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Asset Management Solutions

  1. 1. Insurance Subprime Mortgages: Cutting through the Clutter Asset Management Solutions
  2. 2. Subprime Mortgages: Cutting through the Clutter The subprime mortgage market has been the source of numerous news articles and extensive media coverage during the first quarter of 2007. Concerns surrounding the sector were widely cited as a cause of global sell-off in stocks during the week of March 12. There are conflicting opinions on everything from the size of the market to what the ultimate effect on the housing market and the economy, in general, will be. In this piece we will provide an insight into the product, the market, recent events and DeAM’s current positioning and strategy going forward in this sector. Defining Subprime Subprime obligor characteristics A major source of confusion, particularly among non- FICO Score: 640 and below US investors, is what types of securities are backed by Average Loan Size: ~$200K subprime mortgages. Both Home Equity Asset Backed Preferred Loan Type: Hybrid ARM (2/28, 3/27) – 80+% of Securities (ABS) and Residential B/C (quality) securities originations are backed by subprime mortgage products and there Stated LTV: ~80%; Combined LTV: ~86% is really no difference between the two sectors besides Amortization Type: ~25% 40 yr. term, ~18% Interest Only Debt-to-Income (DTI): ~42% their name. The collateral characteristics and pricing of Loan Purpose: ~40% Purchase, ~55% Cashout, ~5% Rate/Term these two sectors are identical and the market makes no Refi distinction between the two. Documentation: ~ 40% Low/No Doc Simultaneous Second Lien: ~30% There is no clear cut definition of what constitutes a subprime WA Margin: ~5.50% mortgage, other than a loan to a borrower with a tarnished credit history. There are certain objective characteristics, however, which indicate a subprime mortgage. Some of For Illustrative purposes only the characteristics of a typical subprime mortgage pool are outlined in Exhibit A. Generally, obligors have a credit score (as measured by Fair, Isaac’s & Co. or FICO) of 640 or below and a debt-to-income (DTI) ratio of 40% or more. The product of choice for the subprime borrower is a 2/28 Hybrid ARM, which carries a fixed rate for 2 years and then becomes a floating rate mortgage for the remainder of the term. The average loan size is approximately $200K, with a loan-to-value (LTV) of over 80% and a combined loan- to-value (CLTV), which takes into account second liens on Product background: Deal structure the property, of over 85%. Given the higher risk of these Tranche Sizing Credit Enhancement borrowers, the margin charged can be as high 550 basis points over LIBOR, although the initial fixed rate is often AAA “teased” well below this margin by lenders competing for ‘AAA’ 22.75% 77. 25% subprime borrowers’ business. ‘AA+’ 18.60% ‘AA’ 13.95% Home Equity ABS Deal Structure AA 10.50% ‘AA-’ 12.25% ‘A+’ 10.30% A ‘A’ 8.40% A representative Home Equity ABS deal structure is 4.60% ‘A-’ ‘BBB’ 7.65% 5.60% BBB detailed in Exhibit B. The issuer is a special purpose vehicle 4.20% ‘BBB’ ‘BBB-’ 4.85% 3.45% (SPV) that is created to issue securities and purchase the BB 1.50% ‘BB’ 1.95% subprime mortgages with the proceeds. A servicer is hired O/C Excess Spread Residual Holder 1.95% to make collections on the mortgages (principal, interest and default recoveries) that will be passed through to For Illustrative purposes only NIM Security security holders. As shown, various tranches are created with varying priority of repayment and credit enhancement pg. 1
  3. 3. allowing for a wide range of ratings, from as low as ‘BB’ to as high as ‘AAA’. Besides hard credit enhancement from the subordination of lower rated securities and overcollateralization, there is also excess spread available to cover losses and, in some instances, to pay down higher rated securities. If excess spread is not required to cover losses or pay down higher rated securities, it gets passed through to the residual holder, which is usually the sponsor who sold the loans to the SPV. In many cases the residual holder will attempt to monetize the expected collections of future excess spread through the issuance of Net Interest Margin Securities (NIMS), which will be backed by the deal’s excess spread after covering losses and any other payment obligations. The cash flow waterfall for these transactions typically has principal being paid sequentially to the highest rated tranches, until a “step-down date”, after which each rating category shares ratably in principal repayments as long as a trigger event is not occurring. The sequential nature of the initial paydown allows senior rated-classes to build additional enhancement as a percentage of the current amount of mortgages outstanding. The step-down date is usually the later to occur of 3 years into the life of the deal or the point when the