Thursday, April 05, 2007

Alt-A: Another Exceptionally Well-Disguised Blessing

by Tanta on 4/05/2007 07:04:00 AM

LoanPerformance’s December 2006 issue of its newsletter, “The Market Pulse,” is now available online. (You must subscribe (free) in order to download a copy.) It features an article by UBS’s David Liu and Shumin Li which you might not want to read if you are both 1) an owner of certain Alt-A mortgage-backed bond tranches and 2) eating.

I recommend the entire newsletter, which is full of charts and maps and things for those of you who are graphically minded. The Liu and Li article, however, is a must-read for bond geeks. The conclusion:

If [prepayment] speeds slow 20-25% as we predicted . . . [Alt-A] cumulative losses could rise an additional 25-30%, which will be ~200 bps under the weak HPA [less than 5%] scenario.

By comparison, BBB- bonds backed by Alt-A hybrids are generally designed to have credit enhancement of ~200 bps. . . On average, credit support of BBB- bonds will be erased over the life of the deal, although the losses will not hit the BBB- bonds. The bonds will most likely be downgraded due to the serious erosion of credit support. . . .

If the housing market remains flat or turns negative for a prolonged period of time (e.g., [less than] 1% annual HPA for the next 3-5 years), then we expect cumulative losses on these deals to rise another 20% (based on the limited data we have observed in the subprime ARM sector), which will wipe out the credit support of BBB bonds on these deals even without considering the distribution of losses. . . .

In summary--we project baseline prepayment speeds of low 20 CPR (for 5/1s), and therefore cumulative default rates of 12-13%, applying a loss severity of 15% on all defaulted loans - - would result in a cumulative loss of ~200 bps, which could potentially wipe out most of the credit support [of] BBB- rated bonds backed by Alt-A hybrids. And yet - we have not seen any spread movements that suggest investors are taking this into consideration. [emphasis in original]