Some Subprime Mortgage Loans Are Actually Current

I am continually surprised by the overgeneralized predictions about eventual subprime mortgage credit losses lately being thrown around by people who ought to know better. As I’ve discussed here before, Egan Jones’ Sean Egan came up with his preposterous estimate that the guarantors need $200 billion in new capital based on . . . well, no research at all. Bill Gross says that eventual credit default swap losses will tally to $250 billion. How does he come up with that number? He doesn’t say.

In fact, it’s possible to subject these back-of-envelope predictions of Armageddon to a reasonableness test. How? By looking at the actual credit performance of individual mortgage-backed securities issued as the subprime market began to crack up. The most widely followed are the MBS that underlie the ABX indices issued over the past two years, the ABX 06-1, 06-2, 07-1, and 07-2. They represent (as was the plan when they were included in the indices) a meaningful cross section of subprime mortgages underwritten in those time periods.

And as you’ll see in a minute, the credit quality among the different bonds varies enormously. Despite what the talking heads on CNBC would have you believe, not every subprime mortgage written over the past two years is bound to default—and not every MBS issued over that period is headed for a crackup. There is a huge disparity that’s not reflected in the alarmists’ broad-brush predictions of calamity.

Let’s take a look. I’ve pulled out the best- and worst-performing of the 20 loan pools that make up the ABX 06-1 and the 06-2. First, the 06-1:

First moral of story: underwriting discipline makes a difference. And by all appearances, Well Fargo (WFC) is a superior subprime mortgage underwriter than its competitors, particularly WMC (now a unit of General Electric (GE)). Notably, Moody’s (MCO) (who’s apparently as panicked about what’s going on as anyone) acknowledged this very fact last fall when it broke out subprime originators into three tiers, from worst to best. Wells Fargo was, not surprisingly, ranked, among the best.

WMC, by contrast, was in the lowest tier, while Countrywide (CFC) was in the middle. According to Moody’s, delinquency rates of loans originated by Tier 3 lenders have historically run 2.4 times higher than those originated by Tier 1 lenders.

In the two pools we’re looking at here, the Wells Fargo-originated loans have shown a 30% lower delinquency rate than the WMC-Countrywide pool. Moreover, since the Wells pool has a much lower level of balances still outstanding, we estimate its lifetime losses will be only one-third of the mixed pool’s.

That is an enormous difference. But, again, it’s not a tough conclusion to come to if you’re willing to look at the underlying data. What’s more, the difference between the two pools hasn’t come about by coincidence. Underwriting rigor really does count. Take a look:

Notably, the average FICO on the WMC pool is higher than on the Wells pool—and doesn’t even count as subprime by some standards. But the WMC pool is a mess, just the same. The key to the outperformance of the Wells Fargo pool is just what you might expect: a much higher percentage of full-doc loans and much lower exposure to California.

This shouldn’t be a surprise. If you underwrite well, even if you’re underwriting a subprime mortgage, you will very likely get paid back.

My point is that the data for all 80 of these MBS (which were selected to be representative of the market as a whole, remember) is there for anyone who wants to look. Yes, the performance of some of the bonds is truly ugly. But others are holding up remarkably well. If you want to come up with a reasonable estimate of how high eventual losses will be, all you have to do is go through the securities one by one. Yes, that makes for a lot of numbers to crunch. But the analytical work isn’t really all that hard.

Now let’s look at the best and worst loan pools in the ABX 06-2:

Once again, the best-performing pool was also originated by Wells Fargo, and that the worst was originated by WMC. Sense a pattern?

This is why I go apoplectic when I read analysts’ sweeping estimates of huge losses, that were arrived at with no apparent consideration for the characteristics of individual bonds, such as who the underwriter is. The data is there. People ought to look at it.

For ourselves, we have looked at the bond-by-bond data, and we don’t arrive at estimates of cumulative losses from subprime mortgage lending that are anywhere near as high as the huge, back-of-the-envelope numbers that keep making their way into the headlines.

