After the U.S. residential mortgage-backed securities (RMBS) market collateralized by Alternative-A loans fell dramatically in the fourth quarter of 2007, the question now is: When and by how much might it rebound?
In Standard & Poor's Ratings Services' view, a real turnaround isn't likely until 2009, though some improvement may occur later in 2008. Much depends on the degree to which real estate values continue to drop, whether unemployment compounds already-poor performance, and the conforming-loan limit determination for 2008, which is part of the economic stimulus plan that the administration is proposing.
Alt-A loans are residential mortgages that generally conform to traditional "prime" guidelines but that contain features, such as less-than-full documentation or a high loan-to-value ratio (LTV), that fall outside standard underwriting guidelines.
The ongoing credit and liquidity disruption in the capital markets is evident in the Alt-A RMBS issuance volume decline to $11.8 billion during fourth-quarter 2007 from $109.5 billion during second-quarter 2007. By year-end 2007, the secondary market for Alt-A RMBS had all but shut down, with only one full securitization rated in December. Clearly, investors are refraining from investing in Alt-A RMBS, perhaps as they assess how the market may be redefined.
Early indicators of how the market is evolving are beginning to emerge. Lenders are increasingly originating more stable interest-rate products such as long-reset (five-, seven-, and 10-year fixed-rate periods before loan rates reset on a monthly, semi-annual, or annual basis)adjustable-rate mortgages (ARMs) and fixed-rate loans. Combined loan-to-value ratios (CLTVs) continue to trend down, while the percentage of loans with full income documentation is on the rise.
These changes are in response to the high level of severe delinquencies (loans delinquent for 90 days or more, including loans in foreclosure and real estate-owned assets (REO)) in the Alt-A market. After nine months of seasoning, 2007-vintage severe delinquencies are higher than those of the 2006 vintage at similar seasoning, which, in turn, were higher than the delinquencies of the 2005 vintage. We expect RMBS investor demand for Alt-A collateral to remain low until delinquency performance begins to rebound, which may not occur before the end of 2008.
Alt-A Underwriting Shifts To Conform To GSE Standards
In another indicator of how Alt-A origination is changing, lenders are now concentrating primarily on loans that conform to the requirements of government-sponsored enterprises (GSEs) Freddie Mac and Fannie Mae. These are the quasi-federal agencies that either guarantee conforming loans when packaged into RMBS or buy such loans for their own portfolio. Originators have retooled their production and underwriting practices to allow their Alt-A loans to be eligible for sale to the GSEs. This is in direct response to weak RMBS investor demand for Alt-A collateral, which in recent years has been characterized as loans with multiple risk attributes. Such loans may have high LTVs or no documentation for underwriting purposes, or they may be short-reset (two- or three-year fixed-rate periods before loan rates reset on a monthly, semi-annual, or annual basis) ARM loans underwritten to a low FICO score. In the currently distressed RMBS market, many originators apparently feel that their only avenues are either selling to the GSEs or retaining loans on their own balance sheet. Consequently, we expect nonagency Alt-A RMBS issuance to remain relatively low in 2008.
In a hopeful sign for the overall mortgage market, Congress has begun to take action on the Bush Administration's proposed economic stimulus package. One recent proposal (passed by the House of Representatives) may temporarily increase the GSEs' conforming loan limit (to $729,750 from $417,000), which could greatly impact Alt-A origination since Alt-A loans tend to be substantially larger than those of other collateral types. (In 2006, an average Alt-A loan was $350,000, nearly twice the typical subprime loan balance of $200,000.) The Alt-A loan market has high concentrations of properties in California, where high-cost metropolitan areas could disproportionately benefit from the increase in the conforming limit. Although the details are not yet final, if the higher limit passes, it would open a significant piece of the mortgage market to GSE eligibility and increase voluntary prepayment speeds in existing transactions, which could further benefit bond performance.
We isolated the loans that were between the current and proposed conforming loan limit during the past three years. Our analysis estimates that roughly 16%, 19%, and 24% of total Alt-A loans originated in 2005, 2006, and 2007, respectively, would have been agency-eligible under this limit. While the agencies might not absorb all of the loans in this band, these steps would further reduce the loans available for securitization in the nonagency markets and would lower future RMBS issuance volumes. There is a risk that loans that reach nonagency outlets may be perceived to be "passed over" by the agencies and consequently will be priced for bids accordingly. This may further delay issuance volume in the near term.
