06/12/2009

Next Wave of MBS Pain Coming Into Focus

The next shoe is dropping on the already-clobbered mortgage-backed securities market, and this time holders of senior bonds are among those in peril.

The continued deterioration of home values combined with the widespread expiration of lenders' foreclosure moratoriums are accelerating losses in first-lien mortgage portfolios that secure many MBS issues. Rating-agency analysts are privately warning market players of the new one-two punch, which they contend will cause losses for the top-rated classes of many MBS issues.

Subprime-mortgage issues are already hemorrhaging from the latest housing-market conditions, but rating-agency analysts predict the losses will spread over time to bonds backed by alternative-A loans and even mortgages to prime-quality borrowers.

"For a lot of these, it's just a matter of time," said one rating-agency professional. The agencies are believed to be preparing reports on the ominous trend.

It's difficult to tell which issues will suffer losses first given the unpredictability of repayment trends, regional unemployment rates and shrinking home values. But analysts point to several MBS issues whose senior pieces are drifting closer to the danger zone.

For instance, losses on the subprime mortgages backing Natixis' Real Estate Capital Trust 2007-HE2 issue have wiped out all but three of the junior tranches protecting senior-bond holders. Losses ate through five of the subordinate tranches in only the past six months. Mortgages securing the issue, which priced in April 2007, suffered cumulative losses of 17.3% through May, up from 6.2% in October.

Similarly, only two of the original 10 junior tranches of Lehman Brothers' Structured Asset Securities 2006-OW1 still have any value. The February 2006 issue is also backed by subprime mortgages, whose cumulative losses are up to 10.9% from 5.8% in October.

"It's really been over the last couple months that it's picked up," the analyst said.

The new expectations of senior-bond losses subverts the long-held market convention that even MBS backed by the shakiest assets contain adequate subordination and other credit enhancement to protect senior bondholders from losses in all but the most dire situations. Now, however, something resembling a worst-case scenario is becoming reality. The unemployment rate rose to 9.4% in May - its highest level since 1984 - and mortgage defaults rose by double-digit rates across all classes of private-label MBS in April, the latest available data.

Meanwhile, the foreclosure moratoriums that many servicers and states put in place late last year are beginning to expire, and more will do so in coming months. As they do, foreclosures will rise, particularly on subprime mortgages. Foreclosure forecaster RealtyTrac this week said foreclosures jumped 18% in May from May 2008 to 321,480 houses. With home values still falling, it's unlikely that many of the foreclosures will allow lenders to recoup the full unpaid balances on their defaulted mortgages.

Holders of senior bonds backed by second-lien mortgages have already suffered sharp losses. For instance, the senior notes of Countrywide's CWABS Asset Backed Certificates Trust 2006-SPS 1, issued in June 2006, have been posting losses since December. The mortgage portfolio backing that deal has so far lost 52% of its original value.

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