Granted, we might not be right in the end. But I prefer the rigor of our approach of looking at the granular data, and then updating every 30 days as new numbers come out, to the finger-in-the-wind methodology that others are apparently using. The big numbers might get the publicity. But the bottoms-up ones are far more likely to be right in the end.

Tom Brown is head of BankStocks.com.

Comments

[tkenyon:]

Thanks for supplying some rigorous analysis of this mess. The sweeping gloom and doom generalizations out there are really setting off my contrarian radar. When everybody's on the same bus (acting like experts), it's time to wait for the next bus.

2008 Feb 17 08:19 AM

[Greg in Al:]

I admit my concerns are based on fear. With an almost universal acceptance that housing prices in many areas will drop, the LTVs will be very thin, or negative. I have a good FICO score which I want to keep. if I get upside down in my home I won't bail, I'm sticking with it. But will the sub-primers do that? After all, sub-prime is just a politically correct way to say "bad credit". When times get tough and equity turns negative, will the subprimers bail? They have crappy credit anyway, what do they have to lose by walking?

2008 Feb 17 09:09 AM

[vreporter:]

There is far too much inter-dependence between subprime and everything else that's wrong with the housing situation nationally. There certainly are lots of gloom and doomers to portray the situation in a light that may not eventually happen. But may I remind you that we got to this stage because of the lack of transparency about these portfolio strategies underlying the financings - and that problem still remains. So when all things are considered, the gloom and doomers may still be underestimating the net effect when one begins to address inventories of both new and existing homes, the flippers who are now being issued blindfolds and the layoffs from a slowing economy. You make very valid points about the differences within these tranches but that issue alone turns out to be minute compared to the headwinds that are tipping these into the doom and gloom category for varying reasons. In the current scenario, the big picture matters a lot more than the risk management approach to a few securities.

2008 Feb 17 09:58 AM

[urturd:]

fak ur retardedwhoremama's subprime bonds! fak them hard!!!

2008 Feb 17 10:56 AM

[Totally a b...:]

And your point is...?

2008 Feb 17 12:03 PM

[jack kreg:]

Excellent article, more generally, I get the impression that MBS are priced on fear of large future losses, even though current cash flow is not nearly that bad. The financial bet is whether or not people will pay or refinance their mortgages, few of the experts have provided any convincing evidence as to the prediction of this outcome. Hence, the prudent move is to sell, and take current losses, trying to avoid a larger future loss.

2008 Feb 18 02:18 PM

[Richard Weed:]

Our whole market seems to be based on baseless speculation. Rumors of this or that can make the market plumment or jump in significant fashion. It's only when you dig into the facts that you see the sky isn't quite falling yet. Thanks, Tom, for a common sense article for once. It's nice to see some poeple out there are looking at the facts...

2008 Feb 19 12:37 PM

[Gaucho:]

What are you the little drummer boy for the FED jawboning? The subprime are collapsing and yes people are walking away from their mortgages. What planet are you coming from the defaults are huge and growing. Most ARMs don't even reset until March and most options ARMs don't reset until August. Like I said why don't you go and buy those MBIA bonds that are yielding 20% if they are such a great bargain.
The FED is lying about the inflation rate and the housing numbers. If I want the truth I will read Shiller not you nor the FED. The FED will jawbone the pump over a trillion into the economy this year in an effort to pump up this market. They will continue to lie. Who am I gonna believe my lying eyes or the FED or you?

I believe that the FED has already directly interviened in the equities markets.

2008 Feb 21 02:08 PM

[BWEAVER:]

This is a very insightful argument that really gets at the root of the problem, poor underwriting. While CNBC has a tendency to broadcast the "worst case scenario" situation, (ie:Charlie Gasparino) it really is worthwhile to look at the credit quality and income documentation of some fo these loans to assign the appropriate level of risk to these securities. When banks do their "stress testing" the only thing it tests is market sentiment which we all know is negative toward these many of these complex securities which have been created simply to transfer risk from one financial intermediary to another. The true worth can be found by examining the granular data and analytst who have been lauded for thier so-called technical knowledge of the markets should know better. I guess fear trumps fundamentals....

2008 Feb 27 03:33 PM