The temporary increase in the conforming loan limit will likely cause a spike in mortgage activity as borrowers rush to lock in the benefits of lower conforming rates on large loans while they're available. Due to the inability of large-loan (jumbo) Alt-A borrowers to refinance into agency-conforming loans to date, we have noted a divergence of nearly 100 basis points or greater between the 30-year rates on conforming and non-conforming loans, a historically high discrepancy. We also note that the inability of borrowers to refinance loans into agency securitization has lowered prepayment speeds. This, in turn, has resulted in greater loan defaults, as many lenders are unable to free up sufficient capital to offer re-financing to Alt-A borrowers faced with interest-rate resets. In conclusion, should the fiscal stimulus package proceed as is currently expected, we expect origination volumes would be disproportionately front-loaded in 2008 and disproportionately low in 2009 and 2010, while non-agency securitization volumes may remain low for extended periods of time.
We expect this trend toward GSE-eligible origination to continue until RMBS investors begin to exploit what we anticipate to be pent-up demand by strong-credit borrowers for nonconforming Alt-A loans. Simultaneously, certain originators' inability to continue to fund on-balance-sheet nonconforming Alt-A loans will also be a key factor in determining demand for nonagency issuance. As discussed in our previous reports, until the diminished demand for Alt-A collateral reverses, we expect reduced availability of funds for issuance of new mortgages as lenders grapple with liquidity and capital adequacy issues.
Nonetheless, one factor that is leading us to expect increased Alt-A issuance later in 2008 and into 2009 is that the GSEs may not have the capital to absorb all the loans directed their way, as their finances have also been stretched by severe delinquencies. As per our analysis above, the agencies would have required approximately $45 billion, $75 billion, and $62 billion in additional capital in 2005, 2006, and 2007, respectively, to absorb all of the loans that would become agency-eligible under the proposed conforming loan balance. Also, the market for nonagency loans has seen a severe and protracted disruption that's not consistent with economic conditions across all parts of the country (i.e., the most recent S&P/Case Shiller index indicated that three of 20 metropolitan areas experienced home price appreciation over the past 12 months). That has led to what we believe is pent-up borrower demand for nonconforming loans that lenders are either currently not accommodating at all or doing so only through on-balance-sheet funding. We do not expect on-balance-sheet funding to continue on a long-term basis.
Alt-A Issuance Declines Sharply
Alt-A issuance in 2007 was down 34.7% from 2006 levels. Volume of less than $1 billion in December 2007 was in sharp contrast to the issuance of $38.9 billion in June 2007 and much lower than the $40.9 billion in issuance in December 2006 (see chart 1). Clearly, the Alt-A RMBS market is stressed and lacking in investor demand.
Chart 1
Hybrid Interest-Only, POA Loans Lead The Securitized Market
Although total Alt-A RMBS issuance volume has dropped considerably, homeowners' mortgage preferences appear to have remained relatively unchanged over the past several quarters (see chart 2 and table 1).
Chart 2
Table 1
Alt-A: Issuance By Product Type
1Q 2006
2Q 2006
3Q 2006
4Q 2006
1Q 2007
2Q 2007
3Q 2007
4Q 2007
ARM IO (%)
0.9
0.9
0.3
0.6
0.1
0.5
0.0
0.1
Fixed (%)
17.8
16.8
15.4
18.3
16.7
16.3
18.4
9.9
Fixed IO (%)
11.2
11.0
9.3
11.0
11.1
12.2
12.4
6.1
Hybrid (%)
5.0
5.4
4.6
5.1
3.9
4.1
3.6
5.1
Hybrid IO (%)
27.6
28.5
31.7
27.5
30.5
35.7
26.9
31.0
Option ARM (%)
37.2
36.3
38.1
36.5
36.6
30.1
37.3
47.5
Other (%)
0.4
1.1
0.7
0.9
1.1
1.2
1.4
0.3
IO—Interest only. ARM—Adjustable-rate mortgage.
