Subprime Woes Won't Worsen Much

Despite Wall Street's jitters, S&P thinks delinquencies for lower-risk mortgage loans won't rise significantly above historic levels

The Mar. 13 announcement by the Mortgage Bankers Assn. that delinquencies are creeping up for both subprime and prime mortgages came as no surprise to Standard & Poor's Equity Research. In fact, S&P believes rising delinquency and default rates will continue into the foreseeable future.

But the news isn't as bad as some investors perceive, though stocks were punished Mar. 13 because of Wall Street worries about the potential spillover effect from the subprime problems.

"Although we believe that delinquencies and default rates for prime loans will rise in the coming months, we don't expect default and delinquency rates for prime loans to increase significantly above historical levels," says Stuart Plesser, a U.S. equity analyst for S&P.

Strong Choices

Plesser remains most concerned about delinquencies and defaults for low- or no-document loans. And he remains concerned about loans made to individuals with low credit-rating scores. As for defaults or delinquencies on prime loans, he says that's simply not as big a concern for several reasons. First, the loan-to-home value ratios for prime loans are much more conservative than for sub-prime loans. Second, prime loans are composed of more traditional loans like fixed-rate mortgages, while sub-prime loans are more likely to feature exotic alternatives.

S&P Equity Research maintains a positive outlook on mortgage insurers PMI Group (PMI), ranked strong buy, MGIC Investment (MTG), and Radian (RDN), both of which carry a buy ranking.

These companies now selling close to book value hold mostly fixed rate loans, and have little exposure to the sub-prime market. S&P believes these mortgage insurers were conservative in terms of their underwriting standards, and that their reserves are adequate. S&P also notes that a portion of their income is derived from the international market.

As Yet Unstressed

On a different note, S&P is maintaining a sell recommendation on lender Countrywide Financial (CFC) as not only is the company partially exposed to the subprime market, but our analyst also believes its margins will come under further pressure due to a tightening of the secondary market.

In addition, more than 40% of the company's loans are option adjustable rate mortgages, which, due to the nature of these loans, haven't yet been stress-tested. That's because with option-ARM loans a borrower has an option to only pay a percentage of the total interest owed. The balance that borrowers don't pay is added to their loan balance and must ultimately be paid.

In fact, for most of these loans, the borrower is forced to pay full interest when the balance reaches 120% of the original loan amount. In Plesser's opinion, the second half of 2007 will be when borrowers who have been paying the minimum amount are forced to pay full interest.

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