summer project - what is driving subprime & alt-a borrowers to default on their mortgages

8/4/2019 Summer Project - What is Driving Subprime & Alt-A Borrowers to Default on Their Mortgages

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WHATISDRIVINGSUBPRIME&ALTA

BORROWERSTODEFAULTONTHEIR

MORTGAGES?

David WattsMiFPT2009


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Table of Contents

Abstract 3

Background of Mortgage Market & Brief History of Subprime & Alt-A4

Subprime Loan Performance 5

Alt-A Loan Performance 6

A Review of Mortgage Default Literature 7

Characteristics & Quality of Subprime & Alt-A Loans 9

Rate Resets 12

The Scale of Interest Rate Adjustment 17

Interest Only 19

Other Payment Altering Features Negative Amortisation 24

Testing the data 26

De-trending the Data 29

Estimating Negative Equity 31

Conclusion 35

Bibliography 37

Appendix I: Estimating LTV Methodology38


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AbstractIn recent years US mortgages have incorporated more and more payment-altering features to provide borrowers with flexibility. These mortgages arenow defaulting in higher numbers than ever before.

Income shocks such as job loss and divorce are well documented as primarydrivers of mortgage default (see Capozza, Kazarian, & Thomson and others).However, for much of the current crisis, defaults have been soaring in theabsence of major rises in unemployment. As such it is unclear what the exactcause of the mortgage crisis is. There are several competing theories forwhat is causing the record defaults. One, that payment-altering features arecausing payment shocks when they expire. Two, that the payment alteringfeatures enabled borrowers to over-leverage both their equity and theirincomes and they were therefore much more likely to default from the outset.And three, that falling house prices are creating negative equity which isencouraging borrowers in to ruthlessly default.

If it is the case that exogenous, i.e. external to the mortgage itself, paymentshocks such as job loss and divorce increase the probability of default, then itis plausible that endogenous payment shocks those resulting from featureswithin the mortgage are capable of causing mortgage default as well.

Admittedly, research by Phillips, Rosenblatt & Vanderhoff looking at floating-versus adjustable rate mortgages between 1986 and 1992 suggest that"payment shock (induced by teaser discounts) does not increase defaultprobabilities."

In this research I analyse the prevalence of payment shocks in Alt-A andSubprime RMBS and test whether the timing and scale of mortgage paymentchanges coincide with rises in delinquencies.

I also develop a methodology for estimating negative equity in this RMBSloan pools to understand the extent to which increasing numbers ofborrowers entering negative equity coincides with delinquencies

The primary data for the research is derived from 167 Subprime RMBS and59 Alt-A RMBS and was extracted from the prospectuses of those deals.


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Background of Mortgage Market & Brief History of Subprime& Alt-ASubprime loans are not a recent invention. Historically their purpose was toprovide credit to borrowers who had experienced financial distress and were

unable to gain funding in the prime mortgage market. As a result themortgages tended to have payment reducing features that allowed distressedborrowers to pay a low teaser rate for an initial period often two years. Afterthe initial period the rate would reset to a prohibitively large margin over afloating interest rate. The assumption on the part of the lender was that afterthe initial period, the borrowers' credit score would be sufficiently re-established to return to the prime mortgage market. By having a steepincrease in mortgage costs, borrowers were incentivised to refinance with acheaper prime mortgage and repay the loan plus a prepayment penalty. Alsoby making that post-reset rate floating, rather than fixed, the lender wasensuring that the interest-rate risk was bourn by the borrower.

Alt-A mortgages, in contrast, are a more recent phenomenon and thedefinition covers much that is neither prime nor Subprime. At its mostgeneral, Alt-Amortgage borrowerstend to have higherFICOs than Subprime,higher loan-to-valuesthan prime and lowerdocumentation thanprime. Alt-A loansaccounted for onequarter of non-agencyRMBS issuancebetween 2002 and2007. This is less thanSubprime which madeup 37% in that period.However, more Alt-Aloans were retained on banks balance sheets after origination. And soalthough definitive data is difficult to obtain, the size of the total market isroughly comparable to the $1.3 trillion in Subprime with around $600 billionheld in RMBS trusts and a further $400 to $600 billion held by banks onbalance sheet.

While Subprime mortgages were loans to people with poor credit histories,Alt-A mortgages were largely a means of lending more to people with goodcredit histories.


