Second-lien loans, especially in the subprime market, have always been a more questionable investment as of result of their layered risk and second priority payouts. But with the lack of homeowner equity and less home price appreciation, especially in the 2006 vintage, market participants are even more pessimistic about the value that will be extracted from the collateral.
Presently, second-lien issuance has dropped amid tighter lending standards and investor hesitation, with not much in the way of performance pickup. The housing and mortgage market will remain under pressure, at least for the next six to 12 months, said Tom Zimmerman, managing director and head of ABS and mortgage credit research at UBS. "I don't think it is going to snap back quickly."
Among the buzz recently was the dramatically negative ratings actions on securities backed by subprime closed-end second-lien mortgage loans by Moody's Investors Service. The rating agency downgraded its ratings on 131 securities, 111 of which remain on review for possible further downgrade, and it placed 136 securities on review for possible downgrade.
While most of the securities affected had prior ratings of A' and below, a small number had ratings of Aa' or Aaa'. Securities rated Aaa' were downgraded by one notch.
What is particular about the second liens is that you don't go through a lengthy foreclosure process; you write them off, said Nicolas Weill, chief credit officer in the structured finance group at Moody's. "And the writeoff is what is causing the speed at which the transactions are losing credit enhancements and is what is behind the severity of the ratings actions."
Heavy Hitters
Issuers with a higher concentration in the second-lien market that took the hardest hit included Long Beach Mortgage Co., New Century Mortgage Co. and Fremont Investment & Loans.
But not all deals have experienced the same defaults. According to UBS, there were higher cumulative losses and more 60+ day delinquencies in the 2006 vintage for second liens in traditional subprime deals than in the second liens in stand-alone deals, which are usually a combination of subprime and Alt-A and that typically perform a bit better.
Market participants were none too surprised about second lien's poor performance as the underwriting standards for the 2006 vintage are widely understood to be aggressive with weak documentation, higher LTV ratios and lower FICO scores, as noted in a recent report from Wachovia Capital Markets.
And for about six months or so, people have shied away from second liens because their delinquencies have been so high, Zimmerman said. "People knew these bonds were going to be written down, and the values of some these bonds were already trading like they were going to be written down," he said, "so I don't think it had a major effect on prices."
But while the low FICO scores of the borrowers were worrisome, another major red flag was the change in purchase percentage numbers occurring after 2001. The subprime industry, which had initially been a cash-out and refinancing business, was looking to expand its market share, and issuers wanted to go into the purchase loan business to expand their volume. As a result, purchase loan percentage shot up to 78.57% in 2006 from 17.52% in 2001 and even lower, at 7.5%, in 2000, according to UBS.
Lenders expanded the business with a 80% first-lien loan and a 20% second-lien loan, and they pushed that product very hard, Zimmerman said. Prior to 2001, the average second-lien LTV ratio was more than 20% and the average first-lien LTV ratio was in the 60s. But after 2001, the structure became much more standardized. In 2006, the average first-lien LTV ratio compared with the average second-lien LTV ratio was 78.9 to 20, according to UBS, nearly at the 80/20 objective.
That meant those loans had a 0% down payment, Zimmerman said. And to the extent that they were first-time homeowners, "a lot of where these issuers ran into trouble was pushing these 0% down loans to first-time home owners."
On the upside, while the ABX index has seen some dramatic volatility lately, analysts did not seem worried about the high correlation between the index deals and their exposure to second liens. "On average, these deals have only 3% to 4% exposure, with the highest being about 9%," Wachovia said. The bank suggested that the negative price action in the ABX associated with perceived second-lien risk would be short-lived.
Securities affected by Moody's actions include 32 certificates from five transactions originated by Fremont Investment & Loans, IndyMac Bank, Long Beach Mortgage Co., and New Century Mortgage Co. These are aside from certificates from four transactions issued by Bear Stearns Mortgage Funding Trust and certificates from two transactions issued by Ace Securities Corp., among others.
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