A Primer for the Subprime Problem

The growing number of defaults in the subprime-mortgage market has many investors confused. S&P has some answers to common questions

by Victoria Wagner From Standard & Poor's RatingsDirect

As defaults continue to rise in the subprime-mortgage market, Standard & Poor's Ratings Services has responded with downgrades of two of the largest specialty finance subprime lenders: New Century Financial (NEW), lowered to D from CC on Mar. 12, and Fremont General (FMT), cut to B- from B+ on Mar. 5.

The remaining large subprime lenders that we rate, such as HSBC (HBC), Citigroup (C), Countrywide (CFC), and Washington Mutual (WM), not only possess diversified mortgage-banking businesses but have also developed other business lines with revenue sources that should continue to support their core operating performances through this stressed subprime market.

The rising tide of subprime defaults is raising many questions, not only about the subprime market but also about the ramifications of the market's problems for the near-prime and prime sectors, potential new regulations affecting the mortgage market as a whole, and the timetable for a subprime loan market stabilization. Standard & Poor's Ratings Services offers some answers:

Will there be further rating actions related to the subprime downturn?

We don't anticipate a rash of negative rating actions due to rising credit stresses in the subprime-mortgage sector. The rating actions taken on New Century and Fremont reflect the high concentration of subprime mortgages at these businesses and the weak credit performance of their respective subprime portfolios. This performance has triggered funding liquidity concerns, as both companies rely on secured wholesale funding sources.

The business press often refers to the "subprime market" without making any distinctions. Which elements of it are deteriorating, and which, if any, are showing resiliency?

The subprime mortgages experiencing the weakest credit performance are a small subsegment of this market, and one with the highest layering of underwriting risk. By high-risk layering, we mean the tendency to accumulate high-risk credit factors: A low FICO score (low 600s and below), no income documentation, no asset documentation, no down payment or second mortgage collateral in lieu of the down payment, and a purchase mortgage. This "perfect storm" of risk layering in underwriting subprime mortgages is unprecedented.

In addition, the subprime mortgages that were originated in late 2005 and in 2006 are experiencing the highest levels of early payment defaults. However, other segments of the subprime-mortgage market are to date following more normalized delinquency and loss curves.

To what extent do you anticipate delinquencies and losses in the prime or near-prime markets?

For some time, we have anticipated a normalization of commercial and consumer-credit losses across all loan types—including prime mortgages and credit cards—from the historic and unsustainably low levels they have been experiencing during the past several years.

Given the sheer high volume of mortgage loans originated between 2003 and 2004, these loans are reaching their peak delinquency point in the mortgage cycle, which is pushing mortgage delinquency levels higher for most mortgage lenders. To date, prime mortgage delinquencies and losses remain below historical averages.

What percentage of the overall mortgage market are subprime mortgages?

According to the Comptroller of the Currency, subprime originations account for 20% of all mortgages during the past two years. In 2006, 40% of adjustable-rate and interest-only loans were subprime. In 2006, subprime lending volume was at an unsustainably high level, and the recent fallout in credit quality demonstrates that this market segment grew beyond its limits.