Now it's 'Alt A'(ZT)

Defaults on some so-called Alt A mortgages packaged intobonds last year are now outpacing those from subprime loans, accordingto Citigroup Inc.

The three-month constant default rate for 2006Alt A hybrid adjustable-rate mortgages is 2.3 percent, compared with2.2 percent for subprime ARMs, New York-based Citigroup analysts led byRahul Parulekar wrote in a July 20 report. The figures represent thepercentage of balances in a mortgage-bond pool expected to default inthe next year based on 90-day trends.

[Mish comment: Here's thekey phrase "expected to default in the next year based on 90-daytrends". Wasn't it reliance on trends that got rating companies intohot water in the first place? Essentially Moody's, Fitch, and theS&P, all used trends to predict that housing would rise foreverinto the future at a slow steady rate. None of the rating companiesallowed for reversion to the mean or even a flat market for thatmatter. I talked about this in Fitch Discloses Its Fatally Flawed Rating Model.I suspect that we are going to find 2% is a very optimistic number. Ifnothing else the illiquid CDO market now acts as if 2% is optimistic.]

Thespeed at which Alt A hybrid ARMs are being paid off due to home salesor refinancing has also fallen to about the same level as for subprimeARMs, which typically prepay more slowly, the analysts said. Slowerprepayments can make the same rates of defaults more damaging byleaving more of the initial balances outstanding to eat intobond-investor protections.

The combination of challenges mean2006 bonds backed by Alt A mortgages, a credit grade above subprimeloans, may need "lower loss severities to still come out with lowercumulative losses than subprimes," the Citigroup analysts wrote.

Morethan $800 billion of subprime mortgage bonds and $700 billion of Alt Abonds are outstanding, with ARM bonds totaling more than $600 billionand $450 billion, respectively, according to a March report byZurich-based Credit Suisse Group.

[Mish comment: Those numbersare telling. $800 billion in total subprime debt, of which $565 billionis in the most toxic years (2005-2006) and a mere 3% of that debt hasbeen downgraded even though Bloomberg calculates that a full 65% ofthat debt no longer meets the grades originally assigned. See Thoughts on Moody's "Tough Stance" for more information.]

TheCitigroup analysts used Alt A ARMs with five years of fixed rates fortheir study. They didn't include so-called option ARMs, a type of loanwith minimum payments that produce growing debt in $200 billion of AltA bonds.

[Mish comment: There's nothing like excluding the worst of the garbage when coming up with your number.]

BetweenJune 1 and July 17, typical spreads on BBB rated Alt A securitieswidened by 125 basis points to 475 basis points, while spreads forsimilar subprime securities rose 200 basis points to 450 basis points,according to Citigroup.

A Near Halt

As investors flee themarket, a near halt in non-guaranteed mortgage-bond sales and a greaterdifferentiation among securities with the same labels and ratings islimiting consensus among analysts on typical levels. Analysts at CreditSuisse and New York-based Bear Stearns reported higher spreads for bothAlt A and subprime securities in reports last week.

[Mishcomment: This is enormously compounding the ability of homebuilders tosell homes. Some are going bankrupt. It's the same every cycle. Risk ispiled upon risk as trend players project the past forever into thefuture. Greed and fraud both run rampant then the whole thing blows up.]

AltA and subprime loans compose about 13 percent to 14 percent of alloutstanding home mortgages, according to estimates Federal Reserve Bankof St. Louis President William Poole cited in a speech last week.

[Mishcomment: Bulls have been citing the small percentage of subprime debtas if it's too small to matter. How many times have we heard, subprimeis only 8% of the market. Hmmm Now it's subprime and Alt-A are only 14%of the market. But is 14% the extent of the problem? Of course not. Theright questions are: How much total garbage was rated "A" that did notdeserve to be. How much of the originally deserving "A" paper alsodeserves to be downgraded? Thus a seemingly bullish factor is anythingbut. In fact it serves as a warning about how overrated all this debtwas in the first place]

Mispriced Risk

Risk was seriously mispriced as evidenced by the complete collapse of the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leveraged Fund and the sudden widening BBB rated Alt A securities credit spreads by 125 basis points to 475 basis points.

Given how little debt has actually been downgraded so far, those spreads have a long, long way to widen.

CDOs Grind to a Halt

Bloomberg is reporting Homeowners Face Funding Drain as CDO Sales Slow.

TheWall Street money-machine known as collateralized debt obligations isgrinding to a halt, imperiling $8.6 billion in annual underwriting feesand reducing credit for everyone from buyout king Henry Kravis tohomeowners.

Sales of the securities -- used to pool bonds, loansand their derivatives into new debt -- dwindled to $9.1 billion in theU.S. this month from $42 billion in all of June, analysts at NewYork-based JPMorgan Chase & Co. said in a report yesterday.

From$42 billion to $9 billion is quite a collapse. Look at the reduction inunderwriting fees. Think about how much harder this make it to buy anew house or sell and existing one. How quick we forget. Was it a mere7 years ago that the same thing happened in the dotcom bubble?

The Ghost of Drexel Burnham Lambert

Kevin Depew on Minyanville gave everyone a history lesson in point one of Tuesday's Five Things.

1. Ghost in the Machine Slowly Grinding to a Halt

Themarket for collateralized debt obligations is slowly grinding to ahalt, according to Bloomberg, threatening one of Wall Street's sacredcash cows - (read: $8.6 bln in annual underwriting fees) - and reducingthe availability of credit for everyone from major Wall Street buyoutfirms to homeowners themselves.

• Sales of collateralized debtobligations (CDOs), which are used to pool bonds, loans and theirderivatives into new debt, fell to $9.1 billion in July, down from $42billion in June, analysts at JPMorgan Chase (JPM) said, according toBloomberg.
• What's behind the declining appetite for CDOs?
• Thenear collapse of two Bear Stearns (BSC) hedge funds, for one. Thedowngrade of 75 CDOs by the ratings agency S&P, for two. Andconcern about growing losses due to rising homeowner mortgage defaults,for three. Those are just for starters.
• OK, so what are we really talking about here with these so-called CDOs?
• CDOs were created in 1987 by bankers at Drexel Burnham Lambert.
• Wait a minute.
• Did you say Drexel Burnham Lambert?
• Isn'tthat the same firm that was driven into bankruptcy in 1990 due toillegal trading in junk bonds driven by Drexel employee Michael Milken?
• And did you say they were created in 1987?
• The same year the market crashed?
• And wasn't the 1980s known as the "Decade of Greed"?
• Yes, yes, yes, yes and yes.
• So let's see if we got this right.
• Today,in 2007, the market for securities that were created in the "Decade ofGreed" by a firm that was only a short time later forced intobankruptcy due to illegal trading in high-risk bonds is grinding to ahalt?

They say that history does not repeat butit does rhyme. In this case they have it wrong. CDO History is indeedrepeating. What will also repeat is how the Fed will react to theproblem. That way of course will be the same way the Fed reacts toevery problem (by cutting rates). Regardless of whether or not thattactic works the next time (I doubt it), the attempt itself should begood for gold as the yield curve steepens.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/