Hybrid interest-only (IO) and payment option-ARM (POA) loans lead the Alt-A market, but many borrowers and lenders continue to opt for longer initial fixed-rate periods (mostly 5/1 and 10/1 hybrid ARMs). Short-reset ARMs have all but vanished as lenders react to the high early-period delinquencies and the distressed market conditions, which have been compounded for borrowers facing the onset of rate resets. While this trend is apparent in the data below, we note that Alt-A issuance volumes in the past two quarters have been extremely low, which may skew comparisons against prior periods.
POA borrowers, in particular, continue to flock to hybrid POA products, which offer the security of greater interest-rate stability. During fourth-quarter 2007, lenders scaled back or eliminated traditional POA loans. The result: Approximately 56% of POA loans included initial fixed-rate periods of five years or longer, down slightly from 61% in the previous quarter but far greater than the 9% during fourth-quarter 2006. Even if POA volumes resume at historical levels, we expect the switch to longer-reset hybrids to continue, especially if homeowners and lenders become more concerned about interest-rate volatility and the timing and magnitude of future loan recasts.
Non-POA borrowers also continued to demonstrate a preference toward longer-reset ARMs. Since the yield curve is still relatively flat (see chart 3), investors have little incentive to choose short-reset ARMs over long-reset ARMs. Even as the Federal Reserve Board continues to lower interest rates, both the supply of and demand for short-reset ARMs is expected to remain low, as lenders and homeowners alike crave interest-rate stability.
Chart 3
Tighter Guidelines Lead To Reduced Layered Risk
The trend toward loans with lower risk characteristics continued in fourth-quarter 2007. Key Alt-A mortgage risk factors have been improving in recent quarters (see table 2).
Table 2
Alt-A: Volume By Loan Characteristic
2002
2003
2004
2005
2006
1Q 2007
2Q 2007
3Q 2007
4Q 2007
FICO <650 (%)
15.1
12.7
12.5
10.8
12.1
10.3
9.7
8.5
8.4
Investor (%)
10.3
15.9
16.0
14.9
13.2
13.2
12.4
12.8
10.8
Nonamortizing loans (%)
0.0
4.5
47.3
69.1
77.1
78.3
78.5
76.6
84.7
Stated income (%)
61.3
59.8
62.8
69.8
80.5
83.8
83.2
77.9
74.5
Simultaneous seconds (%)
12.7
16.5
30.5
36.0
43.5
42.3
39.5
30.2
30.9
CLTV <95 (%)
3.6
5.5
13.0
14.5
18.5
18.0
13.4
6.5
6.4
CLTV—Combined loan-to-value ratio.
FICO scores and average CLTVs improved substantially in third- and fourth-quarter 2007 (see chart 4).
Chart 4
In the fourth quarter, the average CLTV fell to 91.3% from 94.7% at year-end 2006. In other words, in order to obtain a first-lien, Alt-A loan, the average borrower with a second-lien loan is now required to have, on average, nearly 9.0% equity in the home versus approximately 5.0% at the end of 2006. This represents a material reduction in risk because not only do we continue to note a movement away from simultaneous-second loans (relative to 2005, 2006, and early-2007 levels), but we also see that more and more lenders require all borrowers, including those with second-lien products, to build equity in their homes.
At the same time, average FICO scores (still an indicator of a borrower's credit quality) for Alt-A borrowers were slightly higher in the second half of 2007 (711) than in the first half of 2007 (708) and at year-end 2006 (702), rising by more than 1% in 12 months.
We expect this trend will be sustained as lenders look for higher credit quality in their borrowers.
Homeowners Increasingly Need To Document Their Income Sources
In fourth-quarter 2007, we saw full-income-documentation (at least 12 months of income documentation) underwriting continue to increase quarter over quarter (see chart 5).
Chart 5
Lenders required full income documentation in 25.49% of Alt-A loans during fourth-quarter 2007, up from 22.1% in third-quarter 2007. This represents a material change from the second-quarter 2007 level of 16.8%, which was near an all-time low.
Similarly, no income documentation fell to a three-year low of 0.72% in fourth-quarter 2007 from a first-quarter 2007 high of 12.0%. It also represents a big change from 2006, when the average no income documentation percentage was 12.69%, with a first-quarter high of 14.47%. However, we can't truly validate this trend until deal volume trends higher.
We expect to see a steady increase in the number of full-documentation loans and a continued decline in no-documentation loans throughout 2008 as lenders keep tightening guidelines in response to the weak performance over the past quarters.