enhancement available to each class is doubled from its initial amount. Trigger events are based on credit performance, including delinquencies and defaults, and are designed to protect senior bondholders by re-directing cash flow to the higher rated tranches if performance deteriorates. The Size of the Market It is hard to get a precise figure of the total amount of subprime loans outstanding because the data is not readily available. What is available is data on the subprime Size of market: Subprime share of issuance share of securitized mortgages issued, which is believed $600 $525 $506 30.0% to include over 80% of the subprime market. Based on data from Bear, Stearns, subprime mortgages accounted $500 25.0% $391 for approximately $506 billion of securitized mortgage $400 20.0% Billions issuance in 2006, or 25% of issuance. As shown in $300 $233 15.0% Exhibit C, subprime mortgages have had strong growth $200 10.0% $126 in recent years, with total issuance more than doubling $70 $71 $100 $37 $54 $58 $52 5.0% since 2003 and the share of issuance more than tripling. As a share of total securitized mortgages outstanding, $- 0.0% subprime mortgages make up approximately 15%, l l l l l l l l l l l ta ta ta ta ta ta ta ta ta ta ta To To To To To To To To To To To or almost $1.5 trillion. Alt-A mortgages, which are 96 97 98 99 00 01 02 03 04 05 06 19 19 19 19 20 20 20 20 20 20 20 typically made to higher quality borrowers but with a Subprime $ Subprime % of all mortgages high percentage of no-documentation loans and investor Source: Bear Stearns borrowers, comprise a similar share of the outstanding mortgage universe. The Current Situation Although the issues in the subprime market are only recently being reported in the mainstream media, they were widely known in the asset backed securities market as early as the second half of 2006. Among the troubling indicators were deterioration in performance of loans from the 2005 and 2006 vintage and an increase in early payment defaults (EPDs). Originators were contractually forced to repurchase EPD mortgages from securitizations and whole loan buyers, hurting the originator’s liquidity and prices for loans sold. Importantly, in November of 2006, Moody’s placed on rating watch negative two lower-rated classes of bonds from a deal issued just six months prior. The timing pg. 2
  4. 4. of this action was unprecedented in that the seasoning curve for mortgage product typically resulted in little risk of downgrades early in a transaction’s life and rating agencies rarely take any action on a bond within two years of issuance. Since this time, other rating agencies have taken action on this and other 2006 vintage transactions, with over 30 tranches from 10 deals currently affected. This adverse performance, along with the increased scrutiny from media outlets, has resulted in a dramatic decline in the price of the ABX index, a widening of credit spreads, lower liquidity for securities and originators facing losses, bankruptcies and liquidations. The magnitude of deterioration in performance is shown in Exhibit D, which show Current situation: Increasing delinquencies Recent originations performing worse Source: Credit Suisse, Intex the 60+ delinquency curve by vintage year and for the last five quarters, respectively. As shown, performance of recent vintages of subprime mortgages continues to be worse than earlier vintages. The deterioration has not been limited to subprime, as Alt-A performance for the 2006 vintage has also deteriorated sharply, as shown in Exhibit E. Interestingly, fixed rate loans to both Alt-A and subprime borrowers have not shown the same magnitude of deterioration that hybrid ARM loans have experienced. Exhibits F & G show vintage performance for fixed rate Not only a Subprime phenomenon loans to subprime and Alt-A borrowers, respectively. The difference in performance between fixed rate and hybrid ARM performance is likely due to positive self-selection on the part of fixed rate borrowers, as they have consciously chosen a product without reset risk, indicating a more risk- averse and responsible borrower. What Went Wrong? The credit problems that are evident today can be blamed on a flawed industry structure, where the originators’ profits were made on gains on the sale of mortgages, rather than the spread earned as is typical in the finance business. The flaw can be characterized as the difference between Source: Credit Suisse (US Mortgage Strategy) LoanPerformance a “moving” mentality versus a “storage” mentality and pg. 3
