Mortgages are like wines, they have vintages. Deciding which mortgage is most at risk of default largely consists of looking at its age, because default rates rise steadily over the first four years, before tapering off.
Over the past six months, however, higher default rates have been creeping up on US mortgage lenders and on the holders of the mortgage-backed securities (MBSs) they issue. A study published in March by the New Jersey-based Mortgage Research Group (MRG) provides the bleakest evidence yet that a credit squeeze is under way.
Mortgages issued in 1994 and 1995 are showing higher rates of default than anyone had previously suspected. “The trend was so pronounced,” says Gordon Monsen, president of MRG and a former head of mortgage research at Bear Stearns, “that 1994 originated loans, which were 17 months into seasoning, were defaulting at rates comparable to 1992 loans with more than 40 months of seasoning.”
Western states are suffering the most. Mortgage default rates in California have climbed to 0.6% as cash-strapped consumers, caught by the negative equity on their homes, are assuming more debt than they can afford to service.
Rising credit card bills provide early-warning signals to holders of MBSs. “When some guy is running up a massive credit card bill, it often means that he’s out of work and ultimately that he might have to sell his house,” says Monsen. “But more and more homeowners have decided to walk away – to default – because their houses are worth less than their mortgages.”
The signals could hardly be more ominous. Outstanding credit card receivables in the US have risen from $680 billion to over $1 trillion over the past 18 months.
The study, however, does more than cast light on deteriorating consumer creditworthiness. More worryingly, it exposes a policy shift by lenders on the guidelines they use to decide who to lend to. They are increasingly including a borrower’s mutual fund holdings when they evaluate whether he or she has sufficient savings to service the debt. The problem with mutual fund holdings is that they cannot be liquidated quickly by borrowers to cover for unemployment and other financial mishaps.
The realization is slowly dawning on MBS issuers and bondholders that guidelines may have been stretched to drum up business. “In 1994, when rates backed up, there were very few good borrowers,” says one MBS analyst, “but lending wasn’t curtailed.” The rating agencies agree. “Monsen’s conclusions are valid,” says John Raiter, a managing director at Standard & Poor’s in New York. “We have also observed a relaxation in guidelines to maintain loan volumes, which makes higher levels of default inevitable.”
It seems that lenders have developed a blindspot. “The presumption was that all of these loans were underwritten to government-agency standards,” says Raiter. “But A-quality loans have been made to people behaving like B-quality borrowers.”
The MBS market flourished because of support from Fannie Mae and Freddie Mac. These government-sponsored agencies act as intermediaries, purchasing bank loans and issuing mortgage securities on Wall Street. The Office of Federal Housing Enterprise Oversight has been studying the resilience of agency-backed mortgages and drawing similar conclusions to Monsen, but investors remained impassive as the bonds carry government guarantees.
Higher levels of default will feed through to the private-label market – non-agency backed mortgages – by pushing down bond prices. Mortgage insurance companies, which enhance the credit quality of MBS issues by providing insurance “wrappers”, are set to take the biggest hit. “Perhaps now would be a good time to start shorting mortgage insurers,” says the MBS analyst.
The home equity-backed securities market should also brace itself for troubled times ahead. Consumers are using their homes as the major source of collateral for raising debt, creating a burgeoning market for home equity lending and a new type of asset-backed security (ABS). But the mounting credit squeeze could kill the fledgling market. “As mortgage defaults increase, the loss severity on home equity loans is almost 100%,” says Monsen.
Consumers have been lured into a credit spiral by refinancing credit card bills using their homes as collateral. Lenders have been drumming up business by sending out mailers to people with big credit card bills, offering to refinance the bills, carrying interest rates of 12%-18%, with home equity loans at rates of 8%-10%.
But house prices have remained stagnant or fallen in most parts of the country, which means the value of a house may not to be enough to raise a loan. Lenders have accepted appraisals overvaluing houses to maintain volumes of business.The home-equity loan sector, which generated $12 billion in ABS issues in 1995 – out of a total of $430 billion – already had its sceptics among investors. “Home-equity securities are unappealing because they lump together a spectrum of investment types – from A-quality loans to more risky B and C investments,” says Paul Ullman, co-manager of the mortgage securities portfolio of Alliance Capital Management. “Given that range, it’s difficult to get a handle on the risks. That’s why we’ve stayed away.” Ronan Lyons
