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Sub Prime Surprise ... Not

Nomura Fixed Income Research
Sub-prime Surprise … Not!
Claims of surprise — and even dismay — about developments in the sub-prime mortgage sector
18 April 2007
seem unfounded. Neither business professionals nor policymakers (including legislators, legislative
staff, and regulators) can honestly claim to have been surprised. Actual surprise arguably could have
come only from willful ignorance of market conditions over the past several years. Feigned surprise
likely represents attempts to garner sympathy, to dodge responsibility, or both.
The cooling-off of the housing market and the performance deterioration of sub-prime loans were not
only inevitable but also anticipated by many market participants. The legitimate question was never
"if" the housing market would cool-off, but only "when." Likewise, no lender could ever reasonably
have believed that it would be "safe" to make a zero down payment, stated-income, teaser-rate ARM
to a borrower with a bad credit record.
Ignoring the Obvious: For many sub-prime mortgage loans originated over the past two years,
lenders ignored the famous "Three C's" of mortgage lending: character, capacity, and collateral.
They did so because the market environment allowed them to. By operating at high leverage, the
lenders could book profits from origination activities without regard to the actual quality of the loans or
the magnitude of the risks that they retained.
New Century Financial Corporation
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Contacts:
Source: New Century 10-K Filings
Mark Adelson
(212) 667-2337
The companies could make enough money during the boom times that being able to survive a
madelson@us.nomura.com
downturn was only a minor consideration. As long as the lenders could obtain funding through loan
David Jacob
sales or securitization, they would keep on making loans as fast as possible. In essence, there was
(212) 667-2255
djacob@us.nomura.com
virtually no internal restraint on the kinds of loans that the sub-prime lenders could make.

Edward Santevecchi
Rapidly rising home prices kept the process running for several years. However, by 2005 and 2006,
(212) 667-1314

esantevecchi@us.nomura.com
lending criteria and underwriting practices had become so lax that lenders originated many loans that
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subsequently defaulted during their first few months of existence (i.e., early payment defaults or
EPDs).
So, the next question must be: Why were loan purchasers (and securitization investors) willing to
continue funding loans with declining credit quality? Unfortunately, there is no simple, satisfying
answer. Part of the explanation is optimism. The period from 2002 through 2005 displayed a nearly
ideal confluence of benign conditions for mortgage lending: a strong labor market, a stable economy,
low interest rates, and rising home prices. Conditions were so good for so long that market
participants began to discount the possibility that conditions would change. That was the fatal
mistake. When conditions are perfect, any change can only make them worse.
The "Three C's" of mortgage lending are an idea as old as dirt. They are obvious. They are an
example of an idea that is entirely self-evident and requires no proof. More than 200 years ago,
Alexander Hamilton discussed such ideas in connection with the public debate over whether the
country should adopt the Constitution. Writing under the pseudonym Publius, Hamilton addressed
the people of New York as follows:
IN DISQUISITIONS of every kind, there are certain primary truths, or first principles, upon
which all subsequent reasonings must depend. These contain an internal evidence which,
antecedent to all reflection or combination, commands the assent of the mind. Where it
produces not this effect, it must proceed either from some defect or disorder in the organs of
perception, or from the influence of some strong interest, or passion, or prejudice. Of this
nature are the maxims in geometry, that "the whole is greater than its part; things equal to
the same are equal to one another; two straight lines cannot enclose a space; and all right
angles are equal to each other.'' Of the same nature are these other maxims in ethics and
politics, that there cannot be an effect without a cause; that the means ought to be
proportioned to the end; that every power ought to be commensurate with its object; that
there ought to be no limitation of a power destined to effect a purpose which is itself
incapable of limitation. And there are other truths in the two latter sciences which, if they
cannot pretend to rank in the class of axioms, are yet such direct inferences from them, and
so obvious in themselves, and so agreeable to the natural and unsophisticated dictates of
common-sense, that they challenge the assent of a sound and unbiased mind, with a degree
of force and conviction almost equally irresistible.
