Demistyfying Indymac's Alt-A Lending Business

Thursday's news release from Indymac (NDE) caught my attention and being a trader in the mortgage industry, I was quick to see how this argument won't stand in front of anyone experienced in the nuances of non-prime mortgage.

Indymac PR stated that between 2002-2006 their mortgage performance in terms of default is much lower than the comparable Alt-A universe. That number is 1 basis points versus 5 basis points. Think of basis points as "currency" in the mortgage world for now. The CEO also pitched in: "Saying Alt-A is between Prime and Subprime is like saying Pasadena (Indymac HQ) is between LA and Las Vegas.".

I felt uneasy because these mortgage professionals could have shared four additional data/statistics crucial to make an informed decision to invest in any mortgage lender:

* The years 2002-2006 were the best housing market in recorded US history. Losing 5 basis points versus 1 basis points are not at all meaningfull when the profit of lending the money is 50-200 basis points during the same period.

Indymac, New Century, Accredited, American Home, Fremont, and Countrywide all had explosive growths during the same period precisely because the cost was essentially zero, with specks of defaults happening by chance in the worst of the loans.

A more meaningful statistics would be the delinquency rate of the mortgages that they originate from 2005 onwards, especially the trend in the Q1 of 2007. Delinquency is the "early" stage of default, where the borrowers can have up to 4 months non-payment of their mortgage bills before the lender can start foreclosure proceedings. Such data will reveal the future performance likely to be realized in the coming quarters.

* Alt-A products are almost exclusively adjustable rate, with teaser period of 3 or 5 years. Also a common denominator is the Stated Income feature, where the lender can assess the borrower ability to pay based on the income stated (yes, verbally - the lender takes the note) by the borrower. Stated income loans were originated heavily in 2004 - 2006. This implies that rate adjustment will start occuring this year, and will continue to happen through at least 2010. The bulk of it (70%) will happen in 2007 and 2008.

Why do borrowers choose to state their income for slightly higher interest rate (0.5 -1.5%) ? There are two reasons: the first (80% of the time), the borrowers lack the income needed to purchase a home. Even with a teaser rate their incomes do not qualify them enough loan to purchase homes in high appreciation areas: California, for example, where Indymac headquarter is located. The other reason usually involves privacy concerns regarding their income, which is often part of the tax-avoidant "cash" market. While the second group is clearly better in terms of credit quality, there is no ability on Indymac's part to screen the second group for obvious reasons.

Most likely the first group of people (with severe income constraints) will be the majority of the borrowers. These people will at some point this year or next face 50-100% jump in their mortgage payment. At that point if they cannot refinance to a lower rate, or if their house values drop such that they don't have sufficient equity to qualify for a loan, or if the lending standard increases so that they are cut out of funds, then default will most surely happen.

* The capital market performance of Indymac loans. The capital market trades Indymac loans efficiently in the sense that changing expected performance are immediately reflected in the price that the loan will trade at. Right now, for stated income loans with adjustable rates, in the Alt-A sector, the market implies 50-300 basis points of default cost, depending on several other variables such as credit score and other borrower attributes. This cost alone will eat up most, if not all, of Indymac's expected credit revenue. The good thing is that most likely Indymac will not go under ala New Century - the losses won't kill and Indymac does not depend on Wall Street financing. The bad news: Indymac will not make any money for several quarters as these costs adjust upwards and profit growth suffers.

* Finally, in good times the differences in Subprime, Alt-A, and Prime mortgage borrowers stand out. Their personal attributes make the difference: education, income, and personal resilience.

In bad times housing and employment play much bigger roles than individual strength, such differences may be harder to spot. The proof is in history: using the data over the great depression, no loan will survive. We don't need to go there, take the mini regional housing crashes in the 80s and 90s, and you will see 100x more than expected losses from PRIME mortgages. There was no subprime then, but there was what's called FHA loan for poor people. The prime and FHA loans perform similarly under the stress event. Clearly during this mini-housing bust both types of loans went past their "pain threshold". No one has seen a nation-wide housing declines since the Great Depression. However, neither has anyone seen a more robust and widespread housing market than the period 2002-2006. How severe will the correction be this time then? According to Hovnanian's CEO "only the shadow knows".

Think of the effect as two people in a running contest. One is a better runner than the other. The first time they race on the beach where oxygen is plenty. Clearly the better runner is more likely to win. Then they race again, but this time at altitude, where oxygen is extremely rare and any human body will suffer. There may still be distance, but it won't be that far off between the two. In the worst scenario, both may fall into a cliff and won't be recognizable.

Disclosure: Author has no position in stocks mentioned