Subprime Mortgage Losses: Not as Bad as Advertised

Here’s a question for the subprime mortgage geeks in the house: which is bigger, the dollar amount of realized losses on 2006-vintage subprime mortgages, or the dollar amount of loans that have been repaid?

Take your time; I’ll get to the answer in a minute. The reason I ask in the first place, though, is that the question is a good first step in getting at a reasonable estimate of how high cumulative losses from the subprime mortgage debacle will ultimately be. That happens to be a number, you’ll agree, an awful lot of people on Wall Street are interested in knowing. Yet estimates are all over the place. For its part, Moody’s says its best guess for eventual 2006-vintage losses is between 14% and 18% of originations. Its “stress case” is more like 21%. Some of the more hysterical numbers I’ve read put the eventual cumulative loss at 80% or more.

It’s hard to not get the impression that people are using all kinds of methods to estimate, some sensible and some not, while others are simply sticking their fingers in the air.

But I believe it is possible at this point to get to a reasonably accurate cumulative loss estimate. How? By looking at the credit performance of the $120 billion of bonds that make up the ABX subprime mortgage indices (in particular, by looking at the bonds that underlie the ABX indices created in 2006, when the lending looniness was at its peak) and extrapolating to the market at large. On the one hand, the bonds were hand-picked to represent the market overall; they should behave the same way the market does. On the other, they constitute a small enough universe that an analyst trying to glean future credit performance can take into account details such as loan-to-value ratios and loan originator.

Bond by bond

So we’ve gone through 2006-vinatge ABX bonds in a fair amount of detail to arrive at an eventual cumulative loss estimate. And (not to give away the ending completely) the number is materially lower than the base cases the agencies have in mind, and much, much lower than the apocalyptic predictions you keep hearing on CNBC.

I’ll get to the details in a second. But first, the answer to my question: which is bigger, realized losses or paydowns on the class of 2006? It’s not even close. Of the $600 billion or so of subprime mortgages originated in 2006 (again, by the lights of what have gone on with ABX bonds), $282 billion have already been repaid, while realized losses have come to just . . . $12 billion.

Surprised? Understandable. That’s not to say, of course, that that $12 billion of realized losses to date isn’t destined to balloon to a much bigger number, and that the ultimate losses on the 2006 vintage won’t be many times higher than the subprime losses of prior years. Of course they will. It does, though, give some perspective on how to most accurately predict what the future will bring.

Anyway, allow me to walk you through how I came up with a loss number I believe will turn out to be reasonably accurate, and not especially scary.

We’ll start at the beginning. First, take the $600 billion in subprime loans originated in 2006 and put them into three imaginary piles: 1) loans that have been paid down, 2) loans that have already resulted in losses, and 3) balances still outstanding.

OK? We already know what the losses are on 1 and 2. They are, respectively, $0 and (as I’ve already mentioned) $12 billion.

So the question as to ultimate losses on the 2006 vintage comes down to what happens to 3, the $306 billion in balances outstanding. And actually, we have a pretty good idea what will happen to a big portion of those loans, as well. Of the $306 billion, $100 billion is delinquent by 60 days or more. As any subprime-mortgage banker will tell you, once a loan gets past 60 days past due it’s pretty much doomed these days. So we’ll assume that fully 93% of those delinquent loans go into foreclosure (a much higher rate than is typical, but hardly uncommon recently) and generate a loss severity of 45% (compared to last year's rate of 35%). Estimated losses from past-due 2006 outstanding balances, therefore: $42 billion.

$206 billion performing

That leaves the $206 billion of outstanding balances that are still performing. Obviously, some of those are destined to default, as well. The question that has the financial markets transfixed is: how many?

To get an answer, I looked at which lenders originated the remaining performing loans, where the properties are located, and other relevant factors, and extrapolated past performance into the future. I came up with an estimate that 26% of remaining loans now current will eventually default, which will in turn lead to (again, assuming a 93% roll rate into repossession and 45% severity) $23 billion in losses. The other, 74% of the remaining outstanding balances will sooner or later pay down. The losses from those loans will of course be zero.

