A Sinking Sensation for Subprime Loans

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From Standard & Poor's Equity Research

Small Cracks in Big Banks

This time around, banks have pulled their credit lines to companies such as Ownit Mortgage and Sebring Capital Partners, leading to their demise. Small cracks in the mortgage-loan books at some of the nation's largest banks have begun to appear as well. Subprime home equity loans drove material increases in overall mortgage losses for Citigroup (C), JPMorgan (JPM), and Wells Fargo (WFC) in the fourth quarter of 2006, according to research by Standard & Poor's Credit Markets Services.

The homebuilding sector isn't immune. Should buyers find it more difficult to qualify for mortgages, that could add to builders' woes at a time when many of them are suffering from a glut of unsold homes and falling land prices. Toll Brothers (TOL), the nation's largest luxury homebuilder, said Feb. 8 that orders fell by 33% in its fiscal first quarter, while it expected land writedowns of $60 million to $160 million for the period, exceeding estimates disclosed in December. Centex (CTX) wrote off $435 million and KB Home (KBH) wrote off close to $494 million for land and land options in their quarterly reports released in January.

Meanwhile, banks and other financial institutions along with global investors—many of whom poured into the U.S. residential mortgage-backed securities (RMBS) market in recent years because of the attractive yields on these bonds—may be exposed to souring loans. During the runup to and peak of the recent housing boom, total mortgage credit rose by about 10% annually from 2000 to 2005. In the same period, banks and other credit institutions became more exposed to mortgage debt in the form of loans and mortgage-backed securities. Total mortgage debt outstanding at commercial banks rose at a compound annual growth rate of 11% from 2000 to 2005, and at a rate of close to 7% at savings institutions.

Worse to Come?

But credit deterioration poses pitfalls for investors. Total delinquencies for RMBS transactions issued in 2006 averaged 12.61%, and loans considered seriously delinquent averaged 5.97%, according to research by Standard & Poor's Credit Markets. And there are reports that jitters are hitting the derivatives market as buyers and sellers of mortgage credit protection battle it out, says Action Economics.

Delinquencies and foreclosures may get worse. One out of five subprime mortgages issued in the past two years is projected to end in foreclosure, according to a study released in December by The Center for Responsible Lending, a Durham (N.C.)-based research group. The group also noted that even when home prices were rising, subprime home loans fared poorly, with as many as one in eight, or 13%, of these loans ending in foreclosure within five years of origination.

Niedzielski is a writer for S&P Global Editorial Operations .