S&P Viewpoint

If the heightened layering of underwriting risk in the latest vintage of subprime mortgage loans, which has created a significant rise in delinquent borrowers as of fourth-quarter 2006 and year–to-date 2007, gave investors a sense of déjà vu, it was for good reason. Back in 1998, specialty subprime mortgage lenders experienced similar funding and credit quality stresses. As subprime credit quality showed signs of deterioration, warehouse lenders pulled financing lines and/or raised the margins on the mortgage collateral due to liquidity concerns in the global capital markets sparked by Russian bond defaults and the demise of Long Term Capital Management. A similar pattern of mortgage lending was evident then in comparison with today: When the overall mortgage market volume dropped, the specialty mortgage lenders that thrived on higher production volumes pushed the envelope of risk in underwriting standards in an effort to keep production volumes up.

Another specialty finance sector experienced a similar fall from grace just a few years ago, and how that scenario played out could provide some insights into to what the near future holds for subprime lenders. Between 1996 and 1999, credit card companies were riding high, fueled by the wealth created by the dot-com economy. They offered credit cards to consumers at every income level, with borrowers often not required to provide proof of employment history or salary. When the New Economy bubble burst, many of these individuals couldn't pay their credit card debt, and the party was over. Big, full-service financial services firms, seeing an opportunity, bought up the assets of these stand-alone credit card companies. As a result, most credit card lenders today are parts of large banks. This diversifies their risks and makes any downturn painful, but not catastrophic.

Credit card lending and mortgage lending are fundamentally different businesses, of course. Nevertheless, when specialty finance companies of any kind experience growth stagnation or dramatically falling profits, bigger financial services firms often jump at the potential for new opportunities. In 2006, Wall Street firms announced a series of notable acquisitions of specialty mortgage companies or divisions of larger banks: Merrill Lynch bought First Franklin from NatCity and Morgan Stanley picked up Saxon Mortgage, just to name a few. Also, distressed asset buyers are emerging, seeking to purchase at a discount either whole loans or operating companies. One example of this is hedge fund Farallon Capital Management's April 9 acquisition of Affordable Residential Communities for $1.8 billion. And on April 20, 2007, H&R Block Inc. announced an agreement to sell its subprime mortgage business, Option One Mortgage Corp., to OOMC Acquisition Corp., a newly formed company affiliated with private equity firm Cerberus Capital Management L.P.

While opinions may differ about whether that kind of consolidation is good for the specialty mortgage industry, those financial institutions that already possess highly diversified business models are weathering the subprime storm well and are positioned to benefit from industry consolidation. Lenders with a wide variety of mortgage products tend to employ numerous origination channels and servicing businesses, enjoy geographic diversification, and benefit from earnings of other diversified banking lines that provide stable profitability. Consolidation in the mortgage industry at this point in the cycle provides the opportunity for the survivors to increase market share, reduce operating expenses, and allow for more alignment of risk and pricing.

That's not to say massive consolidation is the only potential scenario. Specialty lenders with diversified mortgage lending and servicing operations can survive the shakeout. If a company can lend to all segments of the mortgage industry--prime, Alt-A, conforming, and subprime--it should perform well through varying credit and interest rate cycles.

Table 1

Top Subprime Mortgage Originators
(Mil. $)	Location	Year-end 2006 volume	Year-end 2005 volume	Year-over-year change (%)
Wells Fargo Home Mortgage*	San Francisco, Calif.	74,249	32,670	127
HSBC Finance Corp.	Prospect Heights, Ill.	52,585	55,534	(5)
New Century Financial Corp.	Irvine, Calif.	51,600	53,596	(4)
Countrywide Financial Corp.	Calabasas, Calif.	40,596	44,637	(9)
WMC Mortgage Corp.	Burbank, Calif.	32,146	31,796	1
Fremont Investment & Loan	Santa Monica, Calif.	31,838	36,242	(12)
Option One Mortgage Corp.	Irvine, Calif.	29,811	40,097	(26)
First Franklin Financial Corp.	San Jose, Calif.	27,725	29,416	(6)
Washington Mutual	Seattle, Wash.	26,837	34,491	(22)
Ameriquest Mortgage Co.	Orange, Calif.	25,578	49,176	(48)
CitiFinancial Credit Corp.	Baltimore, Md.	23,500	20,509	15
Accredited Home Lenders Inc.	San Diego, Calif.	15,603	16,583	(6)
BNC Mortgage Inc.	Irvine, Calif.	13,725	16,072	(15)
Chase Home Finance LLC	Woodcliff Lake, N.J.	11,548	9,655	20
NovaStar Mortgage Inc.	Kansas City, Mo.	10,968	9,266	18
Mortgage Lenders Network USA Inc.	Middleton, Conn.	10,221	4,082	150
Ownit Mortgage Solutions Inc.	Woodland Hills, Calif.	9,376	8,367	12
EMC Mortgage Corp.	Irving, Texas	8,763	17,291	(49)
Aegis Mortgage Corporation	Houston, Texas	8,470	10,500	(19)
First NLC Financial Services LLC	Deerfield Beach, Fla.	7,472	6,020	24
*More than 65% of Wells Fargo's originations are on a co-issue basis for others. Source: National Mortgage News.

