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Subprime Spreads Fall to Pre-Bust Levels
Asset Backed Alert, Harrison Scott Publications Inc. (May 25, 2007)
The values of some new subprime-mortgage bonds are almost back to where they would have been before the industry went into a funk earlier this year.
In fact, market players say that going solely by snapshots of spreads on such products now versus six months ago, it would be virtually impossible to tell that escalating borrower delinquencies and defaults had thrust subprime-mortgage lenders into a monumental credit crunch in between. What has changed, however, is the improved quality of the credits backing the latest round of deals, which has made investors more comfortable in venturing back into the market.
Some of the most notable recovery has taken place among triple-B-rated bonds, which were viewed by many buysiders as toxic just a few months ago.
A $1.2 billion securitization that Countrywide Home Loans priced on Monday offers an example, with an $11.7 million batch of five-year triple-B notes from the issue selling for 200 bp over Libor (see Initial Pricings on Page 14). On Dec. 12, the Calabasas, Calif., lender priced a similar class of securities at a comparable 170 bp over Libor.
When things were at their worst in February and March, some triple-B subprime-mortgage bonds were trading as wide as 1,000 bp over Libor. Looking forward, the consensus seems to be that more improvement is likely.
So are investors' memories really that short? Those keeping an eye on the market think not, pointing instead to massive efforts by lenders to tighten their loan underwriting standards. Those initiatives, they say, should lead to a long-term trend away from the soaring loan delinquencies and defaults that caused this year's upheaval in the first place.
Indeed, many buysiders are still unwilling to touch outstanding bonds whose underlying loans were written under more lax standards. Secondary-market spreads on the bottom investment-grade pieces of those issues are hovering around a far-less-healthy 800 bp over Libor.
Another factor: As investors recoiled from the market, it also became virtually impossible for the subprime lenders with the deepest loan-performance troubles to fund themselves through securitization - or by any means, for that matter. The result is that many, like Fremont Investment & Loan and New Century Financial, have withdrawn from the business or have been put out of their misery altogether, leaving the issuer community populated by big banks and other well-heeled operations.
There was no single event that brought the sector back to its current pricing milestone. And, to be sure, the recent improvement in subprime mortgage bond liquidity actually continues a somewhat surprising trend that was taking shape in April, as some bond buyers realized they would be better served by taking a more selective approach to the market than by abandoning it entirely.
That said, their new level of comfort is far more pronounced that it was when they began creeping back into the market in Mid-April.
Glenn Schultz, who heads asset-backed securities research at Wachovia, said that while it's tedious work to determine the credit quality of subprime-mortgage transactions, especially older deals, the effort can be rewarding for investors who put in the time. Schultz maintains that the key is to ferret out which lenders employed overly generous lending practices, which he identifies as the biggest culprit in turning the asset class sour - not falling home values.
The response from issuers, meanwhile, remains to be seen. It stands to reason that they'll be more motivated to float deals now, given the recent reductions in funding costs. And the thought is that for lenders like Countrywide, an uptick in output is possible.
But stricter lending standards mean there are simply fewer credits available for securitization than before, as does the recent thinning of the subprime-lending herd.
What's more, there has been a decline in CDO-driven activity. Without naming any specific players, Schutz said some issuers were cranking out deals mainly to take advantage of demand from CDO issuers who wanted to buy the products for their deals' collateral pools, often with little analysis. That practice has since fallen by the wayside.
So far this year, issuers have sold $137 billion of bonds backed by subprime mortgages and home equity loans to U.S. investors, down from $190 billion a year ago, according to Asset-Backed Alert's ABS Database. That's a drastic reversal from explosive growth figures that prevailed in previous years, as lenders sought to fund ever-growing books of credits.
Still, subprime-mortgage securitizations continue to account for the largest chunk of the U.S. ABS market, at 42%.