  5. 5. resulted in a poor alignment of interests between those who originated risk (mortgage brokers) and the ultimate Fixed rate deterioration less dramatic holder of that risk (ABS & CDO investors). Originators were focused on maximizing gain-on-sale and overall volumes, rather than risk minimization since their holding period was expected to be short, while investors were focused on maximizing yield in the short term in a low volatility and low return environment, rather than managing risk effectively and ensuring they were being paid appropriately for risk. The industry can be characterized as one with very low barriers to entry, as Wall Street dealers are eager to provide warehouse lending lines to originators, with the lines being secured by the loans originated. In addition, the product is more or less a commodity, with very little product differentiation; originators compete on price (i.e. rate) and service (i.e. underwriting standards). If a particular originator’s rate is off market slightly or its underwriting standards more stringent than the competition, brokers will direct their business elsewhere and volumes will decrease dramatically and immediately. Having a low cost structure is also a determinant of success since the industry is characterized by high operating leverage and a focus on volumes to gain economies of scale. The combination of these factors leads the industry to a classic boom and bust cycle. When margins and profits are high, new entrants are attracted, which leads to lower margins and profits. As margins contract, originators strive to increase volumes to maintain overall profitability, primarily by offering more attractive rates and lowering underwriting standards. Competition at this stage is fierce, as typically there is excess capacity in the industry, and underwriting standards get lowered dramatically. Eventually, margins get to the point where originators cannot operate profitably and there is a contraction in the number of originators, either through bankruptcy/liquidation or voluntary exiting of the business, and capacity drops in line with demand. We are approaching that point now, but there is still too much origination capacity relative to demand and capacity will need to contract further. The Fed as Catalyst The catalyst for both the boom and the bust in the subprime mortgage market is the Federal Reserve and short term rates. As the Fed cut the Fed Funds target rate aggressively and held it at a level of 1% to combat the brief recession and fears of deflation in the early part of the decade, originators gain-on-sale margins increased dramatically due to the relatively steep yield curve and the low cost financing available in the market. Exhibit H shows originators’ gain- on-sale margins dating back to 2002. As shown, early on margins were as high as 5%. These high margins attracted pg. 4
  6. 6. new entrants, which led to a decrease in margins. As Fed’s impact on gain on sale margins the Fed began raising the Fed Funds target rate in June 2004, eventually raising the target rate by 425 basis points, margins were compressed further. Originators began to stretch underwriting standards to maintain and increase volumes and an increasing number of loans were originated that should not have been, leading to an increase in EPDs, worsening performance, and lower demand from investors. Originators are now in a war of attrition, with each struggling to survive in an industry that will be quite a bit smaller than it has been over the last couple of years. The decline in underwriting standards is noticeable when comparing loan characteristics over time. Exhibit I shows certain credit characteristics from the 1998 to 2006 origination years. The table shows that the CLTV of originations has increased from below 80% to almost 86%. This is driven by the sharp increase in loans to purchase borrowers who finance the full amount of their purchase, with almost 30% of originations containing a “simultaneous second” lien at origination, up from about 3% just a few years ago. Along with increased debt as a proportion of a home’s value, there has been a dramatic increase in interest-only and other delayed amortization “innovation” products, and these now make up almost half of all originations versus almost none in earlier years. Finally, looking at the borrower’s weighted average coupon (WAC) of originations over time shows the intense competition that was taking place in the industry. In 2004, the WAC of originations was 7.04% while the Fed Funds rate was just 1%. Since that time, the Fed has raised interest rates 425 basis points, yet Decline in underwriting standards the WAC of originations has increased by only 114 basis Origination Innovation Full Doc Simultaneous points, to 8.18%. This is because of intense competition Year FICO WAC LTV CLTV DTI % % 2nd % in the industry and an attempt to drive volumes by offering 1998 602 9.77 77.5 77.5 35.8 0.0 71.3 0.2 borrowers a low “teaser” rate. These teaser rates mean 1999 597 9.95 77.7 77.8 37.5 0.0 66.0 0.2 that during the initial fixed rate period borrowers get a rate 2000 590 10.56 77.0 78.2 38.6 0.0 74.0 1.3 2001 598 9.60 79.0 79.5 39.1 0.0 72.7 3.3 well below the equivalent fully indexed rate of LIBOR + 2002 611 8.46 79.7 80.3 39.4 0.7 67.5 3.1 5.5%, or approximately 10.80% based on current rates; 2003 620 7.45 80.4 81.8 39.7 3.7 65.1 7.8 this is initially positive for the borrower but subjects them 2004 622 7.04 80.7 83.6 40.3 15.6 62.3 16.2 to payment shock when the loan resets, even without an 2005 626 7.22 80.6 85.3 41.0 32.4 58.8 25.0 increase in interest rates. 