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Hook, lien and sinker

Aegon fixed-income manager Iain Buckle says the American sub-prime crisis is bringing problems in the fixed-income sector as borrowers are defaulting and leaving second-lien mortgages which have been sold on by the lenders and packaged to investors as asset-backed securities.

The last few weeks have seen increased volatility in all parts of the fixed-income market which has been blamed on significant concerns about the sub-prime mortgage market in the US where derivative instruments which reference the performance of sub-prime mortgages have fallen dramatically.

Why is the market so worried about sub-prime mortgages and what are the implications for other fixed-inc-ome asset classes?

A sub-prime mortgage is essentially a mortgage to a borrower with a poor credit profile.

Usually, the borrower has a history of credit problems which could either be previous mortgage arrears or problems in making consumer loan payments.

The broad definition of sub-prime also includes second-lien mortgages.

A second-lien mortgage is one that is lower in seniority to a first mortgage on the same property. In the event of default of a second mortgage, the second mortgage lender can foreclose on the property but the first mortgage lender will be paid out first.

The second-lien lender will be paid out from what is left from the proceeds of the property sale after the first mortgage has been repaid.

As you would expect, sub-prime mortgages tend to experience much higher levels of delinquencies and defaults than prime mortgages. Obviously, sub-prime lenders charge significantly higher rates of interest to compensate for the increased risk of default.

Sub-prime mortgages make up approximately 14 per cent of all mortgages in the US. Most mortgages in the US are not held on the balance sheet of the lender which originated them but are instead are sold on to investment banks which package them up together and sell them on to fixed-income investors in the form of asset-backed securities (ABS).

Hence, most of the risk of default on the mortgages has passed from the originator of the loan to the ABS investor. This is true both for prime and sub-prime mortgages.

What has happened in the sub-prime mortgage market recently to spark so much concern?

To put it succinctly, the mortgages are not performing as well as they should be.

The amount of people who are in arrears on their mortgage or have defaulted on it has increased markedly.

This is perhaps surprising when you consider that the US economy seems to be ticking along quite nicely, with economic growth around trend levels and unemployment relatively low.

Why are sub-prime borrowers failing to make their mortgage payments or handing the keys to their home over to the bank?

Importantly, residential property prices in the US have started to decline. In the six months to the end of 2006, the average US home price fell by over 1 per cent. This trend is likely to have continued into 2007.

The problem is particularly acute in some of the previously hot property markets in the US. For example, the average home price in San Diego, California fell by almost 5 per cent in the six months to the end of 2006.

Why should such a seemingly small decline in house prices result in sub-prime borrowers handing back the keys to their homes?

The reason is that they have no equity value left in their homes. Their home is now worth less than they owe on their mortgage.

Previously, when borrowers got into personal financial difficulty they were able to sell their homes, realise the equity value and then downsize to a smaller home.

For a big proportion of sub-prime borrowers, this is not an option this time round. The US has woken up to the concept of negative equity.

This is partly the result of a dramatic decline in mortgage underwriting standards in the last few years.

Banks in the US, awash with cash, have been falling over themselves to lend money against the value of your home.

Significant house price appreciation in the early 2000s, coupled with the fact that they could pass the bulk of the default risk on to ABS investors, has meant that they are prepared to lend more and more at lower and lower credit standards.

This is not just a phenomenon in the sub-prime market. Of all the prime residential mortgages originated in 2006, only 23 per cent of borrowers had to produce “full documentation” to prove that their current financial situation is as they say it is.

This would include, for example, pay slips and bank statements. Only five years ago, this figure was as high as 66 per cent.

This decline in credit standards has meant that individuals are putting less and less of their own money into their property.

In fact, many sub-prime borrowers have used second-lien mortgages essentially to provide the deposit needed to buy their home. So, the first mortgage provides, say, 90 per cent of the purchase price and then a second lien is used to provide the additional 10 per cent. In effect, from day one, these borrowers have no equity in their home.

