Tuesday, February 20, 2007

WSJ: After Subprime, Danger Lurks

by Bill McBride on 2/20/2007 02:57:00 AM

From Justin Lahart at the WSJ: After Subprime: Lax Lending Lurks Elsewhere

Investors who dabbled in subprime mortgages have learned that risk is a four-letter word. The lesson might need to be applied elsewhere before too long.
When housing was hot, subprime mortgages seemed like a sure thing. ... The default rate has since soared.

Could this happen to other borrowers? Mortgage lenders rely on FICO scores for conventional mortgages, too. And easy money hasn't been limited to mortgages. Yields on junk bonds -- the debt of the least creditworthy companies -- have never been as low against comparable Treasury yields as now. The same is true of emerging-market debt. Defaults on these bonds are low, as they were in subprime a few years ago. But how comforting should that be?
The downturn has been marked by an unexpectedly large number of "early defaults," for which borrowers stop paying shortly after getting their mortgages. [Asset-backed securities research Thomas] Zimmerman sees "soft fraud" in the mix of defaults. Someone might take out a mortgage, buy a home, avoid payments and live rent-free until the marshals come.

Nobody seemed to realize the risks inherent in extending mortgages with loose standards that left borrowers with little skin in the game. The question worth asking now: Where else has lax lending been going on?

If the answer is far and wide, things could get uglier.
My suggestion: take a hard look at CRE and C&D. When "things get ugly", defaults in CRE and C&D really increase (see early '90s on this Fed chart for commercial real estate).