Table 2

Top Subprime Mortgage Servicers
		--Total servicing volume--
(Mil. $)	Location	Year-end 2006	Year-end 2005	Year-over-year change (%)
Countrywide Financial Corp.	Calabasas, Calif.	119,060	120,587	(1)
Chase Home Finance	Woodcliff Lake, N.J.	83,837	67,825	24
Option One Mortgage Corp.	Irvine, Calif.	69,039	79,169	(13)
CitiFinancial	Baltimore, Md.	64,250	57,328	12
Ameriquest Mortgage Corp.	Orange, Calif.	65,000	70,000	(7)
Ocwen Financial Corp.	West Palm Beach, Fla.	52,160	41,989	24
Wells Fargo Home Mortgage	San Francisco, Calif.	51,321	44,715	15
Homecomings Financial	Minneapolis, Minn.	50,849	55,213	(8)
National City Home Loan	Pittsburgh, Pa.	49,545	37,574	32
HSBC Mortgage Services	Charlotte, N.C.	49,465	43,792	13
Litton Loan Servicing Inc.	Houston, Texas	49,024	39,271	25
HSBC Finance	Prospect Heights, Ill.	45,850	36,800	25
Homeq Servicing Corp.	North Highlands, Calif.	44,424	44,790	(1)
New Century Financial Corp.	Irvine, Calif.	40,000	39,600	1
Fremont Investment & Loan	Santa Monica, Calif.	27,500	22,300	23
Morgan Stanley/Saxon Mortgage	Glen Allen, Va.	26,911	24,649	9
Select Portfolio Servicing	Salt Lake City, Utah	26,628	23,961	11
EMC Mortgage	Irving, Texas	20,809	22,575	(8)
Washington Mutual	Seattle, Wash.	19,196	22,415	(14)
Mortgage Lenders Network USA	Middletown, Conn.	17,000	8,966	90

Before looking forward to other potential scenarios, it's instructive to see how the subprime mortgage market reached this point in its cycle.

This market's growth during the past five years is just another manifestation of a relatively new phenomenon: American consumers view debt not as an enemy but as a purchasing power ally. According to Standard & Poor's Chief Economist David Wyss, U.S. household debt levels have risen to a record 137% of household after-tax income, saddling the average household with total financial obligations of about 19% of after-tax income. The Federal Reserve's most recent Survey of Consumer Finances, taken in 2004, found that about one-eighth of all Americans have debt service costs that exceed 40% of their annual income.

By 2006, subprime lending accounted for about 19% of originations but for only 13% of outstanding mortgage loans, because, counterintuitively, subprime borrowers tend to pay off their loans more quickly than does the average home owner. As these borrowers build equity in their homes and their credit improves, they refinance into prime mortgages.

In fact, the current spate of subprime delinquencies and foreclosures may be indicating a trend yet to surface in the broader mortgage market: Adjustable-rate mortgages with high LTVs, including the popular "interest-only" loans, are leading the rise in delinquencies in the national mortgage markets. We do not yet know how this trend of rising delinquencies will translate to higher credit losses.

 Chart 1

So far, the subprime mortgage credit stresses have been confined to the highly layered underwriting risk of subprime adjustable-rate mortgages. The subprime fixed-rate market shows no sign of strain. In fact, foreclosure rates in this sector remain near historical lows.

Our structured finance group has reported that the 2006 vintage of subprime mortgage loans rated in securitizations may be the worst-performing vintage ever. To date, the delinquency and net credit losses are tracking very closely to the 2000-2001 vintage of subprime mortgage loans. But, whereas peak losses for this pool reached 5%, we expect the 2006 vintage to reach a lifetime loss in the range of 5.25%-7.75%.

