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A Primer for the Subprime Problem

The growing number of defaults in the subprime-mortgage market has many investors confused. S&P has some answers to common questions

From Standard & Poor's RatingsDirectAs defaults continue to rise in the subprime-mortgage market, Standard & Poor's Ratings Services has responded with downgrades of two of the largest specialty finance subprime lenders: New Century Financial (NEW), lowered to D from CC on Mar. 12, and Fremont General (FMT), cut to B- from B+ on Mar. 5.

The remaining large subprime lenders that we rate, such as HSBC (HBC), Citigroup (C), Countrywide (CFC), and Washington Mutual (WM), not only possess diversified mortgage-banking businesses but have also developed other business lines with revenue sources that should continue to support their core operating performances through this stressed subprime market.

The rising tide of subprime defaults is raising many questions, not only about the subprime market but also about the ramifications of the market's problems for the near-prime and prime sectors, potential new regulations affecting the mortgage market as a whole, and the timetable for a subprime loan market stabilization. Standard & Poor's Ratings Services offers some answers:

Will there be further rating actions related to the subprime downturn?

We don't anticipate a rash of negative rating actions due to rising credit stresses in the subprime-mortgage sector. The rating actions taken on New Century and Fremont reflect the high concentration of subprime mortgages at these businesses and the weak credit performance of their respective subprime portfolios. This performance has triggered funding liquidity concerns, as both companies rely on secured wholesale funding sources.

The business press often refers to the "subprime market" without making any distinctions. Which elements of it are deteriorating, and which, if any, are showing resiliency?

The subprime mortgages experiencing the weakest credit performance are a small subsegment of this market, and one with the highest layering of underwriting risk. By high-risk layering, we mean the tendency to accumulate high-risk credit factors: A low FICO score (low 600s and below), no income documentation, no asset documentation, no down payment or second mortgage collateral in lieu of the down payment, and a purchase mortgage. This "perfect storm" of risk layering in underwriting subprime mortgages is unprecedented.

In addition, the subprime mortgages that were originated in late 2005 and in 2006 are experiencing the highest levels of early payment defaults. However, other segments of the subprime-mortgage market are to date following more normalized delinquency and loss curves.

To what extent do you anticipate delinquencies and losses in the prime or near-prime markets?

For some time, we have anticipated a normalization of commercial and consumer-credit losses across all loan types—including prime mortgages and credit cards—from the historic and unsustainably low levels they have been experiencing during the past several years.

Given the sheer high volume of mortgage loans originated between 2003 and 2004, these loans are reaching their peak delinquency point in the mortgage cycle, which is pushing mortgage delinquency levels higher for most mortgage lenders. To date, prime mortgage delinquencies and losses remain below historical averages.

What percentage of the overall mortgage market are subprime mortgages?

According to the Comptroller of the Currency, subprime originations account for 20% of all mortgages during the past two years. In 2006, 40% of adjustable-rate and interest-only loans were subprime. In 2006, subprime lending volume was at an unsustainably high level, and the recent fallout in credit quality demonstrates that this market segment grew beyond its limits. Historically, subprime mortgages have represented 10% to 12% of the total mortgage market.

Can the standalone specialty mortgage finance lender survive?

Yes, if its lending is diversified across a broad spectrum of the mortgage market. Those companies with diversified mortgage lending and servicing operations, aligned with strong interest-rate and credit-risk management oversight, can survive the shakeup. Some specialty-finance companies that successfully lend to all segments of the mortgage market have multiple origination and sale channels. Not surprisingly, these are the organizations that perform better through varying credit and interest rate cycles.

Another indicator of a mortgage-banking operation built to last is one with a strong mortgage-servicing business, which is a fee-generating business and provides a hedge to the cyclical mortgage-production business. A strong servicing business also provides a critical infrastructure for growth in mortgage production.