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Subprime Loan PerformanceSubprime RMBS have experienced huge jumps in delinquencies in the pasttwo months. All three of the most recent vintages posted their largest one-

month increases ever inOctober and the largestthree month increasessince March. The risesmean that 8.5% of theoriginal balance within2007-RMBS is more than60 days delinquent andthe number within 2005RMBS have started torise again afterconsistently falling sincethe second quarter of thisyear. It is possible thatthe slowdown indelinquency growth in

2006 and 2007 RMBS and the fall in 2005 deals in the second and thirdquarter are the result of tax rebates mailed out by the Bush government in thesecond quarter. If this is the case, then it supports the notion that paymentability is a determinant of default.

Conversely, the rise in delinquencies in the past two months is likely drivenfirstly by delinquency growth returning to trend after the tax-rebates andsecondly by risingunemployment. As thechart above shows, USunemployment rateshave been rising rapidlysince the start of theyear. Foreclosures andREOs in the 2005Subprime RMBS are 68bp lower than they werein July at 6.8%. REO(real estate owned)indicates that the lenderis now the owner of theproperty following the

foreclosure auction.

And the number of mortgages in default in this report default refers tomortgages in foreclosure or REO in the 2006-vintage deals was alsomarginally lower in October than in July, down 4 bp at 15.6%. Finally, in the2007 Subprime RMBS, defaults are only 111 bp more in October than July,versus an average three-month increase of 417 bp.


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Alt-A Loan PerformanceIn the past three months, 1.23% of the original balance of 2007 vintage Alt-ARMBS has become 60-or-more days delinquent. This pushes the totalnumber of loans that are presently 60+ days delinquent up to 5.7%.

Delinquencies in 2006deals have also startedto grow strongly againafter a substantialslowdown over thesummer. In June, Julyand Augustdelinquencies increaseda total of only 11 bp to5.5% of the originalbalance. Since then, theproportion of loans thatare 60+ days delinquenthas increased to 6.3%.In contrast, the 2005RMBS are performingrelatively well. Thenumber of 2005 mortgages that are currently delinquent is half the number inthe 2007 RMBS 2.8% versus 5.7% and the rate of increase over the pastthree months is three times lower 38 bp compared to 123 bp.

The growth in foreclosures and REOs in the 2006 RMBS was the lowestsince March 2007, 96bp, taking the total to11.5%. And in the 2007deals 1.3% of loansmoved into foreclosureor REO in the past threemonths, taking the totalto 10.6%. The proportionof loans in foreclosureand REO in the 2005Alt-A RMBS rose 55 bpto 5.1% of the originalbalance in the threemonths to October.

As with the slowdown inSubprime foreclosures

and REOs growth, it is likely the result of slower delinquency growth earlier inthe year. However, now that delinquencies have started to rise once more and given that foreclosures and REOs have, like delinquencies, tended toaccelerate into year end it would not be surprising to see the growth inforeclosures and REOs pick up once again.


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A Review of Mortgage Default LiteratureIn the recent crisis, there has been considerable media coverage of ruthlessor strategic default where the homeowner defaults on the mortgagebecause it is worth more than the loan. Terms such as 'walking away' handing the keys to their property over to the bank and "walking away" arebecoming common in describing defaults. In finance terms, the homeowner iseffectively exercising a put option that allows them to sell the property to thebank for the value of the mortgage.

If media coverage is anything to go by, then it appears that homeowners,acting like rational economic agents, are exercising these valuable putoptions in droves.

And as house prices fall further, more and more mortgages will fall intonegative equity where the house is worth less than the loan and more ofthese puts will become 'in-the-money'. As a result, if the media coverage isan accurate reflection of how homeowners behave, then it is a scary prospectgiven that the global financial system is short those put options.

While stories about people mailing their keys back to the bank and riding intothe sunset leaving a mountain of debts lying in their wake make for goodcopy, empirical evidence shows that people tend to default on their mortgagemuch less than an ordinary put-option-pricing methodology would predict.

The Boston Fed in June published a report, Negative Equity and Foreclosure:Theory and Evidence, which argues that negative equity is not a sufficientcondition for default, although it is a necessary condition. As the authorscomment in that article: "current fears that a large majority of todayshomeowners in negative equity positions will soon walk away fromtheir mortgages are probably exaggerated". Negative equity, the authorsargue, is necessary for a default because without it a homeowner strugglingto meet their mortgage payments would simply sell their house, pay off themortgage and extract any residual equity value. As the authors of that reportstate: "Widespread negative equity will not result in a foreclosure boom in theabsence of cash-flow problems"

Empirical evidence of this is provided by the report. Between 1988 and 1993house prices in Massachusetts fell by 23%. By the end of 1991 the report'sauthors estimate that slightly more than 100,000 homeowners in the statewere in negative equity. Over the following three years fewer than 6,500defaulted.

