09/11/2009

MBS Losses Grow Murky as Defaults Rocket


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CORRECTION:

The July mortgage-bond defaults cited in a Sept. 11 article, "MBS Losses Grow Murky as Defaults Rocket," included classes of bonds that S&P had earlier downgraded to "D" and then confirmed at that rating during the month. Of the 2,996 defaulted tranches, 881 had their ratings lowered in July, compared to 289 in July 2008. The rest of the July 2009 tally consisted of confirmations of previous downgrades. In the first seven months of this year, S&P downgraded 7,233 tranches of home-loan securities to "D" while confirming such ratings for 7,624 classes.

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Holders of home-loan bonds are absorbing a one-two punch - deals are defaulting at a rapidly increasing rate, and it has become more difficult than ever to estimate the severity of losses on those holdings.

In July alone, S&P downgraded 2,996 classes of securities backed by prime-quality mortgages, subprime home loans and home-equity credits to "D," declaring them in default after missing scheduled payments. That's up from 143 tranches that the agency downgraded to "D" in July 2008.

That jump punctuates a trend in which the number of mortgage-bond classes slipping into default each month has been soaring since late 2007. In the first seven months of this year, S&P downgraded a whopping 7,624 tranches to "D." Before that, it had declared 1,585 tranches in default, according to data the agency compiled for Asset-Backed Alert.

More than half of the tranches that defaulted in the January-July period, or 4,263, were issued in 2006. Two were from 2008: Lehman Brothers' Structured Adjustable Rate Mortgage Loan Trust, 2008-2, and Barclays' BCAP LLC Trust, 2008-IND1.

The defaults in and of themselves aren't surprising - analysts have been forecasting a jump in home-loan failures for about a year. Some expect the default rate to peak sometime next year.

But the unprecedented number of MBS defaults is paired with another major problem for investors: It is becoming increasingly difficult to predict the magnitude of losses on defaulted bonds, due to the growing lag between the time homes enter foreclosure and the time they are liquidated.

When the housing market crashed in 2007, lenders needed an average of about 18 months from the time of repossession to sell a home. Now, however, the lag is substantially longer due in large part to government modification programs, local foreclosure moratoriums and a still-weak housing market.

It's hard to say exactly how drawn out the liquidation process has become, since lenders and servicers must abide by different timetables for liquidating homes, depending on the applicable state laws.

"A lot of government programs have kicked the can down the road," said Laurie Goodman, a senior managing director with Amherst Securities, a broker-dealer specializing in MBS. She described the growing pipeline of delinquent mortgages as a "stuffed-up toilet," since relatively few of them are getting resolved.

Some 6.7 million homes, or 12.3% of those with outstanding mortgages, have delinquent loans and are waiting to be liquidated, according to Amherst, which based its findings on August data from the Mortgage Bankers Association.

On Sept. 10, Fitch said it was boosting its loss estimates for securitized prime mortgages, based on rising unemployment, growing delinquencies and declining recoveries. The agency now expects average prime collateral losses to reach 8% for 2007-vintage mortgage bonds and 6% among credits underpinning 2006 issues. That's almost twice as much as its loss estimates from March, which ranged from 2.6% to 4.8% among prime mortgages from 2007, and 2.1% to 3.6% for prime loans from 2006.

S&P, meanwhile, has also increased its estimates of loss severities, in part due to the expanding gap between foreclosures and sales. For example, on July 6 it raised its estimated losses for subprime mortgages included in 2007 securitizations to 40% from 31%.

In a July report accompanying the new loss estimates, S&P analysts wrote, "The four high market-value decline states (California, Florida, Arizona and Nevada) may exhibit increased stresses on severities due to continuing extensions in timelines as a result of moratoriums, mediations, and bogged-down court systems."

While modification efforts could lead to defaulted mortgages starting to perform again, they are more likely to just delay the liquidation process since altered credits are likely to become delinquent again.

"As you modify loans, it slows the potential foreclosure and liquidation timeline of that loan," said Vincent Barberio, a Fitch managing director. That said, such efforts tend to delay a home sale by only a few months. "We've seen a very rapid re-default rate," he said

Losses aren't recorded by a servicer until a mortgage is liquidated. The delay can be good for some subordinate bonds and bad for holders of senior bonds because, until losses are recognized, money can continue to flow down to the most-junior classes even after a deal's overcollateralization cushion has been eaten away.

Even amid rising default rates and market uncertainty, there's still money to be made in the MBS business. For example, super-senior bonds backed by option-adjustable rate mortgages were priced around 48 cents on the dollar in August, up from March lows of 30 cents on the dollar, according to Amherst research published on Sept. 2.

Still, the growing pile of mortgages in limbo between foreclosure and liquidation is threatening to undermine people's favorable view of these credits. "There's a huge amount of uncertainty," said Amherst's Goodman. "I think people are being too optimistic. Some securities are overvalued at this juncture."

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