03/04/2007
Subprime cloud hides a silver lining
Sub-prime mortgages have attracted considerable attention, with growing concerns about the adverse implications for both the US economy and financial markets. Here, we put the issue into perspective, with suggested ‘triggers’ for investors to monitor and take action.
Sub-prime mortgages are loans provided to borrowers with a poor credit history. Historically, this market was only 5% of total mortgages but it has grown rapidly in the past 5 years, reaching about 20% of all new mortgages granted in 2006. A related area is the ‘Alt-A’ market, which was originally designed to allow people with good credit ratings to take out a loan with little additional documentation. Again this segment of the market has been transformed to the point where it now accounts for about 20% of total originations.
There are sound structural reasons behind this expansion. The US population has been growing, helped considerably by immigration. However, changes in the financial system have been equally important: the availability of new styles of mortgages, more automated assessment, and increased dis-intermediation of lending via mortgage brokers. Mortgage lending risk has also been dis-intermediated, as the traditional Mortgage Backed Security market opened up to new investors via innovative structured credit products, offering investors high yielding assets apparently secured on rock solid mortgage cashflows.
The current problems in the sub prime and Alt-A markets have not come out of the blue. There were concerns in 2005 and 2006 about borrowers with low credit scores over-extending themselves. About 40% of sub-prime mortgages initiated in 2006 were for 100% of the house’s value, meaning no deposit was put down. However, the chickens have come home to roost in 2007, with media reports of outright fraud and deception.
Delinquencies have grown steadily over the past year, but the stockmarket got a fright a few weeks ago when investors realised the implications for many lenders. In the fourth quarter of 2006, sub-prime delinquencies reached 13%, with brokers reporting another surge this spring. The pain is likely to be felt for some years. Only about 10% of adjustable rate mortgages saw their interest rate re-set in 2006, but 70% will do so in 2007 and 2008. The impact will vary considerably from product to product, but the monthly payment would increase by 33% to $1600 per month on an average loan.
How serious could the problem become? There are bearish forecasts circulating. Lehmans warn that US mortgage defaults could reach $300bn, while Self Help, a credit union, estimates that 2.2 million families could lose their homes. Various scenarios could appear. Although the US housing market has faltered for over a year, house builders still face considerable over-supply of unsold new homes. Mounting foreclosures could put further pressure on house prices, causing a sharp retrenchment in consumer confidence so the economy slows abruptly. Equally, problems could become more widespread if difficulties in the sub-prime market were to feed through into the larger prime banking markets.
Our detailed ‘Focus on Change’ analysis has enabled us to assess the full implications of the sub-prime issue. Already, a considerable amount of bad news is priced in. This can be seen in terms of the changes in share prices and estimated earnings for the firms most affected by these problems. We can see that the investment banks did not hold onto as much of the bad debt as many investors initially thought. Instead, it was passed on in small bundles to a wide array of commercial banks, hedge funds and insurance companies. A key issue in the run up to the next earnings season therefore is whether some investors are forced to admit errors in acquiring this debt.
We believe the sub prime issue is certainly a headwind, but it does not appear sufficient to push the US economy into recession. The total amount of sub-prime and Alt-A debt is worth about $2 trillion, in the context of total mortgage debt of some $10 trillion but, more importantly, total net household wealth of over $50 trillion. Mortgage equity withdrawal totalled about $500bn in 2006, but only about 20% of this was spent, with the remainder saved or invested. Looking at all US consumers, the impact on personal income growth should be limited to the order of 0.25-0.5% a year.
What are the implications for investors? Housing problems will continue to be a considerable drag on the US economy and markets, so there will be opportunities for investors to buy distressed assets when valuations are suitable. Encouragingly, the Federal Reserve is monitoring the situation. Not only was the tone of its latest statement more dovish, but if the problems do become more widespread, the Fed will wish to avoid a credit crunch by easing monetary policy. Traditionally, this has been a strong signal for investors to put more risk in due course into their portfolios.
Andrew Milligan, Head of Global Strategy, Standard Life Investments
First published in Fund Strategy on 16 April 2007
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