What's going on in the subprime mortgage market?

Deep breath... and... subprime mortgages! It's almost impossible, but let's try to be dispassionate here, in contrast to the hyperbole of, say, Nouriel Roubini.

First, where's the risk? A huge chunk of it resides at mortgage insurers, two of which just announced their merger. These companies insure lenders against default on loans with more than 80% LTV, and they seem to be doing reasonably well: the combined MGIC-Radian will be worth over $10 billion. So there's a pretty large equity cushion there before any kind of systemic risk starts turning up.

Who else bears risk? Most subprime mortgage lenders operate as small shops with credit lines from big banks, which securitize their loans almost immediately and keep as little risk as possible on their own balance sheets. So the risk is borne mostly by investors in mortgage-backed securities. Now read this, about a new instrument designed to allow those investors to hedge the risk on hybrid ARM mortgages, many of which are subprime. That's good news: the more hedging that's allowed, the more that the risk ends up in the hands of people who really want it, rather than with bond investors who have found themselves stuck with underperforming paper. But there's better news at the end of the story: it turns out that essentially all of the risk in these MBSs is basis risk and not credit risk. "Your main risk is not default," says one banker in the article.

On the other hand, the riskiest tranches of subprime-backed MBSs are gapping out: to as much as 640 basis points over Treasuries. Even distressed players are cautious, although maybe they just want the market to themselves:

“With subprime mortgages, you’re dancing on the edge of a razor blade – they’re awful investments,” said John Devaney, CEO of United Capital Markets, a specialist in distressed asset-backed securities.

What's certain is that underwriting standards have tightened up enormously since this time last year, which means that refinancing could be impossible to find for many people whose teaser-rate loans are soon resetting. As Russ Winter says:

Conditions are rapidly and clearly tightening for various “toxic” mortgages used by marginal subprime buyers to purchase housing. This would include the ability to refi into churned mortgages (same toxicity with a new term) to avoid two and three year rate resets. This churning in the past has enabled old mortgage pools such as the 2004 vintages to avoid these subprime resets deadlines.

My problem is that so much of the information on this market is anecdotal. I'm quite sure that various lenders have, at some point, offered all manner of crazy mortgages with teaser rates or high LTVs or "stated income" or negative amortization – and I'm equally sure that no lender managed to roll all these different things into one product, as Nouriel would have you believe.

My gut tells me that the main problem lies with the small brokers and origination shops, many of which are closing. Barney Frank is ironically right when he says, as quoted by Nouriel, that "you can't just make a loan and then sell it" to investors without any liability. If that loan turns out to be particularly toxic, there's a very good chance that the investors will make you take the loan back. And the risk of being saddled with vast amounts of what the mortgage industry charmingly refers to as "nuclear waste" is actually much more of a deterrent to originators than any potential legal liability is.

What happens when the small origination shops close their doors? They're not taking back their nuclear waste any more, so it stays in the MBS vehicle, and the spreads on the riskiest tranches – which used to be low on the assumption that the worst loans could be put back to the originator – gap out.

Is this all making a bit more sense now?

My feeling is that the regulatory sideshow, with all its talk of "predatory foreclosure" (which is not the same as predatory lending) is largely irrelevant, an exercise in trying to shut the door to a stable which no longer exists. Yes, some lenders do have large potential legal liabilities, but I don't think those liabilities are going to be remotely big enough to pose a systemic risk.

In terms of individuals, then, a lot of people who took out subprime mortgages when underwriting standards were lax, especially if they hoped to refinance before their adjustable-rate mortgage reset, could find themselves in a world of pain and foreclosure. In terms of the financial markets, on the other hand, I don't see a huge amount of risk. My guess is that there are already hedge funds circling the subprime lenders, looking for opportunities to buy foreclosed properties in bulk – something which would mitigate, to some degree, the oversupply issue in the housing market.

In other words, let's not throw ourselves off any bridges just yet.

Posted by Felix at 11:13 EST