The subprime mortgage market has seen its worst days, experts agree, but they don’t foresee a quick recovery.
Worse, they do see problems with Alt-A and prime loans that need to be resolved before a true rebound occurs. Alt-A loans stand between prime and subprime in terms of risk level.
Several key indicators of problems for Alt-A loans are emerging, said David Watts, an analyst for research firm CreditSights. Watts pointed to the upward resetting of interest rates, the end of interest-only payments, and the end of negative amortization.
“Now it’s the turn of Alt-A in these areas,” he said. “And I don’t see prime escaping unscathed.”
Meanwhile, National Mortgage News estimates that financial institutions issued about $2.65 trillion in subprime loans from 2003 through 2007. As of mid-August, banks had suffered almost $500 billion in losses and write-downs since the subprime meltdown started last year.
In order to speed recovery, financial institutions have been working furiously to rid themselves of the most toxic holdings. In May, UBS sold mortgage-backed assets it had valued at $22 billion to money manager BlackRock for $15 billion, or 68 cents on the dollar.
And in July, Merrill Lynch announced it was unloading $30.6 billion in collateralized debt obligations (CDOs) to private-equity firm Lone Star Funds for $6.7 billion, or 22 cents on the dollar.
Merrill’s deal represents a key sign of progress in the credit crisis that has shaken the global financial system, according to David Jones, senior economic advisor to Mizuho Securities and chairman of Investors’ Security Trust Bank in Fort Myers, Fla.
“In a way, the Merrill Lynch deal is a benchmark in this process,” Jones said.
In March, the Federal Reserve had bailed out Bear
Stearns and opened its lending spigot to investment banks. Then, in July, the Treasury Department announced its full support for Fannie Mae and Freddie Mac.
“And now, the Merrill Lynch sale established a market value for that paper,” Jones noted. “The essence of the credit crisis is to determine the value of those complex vehicles like CDOs, many of which include subprime mortgages.”
To be sure, with Merrill financing Lone Star’s purchase of the securities, the sale nets Merrill closer to 5 cents on the dollar than 22 cents, said Thomas Atteberry, president of First Pacific Advisors in Los Angeles, which manages about $1.3 billion of mortgage-related securities.
Still, a floor may have been set for the price of the unwanted paper, and the market is at least functioning. Lone Star’s deal could inspire other vulture investors to jump in and buy.
Already there have been hundreds of billions of dollars of such transactions, noted Richard Bove, a bank analyst for Ladenburg Thalmann. “All the major financial companies are selling this stuff when the opportunity arises,” he said. “I think investors will buy it. They like distressed debt.”
Many banks are also moving to split themselves into “good bank/bad bank,” with the bad bank entity taking the damaged mortgage-related assets. “The problem is how do you value the bad banks?” said Scott Pardee, a veteran Wall Street executive who now teaches economics at Middlebury College.
“There’s a total loss of credibility for the people who put these things together. You have to be very clever as an investor and go through mortgage by mortgage. You can’t just take the classification of mortgage and say this is worth a buck.”
Subprime accounted for $629 billion, or about 9 percent, of the $6.7 trillion mortgage securities market as of the second quarter, according to data compiled by Julian Mann, vice president of the money manager First Pacific.
However, trouble is also brewing in the Alt-A and prime mortgage categories. Alt-A mortgage securities totaled about $842 billion as of the second quarter, prime jumbo securities $507 billion, and agency securities about $4.7 trillion, Mann’s numbers showed.
The key indicators of problems for Alt-A loans are emerging, said Watts of CreditSights. He pointed to the upward resetting of interest rates, the end of interest-only payments and the end of negative amortization. “Now it’s the turn of Alt-A in these areas,” he said. “And I don’t see prime escaping unscathed.”
As of June, 13 percent of subprime loans were in foreclosure, compared to 5 percent for Alt-A and 0.7 percent for prime jumbo, according to JPMorgan Chase.
On the buy side, First Pacific, which manages about $1.36 billion in mortgage securities, has looked at Alt-A-related investments over the past three or four months but hasn’t pulled the trigger yet, its president Atteberry said.
“We have bought distressed assets in the past and think we will end up doing some buying” this time around, he added. “It could be an Alt-A CMO (collateralized mortgage obligation), a homebuilder’s bond or something in the bank loan space.”
Experts estimate bank losses stemming from the mortgage mess will ultimately reach from $1 to $2 trillion. But Jones said significant write-downs are unlikely after the second quarter of next year. “You can see the end of the crisis,” he said.
The $300 billion housing bill passed last month will go a long way to help financial institutions and the mortgage market, particularly by allowing banks to sell some of their damaged mortgage-related assets to the Federal Housing Administration, Jones added. “This bill will loosen mortgage credit.”
He and others say that the bottom of the mortgage market isn’t far away. “Our thesis is that in the first half of next year we’ll find a floor,” Atteberry said. “Then,” he added, “we could stay flat for two to three years” before a rebound.