A concern that MBS market players have when it comes to recent negative events in the subprime space is whether these will spill into the prime mortgage market.
Lehman Brothers analysts in a report last week reviewed the credit performance in the prime market to see whether there has been a contagion effect. They found that if the issues affecting subprime lead to a significant drop in home prices, then prime credit would be likely to deteriorate as well.
After reviewing recent prime delinquencies, analysts found that those in the jumbo, option ARM and Alt-A sectors, while higher, were still relatively low. In the jumbo sector, delinquencies from the 2006 vintage are running at 17 basis points, analysts said, after increasing from 8 basis points in the previous year. Although this appears to be a significant increase, analysts said a more appropriate comparison is between expected losses and delinquencies so that subordination levels can be used as a proxy. From this perspective, Lehman analysts noted that, "although the subordination in jumbo deals is a sixth that of subprime deals, delinquencies have been less than a 30th."
In the option ARM sector, Lehman analysts observe that delinquencies are running lower relative to comparable Alt-A products (49 basis points versus 85 basis points for 1Q06). Although there remains some uncertainty about performance when the loans get recast, analysts said that with the current delinquencies and loss coverage (10% for option ARMs versus 6% for Alt-A), they are comfortable with the credit exposure to this sector.
Within the prime sector, the Alt-B sector - which is borderline subprime - is experiencing the worst performance. It is running at about 50% of the levels in the subprime sector and is outpacing expectations, Lehman analysts said. They noted that the Alt-B sector recently experienced increased competition from both subprime and Alt-A originators that led to deterioration in underwriting standards. "Given the current state of delinquencies versus subordination, owning credit exposure in the sector doesn't appear attractive." While Alt-B is a prime sector, it accounts for less than 5% of the whole. As a result, analysts do not believe there is cause for concern at an aggregate level.
To help explain some of the reason for the deterioration in performance, analysts looked at additional factors, including changes in collateral composition, shifts in external factors such as HPA, and residuals - which they attribute to deterioration in underwriting. In the jumbo, option ARM and Alt-A sectors, analysts said the bulk of the changes in delinquencies could be explained by the changing composition of deals from 2003 to 2006. In the Alt-B and subprime sectors, sub underwriting standards was one of the main factors. In terms of the HPA component, analysts observed that this has been a less meaningful contributor to performance changes. They added, however, that the recent slowdown in home price appreciation is likely to be better reflected in credit performance later this year and in 2008.
Overall, analysts believe that, while prime credit performance will probably deteriorate from previous years' levels because of the softer housing market, they believe investment-grade subordinates are well protected from principal losses.
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