The Risk o Negative Home Price Appreciation is not factored into the market today
SEVERE EDIT
Robert Rodriguez:
In 2005, we reviewed three mortgage-backed securities that we owned in FPA New Income. What caught our attention was that they were experiencing an elevated rate of delinquency and foreclosures, after only nine months of seasoning. This did not seem to make sense to us since these securities had high FICO scores (710-720). They were Alt-As and we did not understand what was going on, but we were unwilling to stay around to find out, so we sold them without any trouble. At the time, I had conversations with others who noticed these same trends. They were cautious in their outlook toward this sector as well. Now we are witnessing a growing concern regarding Alt-A securitizations. In the April 3, 2007 Wall Street Journal , it reported that M&T Bank Corp. shares, in which Berkshire Hathaway Inc. is a big investor, declined 8.5%. The company announced that it was having trouble selling their Alt-A loans and thus, they would keep the loans, “a move that could knock about $7 million off its first-quarter earnings.” In another article that same day, SouthStar Funding LLC, an Atlanta lender, announced that it would be closing down because the type of loans that it originates, Alt-A, are experiencing the same problems as sub-prime. Alt-A loans are loans that are supposed to be of a materially higher credit quality level than sub-prime and can have characteristics that are equal to prime mortgage loans.
Robert Rodriguez: As we researched this area, we ran across the First American Real Estate Solutions report, “Alt-A Credit — The Other Shoe Drops?” In it the data shows how far the underwriting quality has deteriorated since 2003. The report details how ARM loans have escalated from 1.7% to nearly 70% of total originations, with low documentation rising from 58% to nearly 80%. Furthermore, between 2002 and 2006, IO (interest only) loans rose from 7.7% to 35.6%, of total loans, while negative amortization loans grew from 0.4% to 42.2%, respectively. I could go on but the data obviously demonstrates the deterioration in underwriting standards. Why are these two areas important? Sub-prime and Alt-A originations accounted for nearly 40% of total mortgage loans in 2006. The hunger for housing on the part of the individual, along with the hunger for profits by the originating organizations, created a perfect storm for excesses to develop. In our opinion, all of this is a direct result of the Federal Reserve’s misguided interest-rate policy that led to the steepest yield curve ever. It helped to create a housing bubble of massive proportions that then encouraged buyers and lenders to speculate. The development of liar loans, i.e., low or no documentation loans were able to proliferate because everyone knew that home prices only went up. All of this would not have been possible without the development of the securitization market. The development of sub-prime ABS securities allowed many organizations to rapidly grow their origination base with the goal of selling these securities into the secondary market and, as such, sub-prime loans grew from slightly less than 5% of mortgage origination in 2001 to nearly 20% in 2006. With the easing of credit standards and the ability to sell these securities into the secondary market, an excess demand for housing was created.
Robert Rodriguez: I go through this long discussion since there is quite a bit of debate as to how big and how long the housing downturn might be. There are questions as to how much, if any, house price depreciation might occur. I have seen various studies try to estimate what the decline in home prices might be. These estimates generally range in the 10% to 20% area; however, Robert Shiller of Yale estimates that, if housing were to come back into alignment, after adjusting for inflation and the expansion in the average size of a home, the price adjustment would have to be approximately 45%. This may all sound a bit extreme since there has not been an annual decline in the national average price of a home in the post-WWII period.
Robert Rodriguez: My associates and I wondered, how might a house price decline affect the models that rating agencies use in determining the credit rating of a mortgage-backed ABS? On a conference call with Fitch on March 22, Fitch presented its assessment of the sub-prime ABS market. During the question-and-answer period, my associate, Tom Atteberry, asked the question, “What are the key drivers in your credit rating model?” Fitch responded that it would be the FICO score along with the assumption that home price appreciation (HPA) of low- to mid-single digit would continue, as it has for the last fifty years. Tom then asked, “What would happen to your model if HPA were flat?” They responded that the model would start to break down. If HPA were a negative 1% or 2%, the model would completely breakdown. Thus, if forecasts of 10% to 20% declines in home prices were to occur over a tenyear period rather than one or two, the model that Fitch uses would breakdown and various securitizations with credit ratings of AA or even AAA would experience considerable difficulty. This aspect of risk is not factored into the market today.
Robert Rodriguez: The potential of a breakdown in the rating agency models has serious implications for various types of financial institutions and debt origination structures. It could potentially strike at the confidence in the rating agencies themselves. My associate, Julian Mann, has been studying the area of sub-prime and rating agency involvement. He recently showed me a very garden variety Libor sub-prime floating rate security. The Standard & Poor’s pricing service valued this bond at par while on March 19, 2007, Moody’s rated this bond A3. To affirm the accuracy of this bond’s pricing valuation, Julian went to two brokerage firms that traffic in this type of security and requested what might their bid be, if we were to request a bid. One responded that it would likely be in the $7 area. This does not mean 70% of par but 7% of par, a differential of nearly 93% between what the Standard & Poor’s pricing service indicated and what might occur in the actual market. The other firm declined to indicate a bid but did say that the 7% of par bid was probably the correct one. Julian is continuing to investigate this area to determine whether this is an isolated occurrence or whether this may be the tip of something even larger. It does raise a serious question in our minds.
Robert Rodriguez: Since the conference call with Fitch, there has been a heightened level of discussion by many of our elected representatives as well as from some of the federal agencies. On April 12, Congressman Barney Frank of Massachusetts suggested that mortgage bond investors should be held liable for deceptive lending practices. This was followed up on April 17 when FDIC Chairman, Sheila Bair, said that mortgage investors failed to do due diligence before buying all these mortgages and that “everybody needs to share the pain.” Should any of these misguided comments create the environment to legislate this type of liability, I can assure you that less capital will become available for mortgage loans. This I can say with absolute certainty in the case of the Funds we manage at First Pacific Advisors.
The Word “Risk” Does Not Seem to Be in the Vocabulary of Many Investors
Robert Rodriguez: One additional risk to the sub-prime and possibly the Alt-A and other credit ABS structures is that the credit pipeline has gotten very extended between the providers of capital and the borrowers of capital. With so many different entities between borrower and lender, and with each taking their fractional share of fees, the discipline of the credit underwriting process can become tenuous since the loan is being passed on to another entity. In this case, should the borrower get into trouble, the ability to manage or restructure the loan terms becomes more difficult as these loans are securitized. It is estimated that approximately 75% of all sub-prime loans have been securitized so that a modification of the loan terms may be restricted by the prospectus or legal agreements. With many of these loans held in CDOs (collateralized debt obligations) that are owned by distant third parties, an effective loan restructuring is difficult, if not nearly impossible. This is a decidedly different scenario than what happened in the last credit contraction of 1990-93. Back then, most loans were held in a portfolio by the originating organization and, therefore, a loan restructuring could be done more easily. It will be interesting to see how these new structures operate and how they might affect the economy in a credit contraction. For the past two years, we have been weeding out any questionable loan-structured securities in FPA New Income.
Robert Rodriguez: Should the economy experience a reduction in job growth or the beginning of a rise in the unemployment rate, this could accelerate the negative price adjustment in housing and further cause a weakening in consumer disposable income and spending. Any weakening in employment would also occur at a time when between $1.1 and $2.2 trillion in mortgages will be subject to rate resets this year, according to The Bank Credit Analyst . We feel the risks of this negative scenario are rising, but this risk is not being factored into valuations in the stock market or into credit spreads in the bond market. Again, the word “risk” does not seem to be in the vocabulary of many investors.
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