Sunday, February 12, 2006

Loans to "reset": next two years

Barron’s Online has a report on subprime loans. Highlights, “The red hot US housing market may be fast approaching its date with destiny. Indeed, inside the mortgage trade, much anxiety is being focused on a looming ‘reset problem.’ Over the next two years, monthly payments on an estimated $600 billion of mortgages to borrowers with checkered or no credit histories, the ’sub-prime’ market, may zoom as much as 50% higher, as the two-year teaser rates on hybrid adjustable-rate loans expire and interest payments hit their fully indexed levels.”

“In the past, such resets caused little disruption. For one thing, the sub-prime market was strikingly smaller. Only $97 billion of such mortgages were originated in 1996, compared with a mammoth $628 billion last year and $540 billion in 2004. Sub-prime loans outstanding now account for more than 10% of the total U.S. mortgage debt of $8.4 trillion.”

“Moreover, the reset triggers on sub-prime mortgages have dramatically shortened, with the loosening in underwriting standards. During the past two years, ‘affordability’ products, as the industry has dubbed them, have migrated from prime to sub-prime borrowers.”

“Significant sticker shock impends for sub-prime borrowers. The shock will be even greater for the sub-prime borrowers who are facing not only a jump from a fixed to a floating rate, but also the burden of amortizing principal after two years of interest-only payments. And for many, the interest- rate reset and IO expiration will occur on the same day, a reflection of the ‘risk layering’ prevalent in the sub-prime market over the past two years.”

“Glenn Costello of Fitch Ratings estimates that at least a quarter of all sub-prime borrowers facing resets may have precious little equity left, even with the huge surge in home prices in the past two years. Many piggy-backed loans to borrow the down payment on their homes, in addition to taking on a conventional mortgage. ‘For some borrowers, there will just be no loan-to-value gap left,’ Costello contends.”

“Even more ominous for the sub-prime borrowers with more than $600 billion or mortgages resetting in the next two years would be new standards for ‘nontraditional’ mortgage products that have been jointly proposed by a number of federal regulators.”

“Obviously, any smash-up in the sub-prime market would hurt lenders. Some such as New Century Financial (NEW) are set up as real-estate investment trusts and, as such, retain some of their securitizations and those of other players. In a bad market, most of the blood would spilled in the lower-ranking tranches of sub-prime mortgage-backed securities, bonds rated triple-B minus and below.”

“(A) New York hedge-fund manager is busily shorting triple-B and triple-B-minus tranches in sub-prime securitizations. The fund is also short various collateralized debt obligations, an estimated $50 billion or so invested mostly in the junior tranches of sub-prime securitizations. ‘These CDOs…could get completely wiped,’ the manager says. The liquidity of the sub-prime market depends on continued purchases by CDOs of the randier tranches of sub-prime securitizations. Should this funding dry up, the sector’s financing structure could seize up. And that would spell big trouble not only for sub-prime borrowers, but for the entire U.S. housing market.”


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