Wednesday, July 11, 2007

Alt-A: The New Home of Subprime?

by Tanta on 7/11/2007 10:32:00 AM

UBS has a report out today (not available on the web) which suggests the possibility of an alarming trend in recent (2007) RMBS issuance: while subprime issuance has dropped, as we expected, and "agency" issuance (the GSEs, mostly, are meant by the rather old-fashioned industry term "agency"), particularly of fixed-rate loans and the better quality hybrid ARMs, is edging up as a share of the market, which we also expected, non-agency Alt-A is actually increasing as well, which is somewhat more surprising. At the same time Alt-A volume is creeping up, its credit quality shows some signs of deteriorating. The implication is that loan production that would, last year, have ended up in a subprime security is migrating into Alt-A securities.

In one sense this is hardly surprising: the line between Alt-A, "Alt-B," and subprime has never been sharply clear, as loan quality and underwriting standards operate on a continuum and different participants bucket the loans in somewhat different ways. I put the term "Alt-B" in quotation marks because, while some of you may have heard the term before, it's not universally popular in the industry. Traditionally, credit quality at the level of individual homeowners used letter grades, more or less uniformly, of "A" to mean "prime" credit, "A-" to mean near-prime (FHA programs, for instance, were historically considered near-prime), and "B" and "C" to mean subprime. (There is "D," which has always been considered "hard money" lending, not typically a kind of loan made by institutional mortgage lenders of any sort.) You can, of course, put plusses or minuses on any of these letters, if you want to denote the top or bottom of a range of credits.

Under this kind of rubric, the term "Alt-A" was originally seized upon as a way of describing loans that we used to just call "non-agency." The "A" part indicated prime borrower credit quality, supposedly comparable to the credit quality demanded by the GSEs, but the "Alt" part meant that other characteristics of the loan, apart from borrower credit quality, exceeded the guidelines required by the GSEs. Most famously, these were the high-LTV or CLTV stated income deals. "High LTV" is of course relative to things like occupancy: while the GSEs accept a lot of high-LTV primary residences, they have always been less interested in high-LTV second home or investment properties. So Alt-A has always included much larger percentages of non-owner-occupied loans.

You can see why "Alt-B" is an odd concept, then: the GSEs don't, as a general rule, securitize "B" credit loans. (They do invest in some subprime securities for their retained portfolios, which provides some liquidity for high-rated subprime tranches, but they didn't issue those securities and they don't own the residuals.) So "B" credit is by definition non-agency, whatever terms you offer. The term "Alt-B" is not an attempt to describe a kind of subprime lending as much as it is a derogatory term for the worst kind of officially-described "Alt-A," rather like the term "liar loan" is a derogatory term for the blander "no doc." If it has any clear definition, it generally refers to the lowest-quality segment of the somewhat nebulous "Alt-A" world.

My point is that there has for some time been quite a bit of low-quality Alt-A, enough that the term "Alt-B" has unofficially been used to describe it, but that the expectation has been that guideline tightening in the wake of regulatory guidelines and the general cratering of the housing market would have gone a ways toward bringing the "A" back to "Alt-A." Yet there are hints, at least, that we are possibly seeing the relabeling of subprime loans as Alt-A recently, given the loss of investor appetite for anything called "subprime."

It is, of course, possible that a certain percentage of loans "belonged" in Alt-A all along, but were steered to subprime in order to increase originator commissions or just to jazz volume. If that is so, then seeing those loans get steered back to Alt-A may well be only a matter of justice. I think there's undoubtedly some truth in this, but it seems questionable to me that the addition of "steered" loans into the Alt-A pipeline should more than compensate for the loss of production due to guideline tightening within Alt-A. Unfortunately, we'll probably just have to wait and see on this, but like the UBS analysts, I am concerned that there's still a fair amount of toxicity out there that is just getting relabeled. You can call it "Alt-B" if you want, but that just means it's subprime with high LTVs or reduced documentation, and the point of tightening was to get rid of that stuff, not to bump it up into so-called "Alt-A" securities.

One of the problems with both a slovenly use of terms and a kind of demonization of "The Subprime"--both of which we've seen in the mainstream business press for quite a while--is that it can, actually, enable this kind of problem. Investors are spooked over anything called "subprime," but still not spooked enough to do much due diligence on these deals, so you can easily get a situation in which shaky deals just migrate into the less-demonized category.

To me, the most troubling part of the S&P announcement yesterday was that it both conceded that the data it uses to analyze loan pools may be seriously corrupt, and basically had nothing to offer in terms of fixing that. Adding a fraud-prevention questionnaire to its review of mortgage originators isn't going to solve the problem of inflated appraisals, inflated income, manipulated FICOs, and just plain old half-assed data reporting in the absence of actual fraud. S&P knows this perfectly well, but they (and the other rating agencies) have never been in the business of loan-level due diligence or serious auditing of originators or issuers, and they're not in the position to start now.

As I have argued before, we as an industry have known how to prevent a lot of fraud for a long time; we just didn't do it. It costs too much, and too many bonuses were at stake to carve out the percent of loan production it would take to get a handle on fraud. The only thing that got anybody's attention, finally, was a flood of repurchase demands on radioactive EPD loans and other violations of reps and warranties. If S&P wants to accomplish something, I'd suggest skipping the fraud-detection questionnaire directed to the mortgage originators (they'll just make up good answers to it, for heaven's sake, if they have inadequate operations, and the rating agencies can't verify it), and start slapping some issuers around on their pre-purchase or pre-securitization quality control and due diligence. If you want reliable loan-level data to do your ratings analysis with, you make it expensive for people to give you cruddy data.