Tang said. "If the subprime mortgage market shrinks by 70% to 80%, there is simply not enough loans going into scratch and dent," Tang said.
Scratch and dent growth could also be affected by the Bush administration's plan to freeze interest rates on certain subprime mortgages, some market participants suggested.
A lot of the loans that would have gone into the scratch and dent world are now going to be diverted out of it, said James Dowell, executive vice president and chief operating officer at Mortgage Flex, a software platform for the lending industry. "A borrower's loan is not going to adjust, they are not going to get hit with a higher payment, so theoretically they will continue to make the payment they are making and the loan will be handled as a conventional loan," he said.
Difficult To Model
Part of the problem behind the stall in issuance is the difficulty faced by investors, pool owners and rating agencies in modeling the risks related to scratch and dent. Many of these loans were made under subprime origination programs, and traditionally scratch and dent ratings have been driven in part by subprime ratings analytics, said Gene Haldeman, partner at Thacher Proffitt & Wood. "There are some key differences, however - many subprime loans are classed as scratch and dent because they are re-performing loans, and many of these loans have already experienced a default and subsequent modification, forbearance or other workout tied to the borrower's ability to pay," he explained.
Haldeman said that the kinds of loan workouts and modifications that the industry anticipates in the subprime arena may have already occurred in the case of many scratch and dent loans. Many of these loans are somewhat seasoned and have a decent pay history from the time of origination or from the time of workout. Nevertheless, pools of scratch and dent loans that were originated as subprime loans will be affected by some of the same risk assessment issues as subprime pools in general, he said.
The deterioration of the collateral mix for later vintages also reflects characteristics of the subprime pools. Out of the scratch and dent pools of loans that DBRS rated, which are mostly comprised of re-performing loans that have been paying over the past six periods, the 2005 pools of loans had a 73 to 75 average LTV. This is significantly lower than the 2007 pools that had around 83 to 85 LTVs. Delinquencies in the scratch and dent market also jumped by vintage. 60 plus day delinquencies in the 2005 vintage ramped up to 34% from 28%, on an average basis, in two years, while 60 plus day delinquencies in the 2007 vintage ramped up in just six months to 30% from 15% on an average basis.
Scratch and dent pricing has also taken a hit as a result of the diminished ability to securitize these pools of transactions originated under troubled mortgage programs. "You have a performing loan with 8% interest rate, maybe 10% down and the borrower was full doc, it is ultimately a good loan but for some reason the lender no longer offers that program so the wholesaler has to get it off their warehouse line. But when they were expecting 92 cents on the dollar, now they are getting 72 cents on the dollar," said Christian Kerr, senior vice president and co founder of Paladin Financial. "That is a monstrous hit."
Flight To Quality
There are a number of people who have been moving into the sector to find opportunity, Dowell said. "They are looking for value or looking at an area which they know they can make a profit," he said. These include locations that have retained retail value such as Seattle and the Pacific Northwest, where there still exists a vibrant real estate market.
When these loans do come back, they will be a better product altogether, Kerr said. "Many programs are gone because the industry itself is constricting and becoming more conservative," he said. "Individuals are coming in with companies that have a different business philosophy, that are more loan and borrower oriented. They are going to come in and focus more on the servicing of an asset."
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