SAN FRANCISCO (MarketWatch) - Losses on so-called Alt-A home loans are accelerating and could hit the value of lower-rated portions of some mortgage-backed securities, according to a study released on Tuesday.
Alt-A loans are considered less risky than subprime mortgages, but usually have lower credit quality than "prime" loans. Companies such as IndyMac Bancorp NDE Impac Mortgage Holdings IMH, -4.65% and Countrywide Financial CFC, -16.23% offer them.
Delinquencies have jumped on Alt-A mortgages originated last year with adjustable interest rates that let borrowers pay only the interest for a time.
These loans, known as Alt-A ARM IOs, have seen a four-fold increase delinquencies of at least 60 days, four times the level of similar loans originated in 2003 and 2004, according to the study by David Liu, head of mortgage credit research at UBS, and LoanPerformance, a division of real estate data firm First American FAF, -2.57%
This "alarming" deterioration could have dire consequences for some investors in the BBB- rated parts of mortgage-backed securities (MBS) that contain these types of loans, but the market hasn't priced these risks in yet, Liu warned.
Losses "could potentially wipe out most of the credit support on BBB- rated bonds backed by Alt-A hybrids," Liu wrote. "And yet we have not seen any spread movements that suggest investors are taking this into consideration."
Liu's study, which used LoanPerformance data from the end of January, is based on the housing market remaining relatively flat over the next few years.
"If house prices fall over the next few years, everything in this scenario will be much worst," he said in an interview.
Alt-A loans were originally designed for borrowers with clean credit records, but with other issues that often meant they provided fewer documents or even no documents showing what they earned. These loans were attractive to investors in mortgage-backed securities because they offered higher yields than traditional "prime" home loans, but were underpinned by the cleaner credit records of the borrowers.
The popularity of Alt-A mortgages exploded in recent years. A record $400 billion of these loans were originated in 2006. They accounted for 13.4% of all mortgages offered last year, up from 2.1% in 2003, according to industry publisher Inside Mortgage Finance.
But as the Alt-A business grew, more of these loans were offered to less creditworthy borrowers and the products became more exotic.
"The Alt-A sector is the poster child for
the past decade's tremendous growth and drastic evolution in the mortgage market," Liu wrote in the LoanPerformance study.
Alt-A ARM IO loans have "taken the leading role within continuously expanding borrower leverage in the runaway housing market," he added.
Three quarters of all Alt-A loans originated in 2006 were innovative mortgages such as interest-only loans and option ARMs, he noted.
As ARM IO mortgages took over as one of the dominant ARM products, the performance of these loans deteriorated rapidly, Liu said.
The main reason is that the housing market is much weaker than it was a few years ago and interest rates are much higher, Liu explained. "On top of that, underwriting standards were looser recently," he added.
The deterioration is "alarming" for investors in lower-rated bonds that are backed by these loans, he said.
Mortgage loans are usually packaged together and sold as mortgage-backed securities (MBS) to institutions such as pension funds, insurers, and hedge funds.
They are sliced up into different sections, known as tranches. Higher quality tranches pay lower interest rates, but are less likely to experience losses. Lower-rated slices, rated BBB- and BBB, yield more, but are the first to get hit when losses occur in the underlying mortgages.
An extra chunk of cash is included in MBS - called credit support or enhancement - that protects investors against a certain level of losses.
Liu's study suggests that losses in Alt-A ARM IO mortgages could wipe out the credit support on BBB- rated tranches of some MBS.
"There is a 34% probability that the entire BBB- tranche might get wiped out," he wrote. "Similarly, there is a 17% probability that cumulative losses reach 300 basis points, which could make BBB bonds appear on the endangered species list."
If the housing market remains flat or turns negative for a prolonged period, losses could rise further, "which will wipe out credit support of BBB bonds on these deals," he added.
If credit support on these tranches is erased, investors would still have access to the income. But Liu warned that they would likely be downgraded by credit rating agencies anyway, cutting their value.
There are a lot of moving parts in these projections, Liu said, noting that the analysis is "relatively crude."
"Even so, we believe our results are very powerful and are not currently reflected in the market," he concluded.