The first signs that the subprime market had significantly softened came in mid-2006 when the risk appetite of whole loan buyers significantly declined at the same time that home prices starting falling in some regional housing markets. These shifts, coupled with the higher layering of mortgage underwriting risk, fueled the spike in early payment default (EPD) rates in some of the specialty finance lenders' 2006 originations. The EPD levels reached a peak of high single digits in 2006. Rising EPD rates in the midst of weakening housing markets increased the volume of loans put back to the specialty finance lenders, as the buyers of whole loans exercised their rights under the EPD recourse agreements they had with the mortgage originators. The EPD recourse agreements varied widely among the subprime lenders and were customized, with EPD defined in the range of default at 30, 60, or 90 days. The wholesale-funded specialty finance lenders did not have the funding liquidity, capital, or earnings to support the increasing volume of EPD mortgage loans they had to repurchase. Furthermore, these mortgage repurchases were now at a discounted value given the default status of the loans, further reducing profitability, as previous gains on the sale of these loans were reversed and credit-loss reserves increased.

 Chart 2

What remains true in all mortgage cycles is that the health of the regional and local economies and housing markets is inextricably linked to mortgage credit performance.

Table 3

Standard & Poor's Case-Shiller Home Price Indexes
(%)	January 2007*	2002-2005 average change
Top five cities
Seattle	11.1	12.2
Portland, Ore.	8.7	13.1
Charlotte	7.9	4.1
Miami	4.2	23.1
Atlanta	2.3	4.3
National average	(0.2)	14.3
Bottom five cities
Detroit	(6.9)	3.1
Boston	(5.6)	6.8
San Diego	(4.2)	17.2
Washington	(3.9)	19.5
Cleveland	(2.7)	3.7
*12-month percent change.

We recently reported that the U.S. median home price could drop 5%-6% by the end of this year, on top of a 3% decline during the past 12 months. This reflects falling home sales and starts, which have leveled off about 30% lower than they were two years ago.

Some subprime lenders started engaging in lending practices and offered loan products never before offered to subprime borrowers. The lending practices included a high degree of risk-layering defined as high risk factors: a depressed FICO score (low 600s and below, although no generally agreed-upon standard definition of a subprime FICO score exists), no income documentation, no asset documentation, and no down payment or a piggyback second mortgage in lieu of the down payment. This small subsegment of the subprime market with the highest layering of underwriting risk has experienced the weakest credit performance. As in earlier mortgage cycles, once refinancing volumes start to wane and the overall mortgage and housing markets cool, a subsegment of lenders continues to chase volume without making the appropriate underwriting or pricing adjustments, despite the warning signs.

In contrast, more traditional, fully underwritten subprime mortgages written since 2003 are following normal delinquency and loss curves. We have also noted that these portfolios are not experiencing the same degree of credit performance volatility as those with increased risk factors.

While we rate only a handful of specialty mortgage finance companies, to date we have taken negative rating actions on three that focused on higher risk, subprime mortgage lending: Fremont General, New Century Financial, and H&R Block. Because of the inherent lag of mortgage origination and loan sales and the skittishness and uncertainty in market value prices of subprime mortgages, rising credit costs and ARM reset risk associated with these loans are likely to impede profitability for the next several quarters.

Table 4

Rating Actions
Company	Date	Ratings action	Outlook/CreditWatch implication
New Century Financial Corp	3/2/2007	to 'B' from 'BB-'	placed on Watch Neg
New Century Financial Corp	3/5/2007	to 'CCC' from 'B'	remain on Watch Neg
New Century Financial Corp	3/9/2007	to 'CC' from 'CCC'	remain on Watch Neg
New Century Financial Corp	3/12/2007	to 'D' from 'CC'	remain on Watch Neg
Fremont Financial Corp	3/1/2007	affirm 'B+'	placed on Watch Neg
Fremont Financial Corp	3/5/2007	'B+' to 'B-'	remains on Watch Neg
PHH Corp	3/15/2007	affirm 'BBB-/A-3'	placed on Watch Pos
Residential Cap LLC	3/15/2007	affirm 'BBB/A-3'	outlook remains Negative
H&R Block	3/16/2007	affirm 'BBB+'	placed on Watch Neg

The business press has been asking whether subprime foreclosures will create delinquencies and losses in the prime or near-prime markets. However, most loans in the latter categories have different sets of risk factors, and any weakness will be particular to those specific factors. For example, financial institutions we rate that specialize in loan products with the least degree of inherent risk--prime mortgages--are enjoying steady credit performance.

In fact, the whole notion of subprime lending-related contagion should not be viewed in context of how it might affect other mortgage sectors, but instead how it could affect "downstream" housing-related industries. For example, according to Mr. Wyss, declines in residential construction during the second half of 2006 cut GDP growth by a full percentage point, a pattern that likely will hold throughout 2007. In other words, the most likely effect of subprime-related foreclosures is more houses on the market, which in turn means less home building and fewer construction jobs, ultimately leading to less consumer spending. So while a domino effect may exist, it's one that cascades through different industries rather than through the different types of mortgage loans.