* * *
But in the sciences of morals and politics, men are found far less tractable. To a certain
degree, it is right and useful that this should be the case. Caution and investigation are a
necessary armor against error and imposition. But this untractableness may be carried too
far, and may degenerate into obstinacy, perverseness, or disingenuity. Though it cannot be
pretended that the principles of moral and political knowledge have, in general, the same
degree of certainty with those of the mathematics, yet they have much better claims in this
respect than, to judge from the conduct of men in particular situations, we should be
disposed to allow them. The obscurity is much oftener in the passions and prejudices of the
reasoner than in the subject. Men, upon too many occasions, do not give their own
understandings fair play; but, yielding to some untoward bias, they entangle themselves in
1
words and confound themselves in subtleties.
Foreswearing the Three C's never makes sense and never can make sense. This is not simply a
case of 20/20 hindsight. It is a fair recognition (and acceptance) of the fact that there are business
cycles, real estate cycles, and credit cycles. And it is fair recognition and acceptance of the fact that
bubbles happen. Both the mortgage industry and mortgage investors would do well to remember the
Three C's when the sector enters the next boom phase.
Ignoring the Warnings: Beyond the obviousness of the Three C's, many voices in the market
expressed concern about mounting vulnerabilities over the past two years. Some commentators
addressed the weakening of underwriting standards. Some focused on the housing bubble. Some
1 The Federalist Papers, No. 31 (emphasis added).
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Nomura Fixed Income Research
emphasized housing affordability. Some highlighted the tightening of credit spreads on triple-B
tranches. In all cases they offered warnings and recommended caution – either explicitly or implicitly.
Appendices A through E contain examples of such material in Nomura research between September
2005 and March 2006 — more than a year ago. Other researchers and commentators expressed
similar views. Even mainstream media sources, such as The Wall Street Journal and Dow Jones
Newswires, covered the housing bubble and homeownership issues extensively over the past year.
They beat their drums loud and often.
Some segments of the market simply ignored the warnings. Many sub-prime lenders and some Wall
Street trading desks would not have been able to operate profitably if they had to address risk that
home prices might stop rising. Accordingly, they created projections based on short-term data to
justify their actions. The short-term data reflected strong loan performance during the boom phase of
the cycle. They purposely chose to ignore or de-emphasize data about past busts.
And some quarters of the market listened. Almost immediately after the introduction of the first series
of ABX.HE indices in January 2006, various hedge funds started taking the short side of sub-prime
mortgage credit risk. Many of those players were "macro" funds that based their strategies on long-
term views and insight about market cycles and bubbles.
Clearly, there was ample warning. Therefore, even apart from the Three C's, neither business
professionals nor policymakers can legitimately claim to have been surprised by performance
deterioration in the sub-prime mortgage sector. Can they be disappointed? Sure. Surprised? No
way.
Facing the Key Facts: The current situation in the sub-prime mortgage sector is a natural
consequence of events. It is definitely not a national crisis and arguably not even a problem. It helps
to remember a few key facts when contemplating possible action in response to the current situation:
• It's natural for some mortgage loans to default. If there were no mortgage defaults, it would
mean that credit was too tight.
• Defaults on loans to sub-prime borrowers should happen more often than defaults on prime
loans. That's the nature of sub-prime loans.
• Sub-prime lending was not invented in the last credit cycle. Its roots go back to the creation
of the Federal Housing Administration FHA in 19342 and to the creation of the Federal
National Mortgage Association (FNMA) in 1938.3 FHA insurance and FNMA's "special
assistance" function were the cornerstones of national housing policy for decades.
• The traditional instruments of national housing policy boosted U.S. homeownership above
65% in the mid-1990s, long before the latest cycle of sub-prime lending started around
2002-2003.
2 Pub. L. No. 73-479, 48 Stat. 1246, 1252 (1934)
3 On 10 February 1938 the Administrator of the FHA created FNMA as a subsidiary of the Reconstruction Finance
Corporation.
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Nomura Fixed Income Research
U.S. Homeownership Rate
70%
65%
60%
55%
50%
45%
40%
1900
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
2010
Source: U.S. Census Bureau, Statistical Abstract of the United States 2007, Table 956 and various historical
tables.
• In recent years, non-FHA sub-prime lending has grown at the expense of the FHA-insured
sector.
