In the first quarter of 2007, subprime mortgages provided the first sign of trouble in the credit markets as falling housing prices began to hit borrowers hard. But in the first quarter of 2008, home-equity lines of credit became the new canary in the coal mine. Lenders such as National City have frozen existing home equity lines of credit, and as housing troubles show no signs of abating, these commercial banks are rushing for the HELOC exits with hedge fund-like alacrity.
Indeed, as real wages continue to fall with the recent increase in oil and food prices, the gap between home prices and median income continues to be way out of whack – despite the continuing decline in home prices. Folks, the bottom in housing is simply nowhere in sight.
Amplifying the point was Financial Security Assurance Ltd., which last month said that loss projections for these home equity loans rose in the first quarter. Embattled FSA increased its loss estimate by $355 million in the first quarter, as losses were particularly high in eight of its insured securities backed by home-equity lines of credit.
As everyone knows, these loans consist of lines of credit secured by home equity, which has been disappearing faster than high paying jobs on Wall Street. So far, FSA has paid $104.2 million in net claims on the transactions. Robert P. Cochran, chairman and chief executive of FSA, said that “since the beginning of 2008, these transactions have experienced much higher default rates than ever observed in the past.”
Moody’s then corroborated FSAs public trouble with a news release of its own, disclosing that losses in some of its insured home equity loan transactions had also risen rapidly. Moody’s Investors Services boosted its average loss expectations for securities backed by subprime second mortgages to 17% for 2005 vintage subprime pools, 42% for 2006 vintage pools, and to 45% for 2007 loan pools.
As I wrote earlier, these delinquency figures broken out by vintage illustrate the absolute imperative of investing in Mortgage REITs that have been around the block a few times. Those REITs that started up in the halcyon days of 2005 and 2006 simply have a huge hurdle to overcome: portfolios that are now stuffed full of weak, demand-driven paper. Their workout teams had better be good and well rested, because it looks like they will be busy into the next decade.
Indeed, Ambac cited one transaction where it said delinquencies topped 81% of loans. Significantly, both Ambac and MBIA said they were looking into some loans to see if they lived up to the standards of the securitization agreements. Since many of the underlying loans in question were originated by Countrywide Financial Corp (CFC), one must wonder how carefully Bank of America (BAC) read the investor put provisions in these deals before agreeing to purchase the Company.
Luckily for FSA, it avoided one of the most risky areas of the CMBS market: writing credit default swaps on CDOs backed by all these imploding mortgage loans. However, FSA did write credit default swaps on corporate risk and took a negative market value adjustment of $317.9 million in the first quarter.
In my two earlier articles on mark to market accounting, Mr Market Trips on Mark to Market and the more detailed follow-up How Markit Turned Mr. Market into Mr. Magoo, I emphasized that unlike realized losses, these market value losses only reflect decreases in the market value of the securities in question, not actual cash losses. Consequently, those losses have the potential to reverse if the market moves in the other direction. Thus, in FSA’s case, their $317.9 million negative mark could potentially be erased, or even become a future gain, if credit spreads tighten.
And here is the story within the story: according to FSA CEO Cochran, that has already begun happening. Credit spreads have “tightened significantly since the end of the quarter,” which would mean that FSA could end up recording a positive market value adjustment on its balance sheet in the second quarter. “It is hard to give a number where we stand now, but no doubt it would be positive,” Cochran said.
As the CMBX and ABX continue to tighten, and LIBOR and TED spreads get back to normal, positive market value adjustments (which would be reported as non-cash gains) will become more common. This will be particularly true for seasoned mortgage REITs that stuck to their knitting and resisted temptation with disciplined credit standards. Combined with the additional clarity arising from the adoption of FAS 159, book values will start looking a little more appetizing in the next few quarters.
Good news does not sell nearly as well as bad news, so I guess the traditional news outlets don’t focus on it as much. It sure is fun to write about it though, and it’s just as important as the opposite truths we’ve been hearing so much about. REIT Wrecks has your back!
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