Like measles, financial distress has a nasty habit of spreading. And the repeated protestations by mortgage originators that the problems in the US sub-prime market will not spread elsewhere could be an expression more of hope than experience. It is hard to see how the US prime market can remain unaffected: with 90-day-plus arrears now running at 25% in the US sub-prime sector it is inevitable that there will be a surge in distressed housing sales. This can mean only one thing for US house price appreciation (HPA), which already suffered its steepest fall in 30 years in the third quarter of 2006 – from 13.2% to 3.4%. There are already signs of weakness in the Alt-A mortgage market – one commentator told Euromoney in March: “In six to 12 months’ time the US prime market will be under stress – anyone with a US mortgage origination platform [prime or sub-prime] is going to get whacked. The train is loaded and it is rolling.”
And what about elsewhere? Originating banks have gone to great lengths to explain why the non-conforming market in the UK will not suffer anything like the stress that its US counterpart has experienced. And there are convincing reasons why UK non-conforming mortgages are far less risky: they have lower loan-to-value ratios; lower reset rates (avoiding the payment shock faced by adjustable-rate borrowers in the US) and suffer both lower delinquencies and lower defaults.
But it is an imperfect comparison. Sub-prime mortgages in the US are very easily defined because of the FICO score of the borrower, whereas in the UK a large percentage of non-conforming mortgages are so defined simply because the borrower is self-employed. But the UK non-conforming mortgage sector will – and already is – suffering from the headline risk associated with the US deterioration: by late March shares in Kensington Mortgages, the sole UK independent listed sub-prime mortgage lender, had fallen to 684p (albeit partly because of the departure of its CEO John Maltby and the announcement that it is being put up for sale) having traded at £12 last year. Speaking to Euromoney in April 2006, Kensington treasurer Mark Wilten emphasized that the firm was not for sale at any price; now it might be lucky to find a buyer at all.
And all UK sub-prime lenders will inevitably now face higher borrowing costs. Spreads in triple-B non-conforming RMBS have begun to trend wider in recent weeks, having initially proved remarkably resilient to the turmoil. Even when triple-B US sub-prime home equity loan (HEL) spreads were in free fall (at one stage widening 100 basis points in a week) UK non-conforming triple-Bs did not budge. But as the full extent of the US problems was revealed, definite tiering between UK lenders emerged and book builds on the mezzanine tranches of sub-prime UK RMBS slowed significantly.
The UK sub-prime RMBS market now faces the prospect of further reserve fund draws, and although a spread blowout on the scale of the US HEL sector is not on the cards (the aggressive lending techniques that have plagued the US market have not been widely adopted elsewhere), triple-Bs will almost inevitably end the year 10bp to 15bp wider than they started it. So it does now seem that a few of the US sub-prime chickens that are coming home to roost might end up on the other side of the Atlantic after all.