Peter Chinloy of the American University in Washington reports similarfindings of the UK market in the early 1990s. Between 1988 and 1993, houseprices declined by 24% in nominal terms and by 40% in real terms in the UK.The Bank of England estimates that at the beginning of 1993 two millionhouseholds, 20% of all homeowners, had negative house equity. In anacademic study of the crash, Privatized Default Risk and Real EstateRecessions, Chinloy points out that "While negative equity was widespread,


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the average number of mortgages defaulting in the UK annually from 1991 to1992 was 75,000, a fraction of the two million households with negativeequity. Chinloy asserts that: "Having a put option nominally in the moneyis not sufficient to lead to a ruthless default." He concludes that:"Borrowers generally continue to make their mortgage payments even ifthey have negative equity Negative equity in a house may not be

sufficient to explain default."

Why do people in negative equity not default?The argument most frequently proposed by academics as to why put-optionpricing overestimates the number of people that will default is that the theoryignores "transaction costs". Transaction costs cover a range of factorsincluding the greater difficulty borrowers' face in gaining credit in future,sentimental attachment to the property and to the equity built up, moralqualms and moving costs. As James Kau and Donald Keenan write in AnOverview of the Option-Theoretic Pricing of Mortgages: "The generalconclusion [from empirically examined default behaviour] is thatinsufficient defaults is observed and large levels of transaction costs

would be required to explain the data."

The other frequently cited explanation for low empirically-observed defaultrates is that the option to default in future has value which is often overlookedin option-pricing models of mortgages James Kau and Taewon Kim inWaiting to Default: The Value of Delay.

If one is long a non-dividend-paying stock then the early exercise of anAmerican put means that you no longer stand to gain from any futuredecrease in the stock price. Admittedly, a mortgage is slightly different in thatdefault (the exercise of the put option) will only occur at a mortgage paymentdate. And the option to default in future periods incurs a cost this month's

mortgage payment.

Nevertheless, Kau and Kim propose that uncertainty about house pricescreates value of having the option to default in future. And this value in havingthe option to default in future reduces the need to explain away the lowempirically observed default rates with recourse to transaction costs.

However, it is worth noting that the consensus is not uniform. Analysis byPhillips, Rosenblatt & Vanderhoff of floating- versus adjustable ratemortgages between 1986 and 1992 suggest that "payment shock (induced byteaser discounts) does not increase default probabilities. Rather, higherARM default rates appear to result from reductions in equity due to

depressed local housing markets." If this is the case then negative equitycould unusually be a more significant driver of defaults within Alt-A &Subprime loans, which tended to have a high prevalence of payment-alteringfeatures.


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Characteristics & Quality of Subprime & Alt-A LoansSubprime loans offered lower introductory rates to borrowers with low creditscores to help them recover from financial distress and re-establish theirfinancial histories. At the end of the teaser period, the rate would revert to amore punitive level reflecting the borrower's Subprime credit risk. If by thereset the borrower was still a high credit risk, their only options would be topay the new higher interest rate, sell the house and repay the loan, or default,the idea being that most borrowers' credit scores would have improvedsufficiently by the end of the teaser period for them refinance into a primemortgage with a lower interest rate.

In contrast, Alt-A offered low introductory rates to enable borrowers to affordbigger houses. At the end of the teaser period, people were expected to beable to either refinance with another Alt-A loan or sell the house and extractthe equity value that was 'invariably' created by rising house prices.

The overlap in features between the two markets became increasingly greatfrom 2005 onwards. This meant that while adjustable-rate and interest-onlymortgages were adopted by the Alt-A market as a way of reducing the earlypayment burden, in turn longer reset and interest-only periods and higherloan-to-income levels were adopted in Subprime lending. The only featurethat did not cross the divide into Subprime was the negatively amortisingmortgage Option ARMs or Pick a Pay where borrowers could makemonthly payments that didn't even cover the interest. The deferred interestwas added to the loan.

Before examining the extent and timing of endogenous payment shockswithin Alt-A and Subprime loans it is useful to first understand the leverage inthese loans, what the loan was used or and the level of documentation thatwas provided at origination.

The weightedaverage loan-to-value for 2007Subprime loans inour sample is83.3% versus81.8% for the 2006loans and 78.9% inthe 2005 deals. Thechart to the right

illustrates just howaggressively theseratios rose overtime.

