Alt-A: defaults lie ahead of us, not behind us

I am pretty well satisfied that the subprime mess has reached its pinnacle. While there may yet be many more defaults, much of the disaster in subprime is baked into the cake. It’s time to move on. But, move on to what? Most analysts say recovery, I say Alt-A.

With nearly $400 billion in writedowns already recorded as a result of the subprime crisis, it seems likely that the storm has passed – at least as far as financial services companies are concerned. I don’t mean to dismiss the problems there out of hand, especially given what homeowners are going through; there will be lots of bankruptcies in this sector. But, the global banking system is strong enough to deal with these.

However, what worries me is not subprime. It is Alt-A. In the US, Alt-A is the moniker used to define that segment of borrowers between prime and subprime. To date, the common wisdom has been that the borrowers are more like prime than subprime. I beg to differ. Statistics for Alt-A borrowers are deteriorating rapidly and this looks to be a disaster yet to considered.

Yesterday, The Sacramento Business Journal had an expose on Mark Hanson, who has correctly predicted the magnitude of credit writedowns the global financial system has suffered as a result of the subprime problem. He is looking to Alt-A as the next problem in residential mortgages.

His theory is that other borrowers will follow the path of subprime borrowers, who started defaulting when their mortgage interest rates reset to higher levels. Many alt-A borrowers face a bump in their monthly payments starting mid-2010, according to financial services company Credit Suisse. The firm’s figures, reported in the International Monetary Fund’s report on global financial stability, show a big bubble of U.S. mortgage rate readjustments hitting during that time period, including borrowers with "option ARM" loans that allow a borrower to initially make payments that are so low the balance increases.

Others in the industry say such predictions amount to Chicken Little panic.

Sacramento Business Journal

Is he wrong? Well, Michael "Mish" Shedlock has been looking at this problem and what he sees is very worrying. Tracking loan default and delinquency statistics for an individual pool of mortgages in the Alt-A category at Washington Mutual (WaMu), he saw this in April:

January Pool Stats

  • 19.3% 60 day delinquent or worse
  • 13.15% Foreclosure
  • 1.83% REO

February Pool Stats

  • 22.69% 60 day delinquent or worse
  • 11.62% Foreclosure
  • 3.56% REO

March Pool Stats

  • 25.3% 60 day delinquent or worse
  • 13.35% Foreclosure
  • 4.44% REO

Note the above progression. This cesspool from May of 2007, was 92.6% originally rated AAA, even though loans had full doc only 11% of the time. In less than one year, the pool was 25.3% 60-day delinquent or worse. Of that 25.3%, 13.35% is in foreclosure and 4.44% is bank owned real estate.

Mish’s Global Economic Trend Analysis, 1 Apr 2008

Less than two months later, it looked like this:

Facts and Figures

  • The original pool size was $513,969,100.
  • 92.6% of this cesspool was rated AAA.
  • 22.89% of the whole pool is in foreclosure or REO status after 1 year.
  • 31.17% of the pool is 60 days delinquent or worse

Mish’s Global Economic Trend Analysis, 29 May 2008

Needless to say, this is just one of many Alt-A pools within the CDO and RMBS universe. With resets approaching in earnest in 2009 and 2010 (see graphs from above versus subprime below), one should expect significant deterioration in the overall metrics for these sub-groups. The result will be a wave of writedowns for owners of the CDOs and RMBSs linked to these mortgages as well as significant losses on the underlying loan pool.

Is Mark Hanson a Chicken Little? Hardly.

Additional Sources

Alt-A Problems Grow, While Subprime Takes Turn for the Worse, Housing Wire, 28 May 2008

See: Credit Crisis Timeline for a full list of writedowns and capital raising by institution and a timeline of the credit crunch.

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