2006 620 8.18 80.1 85.8 41.9 44.5 58.2 29.5 *Source: UBS & LoanPerformance Explaining Historical Performance In addition to stretched underwriting, there were other potential indicators that subprime mortgage performance was vulnerable to a downturn. Looking at the historical relationship between home price appreciation (HPA) and subprime mortgage losses shows a strong negative correlation (i.e. as HPA increases, credit losses decrease). This is partially due to the ability of distressed borrowers to refinance to avoid default and partially due to lower severity for those loans that ultimately default. Given the unprecedented increase in real HPA experienced in the US over the last several pg. 5
  7. 7. years, it is hardly surprising that subprime mortgage performance was strong. However, the recent slowing of HPA, and declining HPA in some areas, has exacerbated the weak underwriting standards of recent originations and led to the sharp deterioration in performance that we have witnessed. For those who were following the market closely and analyzing performance drivers in the market, there were signs that historical subprime performance was not as good as the cumulative loss figures indicated. Exhibit J shows performance information for the vintage years 1998-2005. Looking at the 2000 vintage year highlights how strong HPA masked performance issues and how just looking HPA as loss mitigation tool at a net cumulative loss figure can give a false sense of Current comfort on the product’s performance. As shown, total Vintage Total "No Loss" Defaults w/ Net Cum Pool defaults for this vintage was 22.5%, meaning that more Year Defaults* Defaults Loss Loss Factor 1998 17.8% 8.9% 8.9% 6.7% 0.05 than 1 in 5 subprime borrowers who took out loans in 1999 20.3% 10.7% 9.6% 5.9% 0.06 2000 ultimately defaulted on his loan. However, a large 2000 22.5% 12.5% 10.0% 6.5% 0.08 percentage of these loans did not experience a loss, as 2001 18.5% 10.7% 7.8% 4.5% 1.00 either the borrower or the servicer was able to ultimately 2002 12.5% 7.7% 4.8% 2.5% 0.11 pay the loan balance in full. Only a subset of defaults 2003 8.4% 5.9% 2.5% 1.1% 0.21 actually ended up with losses and the ultimate cumulative 2004 7.8% 6.3% 1.5% 0.6% 0.40 net loss for the vintage totaled approximately 6.5%. While 2005 6.1% 5.5% 0.6% 0.3% 0.74 this vintage did experience a minor recession, which likely •Default includes all loans reaching foreclosure, REO or experiencing a loss increased default frequency, it also witnessed extremely strong levels of HPA. The default performance experienced Source: Barclays Capital & LoanPerformance is less than stellar and certainly not as favorable as the ultimate losses for this vintage indicate. Manufactured Housing Redux? Many observers of the current situation are drawing parallels between the current subprime mortgage experience and the manufactured housing ABS performance of the early 2000s, where almost 50% of ‘AAA’ securities were downgraded, with almost a third of these to below investment grade, and over half of all tranches rated ‘A’ or below downgraded to below ‘C’. There are definite similarities between these products, including the subprime nature of the borrowers and a financing mechanism where the ultimate holder of credit risk was far removed from the origination of that risk. However, there are important differences as well, the most important of which is the collateral quality backing the loans. In manufactured housing, loan terms extended 30 years and were backed by an asset that depreciated rapidly, while subprime mortgages are backed by homes located all across the country, which historically have retained their value. It is unlikely that the subprime market will experience the severities of 80-90% that the manufactured housing market suffered. In addition, servicing in the mortgage market is very diverse with a variety of third-parties available to perform this vital function. In manufactured housing, the largest originator, Conseco Finance, was also the largest servicer by a wide margin. When they went bankrupt there were no parties willing or able to service the loans, further hurting credit performance. Absent a prolonged economic downturn, we believe that the manufactured housing experience is unlikely to be repeated. Going Forward DeAM’s current expectation is that a substantial portion of 2006 vintage ‘BB’ & ‘BBB’ classes are at risk of downgrade and potential impairment. The same rating categories from other vintages are also at risk, but to a lesser extent. There are potential favorable outcomes, including the possibility that the Fed cuts rates, leading to an increase in HPA and pg. 6