The same is nottrue for Alt-A which appear to have been less levered in 2007 than 2006 withthe LTV falling from 82.7% in 2006 to 73% in 2007


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This analysis uses the Combined Loan-to-Value, which accounts for the allfixed debt secured against the house. Note that no 2005 and only three 2006and four 2007 deals provide this combined LTV data. The ordinary LTV forAlt-A loans fell less dramatically from 71.3% in 2006 to 70.2% in 2007.

Anecdotally Alt-A loans are often perceived as the main source of financingfor property speculators. This is bourn out by an analysis of the RMBSprospectuses within the sample. As the chart to the left shows, nearly 15% ofAlt-A loans were explicitly for the purpose of investment rather than as a

primary residence. This ismore than three timesgreater than in Subprime.And a further 5% were forsecond homes.

If negative equity is asufficient condition for

default, then investors willbe less attached to theirproperties, eithersentimentally or by thenecessity of needingsomewhere to live. Andtherefore, ought to be

more inclined to default if the house is worth less than the debt. Thissuggests that if negative equity is sufficient for default then an Alt-A mortgagepool should have higher delinquencies and defaults than a subprime poolwith comparable loan-to-values due to the larger number of investors. Whilerecognising that such a comparison ignores many factors including

documentation, salary, resets, and interest only periods, it is worth noting thatdelinquencies and defaults on 2006 subprime RMBS pools are higher than on2006 Alt-A pools despite higher LTVs in the latter.

In terms of what themoney was used forrather than the type ofproperty beingpurchased, Alt-Alending was frequentlyused to refinance in anew mortgage so as to

extend the term orreduce the rate. Giventhat Alt-A borrowersoften depend on theability to continue to rollinto a new Alt-Amortgage when thelow-cost teaser period expires, it is not surprising that more than 15% ofmortgages were for rate or term refinancings.


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In turn Subprime loans were not frequently used for rate or term refinancingsgiven that such lending is designed to re-establish credit scores. Peopleremortgaging with a new Subprime loan may indicate that they have noalternative and have therefore not improved their credit.

Rather Subprime loans were more often used by borrowers to extract equityfrom their properties as house prices rose. More than 40% of loans were forthis purpose. This equity withdrawal was at its peak in 2005 and 2006 whenhouse price were rising most rapidly; by 2007 the proportion had fallen to35%.

A final important feature of Alt-A and to a lesser extent Subprime loans wasthat they required a lower level of documentation than ordinary mortgages. Inthis respect they were supposed to be useful to those with irregular earningssuch as sales people on commissions.

Nearly 15% of Alt-A loans had no evidence of borrowers' salary or assets and

65% had low levels of documentation including no information about salaryand only "stated"assets. Less than 20%of Alt-A borrowers hadfully documentedincome and assets.

Although this istroubling, it is perhapsnot surprising given thatthey were oftenmarketed as lower

documented lending.

More surprising is that40% of Subprimeborrowers had reduced documentation and 2% had none at all. Given thatSubprime borrowers have a known history of financial distress, having nochecks on ability to repay the debt is worrying.

Finally,


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Rate ResetsAll of the 167 Subprime deals examined include adjustable rate loansaccounting for on average 70 to 75% of the loan pool collateral.

Fixed-rate periods on Subprime mortgages tended to last for two years,although three-year and five-year fixed rate periods started to represent asignificant minority of 2007 RMBS mortgages. This means that 98% of 2005-vintgage RMBS loans will have reset by the end of this year and 97% of 2006mortgages will have reset by the end of 2009. However, because of thelengthening in fixed-rate periods on mortgages in the 2007 deals, theproportion that will have reset by the end of 2010 is slightly less at 93%.

Because of the short fixed-rate periods, nearly all of the adjustable rate loansin 2005 RMBS and 70% of those in 2006-RMBS have already reset. And afurther 25% of ARMs in the 2006 deals will adjust in the next twelve months.In contrast, less than 5% of the mortgages in the 2007 securitisations haveshifted to floating rates, although three quarters will reset in the next 12months (see chart below).

Within the Subprime sample, pre-adjustment rates tended to be roughly 7%for loans in the 2005 RMBS and somewhat higher at 8% for the loans in the2006 and 2007 RMBS. See chart below.


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(The mortgages in 2005 RMBS, which will reset between the beginning of2009 and the end of 2011, and are currently paying fixed rates of little morethan 6% represent a tiny proportion of the total loan collateral 2%. And sothese rates are probably not good indicators of Subprime borrowing costs.)