• HUD and the FHA are the regulatory agencies with the primary responsibility for executing
national housing policy. The Office of Thrift Supervision (OTS) and the Office of Federal
Housing Enterprise Oversight (OFHEO) have secondary responsibility. Other financial
regulators are not primarily responsible for national housing policy and they lack both the
experience and the expertise to be effective in that area. Accordingly, other financial
regulators, including the Federal Reserve, the SEC, the Office of the Comptroller of the
Currency, and the FDIC, should not try to take the lead in the housing area. They should let
the experts – HUD and the FHA – take the lead.
• Most defaulting sub-prime borrowers from the 2005 and 2006 vintages are fully or partially
responsible for their predicaments. There are several categories of conduct through which
borrowers got themselves into trouble:
○ First, many of the borrowers got stated income loans and lied about their incomes in
order to borrow more than they could have had they been truthful. Regardless of
whether they were "coached" to lie by unscrupulous mortgage brokers, the borrowers
had to know that they were doing something wrong when they were lying.
○ Second, many of the borrowers gambled on the housing bubble by purchasing their
homes with no down payments. They used piggyback second lien loans to obtain
100% financing on their homes. If the value of a home went up, the borrower would
capture the gain; if the value of the home went down the borrower could simply walk
away. These borrowers knowingly gambled that home prices would continue to rise
and that interest rates would remain low indefinitely. They essentially obtained, for zero
cost, call options on home prices. They simply lost on their bets.
○ Third, many borrowers used stated income loans or 100% financing to borrow
excessively in order to purchase homes that were beyond their means. They wanted to
embrace lifestyles that cost more than they could sustain. These borrowers also
gambled and lost.
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Nomura Fixed Income Research
○ Fourth, many borrowers repeatedly used cash-out refinancing loans as the value of
their homes rose during the housing bubble. This group essentially used their homes
as automated cash machines to support lifestyles that they could not afford with their
regular incomes.
• Defaulted borrowers who (1) lied about their incomes, (2) bet on the housing bubble, or
(3) chose to live beyond their means, are not innocent victims. If a rising level of
foreclosures is a problem, then those borrowers are among those responsible.
• A portion of the sub-prime borrowers who bought homes in the past few years were not
suited to home ownership. Many of them lacked both the resources and financial discipline
to shoulder the responsibilities of homeownership. Loans to such borrowers may seem to
perform well during favorable economic conditions. Under such conditions, the borrowers
often can manage the expenses of homeownership – repairs, maintenance, taxes, and
insurance, in addition to mortgage payments – by repeatedly extracting equity from their
homes through cash-out refinancings. However, the process is doomed from the start
because ideal conditions cannot persist indefinitely. Those borrowers arguably never should
have become homeowners in the first place. For the system to regain a reasonable
equilibrium, many of those borrowers will have to make the transition back to renting their
homes. This group of borrowers probably numbers in the hundreds of thousands.
• Investors in triple-B-rated tranches of sub-prime mortgage ABS should not be surprised if
those securities suffer losses. Securities rated triple-B naturally carry more credit risk than
those rated triple-A. During the boom phase of the credit and real estate cycles, triple-B-rate
sub-prime mortgage ABS should suffer virtually no losses. Conversely, those securities can
become quite vulnerable during the bust phases of the cycles.
• Predatory lending is a real issue. It affects a relatively small proportion of all loans.
• The only innocent victims of predatory lending are borrowers who did not lie about their
incomes, bet on the housing bubble, or choose to live beyond their means. Innocent victims
of predatory lending also must have been ignorant about the terms of the loans that they
were taking. They must have signed papers without understanding them.
• There is no universally accepted definition of predatory lending. In our view, predatory
lending occurs only in two types of situations. The first type is where a lender lies to a
borrower about the terms of a loan. The second type is where the terms of a loan are
unconscionable.
• The sub-prime mortgage sector may need to confront the problem of finding replacement
servicers for pools with high delinquency rates. The original servicer of a pool may resign or
go out of business. The original servicing fee for the pool might not be sufficient to attract a
successor servicer. If that happens, it may become necessary to raise the servicing fee.
