The biggest losses in the mortgage world have generally been taken on second liens – what in the real world are generally known as home equity lines. If you have a mortgage and a home equity line, and you default on your underwater mortgage, then the chances of the home equity lender getting anything at all are slim indeed.
So it’s not uncommon for bonds backed by home-equity lines to have recovery rates of zero when there is a default. But in one case, a bond known as Bear Stearns 2007-01, closed in April 2007, it’s not just the recovery rates which are dreadful, it’s the default rates, too. According to an Ambac presentation (Ambac was an insurer on the bond) losses have already reached 9.9%, which is pretty bad. But just look at projected losses, over the life of the bond: 81.8%!
As David Wallis, Ambac’s chief risk officer, explains, this means that 81 of every 100 borrowers in that pool will simply walk away from their loans. Which, he says, "sounds pretty bad to me". And that’s assuming a sharp drop-off in default rates going forwards:
On the other hand, notes Wallis, you have to assume a sharp drop-off in default rates going forward:
It is true, it is a fairly sharp diminution. However, it has to be because if it is not, you end up with more than 100% of collateral loss, which does not make any sense either.
Here we have asset-backed bonds which are essentially backed by no assets. Remember that the whole point of an asset-backed bond is that you don’t need to worry so much about credit risk, because you’ve always got collateral. Oops.