Subprime Spreads Blow Through the Roof
Is the Alt-A Market Next?



After widening for several months, subprime yield spreads have skyrocketed in the month of February, leaving subprime lenders with inventories that are deeply under water. At particular risk are high-LTV pools and subprime seconds, which are trading as much as 10 points below where the same pools would have traded six months ago.

Investors are worried as the 2006 vintage subprime loans are demonstrating the worst Early Payment Default (“EPD”) experience seen in years. Credit standards were relaxed substantially during the real estate boom over the past decade, and throughout the 2002-2005 period, borrowers who were having difficulty paying their loans could sell their homes or refinance using newly-found equity.

Now that the real estate market has softened, these options are just not available to borrowers any more, and defaults are on the rise. Rising defaults may, in turn, cause an increase in unsold housing inventories and cause further downward pressure on the real estate market.

The bottom line is that we can’t really predict where the downward spiral will end, but most industry observers expect the troubles in the subprime space to persist throughout 2007. Depending on the magnitude of the downturn, we could see investor appetites for Alt-B loans and higher-risk Alt-A loans soften considerably as well.

At particular risk in the Alt-A segment are those borrowers who have used their home equity to cash out every year or two, and in effect have been using their housing appreciation to supplement their cash flow. These borrowers often have taken out no-doc or stated income loans, and have used their housing appreciation to juggle their debts and keep their credit scores relatively clean.

Now that the party is over, we can expect an increase in defaults in the reduced doc segment, and this could cause problems for every Alt-A lender. As investors get increasing numbers of these loans going into foreclosure, they will get more aggressive in trying to prove “income fraud” on the initial application. This will mean a lot more repurchase requests even for lenders that don’t originate subprime product, and a lot more losses for cases that can’t be adequately defended.

If you haven’t done so already, now is the time to take a hard look at your process for validating the reasonableness of borrower’s stated income. Borrowers who are taking cash out should be treated with extra caution, particularly if they maintain a high amount of consumer debt relative to their income.

It’s also time to take a hard look at your no-money-down piggyback loan programs. Pools of 95-100% CLTV seconds are currently trading in the mid-90’s, regardless of WAC, even when the borrowers have decent credit scores. Lenders are advised to use extreme caution with these programs, or even to eliminate 100% CLTV’s until the market stabilizes.