The impact would be borne by the holders of the subordinated interest in the pool. Similar
kinds of situations have occurred in the manufactured housing and credit card securitization
areas.
• The American system of government is the most nearly perfect form of government ever
created. Nevertheless, the individual branches of government sometimes do questionable
(or monumentally stupid) things. The judiciary produced the notorious Dred Scott and
Plessy v. Ferguson decisions.4 The executive branch gave America the Watergate scandal
4 Dred Scott v. Stanford, 60 U.S. (19 How.) 393 (1856); Plessy v. Ferguson, 163 U.S. 537 (1896). For a libertarian
view of the all-time 10 worst Supreme Court decisions see
http://kipesquire.powerblogs.com/posts/1137871280.shtml.
For another compilation see
http://www.hereandok.com/WorstSupreme.html.
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Nomura Fixed Income Research
and WMD in Iraq. Congress has passed reams of well-intentioned but ill-conceived
legislation such as the Sarbanes-Oxley Act, which costs American businesses tens of
billions of dollars but produces scant benefits to investors.
What's Next?: The weakening performance of sub-prime mortgage loans raises questions in two
areas. The first area relates to loans that already exist. Are there reasonable policy responses for
dealing with defaulting loans? Should loan servicers change their servicing strategies or fine-tune
their practices? The second area relates to whether lending practices should change so that lenders
make loans differently in the future. Should credit standards be generally tighter or looser? Should
certain loan products be discouraged or outlawed? Should the anti-predatory lending laws be
changed or toughened?
Here is how we would answer several of the key questions in the first area:
• Taxpayers should not be asked to bail out borrowers who (1) lied about their incomes,
(2) bet on the housing bubble, or (3) chose to live beyond their means. Those borrowers are
culpable. Taxpayers should not have to pay to save them from their own irresponsible
behavior.
• Policymakers should not impose a moratorium on foreclosures. A moratorium likely would
produce a spike in foreclosure volumes as soon as the moratorium ends. The spike in
volume probably would stress the capacity of the system to handle foreclosures properly
and might reduce the servicers' ability to work with borrowers on alternatives to foreclosure.
In addition, a moratorium could increase the severity of losses to lenders. In an environment
of falling home prices, any delay liquidating properties can increase severities because the
sale prices decline with the passage of time. Unpaid interest also increases as time goes
by. Final y, the physical condition of properties is prone to deteriorate during a moratorium
because defaulted borrowers refrain from spending money on necessary repairs and
maintenance.
• Loan servicers should accelerate their processing of foreclosures and simultaneously
pursue non-foreclosure default resolutions.
• Loan servicers should increase the use of short sales as a means of resolving loan defaults.
A short sale occurs when a lender agrees to let a defaulted borrower sell his home and to
accept the net proceeds of the sale as full satisfaction of the mortgage debt. Short sales
may be especially effective when the true level of a borrower's income is not sufficient to
fully bear the expenses of homeownership.
• Loan servicers should use modifications as an additional tool for resolving loan defaults.
However, servicers should use loan modifications only when true level of the borrower's
income can support the modified loan as well as the other expenses of homeownership.
Servicers should not use loan modifications to keep a borrower in a home that is visibly
disproportionate to his true level of income. Servicers should use loan modifications only
when they have a high level of confidence that the modified loan will not re-default within two
years. Additionally, contractual limitations on the use of those tools, which are present in
some securitizations, must be respected.
• Innocent victims of predatory lending should be allowed to refinance their loans without
payment of prepayment penalties.
• Innocent victims of predatory lending should be allowed to recover civil damages from
entities and individuals who commit predatory lending. They should be allowed to recover
damages from both mortgage brokers and lenders. They should be al owed to pursue class
action lawsuits.
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Nomura Fixed Income Research
• True predatory lending is despicable5 conduct and the penalty for committing it should be
harsh. Predatory lending should be a crime punishable by imprisonment.
• Neither taxpayers nor lenders/investors should be required to pay so that an innocent
borrower can remain in a house that is disproportionate to the true level of his income. A
borrower with a $45,000/year income should not get subsidized to live in a house
commensurate with a $60,000/year income simply because he is a victim of predatory
lending.