So. Let’s add up all the actual and estimated losses and see how the numbers shake out. Here goes:

Realized 2006-vintage subprime losses to date: $12 billion

Estimated future losses on outstanding balances 60 days or more past due: $42 billion

Estimated losses on outstanding balances still current: $23 billion.

Add those three numbers up, and you get $77 billion in cumulative realized losses on the 2006 vintage. Divide it by originations and you come to a loss rate of . . . .

Actually, before I get to that number, let’s go back and revisit the loss estimates the rating agencies and the bears have in mind. Moody’s base case for 2006 losses, recall, is between 14% and 18%. Its stress case is 21%. Fitch’s stress case is 21%, as well, while S&P’s is 18.8%. The Charlie Gasparino/Bill Ackman/George Soros Axis of Doom, meanwhile, surely has a number in mind that is much, much higher.

$77 billion in expected losses

But, as we’ve seen, if you actually go through the numbers trust by trust, look at what’s happened so far, and make some conservative assumptions about what will happen in the future, you get to estimated total losses of $77 billion. Divide that by the $600 billion in 2006 originations and you get to a total loss rate of just 12.8%. That’s well short of Moody’s base case, and nowhere near the stress cases that the agencies have put out.

You might object to some of my numbers here. Fine, but you can only object to a few of them. You can’t dispute, for example, that nearly half of the subprime class of 2006 has already been paid down, for instance, or that, of the remaining balances, roughly two-thirds are still performing. Those are simply facts.

You might, on the other hand, argue that my 45% severity assumption is too low, or that more than 93% of 60-plus-day delinquent loans will eventually roll into foreclosure. In fact, that’s what Zach did. But even if you assume delinquency roll rates that are even more severe than the elevated numbers I'm using, as he did, you still only come up with an ultimate loss rate of just shy of 16%. As far as that goes, UBS, the only firm on the sell-side that’s analyzed the credit performance of the ABX bond by bond, uses loss estimate embedded in the price of the ABX itself and comes to an estimate of 18%.

It’s notable, I believe, that all these numbers, even the ones based on hyper-severe assumptions, aren’t terribly different from one another. And it’s even more notable that they’re all well short of the agencies’ base cases, let alone their stress cases.

Or let’s turn things around. How bad would things have to get for the Moody’s base case to actually happen? Unbelievably bad—literally. The 16% midpoint of Moody’s base case translates into $96 billion in eventual losses. Twelve billion dollars has already happened. Fine. But, as we’ve seen, $282 billion of the $600 billion in 2006 originations has already been paid down. Those loans won’t default. Of the $306 billion that’s still outstanding, $100 billion is seriously delinquent. We have a good idea of what’s in store for those loans; they’ll likely generate another $42 billion in losses. That still leaves us $42 billion short of the $96 billion needed to get to a 16% loss. By definition, it can only come from the $206 billion in remaining, performing loans. If you assume 50% severity, that means that of the remaining performing loans—the strongest horses in the field so far—fully 41% would have to default.

Stress case losses would be stratospheric

And that’s just to get to the base case. To get to the agencies’ stress cases of a 21% cumulative loss, 71%--yes, that number starts with a “7”--of the remaining performing loans would have to go bad.

I don’t buy it. I don’t buy it, in particular, because at the margin the news from the subprime mortgage credit front seems to be improving. The rate of loans moving from current to 30-days delinquent has slowed over the past few months. And the rates at which delinquent loans are rolling into later-stage buckets seems to have stabilized. It’s as if—can you believe it?—things have finally stopped getting worse. That’s something else you won’t be hearing on CNBC anytime soon.

For months now, investors’ default habit has been to assume the worst regarding subprime mortgage credit. It’s been the profitable habit, too. But this whole time, people seem not to have noticed that a lot of subprime borrowers have paid down their loans completely, and that most others are still current. Guess what? That will keep on happening. And as it does, the subprime mortgage crackup will at last come to an end. In the end, I suspect, the wild-eyed losses being thrown around by the bears will turn out to be way, way off the mark. Don’t take my word for it. Just look what’s happened to the 2006 vintage so far.