Investor-Owned Homes Seen Less Frequently
In general, we see that investor-owners of residential real estate make up a lower percentage of the loan pools securitized during the fourth quarter when compared with the same quarter in 2006 (see chart 6).
Chart 6
The average percentage of investor-owned homes declined to approximately 12.7% of total issuance in 2007 from 13.2% in 2006. Lower overall purchase quantity and declining home prices are consistent with our expectation that the trend of investor loans declining will continue into the early part of 2008. This is because greater numbers of real estate investors appear reluctant to put their money into properties that could continue to decline in value. Lenders are also increasingly applying more-stringent underwriting requirements for investor-owned homes. We expect that real estate investors may have to reposition their portfolios before they increase spending on additional properties again, possibly by refinancing properties acquired with the intention to generate income in the medium to long term while taking losses, if any, on properties initially acquired with the intent to be held for a short period.
Refinance Loans Are Still On The Rise
Non-cashout refinance loans continue to steadily increase their share of Alt-A issuance, constituting 26.3% of the volume in fourth-quarter 2007, up from 25.1% in third-quarter 2007 and only 18.0% during the same quarter in 2006 (see chart 7).
Chart 7
One main reason for the increase in Alt-A refinancing seems to be borrowers seeking longer-term interest rate stability when faced with the prospect of upcoming resets and even-tighter underwriting guidelines for hybrid products with short fixed-rate periods. However, with the Federal Reserve's recent rate cuts and the potential increase in the GSE loan limit, we expect that lenders will focus refinancings toward loans that agencies can buy. Further, poorer credit profiles for borrowers and the decline in home prices may reduce the loans eligible for refinancing.
Refinance (non-cashout) issuance is still reflecting the substantial shift in product type that began in 2006, as borrowers have opted for loans with additional interest-rate stability (see table 3).
Table 3
Alt-A: Refinance Distribution (Non-Cashout) By Loan Type
1Q 2006
2Q 2006
3Q 2006
4Q 2006
1Q 2007
2Q 2007
3Q 2007
4Q 2007
ARM (%)
50.9
48.7
48.9
45.4
35.1
18.7
16.7
21.7
2/1 ARM (%)
2.5
2.4
0.9
0.7
0.4
0.3
0.4
0.2
3/1 ARM (%)
2.9
2.5
2.5
2.0
1.9
1.7
0.6
1.7
5/1 ARM (%)
8.8
10.5
15.5
19.4
27.8
37.6
42.9
56.6
7/1 ARM (%)
4.2
4.3
6.1
4.7
6.3
9.9
7.4
4.5
10/1 ARM (%)
3.5
5.9
4.9
2.6
3.2
7.5
7.1
2.8
Fixed (%)
27.1
25.1
21.0
24.6
24.5
23.6
23.9
12.3
Other (%)
0.1
0.6
0.3
0.7
0.7
0.7
0.9
0.2
ARM—Adjustable-rate mortgage.
Loans with five-, seven- or 10-year fixed periods increased to 63.9% of total Alt-A refinance (non-cashout) issuance in fourth-quarter 2007, up from 57.4% during the third quarter. This was also supply-driven, primarily because lenders are more likely to offer five-year ARMs and fixed-rate loan products over three-year or option-ARM products.
As refinance (non-cashout) issuance increases, the percentage of purchase loans has steadily decreased to 35.3% in fourth-quarter 2007 from 48.9% in first-quarter 2006. That's because the housing market slowdown has pushed the inventory of unsold houses to recent highs.
Data released by the National Association of Realtors indicate that about 3.6 million homes were on the market as of December 2007. At the current sales rate, that's a 10.5-month supply of houses, and the fourth-highest month on record. Inventory had dropped to a low of a 3.6-month supply at the peak of the housing boom in January 2005.
This supply glut is a primary contributor to the downward pressure on housing. In the short term, this has created pricing uncertainty in the housing market and further discourages buyers. Borrowers in general—not simply Alt-A borrowers—appear willing to watch from the sidelines until they detect a bottom in the housing market that affords them an attractive entry point.
Alt-A Delinquencies Continue Their Sharp Rise
Delinquencies for the 2006 and 2007 vintages continue to go up rapidly (see chart 8).
