Is Subprime Toxic Waste Leaking into Investment Grade Mortgages?

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Includes: KBH, PHM, TLT, TOL, XHB
by: E. Jardine, CFA

The theory goes that toxic waste, when confined to a holding cell, is of concern for residents of a nearby town as long as it is contained. However, a small spill of toxic waste can contaminate an entire supply of drinking water. Recently, there has been anecdotal evidence that small spills of subprime loans are working into the entire mortgage market. This is converging for both the mortgage investor in the form of higher rates and the homeowner in the form of lower prices.

It is no doubt that the High-Grade Structured Credit Strategies Enhanced Leverage Fund at Bear Stearns (NYSE:BSC) is causing ripples even in the higher grade mortgage portfolios. When they auctioned $5bln in securities last week they sold the mortgages that they could sell, not the ones that they wanted to sell. The most illiquid CDO's are probably still being held in the hope surviving the current liquidity event. Merrill Lynch is even giving them more time to come up with funds in a surefire sign that the brokerage house doesn't want to take the chance of a low asset recovery rate on this bottom of the barrel debt. It is interesting to note that this liquidity crisis probably originated with losses on these illiquid CDO tranches but has made percolated to leave a small imprint on the investment grade mortgage market.

For the homeowner, the same types of problems are matriculating from the first time buyer neighborhoods with high rates of delinquency and high LTV's to the investment grade locations that are historically immune to price declines. This is no sooner the case than in the Bay Area when you compare the subprime market of Oakley, CA to the investment grade market of Berkeley. In an unscientific survey of 100 homes I found that nearly 20% are listed on the MLS at prices below previous sale prices. The average markdown is 10%. Just imagine the pain of paying the agent 6% on top of that! This doesn't reflect the many homes that will be sold 10% below their asking price. Meanwhile, the ripples in the river delta town of Oakley are slowly matriculating to investment grade towns like Berkeley. The college town should be immune to the subprime mess but there are also many homes that are listed near sale prices from Summer 2005. However, few are seeing the 10% average markdowns present further upstream.

The timing could not be worse. Tighter lending standards from liquidity events and declining prices pressed by higher rates. Fed policy makers will clearly state that the problem is contained but the market is starting to show signs of a contamination in the higher quality locations and loans. Let's just hope that they admit the problem before it reaches corporate credit spreads and the high end consumer.