The specialty-finance lenders that aren't part of a bank—and thus can't rely on deposits for at least partial funding—face great liquidity and funding challenges. Instead, their growth depends on access to the capital markets and third-party funding, such as mortgage-warehouse lines. Critical to keeping these funding lines open are capital strength and good credit quality. Once these two critical measures deviate from their expected paths of performance, the access to funding weakens, and in extreme cases, such as that of New Century, is shut down.

Did subprime lenders lower their lending standards dramatically in the past 12 months?

Some did. The risk layering of mortgage underwriting we refer to above is evident of the lower lending standards. Also, the wider acceptance of nontraditional mortgage products (such as interest-only loans) by consumers, lenders, and investors added to the shift in higher credit risk for subprime mortgages.

The growth of these products and loosened underwriting standards prompted U.S. bank regulators to tighten standards on Oct. 4, 2006. Even more recently, on Mar. 9, 2007, the Federal financial regulatory agencies issued a proposal calling for raising standards for qualifying borrowers and requiring more detailed disclosure of loan costs to prevent predatory lending practices.

Subprime mortgage lenders often sell most of their loans to investors. Can we expect institutions that buy subprime loans to stay away from these investments for a while? What about organizations that lend to, insure, regulate, and securitize subprime lenders—will they stay away now?

The slowing real estate market and the spike in early-payment defaults on some subprime mortgage loans have naturally made buyers more cautious, which will dampen loan volumes. Clearly, the subprime loans out of favor with investors and Wall Street buyers are the 100%, or high loan-to-value loan, with no stated income and no stated asset verification. Specialized subprime lenders will continue to originate only those loans that can be sold to the secondary markets, as they tend to not be portfolio lenders. The majority of their volume is "presold," or tailored to specific buyers/investors of their loans.

We expect some financial institutions that provide mortgage warehouse financing to specialty mortgage lenders to either exit this business or reduce their volume of financing during the next year. The degree of exodus will depend on the financial institutions' commitment to the business, as well as other business relationships they may have with the lenders they're financing.

When will the subprime market stabilize?

We anticipate stabilization by the end of 2007, but the ultimate timeline will depend on the broader economic trends in the U.S., including market interest rates, unemployment, and regional housing trends. When loan volumes decline, the profitability challenges for specialty-subprime lenders proliferate. Consolidation will continue, as the housing markets continue to slow and these lenders sell out to larger companies or close their doors altogether, voluntarily or through bankruptcy (see, 2/19/07, "Out of the Basement for Housing").

What will be the overall effects on big banks?

The financial impact should be minimal. The rated banks' exposure to subprime mortgages is in the range of 9% to 12% of loans held for investment, and typically 10% to 15% of overall loan production. Large financial institutions have the advantages of diversified product portfolios, overall business diversification, and adequate long-term funding, including the access to deposits. Also, several of the larger banks never aggressively pursued the subprime market or aren't in the business, such as Bank of America (BAC).

What are the credit implications of a continuing drop in the growth rate for residential real estate values?

During the next year, mortgage-bank profitability will be under pressure and will undoubtedly see limited growth, given the current negative trends in the mortgage and housing markets. Although these markets are inherently cyclical, the degree of cyclicality is critical to the potential credit exposures embedded in residential mortgage loans. Housing values and market trends are regional and localized, so a lender's geographic diversification clearly benefits credit performance. To date, the region of the country experiencing the most acute housing value decline is the upper Midwest, with Michigan and Ohio among the weaker housing states.

The housing markets are currently experiencing a "correction" of the rapid price appreciation levels experienced during the past three years of record mortgage volumes, which were fueled by historic low mortgage rates. According to the recent Office of Federal Housing Enterprise Oversight House Price Index, home price appreciation slowed to an annualized rate of 1.1% in fourth-quarter 2006, the slowest level since first-quarter 1999. We expect the mortgage-origination market to shrink in 2007, with current estimates indicating mortgage originations for the year will be 5% lower than in 2006.

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