December 14, 2006
Inadequate Research and Definition of Industry Terms Belies Portrayal of SubPrime Borrowers
Analysis of:
Subprime Borrowers are Falling Behind on Payment |
This analysis is solely the work of the author. It has not been edited or endorsed by GLG.
Implications: This article, which was published on the front page of the Wall Street Journal on December 5th, is a prime example of how lack of knowledge of an industry can lead to incorrect or unsubstantiated interpretation of market trends and data.
The authors report that "Subprime" borrowers are increasingly delinquent and that investors in Subprime mbs could lose principal even on investment-grade rated tranches, something that has never happened (except in the incidence of fraud) in the entire history of the US mbs market.
Since the authors do not provide the readers with an objective definition of subprime, or other salient facts which are essential to the article's message that subprime market participants are in danger, this article should be read with significant skepticism.
Analysis: While the article is exceptionally well-written and tells a compelling story, I feel that several crucial facts that are essential to a comprehensive depiction of the issues raised in the article are ignored or intentionally omitted..
There are more objective sources of subprime mortgage performance information, such as Loan Performance, a company which maintains a mortgage performance database consisting of information provided to it by mortgage lenders that originate over 70% of subprime mortgages. In addition, the rating agencies, which require issuers of all rated mbs to provide detailed information for purposes of surveillance, could also have provided you with a more robust and comprehensive data. I'm surprised that WSJ reporters would rely on one source to illustrate such a significant point and then neglect to obtain an explanation from the source as to how it acquired such information.
The authors report that "Subprime" borrowers are increasingly delinquent and that investors in Subprime mbs could lose principal even on investment-grade rated tranches, something that has never happened (except in the incidence of fraud) in the entire history of the US mbs market.
Since the authors do not provide the readers with an objective definition of subprime, or other salient facts which are essential to the article's message that subprime market participants are in danger, this article should be read with significant skepticism.
Analysis: While the article is exceptionally well-written and tells a compelling story, I feel that several crucial facts that are essential to a comprehensive depiction of the issues raised in the article are ignored or intentionally omitted..
For example, most mortgage industry professionals and experienced investors are aware that there is no uniform definition of "subprime." In general, the term refers to loans that have a certain combination of characteristics that assist the mortgage lender in evaluating the borrower's willingness and ability to pay: (credit scores/income/employment/amount of down-payment) and the documentation requested by the borrower (no documentation/minimum documentation/no income verification/some income verification). In addition to borrower credit worthiness and documentation, property type may also used by a mortgage lender/purchaser/rating agency or mbs investor to determine whether a particular loan is a "subprime" loan.
Because of the lack of uniformity among mortgage lenders originating subprime loans, most investors use the rating agencies (Moody's Investors Service, Standard and Poor's, Fitch Rating ) definition of subprime mortgage loans, which are contained in their published rating criteria as well as the models used to derive the credit enhancement and ratings for subprime mbs. Therefore, a market-neutral definition(i.e one that is not provided by a mortgage lender or an mbs broker/dealer) of subprime mortgage exists. I'm curious as to why the article failed to describe this lack of a precise definition and did not use rating agency criteria, as opposed to a graph provided by a broker/dealer, to illustrate subprime delinquencies.
The article includes a graph illustrating the escalating percentages of securitized subprime mortgage loan delinquencies. The source of the graph is cited as UBS. However, the definition of "subprime mortgage" used by UBS to create the graph is not revealed, nor is the methodology they used to create it.
Most mortgage professionals would agree that the subprime market, as it exists today did not begin in 1997, and even conceding that it did, the definition of "subprime" has significantly expanded since 2000. This phenomenon of loosening credit standards that occurred over the past ten years may account for the dramatic escalation illustrated by the UBS graph-a strong possibility that was not mentioned in the article.
Another point regarding the source of the UBS information: Reg AB, an SEC requirement that mbs issuers publish performance information related to specific loan characteristics of securitized mortgages,became effective last year. Before then, specific performance information on specific types of securitized mortgage loans (e.g. alt-a, prime, subprime) was extremely difficult to obtain. While mbs issuers were always required to report delinquencies, the reports were not so detailed as to reveal the credit characteristics of the loans that became 60 days delinquent. I realize that some issuers may have made this information available to investors before the passage of Reg AB, however, this information certainly was not published. Again, I don't understand how UBS was able to obtain such specific information on securitized subprime mortgages (other than that related to their proprietary transactions) as far back as 1997.
There are more objective sources of subprime mortgage performance information, such as Loan Performance, a company which maintains a mortgage performance database consisting of information provided to it by mortgage lenders that originate over 70% of subprime mortgages. In addition, the rating agencies, which require issuers of all rated mbs to provide detailed information for purposes of surveillance, could also have provided you with a more robust and comprehensive data. I'm surprised that WSJ reporters would rely on one source to illustrate such a significant point and then neglect to obtain an explanation from the source as to how it acquired such information.
In addition to failing to objectively define or to cite an objective definition of "subprime", the article also fails to disclose what to me is, a blatant conflict of interest. The article refers to analyses conducted by RBS Greenwich, UBS and Merrill Lynch, all of which reveal escalating foreclosures and, in the case of Merrill Lynch, forecast losses caused by defaulted subprime loans which could exceed the amount of non-investment grade mbs tranches, thereby exposing investment grade mbs investors to principal losses.
It is no secret that these very same firms, along with others, have been giving client presentations that advocate shorting BBB rated mbs tranches. This information, had it been disclosed, or had you even inquired whether any of the firms currently hold or advocate a short position in investment grade mbs and revealed the responses, would definitely impact the interpretation of the analysis referred to in the article.
Finally, it is also industry-wide knowledge that mortgage originations have significantly dissipated in 2006. Nonetheless, a strong demand for mbs continues from CDO investment vehicles, overseas investors and others. Wall Street firms which rely heavily on income from underwriting and trading mbs are under tremendous pressure to obtain as many mortgage portfolios as possible. This has led to many firms, such as Morgan Stanley, Merrill Lynch, Bear Stearns and others purchasing subprme originators in order to capture their own source of subprime mortgages.
Clearly, it is to the benefit of such firms as Merrill Lynch, RBS Greenwich and UBS, to distribute information designed to denigrate the subprime mortgage industry. If the market believes them, and the market generally believes the Wall Street Journal, the stock of subprime originators tanks and Wall Street can take advantage of the discount that they themselves have created.
I'm not so naive as to think that I can rely on everything I read. However, I expected more from the Wall Street Journal. I'm also not a reporter; but it seems to me that, had the research been a bit more extensive, the article would have been much more comprehensive and much more worthy of publication on the WSJ's front page.
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