Subprime Woes Subdue Some Winners

Worries about defaults have led investors to shun lenders, but S&P thinks mortgage insurers deserve a closer look

When news of deteriorating credit quality hurting subprime lenders made headlines late last week, investors punished the good, the bad, and the ugly indiscriminately. Standard & Poor's Equity Research believes there's an opportunity to pick up good names that were sold off unfairly last week. But investors should be forewarned: There are still potential pitfalls for many financial firms, as S&P thinks their holdings of new-fangled mortgage products with adjustable rates and flexible payment options could face some hurdles in the coming months (see, 2/14/07, "A Sinking Sensation for Subprime Loans").

Warnings last week from New Century Financial (NEW; not followed by S&P Equity Research) and HSBC Holdings (HBC; ranked 3 STARS, hold) about credit deterioration in their subprime mortgage books sent the S&P Thrifts & Mortgage Finance sub-industry index down more than 2% in the four trading days to Feb. 9's close. Shares of financial-services firms with exposure to the subprime market—including Countrywide Financial (CFC; ranked 1 STAR, strong sell) and Washington Mutual (WM; ranked 3 STARS, hold)—also fell. S&P Equity Research downgraded Washington Mutual to hold from buy on Feb. 12.

The negative sentiment extended to mortgage insurers. PMI Group (PMI; ranked 5 STARS, strong buy) and MGIC Investment (MTG; ranked 4 STARS, buy) also fell.

Limited Damage

S&P analyst Stuart Plesser sees clear differences, and thinks some names were unfairly bid down. While he agrees that both sectors are vulnerable to a decline in credit quality, he thinks mortgage insurers are far less exposed to adjustable-rate mortgages (ARMs) and, to a lesser extent, the subprime market overall.

As a group, the mortgage insurers covered by S&P Equity Research have only about 20% of insured loans exposed to adjustable rate mortgages and 4% to option ARMs. While mortgage-insurer claims are forecasted to rise modestly along with deteriorating credit conditions this year, S&P thinks damage from the trillions of dollars in ARMs should be limited as rates reset higher in 2007. Plus, in general, mortgage insurers have smaller average loan sizes, which protect against downside risk should the loan go into foreclosure, Plesser says.

Meanwhile, S&P thinks another trend forecasted for 2007 might benefit mortgage insurers. As the interest rate for fixed-rate mortgages increases, homeowners should be less inclined to refinance loans. This should result in higher persistency rates for PMI Group and MGIC Investment, a positive for revenues, Plesser says.

Lingering Loans

Lenders have also turned to mortgage insurers as they seek to qualify their loans for sale to government-sponsored entities like Fannie Mae (FNM; ranked 3 STARS, hold) and Freddie Mac (FRE; ranked 3 STARS, hold). Both entities require mortgage insurance when the ratio of the loan to the value of the home is higher than 80%. Lenders were able to avoid mortgage insurance when interest rates were at or near historically low levels in 2003 through 2005 by pushing borrowers into second-lien or even third-lien mortgages known as "piggyback loans."

But Plesser notes that mortgage insurance has proven to be more cost effective, with short-term interest rates well above where they were in the 2003 through 2005 period. MGIC's primary insured loans in force, for example, fell at a compound annual growth rate of 9% from 2003 through 2005. With higher interest rates in 2006, however, the trend reversed, as MGIC reported 3.8% growth in primary loans in force, according to Plesser's research.

For their part, lenders like Countrywide and Washington Mutual could encounter some bumps in the next few quarters, says Plesser. Washington Mutual sold most of the subprime loan production business it originated in 2006—a positive, as many banks and lenders have experienced higher-than-expected credit deterioration from subprime loans extended to borrowers last year. But Plesser says around 8% of Washington Mutual's loan book still comprises subprime loans originated in previous years, which could still hurt the thrift in the quarters to come.

"Recasting" Risks

Countrywide and Washington Mutual also face some risks from so-called "recastings" of pay-option ARMs. While borrowers with these loans are able to pay less than the monthly interest, that unpaid interest gets tacked on to the loan balance. This results in "negative amortization," as the balance of the mortgage loan increases.

The terms of these loans usually call for borrowers to make higher minimum payments once their balance hits 120% of the outstanding loan. If borrowers were paying the minimum, these recasts will likely occur by the second half of 2007, Plesser says. Unlike fixed-rate loans, which have decades of underwriting data behind them and can be modeled under various interest-rate scenarios, pay-option ARMs haven't been stress-tested in an environment where home-price appreciation is slowing, and even falling in some regions of the country.

Roughly 28% of Washington Mutual's loans held are in these riskier option-ARM mortgage products, according to Plesser. By contrast, pay-option loans comprise more than 40% of Countrywide's interest-earning assets.

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