  8. 8. investors’ risk appetite. Also, servicer modifications and extensions, along with potential public and private sector subsidies, may support troubled borrowers and lessen the impact on the market. There are also downside risks, the most worrisome being that there is a liquidity or credit crunch due to lack of investor appetite, tighter underwriting standards and/or regulatory and legal restrictions that stop the flow of credit to subprime borrowers. It should also be noted that the current poor performance is occurring at a time of modest growth and low unemployment and any slowdown in the US economy or uptick in unemployment will likely lead to another leg down in performance. Fears of a credit crunch are worrisome because an estimated $200+ billion of subprime mortgages are due to reset in 2007, with a similar amount due to reset in 2008. The fact that most of these loans had low introductory “teaser” rates means they will reset to markedly higher rates, even absent any interest rate increases. Historically, borrowers refinanced at reset, reducing or eliminating the payment shock. However, if lenders are unwilling to lend on similar terms and home price appreciation has not helped borrowers increase their equity in their homes, refinancing may not be available. Absent modification to the loan terms, this will likely lead to a spike in delinquencies and defaults after the reset date. DeAM’s Positioning DeAM recognized the risks inherent in the subprime mortgage market and was positioned accordingly. We were generally underweight the sector and had an up in quality bias across the vast majority of our accounts due to concerns about valuation. In particular, our direct exposure to subprime mortgages rated ‘BBB’ or below as of March 1, 2007 was less than $12MM. This accounts for less than 0.05% of the $22.3 billion in structured finance assets managed by the structured finance team in New York as of that date. In our US CDO business, we focused on managing high grade structured finance CDOs, which are backed DeAM’s Subprime credit view by securities rated ‘A-‘ and above, rather than mezzanine deals, which are backed by securities rated in the ‘BBB’ Breakeven Loss Estimates: and ‘BB’ category. We chose these types of transactions based on our belief that there was better relative value in Rating: Moody’s: Bear Stearns: AAA 26-30% N/A the higher rated assets. AA 18-21% N/A A 13-15% 15-19% From a pure credit perspective, investors should not lose BBB 10-11% 8.5-13.75% sight of the fact that transactions backed by subprime BB 7-8% 7.84% mortgages offer significant credit enhancement and structural protections. Exhibit K shows the estimated Source: Moody’s, “Challenging Times for the US Subprime Mortgage Market”, March 7, 2007 Bear Stearns, “The Subprime Market: Discussion of Current Event”, March 9, 2007 break even loss rate on a pool of subprime mortgages for each rating level by Moody’s and Bear Stearns. The differences in loss rates are due to different assumptions, primarily as it relates to the timing of losses, and how they affect excess spread available. Moody’s estimates that ‘BBB’ rated bonds can withstand pool losses of 10-11% vs. Bear Stearns estimate of 8.5-13.75%. Bonds in the ‘A’ category can withstand losses of 13-15% according to Moody’s, while Bear Stearns estimates these bonds can withstand pool losses of 15-19%. In March 2007, Moody’s stated that their initial loss expectation for the 2006 vintage was in the 5.5 – 6% range, while S&P said their updated expectation for ultimate losses for the 2006 vintage was 5.25-7.5%, indicating that there is significant protection available relative to expected pool performance before these tranches begin to take losses. While it is early to make a definitive call on the ultimate losses of the 2006 vintage given the long seasoning curve of pg. 7
  9. 9. these assets, DeAM believes that cumulative net losses of 10% is a realistic possibility for the 2006 vintage. At this level of losses, the ‘A’ rated category and above should generally remain protected from losses, although there is a significant risk of downgrades. DeAM believes that the current shakeout occurring in subprime is ultimately healthy for the market. The current expectation of direct losses is painful but not, in and of itself, overwhelming. Applying 10% losses to the total amount of subprime mortgages outstanding results in total losses of approximately $150 billion, a significant sum but eminently manageable for the economy as a whole. Potential knock-on effects are less clear and potentially more serious, but predicting the possible impact at this time is very difficult. Market Opportunities The subprime mortgage market is in the early stages of a shakeout that will be painful for some but lucrative to those brave enough, but also disciplined enough, to take advantage of the current dislocation. Recent spread widening has provided opportunities, but investors