By now, if you've been reading HW, you know that prime mortgages are starting to look pretty troublesome -- both in first and second liens. And while the raw percentages are less than subprime, the raw numbers are set to be much larger as the mortgage mess looks to move up the value chain. The reason why is simple math: there are more prime borrowers than in other credit classes. So a default rate of 4 percent in prime might exceed a 12 percent default rate in the subprime credit class, in terms of the raw number of defaults. And, from a secondary market perspective, RMBS and CDO deals were structured with a very different set of assumptions across credit classes; meaning that a 4 percent default rate in prime may do the same damage to existing prime deals that a 12 percent default rate did to subprime deals, relative to credit enhancement levels. Last week, we published a well-read story that analyzed the latest HOPE NOW data to show that trouble among prime borrowers is picking up steam relative to borrowers in the subprime credit bucket. We've also been giving readers the inside scoop on troubling trends in Alt-A mortgages over the past few months, suggesting that credit rating agencies would need to boost their loss assumptions (which S&P did last week). The NY Times picks up the same trail on Monday:
Homeowners with good credit are falling behind on their payments in growing numbers, even as the problems with mortgages made to people with weak, or subprime, credit are showing their first, tentative signs of leveling off after two years of spiraling defaults. The percentage of mortgages in arrears in the category of loans one rung above subprime, so-called alternative-A mortgages, quadrupled to 12 percent in April from a year earlier. Delinquencies among prime loans, which account for most of the $12 trillion market, doubled to 2.7 percent in that time.
Much of the story covers ground we've traversed here repeatedly during the past six months, but it's one particular line of thought in the story that stood out to us for how utterly wrong it will eventually prove to be:
Over the years, some loans will be paid off as homeowners sell or refinance, and some homes will be foreclosed upon and sold. That reduces the number of loans from those earlier years that could default. Also, since the credit market seized up last year, lenders have become much more conservative and have stopped making most subprime loans and cut back on many other popular mortgages. [emphasis added]
Come again? The fallacy here, one that tends to be repeated throughout the non-industry press, is that by cutting back on subprime, lenders have somehow stopped the spigot of borrower defaults -- which is at the very least a display of backwards logic, given the focus of the NYT's story, which is about how borrower defaults outside of subprime are now becoming the focus of collateral risk. It's also telling, in terms of popular perception, that "exiting subprime" represents a tightening of lending standards, and a "more conservative" lending strategy. In a word, nope, and you need look no further than option ARM lending for proof of that -- the large players in the neg-am space only pulled the plug on their products in this area just a month or so ago. And they've only just begun to pay the price for their billions of dollars' worth of lending in this space. The problems that plagued subprime lending -- loose underwriting criteria, pervasive fraud, products dependent on either serial refinancing and/or continued home price appreciation -- are every bit as pervasive in prime lending as they were in subprime. The only difference is that subprime borrowers are on the margin from a credit and income perspective relative to their prime counterparts; that's the very definition of credit class, and it means that when things go south, its the subprime borrowers that fall off of the cliff first. We've already noted in coverage here on HW that the 2008 vintage is starting to look at least as bad as the 2007 vintage from a collateral performance perspective -- which suggests that the problems in the industry have little to do with credit class, and far more to do with leverage and declining home prices than anything else. Remember the two waves of defaults that we first wrote about last October? That second wave is still out there, folks.