Editor’s note: How bad will the real estate market get before it gets better? Inman News compiles the facts and analysis in this five-part series. (Read Part 1, “The housing market: How bad will it get? Part 2, “Vendors cope with real estate downturn“; Part 3, “Market forces, regulators threaten credit crunch“; and Part 5, “Diminished role for GSEs, FHA.”)

While lawmakers and regulators are still pondering whether to take more drastic steps to rein in lenders, market forces have already tightened underwriting practices.

Worries about the performance of securities backed by subprime loans could also restrict the flow of investment capital into mortgage lending, raising the cost of borrowing.

On July 12, Standard & Poor’s downgraded $6.39 billion in mortgage-backed securities backed by subprime loans. The ratings agency’s move, which affected 562 classes of mortgage-backed securities (MBS), caused a stir in bond markets.

Although the downgraded securities represented only a small percentage of the $565.3 billion in MBS rated by Standard & Poor’s between the fourth quarter of 2005 and the fourth quarter of 2006, the ratings agency also said it would change its ratings methodology going forward.

From now on, Standard & Poor’s said, its cash-flow assumptions would presume faster voluntary and involuntary (default) prepayments, and that default expectation for 2/28 hybrid ARM loans would increase by approximately 21 percent.

That could mean less favorable ratings for future MBS issuances and higher interest rates for subprime borrowers as Wall Street investors demand greater returns for the risk involved in making such loans.

The move by Standard & Poor’s came as it and the other two major ratings agencies — Fitch Ratings and Moody’s Investors Service — came under fire for allegedly failing to accurately gauge the risk of securities backed by subprime loans.

Moody’s Investors Service took similar steps the same week, downgrading 399 securities backed by first-lien subprime mortgage loans with an original face value of more than $5.2 billion.

On the same day Standard and Poor’s made its announcement, Fitch Ratings said it was weighing downgrades on 170 securities backed by subprime mortgages valued at $7.1 billion, and 19 collateralized debt obligations (CDOs) with subprime exposure.

Last month, Bill Gross, the manager of PIMCO, the world’s biggest bond fund, said analysts at the ratings agencies were beguiled by the “6-inch hooker heels” of collateralized debt obligations (CDOs), which include securities backed by subprime loans and derivative investments that Gross said heighten risk.

Gross’s comments came after Bear Stearns was forced to pledge up to $3.2 billion to prop up one of two hedge funds at risk because of investments in mortgage-backed securities. Gross said Bear Stearns had merely “papered over” the problems in the funds, and that problems in subprime lending threaten the entire economy because “the willingness to extend credit in other areas … should feel the cooling Arctic winds of a liquidity constriction.”

Standard & Poor’s estimates 13.5 percent of U.S. CDOs have some risk of losses through their exposure to subprime loans, and analysts at Credit Suisse believe banks could end up losing $52 billion through the loans to they’ve made to hedge funds and their own investments in CDOs containing securities backed by subprime mortgages.

In addition to providing liquidity for subprime lenders, investors in CDOs are helping buoy stocks by fueling a wave of acquisitions of publicly traded companies by private investors. That’s one reason some economists are worried that problems in subprime lending could spread to the rest of the economy.

Another threat the downturn in the housing market poses to the economy is that with consumers no longer able to use their homes at automatic teller machines — withdrawing money against the equity they hold — consumer spending will decline, with a corresponding hit on corporate profits.

Some experts don’t share Gross’s concerns that the problems subprime loans have caused for CDO investors pose a threat to the economy.

Tyler Yang, president of Integrated Financial Engineering Inc. in Rockville, Md., says if investors are reluctant to put money into CDOs, that could result in demands for higher yield spread premiums by alternative investors, higher premiums for private mortgage insurance, and less efficient hedging of credit risk through the use of conforming loan credit derivative swaps.

But there are so many alternative investors — including traditional purchasers of mortgage-backed securities like insurance companies and pension funds — that the impact of a move away from CDOs on prime mortgage lending is “not likely to be material,” Yang said.

Before the CDO became popular, there were “already many funding sources for the mortgage market,” Yang said. “The CDO became a bigger portion (of mortgage lending funding) in recent years mainly because they offered better prices for lenders.”

Yang said international investors will continue to be another source of funding for mortgage lenders. To investors in Asian nations with low interest rates, the 5 or 6 percent return on MBS is “very attractive,” Yang said.

(About 49 percent of the benchmark notes issued by Fannie Mae in 2006 were purchased by non-U.S. investors, including private institutions and non-U.S. governments and government agencies, the company said in its most recent annual report.)

But there’s no guarantee investors will be willing to continue financing subprime loans, Yang said. If that’s the case, so be it, he said.

“The subprime market should never have grown so large and so fast in the last few years,” Yang said. “My personal opinion is the markets should think about whether it’s optimal for those subprime borrowers to get mortgage loans. Since (by definition) subprime borrowers have had recent financial difficulties, maybe this is not the best time for them to commit to additional debt obligations” in the form of a mortgage.

Joseph R. Mason, associate professor of finance at Drexel University’s LeBow School of Business, said that if investors direct less money into subprime mortgage lending, that will help return stability to housing markets.

“If you start with the basic premise that we had too much capital devoted to the industry to begin with, and the amount devoted to mortgage lending created instability, the question is do you really want that much money flowing into the sector?” Mason said. “These products used to be regulated for stability when they were offered through the banking sector. The banking sector found a way to get these off their balance sheets so that they are no longer regulated for stability, but it’s just as crucial as it ever was.”

Mason, the co-author of a recent paper on the impact of CDO market disruptions on mortgage-backed securities, said the firms that issue mortgage-backed securities should provide more transparency to investors so they are better able to price risk.

Mark Adelson, the head of structured finance research at Nomura Securities International, said investor confidence in CDOs isn’t a make or break issue for the subprime lending industry.

“The CDO sector made for some stupid pricing on risk,” Adelson said. But “the presence or absence of credit for subprime borrowers does not rely on the CDO sector.”

While Standard & Poor’s, Fitch and Moody’s have all taken fire for their alleged failures in assessing the risk of securities backed by subprime loans, that job is complicated if those risks are intentionally obscured.

A recent report by the Mortgage Asset Research Institute (MARI) found a 30 percent increase in suspected mortgage fraud incidents during 2006. The quality of data on borrowers and loan characteristics provided by lenders to the ratings agencies “has also come under question,” Standard & Poor’s says.

“Data quality is fundamental to our rating analysis,” the ratings agency said in a report explaining its decision to reconsider its ratings on MBS classes issued in 2005 and 2006. “The loan performance associated with the data to date has been anomalous in a way that calls into question the accuracy of some of the initial data provided to us regarding the loan and borrower characteristics.”

Mason said that just as lawmakers should not bail out troubled borrowers or try to facilitate loans to people who wouldn’t otherwise qualify, investors in mortgage-backed securities should be allowed to suffer their losses. Only then, he said, will they demand the transparency needed to assess the risk of such investments.

Adelson, too, opposes some of the more aggressive remedies proposed by consumer groups and lawmakers, including federal preemption of predatory lending, a moratorium on foreclosures, and mandatory, “one-size fits all” loan modifications.

“If loan modification works for the lender, I’m all for it,” Adelson said. “The purpose is to reduce (the lender’s) loss. If it happens to help the borrower, fine. I just don’t care if it helps out the borrower. That’s a little unpopular view — some people say I’m mean, that I don’t care about the borrowers, but it’s not about niceness or meanness, it’s about business.”


Send tips or a Letter to the Editor to matt@inman.com, or call (510) 658-9252, ext. 150.

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