Interest Rate Roundup

Tuesday, May 13, 2008

Why seconds are performing so poorly: One FL example

Bank of America made some headlines today when it announced that losses on its book of home equity loans, or second mortgages, would be worse than expected. Specifically, according to Bloomberg:

"Bank of America Corp., the nation's biggest consumer bank, said losses on home-equity loans will be even worse than predicted three weeks earlier, adding to evidence that more consumers are falling behind on debts.

"More customers are under financial stress and using credit cards to pay for necessities, said Liam McGee, president of the consumer and small business division, at an investor conference today in New York. Losses on the bank's $118 billion in loans linked to home values may top 2.5 percent, higher than the 2 percent to 2.5 percent projected last month.

"Credit-card customers are cutting back on retail, travel and entertainment purchases, said McGee, whose company is the nation's largest credit-card issuer and ranks No. 1 by deposits. That backs up economists and bankers who say the U.S. may be teetering near a recession as consumers struggle with job losses and gasoline prices of more than $4 a gallon.

"McGee said Bank of America expects the economy, measured by real gross domestic product, will shrink in the second quarter. The bank had $184 billion of credit card debt outstanding at the end of the first quarter and about a 20 percent market share.

"Credit and debit-card purchases for "necessary'' items, including fuel, food and utilities, grew by 13 percent in the first quarter, while spending for retail, travel and entertainment increased 0.5 percent, the bank said today."

Meanwhile, Moody's Investors Service is out on the tape talking about how the bond insurers MBIA and Ambac Financial face "meaningfully" higher losses on HE loans and CDOs. Specifically, Moody's says seconds are performing much worse than expectations. Here's an excerpt from the firm's "U.S. Subprime Second Lien RMBS Rating Actions Update," which provides some more details on what the firm is seeing:

"Losses to date on loans backing 2005-2007 vintage subprime second lien-backed RMBS have greatly exceeded Moody's original expectations. Beginning early in their lives, second lien pools included in 2006 and 2007 transactions saw substantially higher delinquency and loss levels in comparison to earlier vintages at the same level of seasoning. Three months after issuance, serious delinquencies (those more than 60 days) on 2006 vintage loans were 2.7% of original issuance compared with 1.7% for 2005 vintage pools. 2007 vintage loans deteriorated even more rapidly; by month three, 5.3% of loans were seriously delinquent, nearly double the level for 2006. The extreme level of early payment default seems to be attributable to aggressive loan underwriting as well as to payment behavior by certain homeowners who may never have intended to make a payment on their loans.

"Pool losses came quickly with the rapidly rising delinquencies. Unlike first lien loans that go through a lengthy process of foreclosure, second lien loans are written off by servicers when they expect that no recovery is foreseeable. In light of the pressure on home prices and limited or negative borrower equity in their homes, many second lien loans were simply written off after being delinquent for six months. Because the limited borrower equity left little room for recovery, many of the loans have defaulted with severities around 100%."

"With only 15 months of seasoning, 2006 vintage loans have lost nearly 10% of their original balance, and 2007 vintage pools have lost just over 8% by month 9. Even with these early losses, the pace of delinquency has not yet significantly slowed with seasoning. Troubled borrowers concerned about losing their houses tend to default on their second lien loans before their first lien loans because, with no equity in the home, the second lien lender has little incentive to pursue foreclosure."

That's a lot of jargon and industry-speak to digest -- and it might leave you wondering what things look like on the ground. What's happening with second lien loans in the "real world" and why are they performing so poorly?

Well, I just stumbled across a nearby town house listing. It's advertised as a short sale at $108,000 (subject to bank approval, of course). So I did a bit more digging into the property's history. Turns out it sold for just under $80,000 in August of 1990, then next changed hands for a little less than $90,000 in May 2001. Total gain in almost 11 years: about 13%.

It next sold for $94,000 in November of 2002. But shortly thereafter, our bubble here in South Florida started inflating. Before long, people were outbidding each other left and right for both new and existing homes and lending restrictions were being slashed to the bone. The same property then changed hands for $170,500 in October 2004 -- up more than 81% in just under two years.

Here's the kicker -- it looks like the property was financed with a $153,450 first mortgage and a home equity line of credit for $17,050. Yes, that means the buyers put nothing down on a home that had almost doubled in value in just a couple of years. And yes, this same town house -- with $170,500 in loans (minus whatever principal has been paid down in the meantime) -- is now being marketed as a short sale for almost $63,000 less. I'm betting the second lien lender isn't feeling too warm and fuzzy about his loan.

Hopefully this example gives you an idea why second lien lenders are in a world of hurt, especially if they're loaded up with loans against properties in markets where values are deflating fast.


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