Will Other Mortgage Dominoes Fall?

Gretchen Morgenson

IT’S amazing how long it can take investors to see that the wheels are coming off a prized investment vehicle. Denial, after all, is a powerful thing.

But when an imperiled favorite happens to be a pool of asset-backed securities — especially those involving home mortgages — denial can be compounded by outright blindness to the real risks of that investment. That may explain why, even as everyone concedes that the subprime or low-grade mortgage market has fallen into the sea, the vast pools of mortgage-backed securities built in part on those risky mortgage loans still appear to be on solid ground.

Investors, chasing the buzz of ever higher yields, have flocked into the mortgage-backed market in recent years. Nobody wants to think that the possibility of a wide-ranging subprime debacle is also a harbinger of looming problems for investments tied to those loans. But the reality is that these vehicles — and the collateralized debt obligations that hold them — are not as secure as many believe. And that has broad implications for the capital markets.

Consider how torrid the issuance of these securities has been in recent years. In the last three years, for example, big banks and brokerage firms almost doubled the amount of residential loans they issued, going to $1.1 trillion last year from $586 billion in 2003. Many of these loans have been packaged into collateralized debt obligations and sold to pension funds, hedge funds, banks and insurance companies. For example, 81 percent of the $249 billion in collateralized debt obligation pools in 2005 consisted of residential mortgage products.

Collateralized debt obligations are made up of different segments — known as tranches — based on credit quality. Because buyers of these securities were looking for yields, subprime loans make up a large portion of most collateralized debt obligations.

Wall Street, of course, has coined major money in this area. Mortgage-related activities at the major firms generate an estimated 15 percent of total fixed-income revenue, according to Brad Hintz, an analyst at Sanford Bernstein.

BUT few seem worried about what might happen to these players if tremors in the subprime market worsen, or if supposedly more-creditworthy loans in the upper tranches begin to go bad.

One of the arguments for why mortgage loan pools have held up even as the subprime mortgage industry has collapsed is that their collection of a wide array of debt obligations provides a margin of safety. In addition, downgrades on these loans from the major rating agencies have been relatively modest.

This is puzzling, given the wreckage in the subprime market — lenders going bankrupt, stocks of issuers falling, default rates on new loans well above historical averages. Last year, Moody’s Investors Service, for example, downgraded only 277 subprime home equity loan tranches, just 2 percent of the home equity securities rated by the agency. So far this year, the firm has issued 30 downgrades, mostly on mortgages issued from 2001 to 2004. Among the 2005 and 2006 issues, many of which are defaulting at high velocity, Moody’s has put 62 tranches on review for possible downgrade. That is less than 1 percent of the total subprime deals rated in those years.

“Seeing weaknesses in collateral or subprime loans, we have increased our loss expectations by 25 to 30 percent,” said Debashish Chatterjee, a senior analyst in the residential mortgage-backed securities area at Moody’s. “We see the ratings outstanding on deals securitization in 2005 and 2006 and have taken steps to provide credit enhancement on them.”

But credit enhancement does not necessarily involve cash. Instead, the cushion can be additional mortgages or loans, which may also become vulnerable.

It is becoming clear, however, that subprime mortgages are not the only part of this market experiencing strain. Even paper that is in the midrange of credit quality — one step up from the bottom of the barrel — is encountering problems. That sector of the market is known as Alt-A, for alternative A-rated paper, and it is where a huge amount of growth and innovation in the mortgage world has occurred.

The Alt-A segment of the market used to consist of mortgages issued to professionals — like doctors — with unpredictable incomes. Now Alt-A is dominated by so-called affordability mortgages — adjustable-rate interest-only loans, 40-year loans and silent-second loans. You, dear risk-taking homeowner, know all about these loans that allowed people to buy a house that might have been beyond their means but looked attractive because they didn’t need to make payments on the principal in the early years.

In 2006, according to UBS, interest-only loans, 40-year mortgages and option-adjustable-rate mortgages comprised more than 75 percent of Alt-A issuance. These loans often have little documentation of a borrower’s income and rack up higher mortgage debt against the value of the underlying collateral (i.e., the house). UBS said that 76 percent of adjustable-rate interest-only loans written in 2006 had low documentation, while 57 percent had loan-to-value ratios greater than 80 percent. No surprise, then, that 3.16 percent of these loans are already delinquent by two months or more.

Worried?

Last week, Standard & Poor’s Rating Services put 18 classes of securities from 11 residential mortgage pools on watch for a downgrade. Alt-A loans were among those on the watch list, but S.& P. said its move to credit watch status on these mortgages would have no impact on outstanding C.D.O. ratings.

Relying on rating agencies to analyze the risk in collateralized debt obligations may be unwise, however. Back in May 2005, Alan Greenspan noted the complexity of collateralized debt obligations and the challenges they pose to “even the most sophisticated market participants.” He warned investors not to rely solely on rating agencies to identify the risks in these securities.

THAT is also the view of Joshua Rosner, a managing director at Graham & Fisher & Company, and Joseph R. Mason, associate professor of finance at Drexel University’s LeBow College of Business. The pair published a paper last week, “How Resilient Are Mortgage-Backed Securities to Collateralized Debt Obligation Market Disruptions?” analyzing C.D.O.’s. The Hudson Institute, a nonpartisan policy research organization in Washington, financed their research.

Mr. Mason and Mr. Rosner find that insufficient transparency in the C.D.O. market, significant changes in asset composition, and a credit rating industry ill-equipped to assess market risk and operational weaknesses could result in a broad financial decline. That ball could start rolling as the housing industry weakens, the authors contend.

“The danger in these products is that in changing hands so many times, no one knows their true make-up, and thus who is holding the risk,” Mr. Rosner said in a statement. Recent revelations of problem loans at some institutions, he added, “have finally confirmed that these risks are much more significant than the broader markets had anticipated.”

Mr. Mason and Mr. Rosner say it is only a matter of time before defaults in mortgage pools hit returns in collateralized debt obligation pools. Of greater concern, they say, will be the effect on the mortgage market when investors, unhappy with poorly performing C.D.O.’s, sell them and move on to other forms of collateral. They cite the manufactured housing market as a disturbing precedent; after that market collapsed in 2002, managers of collateralized debt obligations avoided the sector.

A similar shrinkage could occur in the residential mortgage sector as defaults mount. “Decreased funding for residential mortgage-backed securities could set off a downward spiral in credit availability that can deprive individuals of homeownership and substantially hurt the U.S. economy,” the Mason/Rosner paper said.

So far, the pain from subprime defaults has been muted. Market participants are cheered that lenders are finally tightening their loan standards, albeit a bit late. Unfortunately, the damage of the mortgage mania has been done and its effects will be felt. It’s only a matter of when.