The Homes May Be Solid, but the Loans Look Shaky

AS the American housing market has slowed, innovations in mortgage financing that Wall Street pioneered in recent years have come to the fore, with some indications that the structures are shaky.

At the heart of the issue are mortgage-backed securities for subprime mortgages. Through financial alchemy, inherently risky loans were bundled together and sold as mostly solid investments with investment-grade ratings.

In such a structure, the senior securities get first claim on mortgage payments. Thus they can be safe and offer low interest rates, while the more junior securities offer higher rates with more risk. Most of the securities could get AAA ratings, the highest possible, and nearly all got investment-grade ratings.

Every pool of mortgages is different, of course, but traders wanted a way to trade something like generic subprime mortgage-backed securities, and the Markit Group produced the ABX indexes. Each six months, Markit puts together tranches from 20 deals sold in the previous six months, and trades securities whose eventual value will be based on the performance of those tranches.

The accompanying charts show the performance of those indexes, and they show how defaults have risen rapidly in the underlying mortgages in securities issued in the last half of 2006. (The next series will be released July 19.)

The prices are similar to bond prices, with a price of 100 indicating traders see little risk in the security, and lower prices showing growing concern. The prices on AAA and AA series have shown little weakness, and are not shown here. But even the A-rated tranches have lost value as nervousness has risen, and the lower groups, rated BBB and BBB-minus, have plunged, particularly for the newest group.

The first sharp slide came at the end of February when disturbing data on rising foreclosures for those homes was released. Cooler heads soon prevailed, and prices recovered much of their losses, but they have since lost all that and more as the trends continued. Those trends, for the mortgages in the various series, are also shown, using averages computed by UBS Investment Research.

Just why the latest group is doing so badly is still a matter of debate. Were these borrowers less creditworthy, or is it just that weak home prices left them unable to refinance or sell their homes if they had trouble making the payments?

Some clues can come from studying the widely varying performance of differing mortgage pools. Consider two in the 2007-1 series. Both are primarily made up of adjustable rate loans, but one, from JPMorgan, has very few problem loans so far, while almost 20 percent of the loans from the other, issued by the Home Equity Asset Trust, are in trouble just nine months after the security was issued.

The problem pool is dominated by mortgages that have balloon payments and properties worth little more than the loans. The other one has subprime borrowers, but the loans appear to have been made on a much more conservative basis.

Most of the mortgages that underlie the 2007-1 series were made as “2-28” loans, whose interest rates reset after two years, rising by as much as six percentage points. The fact so many of the loans are having difficulty a year before the reset suggests that much greater problems could lie ahead. The rating agencies that decided that the lower tranches of these securities were investment grade were using models that may not have underestimated the possibility of falling home prices and the problems that would cause for borrowers. Clearly, some of those trading the ABX indexes think the agencies were too optimistic in their ratings.