Defaults in the subprime mortgage arena raise fears that the malaise might spread. But diversification reins in the risk for bondholder.
According to the Mortgage Bankers Assn., an industry trade group, delinquencies in mortgages of all types rose to about 5% in the fourth quarter of 2006, the highest level of late payments since the second quarter of 2003. Actual foreclosures edged up to 1.2%. In the subprime segment of the market, the scenario was decidedly worse. Delinquency rates rose to 13.3% in the fourth quarter of 2006, while the foreclosure rate climbed to 4.5%.
Over the past year, a rise in early payment defaults has led dozens of mortgage lenders, including New Century Financial, to either file for bankruptcy or exit the business entirely. Large brokerages and banks, including HSBC (HBC), have warned of huge losses arising from their subprime loan operations.
Left Holding the Bonds According to Randall Bauer, a fixed-income portfolio manager at Federated Investors, the total U.S. mortgage-market value is estimated at $9.5 trillion to $10.5 trillion, with about 15% of the total represented by subprime assets.
While the problems for subprime borrowers and lenders appear clear, the impact on mortgage bondholders depends on a variety of factors. Some mortgage bonds, such as those issued by the Government National Mortgage Assn. (Ginnie Mae or GNMA), are guaranteed by the federal government and bear no credit risk.
Bauer says the current crisis was facilitated by the housing boom of the past few years, which caused a substantial expansion of mortgage credit, particularly in non-traditional areas like subprime.
“Over the past five years, lenders got more aggressive in the types of mortgage loans they were willing to underwrite, leading them in many cases to loosen standards,”he notes.”Investment banks and brokerages expanded their activity in securitization–the process of bundling mortgages into collateralized mortgage obligations (CMOs) and selling them as bonds, backed by loan payments, to investors hungry for higher yield in an environment of low interest rates.”
Fuel for Speculation
This allowed more people with poor credit and low income to purchase homes, Bauer says, and also fueled a significant speculative element in the marketplace. Hence the explosion in both the subprime business and the Alt-A market, where mortgages are made to borrowers who have better credit quality than subprime borrowers but do not conform to standard agency underwriting guidelines.
According to the Securities Industry and Financial Markets Assn. about $2.12 trillion of mortgage-backed bonds were sold to investors in 2006. Of that sum, about $540 billion are backed by subprime mortgages, Bear Stearns estimates.
Mortgage-backed securities have been the largest sector of the bond market for many years, exceeding Treasuries and corporate bonds. Essentially they are bonds that represent claims to cash flows from a pool of mortgage loans. The loans backing these bonds are issued by various mortgage lenders, savings and loans, commercial banks, and others.
Safety in Numbers
The MBSs themselves are typically issued by quasi-governmental entities like Ginnie Mae, or federally chartered enterprises like the Federal Home Loan Mortgage Corporation (Freddie Mac) (FRE) and the Federal National Mortgage Assn. (Fannie Mae) (FNM). These mortgage securities are high quality and carry essentially no credit risk. Investors are guaranteed interest and principal payments, but are subject to prepayment risk.
Mortgage-related securities found in mutual bond funds may be structured as collateralized debt obligations (CDOs). These vehicles purchase pools of mortgage bonds (or other CDOs) and like the underlying CMOs they invest in, segregate risk into”tranches”–the upper tranches are generally considered high-quality assets since the lower tranches are the first to absorb losses in the underlying pool.