For the second area, relating to whether lending practices should change in the future, some
questions have reasonably clear answers. However, others require decisions over which reasonable
people can differ. For some of those, we present various alternatives:
• The FHA single-family programs6 should be slightly expanded so that they can recover
some of the market share lost over the past several years. FHA loan limits should be
slightly increased for high cost areas. The current loan limit in high cost areas is just
$362,790. Additionally, Congress should give the FHA authority to charge variable
insurance premiums based on the level of risk associated with a loan.
• A tightening of credit standards back to where they were five or ten years ago would lower
the rate of homeownership, but probably only by less than two percentage points.
• Any legislative or regulatory decision to tighten lending standards could be implemented
either directly or indirectly. Direct implementation would take the form of outlawing or
banning certain types of loan products. Indirect implementation would take the form of
making it excessively burdensome or expensive for lenders to offer those products. Direct
implementation of policy decisions is preferable because it generally reduces unintended
consequences.
• An example of direct implementation would be to outlaw al types of loans other than the
traditional 30-year, fixed-rate, fully-amortizing mortgage loan with a maximum LTV of 80%,
unless covered by mortgage insurance. That would be an extreme action. However, based
on the fact that Congress took the extreme action of passing the Sarbanes-Oxley Act after
the Enron debacle, it seems conceivable that Congress could take similarly extreme action
in the mortgage area.
• Usury laws are another example of direct implementation. Such laws generally reflect a
policy decision to protect borrowers from themselves. Usury laws act directly on the lending
process by restricting the rate of interest on consumer loans.7
• An alternative to outlawing or restricting (directly or indirectly) certain loan products might be
to create a licensing system for borrowers who want to use them. For example, a possible
system might work as follows: Basic loan products such as fixed-rate fully amortizing loans
would require no license. Riskier products such as ARMs, interest-only loans and negative
amortization loans could require successively higher levels of licenses – roughly similar to
the various classes of drivers licenses based on different types of vehicles (i.e., car, bus,
medium truck, heavy truck, hazardous material, etc.)
5 In California, the term "'despicable' connotes conduct that is so vile, base, contemptible, miserable, wretched or
loathsome that it would be looked down upon and despised by ordinary decent people." In re First Alliance
Mortgage, No. 04-55920 (9th Cir. 8 Dec 2006) (quoting Lackner v. North, 37 Cal Rptr. 3d 863, 881 (Cal Ct. App.
2006)). Lending activity that does not rise to the level of "despicable" should not count as predatory lending.
6 National Housing Act § 203(b), 12 U.S.C. § 1709(b). The related regulations are in 24 C.F.R. Part 203.
7 For example, in New York, the general usury rate is 16%. NY Banking Law § 14-a(1). Second degree criminal
usury occurs in New York when a person charges interest at a rate above 25% without having the legal
authorization to do so. NY Penal Law § 190.42.
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Nomura Fixed Income Research
• Policymakers should not impose unlimited assignee liability for predatory lending. However,
if they do, they should create a safe harbor for assignees that have clear policies against
purchasing predatory loans and that apply reasonable due diligence to screen the loans that
they purchase.
• If federal policymakers create a federal anti-predatory lending law, the law should set a
minimum standard but it should not preempt state laws that are more stringent.
• Stated income loans should be outlawed. Simply outlawing stated income loans to wage-
earners would not work because any applicant who wants a stated income loan would
simply claim to be self-employed. The lending industry should not encourage or support tax
cheating by self-employed borrowers who want to claim greater income on their loan
applications than they do on their tax returns.
• An indirect alternative to outlawing stated income loans would be to require all lenders to
report borrowers' stated incomes to the IRS. The IRS could then match a borrower's stated
income to his reported income and initiate audits when there is a difference. This alternative
would likely bring the origination of stated income loans to a screeching halt.
• Lenders should not be made responsible for stupid decisions by their customers. Actually,
the notion of making them responsible for their customers' stupid decisions is preposterous.
What would be next? Making used car salespeople responsible when their customers don't
pick the car that best meets their needs? Making clothing salespeople responsible when
their customers pick ugly clothes? Making realtors responsible when their customers pick
bad homes? Making fast food chains responsible when their customers get fat?