Tom Brown is head of BankStocks.com.

Comments

[Vikram]

Great analysis. I have been predicting write-ups for some time. I expected that to happen in 2-3 years, but we might seeing them even sooner. As all the 2006 vintage is reset later this year, the losses sustained (or the lack of losses) will be obvious. So first and second quarter of 2009 might be the write-up quarter with banks booking big profits.

That will work well for their bonus cycle also. Banks will wait till the end of the year before they start buying the 2006 vintage paper. The marks will improve in early 2009. Bankers will get the bonuses (typically stock) at depressed values, then start buying 2006 vintage paper to get their mark to fair value, and then announce billions of write-ups as their current distressed positions get marked up. The stocks should be rocking then and the value of their bonus suitably magnified.

[IanB]

A question: I would expect that the $282bn of the 2006 vintage that has been repaid was done with refi's, rather than cash paydowns. Since 2007 loans won't be getting refi'd any time soon, won't the loss profile of 2007 loans look more like that of the $318bn balance of the 2006 vintage? In other words, why should we expect the 2007 loans made to refi those 2006 balances to perform any better than the average 2006 loan?

[Tim Plaehn]

Excellent analysis. Lenders are taking a 45% haircut on repo'd properties. That is scary, but it is good to see someone actually show what will get paid off. Who is holding the remaining unpaid mortgages?

[tcornelison]

An interesting follow up would be to calculate the total write downs taken to date by the Banks. The figures definitely exceed the total losses you predict here.

[JKirk]

IanB makes a decent point about refi'd subprime loans. However, I expect that any lender that's refi'd one of these loans in the current environment of extra-tight underwriting standards has done their DD. Also, there's a good chance they're still holding the loan on their books as securitizations have slowed way down. Perhaps, those that have refinanced fall into that category of borrowers that Congressmen (especially Democrats) have identified- those who were capable of getting non-subprime loans but were sold (or chose themselves to get) a subprime loan in 2006.

[set]

Like many others, I expect writeups in the future to generate profits for the Holders. How much is the question.

Another major question with this excellent analysis is the source of funding for the repaid subprime paper. Has this toxic credit been move nother credit areas? In terms of the big picture, has their been any improvement?

[IanB]

Agreed, JKirk, many of the refi loans were probably made in the second half of 2007 when standards were starting to improve. However, I don't imagine that half of the 2006 subprime borrowers suddenly became better credits in 2007. Agreed also that many or most of those loans are still on the originators' books.

[D. Metzer]

As a refi-er myself this past month, I was able to move from a 3 year ARM at 6% that would have reset to over 8% to a fixed rate at 5.75%, thus lowering my payments.

Of course my original loan was not considered subprime, but it is an example of how a 2006 vintage loan could be paid off and moved to the next year, but at safer margins for the borrower.

I also think it is important that alot of the default cascade was started by second home purchases in Arizona, Nevada, California and Florida as investment vehicles. I would assume that most of that has already washed out of the system by now.

[sumosama]

Great analysis and perspective. Look for massive write ups and profits in 2010 and beyond when the new sets of leadership at the usual suspects (C, WFC, CFC, WM, ...) need to show the benefits of the leadership changes.

[Ryan Freund]

With house prices declining and cost of living skyrocketing, I believe your $100 billion estimated losses, of the $306 billion, is inaccurate. Only time will tell, though, as it's really up in the air.

I am particularly curious as to how you seem to think CNBC has been all doom and gloom. They have been pumping bank stocks and saying "the worst is over" louder and more often than anyone else.

As a sidenote, I agree that the subprime mess is getting cleared up. Prime, Alt-A, auto loans, and commercial loans are not out of the woods yet. If those perform well, your analysis that everything is OK now is probably correct. If they don't perform well (and honestly, I don't see how they can), then everything is about to get much much worse.

