Not A Subprime Problem; Loan-To-Value Ratio

A: What happens when prime starts to behave like subprime? The mess we are in is being blamed mostly on 'subprime' and the securitization of these lower quality loans that have gone from bad to worse lately. However, it's important to note that this is a complete mortgage/debt problem, not just subprime, and that there is a much wider pool of mortgages out there consisting of near prime (alt-a) and prime loans that are seeing rising delinquencies as well. If subprime defaults ultimately led to a collapse of the securities derived from these bad loans, what happens if this same infection hits near prime & prime bonds as well! Well, the rating agencies and analysts are starting to warn about this possibility. This is not just a subprime problem!

Out of anyone, I would say Bill & Tanta over at Calculated Risk has been the most vocal blogger out there arguing this point! Just check here, or here, or here, or here, ahh you get the point.

Today, S & P cut it's ratings on $7 Billion worth of Alt-A Mortgage Bonds, the higher quality version of those subprime mortgage backed securities that have led us into so much pain. According to Bloomberg:

Standard & Poor's reduced its ratings on about $7 billion of Alt-A mortgage securities, citing a sustained surge in delinquencies during the past five months on loans considered a step above subprime.The lowered bonds represent about 1 percent of the $694 billion of securities backed by Alt-A mortgages created in 2005 and 2006, the largest ratings company said today in a statement. Countrywide Financial Corp., Bear Stearns Cos., and Lehman Brothers Holdings Inc. issued the most debt downgraded, S&P said.

"These actions reflect a persistent rise in the level of delinquencies among the Alt-A mortgage loans supporting these transactions," along with S&P's expectations for further home price declines, the New York-based unit of McGraw-Hill Cos. said. Prime 'jumbo' mortgages from recent years packaged into securities also have rising delinquencies that may create losses among some bonds with investment-grade ratings, according to reports yesterday by New York-based securities analysts at Credit Suisse Group and UBS AG. UBS called increases in late payments on adjustable-rate mortgages, or ARMs, from this year 'alarming.'

This is a complete mortgage & debt problem that is spreading from subprime into alt-a, prime, hybrid option ARM's, cosi & cofi loans, neg amortizing loans, HELOC's, credit card debts, auto loans, etc..

Subprime was simply the spark that lit the fire and is getting most of the attention in the mass media. To think that defaults will not spread to higher quality borrowers is wishful thinking. And to think that the mortgage bonds derived from these higher quality loans will not be affected, is wishful thinking. As home prices fall, the all important Loan-To-Value ratio (or so called LTV) rises. And as the LTV ratio rises, the credit quality of the derived security on this loan falls. Let me explain with a hypothetical borrower and a house whose price has fallen over the past year.

1 YEAR AGO

HOME VALUE ---> $500,000
LOAN ---> $400,000
LOAN-TO-VALUE ---> 80%

SAME HOME TODAY - Nothing Changes Except Home Price

HOME VALUE ---> $425,000
LOAN ---> $400,000
LOAN-TO-VALUE ---> 94%

Notice how the LTV ratio for this homeowner jumped up to 94% now that the value of the home has gone down! In many local markets outside Manhattan, this is a grim reality. Now, as the LTV ratio rises, the derived security from this loan's credit quality falls; it's a higher risk. In other words, the prime loan starts to behave like a subprime one!

You can imagine what happens when the value of the home falls below the loan amount, leading to a LTV ratio of over 100%! Not a good situation for the homeowner or the investor/holder of the mortgage backed security. Should this borrower default, it's losses all around. So what we are seeing here is a deterioration of LTV's as home prices fall, which could lead to credit downgrades; a vicious cycle.

Think about how many Alt-A loans out there, whose underlying collateral (the house) is falling in value, are at risk for credit quality downgrades! Recently CIBC has said that loan-to-value ratios are a better measure of risk than FICO scores. According to Marketwatch.com's article, "Forget FICO":

"The modern foundation of the lending market is about to be uprooted as FICO scores, the long trusted gauge for lenders in determining risk and price, will prove virtually meaningless in this credit cycle," wrote analyst Meredith Whitney in a research note.

"Today, as a higher percentage of people own homes and many of them have taken on 'too much house' or high LTV [loan-to-value] loans, things are different," Whitney said Wednesday.
She added that many individuals previously considered 'prime' customers who took on loans with LTV ratios of 80% and higher are performing closer to subprime loans.

"For those lenders overly weighted to FICO scores in underwriting, we expect the rudest awakening," Whitney wrote.

I bolded the very important sentence in this excerpt: "...many individuals previously considered 'prime' customers who took on loans with LTV ratios of 80% and higher are performing closer to subprime loans."

Get it? Citigroup has the highest exposure to mortgages held with high LTV ratios and many analysts expect a further $4 Billion - $6 Billion hit in 2008 due to losses on these loans. When prime becomes subprime, no one wins! This is not a subprime problem, but we all may become suprime at some point during this credit cycle.

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