• Alternatively, policymakers could change the fundamental nature of the lender-borrower
relationship by making the lender a fiduciary with an obligation to act in the borrower's best
interest. Such an extreme action likely would cause a significant increase in the cost
borrowing.
Conclusion: There is no sub-prime surprise. High delinquencies and defaults are an inevitable
result of the kinds of loans made in 2005 and 2006. Ignoring the Three C's of lending could produce
no other result. Moreover, the warnings were loud and clear. The warnings also were numerous and
frequent. And they came from many diverse sources, including the general media.
The current flurry of activity to "do something" about the sub-prime mortgage situation is a day late
and a dollar short. Policymakers and market participants who don't like the current situation should
have acted sooner by taking obvious preventive measures. Both policymakers and market
participants share responsibility for the current situation by having ignored the warnings and having
failed to act sooner.
Unfortunately, some policymakers are trying to exploit the current situation by pandering to defaulted
borrowers. That conduct is counter-productive. Policymakers and market participants need to come
to grips with reality. There likely will be an uncomfortably high level of foreclosures. Despite the best
of intentions, rescue attempts on many loans probably will fail. And, lastly and most importantly,
policymakers should refrain from taking drastic, ill-conceived actions that ultimately do more harm
than good by unduly reducing the availability of mortgage credit to American families.
— E N D —
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Nomura Fixed Income Research
Appendix A
Update on U.S. Fixed Income Market Conditions (9/7/05):
Residential mortgage-backed securities (MBS) continued to display strong credit performance in
2005. For the second quarter of the year, S&P reported an upgrade to downgrade ratio of roughly
306:45 for residential MBS backed by prime-quality mortgage loans. Although the number of
residential MBS downgrades has increased notably, the ratio of upgrades to downgrades remains
strongly positive. Against the backdrop of a strong rating performance for MBS, concerns are
growing about the possible impact of "bubble" conditions in the U.S. residential real estate market.
Those concerns are amplified and aggravated by the growing use of so-cal ed "affordability"
mortgage products such as interest-only mortgage loans, adjustable rate mortgage loans, and loans
that allow for "negative amortization." For example, the June 18 issue of The Economist reported the
following statistics, which reflect the growing risk in new mortgage loans:
• 23% of homes purchased in 2004 were purchased for investment,
• 14% of homes purchased in 2004 were second homes,
• 42% of first-time homebuyers and 25% of all homebuyers made no down-payment on their
home purchases in 2004,
• more than 60% of new mortgage loans in California were interest-only loans or included
negative amortization features, and
• adjustable rate mortgage loans (ARM) account for 50% of new loan production in the states
that have had the greatest home price increases.
We believe that the most probable resolution of the bubble conditions in the U.S. residential real
estate market will be an extended period of stagnant home prices. However, disruption of the
favorable economic environment has the potential to trigger sudden price declines. Even though the
likelihood of such a disruption is less than 50%, market participants should not ignore the potential
downside. Price declines of more than 30% are possible in the areas that have experienced the
greatest degree of price appreciation in recent years.
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Nomura Fixed Income Research
Appendix B
Report from Boca Raton 2005: Coverage of Selected Sessions of ABS East, p. 11 (9/20/2005):
Affordability Products: One investor panelist is trying to limit his exposure to interest-only loans and
to silent (piggyback) second mortgage loans. The investor is also wary of sub-prime loans with no
documentation or limited documentation of the borrowers' incomes. The alt-A mortgage loan sector
has established a limited but measurable record of success with stated income loans but the
sub-prime sector has not.
Another investor panelist expresses skepticism about affordability products and questions whether
the market prices them correctly. She is concerned that lenders determine whether a borrower is
qualified based solely on the level of the initial payments on a loan without regard to increases that
are likely to occur. The panelist applies caps to the level of affordability collateral that she will accept
in deals that she purchases, including a 10% cap on interest-only loans.
A third investor deals with affordability products by requesting additional information about them.