[Ryan Freund]

After reading the comments - IanB has an excellent point. How were these loans paid? If it's through refis, then doesn't that mean that $282 billion is still at risk?

[venividivici]

Enter your comment here
Oh great analysis Tom. What you don't bother to address is the myriad of other problems in the mortgage industry. I'll give you just one from this morning. Ambac is going down the tubes.
Keep on pumping old boy!

[JeremyL]

I agree about the refi's, the loans didn't actually go away, they got refinanced, still the same loan just different terms (hopefully not an ARM). The author should apply some loss rate to the refi'ed loans. What percentage should that be? Historical subprime loss rates?

[Ryan Freund]

If those in the $282 billion bucket are indeed refi's, this article is quite misleading and should be clarified! Hopefully that wasn't the author's intent!

[fxtrader07]

great article to put things into perspective, thanks a lot Tom Brown.
I suggest some posters keep to the scope of the article. Obviously, Tom did not want to analyse each and every aspect of the credit crisis here. total writedowns by banks and finance companies include much more than just subprime mortgage losses, so arguing that the 300bn exceed tom's total estimate is off the mark.
that being said, there are more losses very likely to come from other parts of banks' loan portfolios and it remains to be seen how much of these can be matched by future write-ups on subprime loans

[jgroom]

As others have mentioned, I wonder where the $282B number came from? The only way that the losses from that segment would be zero, as the author implies, is if they were actually paid down by the borrowers, which I would geuss never happened. Normally you would not have half the borrowers refi within 2 years, so what is happening here? And if the $282B are in fact refis, what is the default rate on that new money? It has just moved from one pocket to another? Of the total $600, I would guess that at this point almost none of it has really been taken out of the loan pool, through borrower payment, and very few of the foreclosed houses have actually been sold to new owners, so almost none of the $600 is really "paid off".

[helplessobserver]

John G has it right, 0 loss on a loan means all terms were met and the obligation has been extinguished. Any other defination is jus bull crap.

[Vikram]

The borrower who was sub-prime in 2006, is probably Alt-A right now. Two years of on-time mortgage payments can do wonders to your credit report. There are Federal programs which are helping these home-owners refi too. A lot of subprime loans were taken by single parents, minorities etc who had steady income but could not get the downpayment in place. As long as these folks maintained their jobs, they would not have a problem in getting a refi, especially when the system is working in your favor.

[Vikram]

Also most sub-prime were 2/28 ARMs which reset after two years. That is why folks refi within two years if they can.

[paper200]

Good optimistic analysis, but why have the feds taken drastic steps, they may have as well as given away $100 billion directly and cleaned the problem. Instead add up the 160 billion rebates, 200 billion bailout + drop in interest rates foro the bankers to show blackink. Don t get it - though hope your scenario turns out true and in 2-4years make a boatload!

[JKirk]

Thought I'd point out that this analysis by Mr Brown was referenced on the Ambac CC during the Q&A. They agree that it's getting hard to hit the absolute $ amounts needed to reach the higher loss estimates being published.

I also want to echo previous comments about the speed of refinance- it's very fast when it's to the advantage of the borrower - like when rates improve (which they have versus 2006 and 2007), your credit improves (due to a better payment track-record), and when lenders and servicers are working hard to get quality lenders out of ugly looking loans so that they don't end up taking on real estate. The speed of prepayments is actually a major factor that drove the creation of MBS- they created different tranches so as to move prepayments to tranches with a shorter target maturity and only interest payments to tranches for investors that wanted longer maturity bonds.

Also, from my perspective (first time homeowner as of August 2005) it's still a much better deal to pay my mortgage than to walk away (and maybe lose a little equity) and then have to pay rent. My last mortgage interest payment (@6%) was less than the cost of rent for a 2 bedroom apartment and I like living in my home a lot more than renting an apartment. Even if you are upside down on your home, if you can pay the mortgage you'll probably like your current lifestyle more than you'd like living in a smaller home, in an apartment, or moving in with family.