Moreover, well before the current subprime market woes, we anticipated that other types of mortgage loans would experience increased stress. We expected a normalization of commercial and consumer credit losses across all loan types--including prime mortgages and credit cards--from the unsustainable low levels of the past several years. Loans originated between 2003 and 2004 are now reaching their peak seasoning--or delinquency point--in the mortgage cycle, and given the high volume of loans from this period, it's pushing delinquency levels higher for most mortgage lenders. Still, to date, prime mortgage delinquencies and losses remain below historical averages. We expect overall mortgage performance to track the level of delinquencies and net credit losses in the 2000-2001 period, which was the last time mortgage credit performance was under stress.

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We anticipate stabilization in the specialty mortgage market by the end of 2007, but the ultimate timeline will depend on the broader economic trends in the U.S., including market interest rates, unemployment, and regional housing trends. In the interim, profits will be tough to come by in subprime mortgage lending.

In the current environment, a major issue for specialty mortgage lenders that wish to remain stand-alone companies will be squeezing earnings out of their loan portfolios. Pricing of subprime loans held for sale in the first half of 2007 will be down given the lower demand for these loans at this point in the cycle. Write-downs of retained interests from subprime mortgage securitizations, a trend that surfaced in fourth-quarter 2006, will also weigh on profitability. Other credit-related costs that we expect to rise in 2007 include loan delinquency levels and net losses, loan work-out and restructuring costs, demands for higher loan-loss provisioning, and compliance costs. Add to this the pervasive existence of a flattened and inverted yield curve, which will stall the growth of net interest income tied to mortgage lending. We note, however, that although credit costs will rise, they are doing so from a very low base and should remain at generally manageable levels for the rated financial institutions. Business diversification at larger financial institutions also offers a cushion to buffer lower mortgage profitability. We expect the total mortgage origination market to shrink in 2007 as credit gets tighter, with current estimates indicating 5% fewer mortgage written than in 2006. However, the volume of subprime mortgages may be down as much as 20%-30%. Suffice to say that declining loan volumes are bad news not just for subprime lenders, but for all lenders.

What does all this mean? During the rest of 2007, mortgage bank profitability will be under pressure. Although the mortgage and housing markets are inherently cyclical and thus periodic downturns are common, this slump is also feeling the effect of the seasoning of loans and the fact that the delinquency point in the cycle for 2003 and 2004 loans is currently kicking in, compounding the problem.

Overall, the 2007 mortgage cycle is moving to one of higher delinquencies and losses for all mortgage loans, based on several different measuring sticks. Home price appreciation slowed to an annualized rate of 1.1% in 2006, the worst pace since first-quarter 1999. Meanwhile, the National Association of Realtors April 2007 estimates that existing home prices will decline 0.7%, and new home prices will only rise 0.4% in 2007. This housing recession, coupled with a very difficult interest rate environment--with the inverted yield curve--poses a great challenge to bank and finance company profitability in 2007, with regional differences in housing markets driving the degree of stress.

Things are quite a bit different from a ratings point of view, however. Within Standard & Poor's core rated banking universe, subprime loans typically account for 10% to 18% of total mortgage production and an average 9% to 12% subprime exposure in the loan portfolios held on the balance sheet. In our view, this sector is under little stress from a ratings perspective. Given this limited scope, we are currently expecting very few additional subprime-related negative rating actions among the financial institutions we rate. This is a generalization, of course, that depends on how deep and long the housing recession turns out to be, regional unemployment rates, and the overall economic growth.

The bad news for specialty mortgage companies is that they were already on the regulatory radar screen even before the current credit stresses. U.S. bank regulators issued "Interagency Guidance on Nontraditional Mortgage Product Risks," on Oct. 4, 2006. More recently, federal financial regulatory agencies released "Interagency Proposed Statement on Subprime Mortgage Lending," on March 9, 2007, giving guidance on underwriting and critical disclosures lenders need to provide to borrowers. The U.S. Senate is holding a series of hearings on the subprime mortgage market.

It's a good bet that additional Senate hearings and further governance guidance likely will continue, as could potential banking legislative changes. As a result, we expect compliance costs to rise in 2007, as institutions under the guidance of banking regulators face new standards governing--and perhaps to some degree curtailing--their lending activities. Today, many specialty finance lenders are making critical changes to their underwriting standards to reduce layered risk factors. Based on these underwriting adjustments alone, we estimate that mortgage volumes at many of these lenders will drop by as much as 30% over the prior year.

Is there an upside to all of this? We expect to see some more rational pricing and underwriting as a result of the current subprime correction. Plus, companies that can take on the assets of distressed lenders have opportunities for increased market share and growth.

Writer: Michael Brewster

Research Assistants: David Rogovic, Rashmi Shah