A greater element of risk.

Author:Keane, Brendan J.
Position::Mortgage products
 
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Many lenders have embraced riskier underwriting strategies and mortgage products to offset sagging origination volume. The move toward more adjustable-rate loans and B and C mortgages has introduced a higher level of risk in the U.S. private-label mortgage-backed security market. The outlook is for these trends to continue and for issuance activity to remain depressed.

The refinancing boom of 1993 was brought to a virtual halt by the end of 1994 under pressure from rising rates. The resulting slide in mortgage originations has continued well into 1995. But higher rates have prompted more than just reduced refinancing and mortgage-backed security issuance. The fall off in origination business has resulted in fundamental changes in the nature of loans offered and securitized, as more loans are being made to riskier borrowers.

As originations dwindle, the fight for market share among lenders has spilled over to the securitization of first-lien, private-label, mortgage-backed securities (MBSs), with adjustable-rate mortgages (ARMs) and B&C lending programs serving as the primary weapons. Other lenders are adding reduced-documentation and high loan-to-value (LTV) ratio loans to their marketing arsenal. These reduced-credit quality products are expected to remain popular during 1995 and 1996.

Private-label securitization also has been affected by the expansion of the "B-piece" market, characterized by lower-rated and volatile subordinated classes of mortgage security offerings. As if not faced with enough challenges, investors must also consider the impact that legal developments, such as Rodash-type decisions, may have on their securitized investment. (The Rodash v. A.I.B. Mortgage Co. case involves a class-action challenge brought on behalf of borrowers for technical Truth-in-Lending Act disclosure violations by the originating lender. Currently, legislative efforts to provide further protection for lenders from such suits are moving forward in Congress. In fact, in early April, the House passed a bill that imposes a moratorium on class actions involving the Rodash matter. The bill prevents new class actions until October 1, thus creating a moratorium period that is designed to give Congress sufficient time to act on the underlying issues in the case.)

While these are the key developments shaping the U.S. mortgage-backed market, in numerous international MBS markets the further development of structured finance in recent years has greatly expanded the investment choices. The potential for growth in these and other regions will bring even more investment choices to the fixed-income market.

The broad impact of higher interest rates

The Federal Reserve's tightening of monetary policy led to a significant increase in interest rates during 1994 and the early part of this year, severely affecting home financing activity. Mortgage originations plummeted during the last nine months of 1994, as interest rates surged and refinancings crashed to a halt. The Mortgage Bankers Association of America (MBA) estimates a 24 percent drop in 1994 originations to $774 billion from 1993 lending volume of $1.01 trillion. Refinancings, accounting for 65 percent of originations in 1993, are estimated to have dropped 71 percent to $186 billion, or 24 percent of originations for 1994. Moody's estimates that jumbo residential mortgage production, the bulk of private-label securitization, fell by more than 50 percent during the year.

First-quarter 1995 origination levels indicate the fall off in origination activity may be leveling off. The MBA economics department forecast calls for 1995 first quarter lending volume to be $155 billion, followed by $148 billion in the second quarter of 1995, $152 billion in the third quarter and $148 billion in this year's fourth quarter.

Moody's expects purchase and adjustable-rate mortgage originations to be robust through 1995 and early 1996, but they will not compensate for lost refinancing activity. Reflecting anticipation that housing starts, existing home sales and new home sales will all show declines over last year, lending volumes are expected to continue their slide in 1995 and early 1996. Although that shift will result in a greater percentage of purchase mortgages, 1995 volume in non-conforming mortgages are expected to decline as much as 20 percent from last year. Continuing the upswing in ARM originations, (last year the share of new originations that were ARMs grew from 20 percent in January to 50 percent by December), Moody's expects ARMs to account for more than half of 1995 non-conforming residential lending volume.

Private-label activity down substantially

The decline in mortgage originations resulted in dramatically reduced first-lien 1994 residential mortgage securitization volume. By Moody's calculations, the rate of private-label securitization equaled 7.7 percent of residential mortgage originations in 1994, compared with almost 9.5 percent in 1993. Furthermore, the second half of the year accounted for only 27 percent of 1994's aggregate securitized volume [ILLUSTRATION FOR FIGURE 1 OMITTED].

Moody's expects 1995 private-label mortgage-backed securitization of first-lien residential mortgages to decline by almost one-third to $40 billion from 1994 levels of $59 billion [ILLUSTRATION FOR FIGURE 2 OMITTED]. Indeed, private-label securitization has continued its decline through the first quarter of...

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