Friday, March 21, 2008

Subprime Investments

In my last post, I noted Ben Bernanke's remarks last May about how most subprime mortgages were still making payments.

You might not know it from media reports, but this remains true today.

What are current mortgage default rates? The Mortgage Banker's Association's press release from March 6 states that the delinquency rate for one-to-four unit residential properties was 5.82 percent in the fourth quarter of 2007. In the fourth quarter of 2006, that rate was 4.95 percent. Is that a large or small increase? Beauty is in the eye of the bondholder, I guess. The rates are higher for subprime mortgages; the above numbers are overall.

Going back to Bernanke's point, it remains true that the vast majority of all mortgages, even subprime mortgages, continue to make payments. Consider that fact in light of the tremendous losses reported by banks such as UBS, Citigroup and Bear Stearns. Those losses are reported losses, due to writedowns of the value of securities held by the banks that are backed by mortgages. In many cases, the losses are not due to "mark to market" but due to "mark to model" because market prices simply do not exist. Also, if one looks at the way the trust pools are set up, and the way the cash flows are split across the tranches, it becomes clear that there is quite a lot of "overcollateralization" of the senior tranches. That is, there has to be really significant impairment of the overall mortgage pool backing the securities before most of the securities are hurt. There is also this issue of "excess spread" that creates more of a cushion: the rates that the mortgage holders pay exceeds the rate paid to the securities backed by the mortgages; the excess goes initially into a pool that takes any initial defaults.

You can actually see the default rates for collateralized mortgage pools on a Bloomberg terminal. The data available on one of those is really amazing. Not just prices and rates, but the actual payment performance of the underlying mortgages.

If Bernanke and the Fed are successful in keeping the economy away from recession, or at least deep recession, and at remedying the adverse-selection based credit crunch, then defaults should not increase too much further.

I for one would not be surprised to see some investment banks end up reporting large profits as their securities holdings get revalued upwards.

1 comment:

Jim Bauer said...

I think Bear Stearns is simply an example of too much concentration on one thing. I'm surprised a company that's been around the bend more than a few times throughout history would make such an enourmous mistake that ultimately uprooted it from the banking world.