need to tread carefully and consider the objectives of their portfolios. The positive basis between cash bonds and single-name CDS indicates that additional widening may occur and a more attractive entry point may exist, but timing the bottom of the market is difficult and allocating some capital to the sector while keeping “powder dry” to take advantage of additional widening makes sense. For yield-focused, buy- and-hold accounts, now is a good time to enter the market to take advantage of wider spreads, particularly in higher rated securities. For total return and less constrained investors, there may be opportunities in certain lower-rated securities that have been unfairly punished and are due for a bounce back in price, but this part of the market should be traded actively and investors should maintain a strong sales discipline. DeAM will be monitoring the credit performance of loans hitting their reset date to determine the impact, if any, of a pullback in investor’s appetite on the ability of borrowers to refinance. We are also monitoring potential regulatory actions, both positive and negative, as well as changes to servicing standards to gauge its effect on these transactions. The structural nuances of the transactions, including the trigger mechanisms, will provide low risk opportunities to profit from discount bond pricing. As always, selectivity is key, but we believe the current dislocation in the subprime mortgage market and the CDO market will provide opportunities for investors with strong knowledge of the sector, a healthy risk appetite and a disciplined investment process. pg. 8
  10. 10. This material is intended for informational purposes only and does not constitute investment advice or a recommendation or an offer or solicitation and is not the basis for any contract to purchase or sell any security or other instrument, or for Deutsche Bank and its affiliates to enter into or arrange any type of transaction as a consequence of any information contained herein. To the extent permitted by applicable law, no member of the Deutsche Bank group, or the Issuer of this document or any officer, employee or associate of them accepts any liability whatsoever for any direct or consequential loss arising from any use of this presentation or its contents, including for negligence. Although information in this document has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fair- ness, and it should not be relied upon as such. All opinions and estimates herein, including forecast returns, reflect our judgment on the date of this report and are subject to change without notice. Such opinions and estimates, including forecast returns, involve a number of assumptions that may not The comments, opinions and estimates contained herein are based on or derived from publicly available information from sources that we believe prove valid. to be reliable. We do not guarantee their accuracy. This material is for informational purposes only and sets forth our views as of this date. The This document is only forand these views are subject to change without allowed without prior written consent of any member of the Deutsche Bank AG underlying assumptions professional investors. No further distribution is notice. Group. The material does not constitute investment advice and should not be relied upon as the primary basis for any investment decision. This document may not be reproduced or circulated without our written authority. The manner of circulation and distribution of this document may be restricted by that or regulation in certain countries, including the United States. Persons into whose possession this document may come are required to Please note law this presentation is not intended to provide accounting, tax or legal advice and should not be relied upon as such. Any specific inform themselves legal questions concerning the matters described in this presentation should be discussed with your accounting, tax or legal advisor. accounting, tax or of, and to observe, such restrictions. ‘Deutsche Bank’ means Deutsche Bank AG photocopied or duplicated in any form by any means or (ii) redistributed without is the marketing name for No part of this material may be (i) copied, and its affiliated companies as the context requires. Deutsche Asset Management DeAM’s written consent. asset management activities of certain affiliates of Deutsche Bank AG. Deutsche Asset Management is the marketing name in the US for the asset management activities of Deutsche Bank AG, Deutsche Bank Trust This articleAmericas, Deutsche Asset Management Inc., Deutsche Asset Management Investment Services Ltd., Deutsche Investment Management Company represents the views of Deutsche Asset Management’s Global Insurance Asset Management. Different business areas of Deutsche Bank may hold viewsInc. and Scudder Trustexpressed here. Americas that differ from those Company. CE121604_Muni_Bro MARS #20116 MARS #15012