The Financial Times' Lex is usually a source of level-headed analysis and grounded reasoning in matters financial, but like many in the financial press, even Lex tends to get misled in trying to make sense of mortgages. And if Monday's column on Alt-A mortgages is any indication, the old adage that says Wall Street doesn't understand mortgage banking is alive and well. You don't need to read the rest of the column; all you need to read is the foundation used to build it:
The idea of just handing the keys back and walking away from a house worth less than the loan made against it tends to catch the imagination. Hence fears that the expiry of initial fixed rates on Alt-A loans could result in another wave of foreclosures, just as the pain in the sub-prime segment appears to be peaking. Yet there are reasons for cautious optimism. Alt-A borrowers have better credit records than sub-prime debtors, and the pool of Alt-A mortgage backed securities is smaller - about $600bn for loans made between 2005 and 2007, compared with about $1000bn for sub-prime.
What's wrong with this: The issue with defaults has never been about credit record; it's about risk-layering, and you'd expect the financial markets to understand this by now. Take a borrower with poor credit history, add in an adjustable-rate loan, DTI underwritten at the teaser, stated-income underwriting, and so forth and you've got a layer cake of risk with so many layers in it that it's a wonder it could ever stand to begin with. Alt-A borrowers face similar risk-layering, including piggybacked second liens and stated income borrowing, among others. When it comes to RMBS, it's not about the sheer volume of securities issued; it's about the credit enhancement that exists to protect investors once collateral defaults occur. And comparing Alt-A issues to subprime, it's no contest: Alt-A is so much thinner in its padding for losses that a lower default rate could hurt investors in Alt-A deals far worse than anything we saw in subprime. The only saving grace here is reach; because Alt-A deals didn't yield what subprime did, fewer got pulled into CDO issues. There are large chunks of Alt-A that didn't get securitized, but instead were held in portfolio for the interest income benefits: and that would be your option ARMs. Which means that while mushrooming defaults may not hit RMBS investors, they will hit the loan portfolios of more than a few commercial banks. Taken together, the above suggests that if anything, we should be as much concerned about where Alt-A heads over the course of the next 12 months as we have been about subprime. (And, even with subprime, it's worth noting that many defaults staved off by low interest rates haven't escaped the guillotine for good, since most continue to re-adjust every six months. If rates increase, subprime defaults will likely ratchet forward again).