Chart 8
Severe delinquency rates (including loans that are 90-plus days delinquent, loans in foreclosure and bankruptcy, and loans representing REO after foreclosure) for the 2007 vintage are exceedingly high. They're even higher, on average, on a seasoning-adjusted comparison than the 2006 vintage, which has had unprecedented delinquencies within the Alt-A segment. Further, delinquencies for both the 2005 and 2006 vintages continue to go up as these transactions age. Most 2007-issued transactions have yet to experience major losses, but loans are expected to be liquidated into a very weak housing environment, possibly increasing loss severities.
In our view, the poor delinquency performance observed in the 2006 and 2007 vintages will likely get worse, considering that the majority of loans within these vintages have yet to reach their interest-rate resets. Although recent reductions in the Fed funds rate may dull the payment shock associated with some of the upcoming interest rate resets, we still expect delinquencies to rise as resets occur.
Many struggling homeowners in this distressed market will not be able to refinance their way out of ballooning mortgage payments. Lenders have substantially tightened underwriting guidelines, and declining real estate values have eroded home equity in recent months. Only a fraction of the original Alt-A borrowers are expected to qualify for current refinance programs. In the meantime, borrowers will continue to struggle to make payments. We expect falling home prices may lead to high loss severities on loans that ultimately default because lenders will be unable to recover the full amount of their loans after foreclosure sales.
Based on our analysis of loans supporting Alt-A RMBS transactions, at nine months of seasoning severe delinquencies of Alt-A loans in 2007 were at 3.88%, as opposed to 1.91% for the 2006 vintage and 0.68% for the 2005 vintage, each expressed as a percentage of the current outstanding principal balance (see chart 9).
Chart 9
As we discussed above, a major reason for the increase in delinquencies is the decline in home prices. The Standard & Poor's/Case-Shiller U.S. Composite 20-City Home Price Index continued to fall during fourth-quarter 2007 to levels below those in third-quarter 2005 (see chart 10). As of November data, over the past 12 months, the index has lost approximately 7.7% of its value although significant variations exist between submarkets. In fact, house prices are already down 13.2% in Las Vegas, 12.9% in Phoenix, 12.6% in Tampa, and 11.9% in Los Angeles, each over the past 12 months.
Chart 10
Standard & Poor's Chief Economist David Wyss recently forecasted nationwide home prices to fall by approximately 13% from their peak values. This will continue to put a damper on Alt-A originations in the near term as potential buyers wait for prices to show some stability, and it is likely to prevent borrowers from qualifying for refinancing under more-stringent origination guidelines, ultimately again affecting loan defaults.
While it's still far too soon to draw a conclusion regarding the 2007 vintage's performance, early data continue to suggest that the deterioration in the 2007 vintage may be the worst ever for the Alt-A market.
Extended Housing Slump May Yield High Cumulative Losses
Indeed, given the limited seasoning of the 2006 and 2007 vintages, the spike in severe delinquencies is unprecedented. We remain concerned that an extended housing downturn could lead to a prolonged period of high delinquencies and, ultimately, high cumulative losses. Average losses are currently lower than the 'B' (a highly speculative-grade rating category) enhancement levels (see chart 11).
Chart 11
Typically, 'BBB' (an investment-grade rating category) enhancement is three to four times 'B' enhancement. Although individual transactions will exhibit different behavior, it will take longer to see actual realized losses at the investment-grade credit enhancement levels across the universe of Alt-A securities.
We are closely monitoring the performance of these transactions, and have already taken action on the 2007 vintage (see "536 U.S. 1st-Lien Subprime, Alt-A, Closed-End 2nd-Lien 2007-Vintage RMBS Classes Downgraded," published Nov. 16, 2007, on RatingsDirect).
Following the CreditWatch placement of our ratings of Alt-A transactions in November 2007, we took further action on the 2005 and 2006 vintages in December (see "S&P Cuts 1,292 U.S. Alt-A RMBS Classes From 2005 And 2006," published Dec. 19, 2007, on RatingsDirect).
For upgrades and downgrades in 2007, see chart 12.
Chart 12
We'll continue to monitor the market and refine our rating assumptions to address performance trends, and we may take additional rating actions if those trends warrant them. At this point, however, we don't expect a quick rebound in Alt-A RMBS issuance volume or in the performance of recent-vintage transactions.
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