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Nomura Fixed Income Research
Appendix C
Report from Boca Raton 2005: Coverage of Selected Sessions of ABS East, p. 15-16 (9/20/2005):
The HEL ABS sector has grown 21% in 2005 compared to 2004. The rate of homeownership in the
U.S. continues to climb. Home price appreciation remains strong. Affordability products account for
a growing share of production.
On the other hand, loan-to-value ratios (LTVs) and debt-to-income ratios (DTIs) are rising. The
proportion of loans with full documentation of the borrowers' income and assets is dropping. Margins
on adjustable rate mortgage loans (ARMs) are tightening. The share of interest-only loans is rising.
Consumer credit scores (FICO scores) are rising somewhat, particularly on the ARM side. The top
10 HEL ABS issuers account for about 60% of total issuance. Broker-dealer securitization programs
account for about 30% to 35% of total HEL ABS issuance. Spreads are tight by 5-year historical
standards, particularly on single-A and triple-B tranches.
One panelist observes that today's mortgage borrower can get a better deal on a mortgage than ever
before. Margins on sub-prime loans have compressed to get closer to the margins on prime loans,
luring some prime-quality borrowers to go to sub-prime lenders.
Another panelist feels that margins have gotten too low. Part of the problem is how the lenders allow
loan applicants to lock interest rates at no charge. The push for market share is driving irrational
pricing; lenders are not adequately pricing for the risk of their businesses.
One of the new affordability products is 40-year mortgage loans. Some 40-year mortgage loan
products are fully-amortizing and some provide for amortization on a 40-year schedule but have
balloon payments after 30 years. Forty-year loans are a direct substitute for interest-only loans.
They are very popular in areas with high home prices. The 40-year products have supplanted much
of one major originator's interest-only production. Another panelist feels that the incremental risk on a
40-year loan is only slightly greater than that of a basic 30-year loan. A third panelist agrees that
40-year loans are supplanting interest-only loans.
Fitch believes that the default probability of 40-year loans is about 5% higher than comparable
30-year loans. Another panelist feels that there is a slight decrease in risk on an interest-only loan
compared to a 40-year loan.
Fitch observes that underwriting standards have become looser in recent months. That has occurred
in the context of other developments with mixed implications for credit quality. First, FICO scores
have improved. However, although FICO scores are effective at sorting borrowers by relative risk,
they do not give a strong measure of absolute risk. Also, the market lacks historical data for
regression analysis on the performance of affordability products and limited documentation loans.
Accordingly, it is not possible to tell whether the improvement in FICO scores fully offsets the other
factors. Also, even though FICO scores have gone up, so have LTVs and DTIs. Many reported DTIs
are higher than 45%. Moreover, because DTIs are calculated on starting rates, the "true" DTI of
many loans is higher than 50% or 55%.
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Nomura Fixed Income Research
Appendix D
Report from Arizona 2006: Coverage of Selected Sessions of ABS West 2006, pp. 8-9 (2/15/06):
One panelist explains that consumers always are the key driver behind the economy. A softening
housing market would produce a decline in consumer spending because of both the wealth effect and
the reduced employment in the housing and construction sectors. Other factors, such as energy
prices, the threat of terrorist attacks, and the housing bubble, are also important, but somewhat less
than consumers. Real estate is a regional market and, therefore, there should not be a national real
estate crisis. According to the Office of Federal Housing Enterprise Oversight (OFHEO), Phoenix
had home price appreciation of 34%, which was the highest of any metropolitan statistical area
(MSA).8 According to PMI, there is a 26% chance of home price declines in the next two years.9 The
most affordable places in the U.S. are North Dakota and South Dakota. The least affordable are
California, Massachusetts, and Florida.10 The bottom line is that some places are expensive and
some are not. Although there are regional bubbles, there is not a national one.
A second panelist notes that the outlook for the subordinate and mezzanine segments of the sub-
prime mortgage space is "path dependent." The key factors are employment and interest rates. A
third driver is housing prices, which have been fueled in certain markets by mortgage affordability
products. Employment is strong. There appears to be little risk on the jobs front. On the other hand,
there appears to be greater risk from the potential for rising interest rates. Interest rates are rising
already, which is a problem. Either the Federal Reserve or foreign investors could push rates higher.
