As the bulk of loans underlying the ABX.06-1 index approach their reset, market participants now say the performance of these mortgages could start 2008 off on a better footing than previously expected. They cited the better quality of the underlying loans and the timing of the resets as the factors contributing to the better outlook.
Currently, the ABS market is dealing with the uncertainty of how the securities will perform after these loans reset. These dark clouds notwithstanding, a bright spot for the 06-1 vintage is the fact that refinancing alternatives for these borrowers still exist, some market players said.
"Everything is lining up pretty good for the 06-1," said Mark Adelson, a principal at Adelson and Jacob Consulting. "Home prices have fallen just a little bit. The credit remains pretty available for people who are making their payments, and interest rates are still low. When I hear consumer groups coming forward and saying people can't get loans, I will believe it. When I hear lenders saying credit is tight, I am not as convinced."
At the same time, some of these borrowers might not have negative equity in their homes if their loans were made in 2005. When such loans hit their reset dates, interest rates could be more benign than they were in 2005, at least the benchmark interest rates could be. This could bring back some financing opportunities, a mortgage market participant said.
The collateral performance of the 06-1 index has also shown signs of strength when compared with the 06-2 and 07-1 indices. In a breakdown of negative rating activity by index through Nov. 19, Moody's Investors Service downgraded only 5% of the triple-B tranches of the 06-1, compared with 90% and 95% of the same tranches in the 06-2 and 07-1 indices, respectively. At the single-A tranche level, Moody's did not downgrade any of the collateral for the 06-1 index. However, 55% and 85% of the single-A tranches were downgraded for the 06-2 and 07-1 indices, respectively.
There is some merit in the argument that 06-1 collateral is distinctly superior, said Karandeep Bains, associate analyst at Moody's. "If you look at the delinquency buildup for the underlying vintage of 06-1 and compare it to 06-2 and 07-1, it is distinctly lower," he said. The weighted average expected loss estimates for the deals underlying the 06-1 were 6.2% of the original balance, while they were at 12.3% of the original balance for 07-1, or almost twice the loss, according to Moody's. The current average overcollateralization shortfall, based on the target overcollateralization levels for the ABX.06-1 index, is 16%. However, if the two worst deals - LBMLT 2005-WL2 and SAIL 2005-HE3 - were removed from the mix, the average overcollateralization shortfall would be reduced to 4.5%, Moody's said.
For 06-1, the month-over-month change in serious delinquencies for November was 288 basis points, higher than the 257 basis points seen in October, according to a Citigroup Global Markets report. However, the increase in the 06-1 delinquencies is the result of the higher prepayment speeds, the firm said. The bank added that the change in 60-plus-day delinquencies as a function of the original balance is 101 basis points, which is less than the 124 basis points seen in October.
Furthermore, while remittance data from November demonstrated continued weakness in the collateral, it also showed a lack of significant acceleration in deterioration. That, combined with an easing tone from Federal Reserve officials, has also led to improved sentiment in the market, JPMorgan Securities analysts said in a recent report.
ABX pricing is influenced by several factors aside from credit, therefore performance uncertainty as well as uncertainty regarding the overall state of the economy has kept prices at depressed levels, despite some of the underlying value. "From a pure credit perspective, this is the best performing vintage [of the ABX]," said Navneet Agarwal, vice president and senior analyst at Moody's.
The Lesser of Two Evils
However, others maintain that pricing corrections that took place toward the end of the summer, have mostly taken into account the expectation for big losses. "In general, the prices now are based on realistic forecasts," said Jonathon Weiner, vice president in analytics at Applied Financial Technology, a mortgage analytics company.
In fact, some market participants argue, while the vintage may perform better than expected for the following indices, the market is just comparing bad performance to worse performance.
"Total defaults on 06-1 are approaching 30%. If that is good then we are all a little jaded at this point," a mortgage market participant said. "You can make an argument that the 06-1 should perform better because those people maybe have a little bit more accumulated real estate appreciation, there weren't as many 100% CLTV loans and not as many stated doc loans, but it is all relative," he said.
Other market participants agreed, adding that the performance of the late 2005 vintage was far worse than the following vintages. "The 2005 vintage and the 2006 vintage have ended up being the worst performing vintages in a long time," said Ajay Rajadhyaksha, head of U.S. fixed income strategy at Barclays Capital. "In the case of the borrowers whose mortgages were given out in late 2005 - and who still have some equity in their houses - a lot of these borrowers are being encouraged to sell their houses and pay off their loans, which is the correct economic decision for them," Rajadhyaksha said. The problem here is that the borrowers' equity is going to vanish as home prices continue to fall, he said.
Falling home prices happen to be the main driver behind performance, Rajadhyaksha said. "Borrowers took on way too much leverage because they were allowed to by the market," he said. "Falling home prices are a much bigger risk to U.S. mortgage credit than the payment shock. This does hurt at the margin; there is no question about that. But the reason that people are getting into trouble, and the reason why the 2005 vintage is not performing as badly as the 2006 loans, is that people did not factor in that the much bigger issue would be home prices going up or down. And home prices were still going up in 2005."
Furthermore, while home prices are down, they have not dropped to their expected lows. Home prices have dipped 5%, UBS said in a recent report. Analysts from the firm expected that total cumulative peak-to-trough losses in home prices would be 15%.
Meanwhile, Applied Financial's Weiner expects 0% home price growth or even negative 5% appreciation over the next year.
The Loan Mod Question
Loan modifications - including the most recent plan by Department of Treasury Secretary Henry Paulson to freeze interest rates on subprime ARM transactions - might also play into collateral performance. The plan is described as ambitious in scope, but the market does not seem to think Paulson's plan will have much of an impact. This is especially true for the 06-1 since 2/28 loans in the 06-1 are ineligible for the "fast track," because many of these loans reset before the Jan. 1 cutoff date, JPMorgan said.
UBS predicted that the total number of loans helped by the plan would be 340,000 to 400,000. This is out of the 1.3 million loans resetting from Jan. 1 to July 31, 2010.
However, the loan modification plan might moderate ABX pricing a little bit, easing some of the hysteria by reducing the frequency of foreclosures and the loss severity on the loans. Despite the fact that the ABX.06-1 will not greatly benefit from the modification plan, 06-1 has rallied the most in the past two weeks, JPMorgan said.
The market will have to wait several months to see how delinquencies in the 06-1 loans play out. While the 07-1 loans are worse than the loans issued in the second half of 2005, there is the issue of seasoning that could delay performance results. "We have not seen a spike in the delinquency numbers as a percentage of original balance for this vintage, which might lead you to believe that maybe the obligors underlying to ABX.06-1 are not defaulting right after reset," Bains from Moody's said. "But it is still too soon; I would still wait a couple more months and have more data points before I categorically state that."
Indeed, there are lags between the time that a loan becomes delinquent, the instigation of the foreclosure process and actual losses, Weiner said. "When the dollar losses will be reported on these securities, we are currently showing that peaks about one year from now."
With market conditions expected to further deteriorate and home prices still declining, conditions for the resets do not look as bad compared with some of the upcoming vintage resets. "We can start to see less pressure for 06-1 because even though the future is hard to predict, the relevant future is only a couple months away, and things are pretty good right now," Adelson and Jacob Consulting's Adelson said.
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