ABS investors have been concerned for some time about the decline in mortgage underwriting standards and the potential impact on sub-prime mortgage performance.

This concern has been reflected in the movements of derivative instruments that reference the performance of sub-prime mortgages.

The exotically named 2006-2 BBB-ABX index reflects the performance of sub-prime mortgages originated in the second half of 2006.

It started to fall towards the end of last year as investors became concerned about the rising delinquencies and defaults in sub-prime mortgages.

However, the index really started to tumble when, at the start of February, HSBC announced that its US mortgage finance arm, HSBC Finance (Household), had under provided for potential losses on its sub-prime mortgage lending by almost $2bn.

It is possible that HSBC had been holding these loans on its balance sheet because they failed to meet the criteria needed to securitise them as ABS bonds.

This announcement significantly heightened the concern about potential defaults on sub-prime ABS bonds and the 2006-2 BBB-ABX index started to tumble. It fell from 95 at the start of the year to 63 at the end of February.

The immediate impact of the anxiety in the sub-prime ABS market was an increase in nervousness of fixed-income investors.

When investors get more nervous, they demand a higher-risk premium for holding risky assets, such as lower-rated corporate bonds and high-yield bonds. Similarly, they place a greater value on the security offered by government bonds.

Apart from the increase in uncertainty, what are the implications for other fixed-income markets?

The immediate question is whether the increase in delinquencies and defaults is about to spread to the prime mortgage market in the US.

Our view is that the performance of prime mortgages is likely to deteriorate to an extent but nothing like what we have seen in sub-prime.

The credit quality of prime borrowers is significantly higher than that of sub-prime and they tend to have much higher levels of equity in their property. Hence, their ability to withstand a period of house price depreciation is that much greater than for sub-prime borrowers.

We would need to see a sustained drop in US property values before we became really concerned about the outlook for prime mortgages in the US and this is not our core scenario.

Another concern is the potential impact on the owners of sub-prime ABS bonds. These bonds are the most exposed to the poor performance of sub-prime mortgages and have seen the biggest fall in value.

In particular, there is a concern that a number of US investment banks are both big holders of the most junior sub-prime ABS bonds, and have been holding recently originated sub-prime mortgages with the original intention of packaging them up as new ABS bonds.

The worry among investors is that the investment banks are facing big losses from their sub-prime mortgage exposure.

Both the equity prices and credit spreads of banks such as Merrill Lynch and Morgan Stanley have come under pressure in the last few weeks.

Our view is that the move wider in credit spreads of US investment banks is something of an over-reaction.

These banks are very large diversified institutions that have been extremely profitable in recent years. There is no doubt that these institutions will have experienced losses on their sub-prime investments but we do not think they will be material enough to threaten their credit-worthiness.

Perhaps the most difficult fallout from the sub-prime woes to quantify is the impact on the wider US economy.

The concern is that increasing defaults and delinquencies in the sub-prime market will lead lenders to tighten their lending standards in all mortgage products.

A recent Federal Reserve survey of senior loan officers throughout the US showed that 15 per cent of respondents had tightened standards on residential mortgage loans.

A general tightening of credit standards is likely to lead to lower consumer activity in the US as people feel the pinch. This has potentially serious implications for an economy that has been buoyed by a very strong consumer in recent years.

To date, the malaise we have experienced in sub-prime mortgages has been well contained to that specific market. There has been a pick-up in risk-aversion as investors consider the potential implications of the sub-prime meltdown but no widespread panic.

We see a contagion to the much bigger prime mortgage market as unlikely and we think the concern about the impact of potential losses at investment banks is overblown. Our main area of debate is on the effect on the US and global economy.

Any significant decline in consumer activity in the US as a result of tighter credit conditions could see a slowdown in both the US and global economy. It is too early to tell if this is likely to be the case but it is likely that fixed-income markets will remain nervous until the outcome becomes clearer.


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