Sub-prime lenders are finding it difficult to make money because of the rising rates. At the same
time, housing demand is marginally declining. There is potential for slowing growth of home price
appreciation and, consequently, slowing consumer spending.
There is pricing pressures in the sub-prime mortgage sector. Sub-prime mortgage lenders are
struggling to make profitable loans in the current environment. Consolidation among sub-prime
mortgage lenders is likely. If sub-prime lenders let their underwriting standards or business practices
slip then investors – especially triple-B investors
– may pull away from the market.
That could cause spreads to widen and place further stress on lenders' profitability.
Rising home prices over the past few years have been the key element of the wealth effect.
Government measurements of disposable income do include capital gains and, therefore,
underestimate consumers' spending ability.
For the housing bubble to burst, the economy would first have to slip into decline. Absent a
deteriorating economy, the bubble should not burst. Another view is that there is a strong possibility
that today's benign conditions might not persist. Investors in triple-B securities should carefully
scrutinize deals to differentiate which triple-B tranches could withstand deterioration from those that
could not.
A panelist from a bond insurer feels that the market is mis-pricing risk at the triple-B for sub-prime
mortgage ABS. Today's spreads are too tight to justify the risk. Another panelist agrees, stating that
pricing all over the fixed income landscape seemingly dismisses the potential for problems. In the
area of triple-B-rated sub-prime mortgage ABS, strong demand from CDOs is the main factor keeping
spreads at their tight levels.
8 Office of Federal Housing Enterprise Oversight, House Price Appreciation Slows from Record-Setting Pace, But
Remains Strong – OFHEO House Price Index Shows 12 Percent Annual Increase, press release, at 2 (1 Dec
2005) <http://www.ofheo.gov/News.asp?FormMode=Releases&ID=258>.
9 PMI Mortgage Insurance Co., Local Economic Patterns and MSA Indicators, Economic & Real Estate Trends at
3 (Winter 2006) <http://www.pmigroup.com/lenders/media_lenders/pmi_eret06v1s.pdf>.
10 Dunlevy, J., J. Manzi, J. Garfield, E. Santevecchi, and D. Berezina, RMBS: How Affordable Is Housing, Really?,
Nomura fixed income research (24 Jan 2006).
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Nomura Fixed Income Research
Appendix E
Fixed Income Market Update March 2006, pp. 5-6 (3/6/06):
Residential MBS: Residential mortgage-backed securities (MBS) continued to display strong credit
performance in 2005. According to Moody's, the upgrade rate was 6.8%, while the downgrade rate
was just 0.9%. Although that performance is impressive, it is somewhat less so than the prior year's:
in 2004 the upgrade rate had been 8.8% and the downgrade rate had been just 0.1%. Against the
backdrop of a strong credit performance for MBS, concerns are growing about the possible impact of
"bubble" conditions in the U.S. residential real estate market. Those concerns are amplified and
aggravated by the continued use of "affordability" mortgage products such as interest-only mortgage
loans, adjustable rate mortgage loans, and loans that allow for "negative amortization." In many
areas, more than a third of all newly originated residential mortgage loans include affordability
features.
We expect that the U.S. real estate bubble will end with a reasonably soft landing: a long period of flat
home prices. However, we also feel that adverse scenarios are possible, though much less likely. In
a highly adverse scenario, price declines could be a much as 30% in areas that have had the
"hottest" real estate markets in recent years.
Losses on a residential mortgage loan should occur only when two conditions exist at the same time:
(1) the borrower becomes unable to meet his monthly payment obligations and (2) the value of the
property securing the loan is less than the amount necessary cover interest, principal, and related
expenses. Thus, even if home prices decline significantly, losses on mortgage loans need not
increase proportionately if borrowers continue to be able to afford their monthly payments. If home
prices decline, losses on mortgage loans would become more sensitive to conditions in the labor
market because borrowers who lose their jobs would be more likely to default on their loans. Over a
somewhat longer-term horizon, losses on mortgage loans would become increasingly sensitive to
interest rates as borrowers on adjustable-rate loans potentially face the impact of rising rates.
— E N D o f A P P E N D I C E S —
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