The higher rates for the 2006 and 2007 loans is partly a result of highermortgage rates ingeneral. As the chart tothe right shows, medianprime mortgage rateswere roughly 100 bphigher in 2006 than they

were 2005.

However, pre-adjustment rates onSubprime loansincreased by more thanprime rates. Interestrates on 2007-Subprimeloans were roughly 180bp more than those on30-year fixed rate primeloans in that year.

Whereas, for the 2005RMBS, the average ratefor Subprime loans wasonly 130 bp more thanthe median 30-year prime lending rate. This increase over prime lendingrates may represent the lengthening in fixed rate periods for Subprimeadjustable rate mortgages.


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Of the 75 Alt-A RMBS within the sample, 44 are collateralized entirely byadjustable rate mortgages and a further three include some adjustable rateloans. The percentage of adjustable rate loans in those three RMBS is 58%.Out of the 47 that include reset mortgages, we were able to examine 40; theother seven are private placements and so prospectuses are not publiclyavailable. Within this sample, adjustable rate loans represent more than

half of the collateral in the 2005- and 2007-vintage RMBS, and more thanthree quarters of the mortgages in the 2006.

Of the 2005-vintage RMBS that include ARMs, 14% of the resets occurredwithin the first 12 months. For the 2006 and 2007 RMBS, the proportion is29% and 35% respectively (see chart below).

The most common time-period for resets in Alt-A ARMs is five years,with around half by dollar value of all loans within the 2005- through2007-RMBS sample resetting in that timeframe. The spikes in the chartabove for the short-term adjustments are the result of several deals includingresets that occur immediately after the RMBS's launch. Further out there arealso clusters of resets in the seven- and ten- year range for all three vintages.

Loans that adjust in the first twelve months should by now all have moved tofloating rate terms. This also applies to the 2007-Alt-A because there are nodeals within the sample issued after the first half of 2007 due to the marketfreezing up. And so in the chart below which shows the percentages ofresets monthly from 2007 through 2017 we have removed the loans that

triggered within the first 12 months (as such the percentages are larger thanin the chart above).


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This shows that both the 2005 and 2007-vintage RMBS include a reasonablylarge volume of loans that reset after roughly three years. In contrast,although the 2006 RMBS have plenty of mortgages resetting between early2008 and late 2009, the timing is less focused around the three-years-after-issuance area. The result is that both the 2005 and 2006 RMBS havealready begun to experience reasonably large numbers of resets. Forthe 2005 deals, those resets largely petered out this summer past, andwill not restart again in earnest until late 2009. For the 2006 RMBS, therewill be an almost continuous flow of resets between now and the end of2009 at which point there will be a hiatus until the five-year resets kick in thethird quarter of 2010.Within the 2007

RMBS, other than asmall spike in early2009, very fewmortgages resetuntil the start of2010.

The chart to the rightshows Alt-A RMBSissuance for 2005through 2007. Themarket's peak

occurred in 2006with $365 billionworth of issuance.By assuming that the proportions of loans with adjustable rates in each of thethree vintages in the Alt-A sample are roughly similar to the total Alt-Auniverse (56% in the 2005, 76% in the 2006 and 57% in the 2007 RMBS) andthat the percentage of loans by value that remain outstanding in the sample isalso similar to total Alt-A universe (47% in the 2005, 75% in the 2006 and


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53% in the 2007 RMBS) we can broadly estimate the volume of Alt-Amortgages that will reset each quarter in the coming years.


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The Scale of Interest Rate AdjustmentAs the chart below shows, the fixed-rate, pre-adjustment interest onSubprime loans tended to be roughly 100 bp more than for Alt-A. Interestrates on Subprime loans hit as much as 9% but in general they tended toremain between 7% and 8%. Alt-A loans, on the other hand, were closer to6%, although rates as low as 5% were offered for 2005 mortgages resettingwithin the first 12 months.

A more major difference between Subprime and Alt-A lending rates is,however, apparent after the resets see chart below. Alt-A loans tended toreset to roughly 250 to 350 bp more than benchmark (frequently six-monthLibor), and did not exceed 400 bp on top of Libor.


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For Subprime, in contrast, rates tended to be much more prohibitive at closerto 600 bp more thanbenchmark. Note thatthe mortgages in thechart above that resetafter 2010 to lower rates

of 500 or even 400 bpover benchmarkrepresent only 5% of thetotal 2005- through 2007loan collateral. Andthose loans tend to havehigher fixed rate levelspre-adjustment.

The result of these higher margins on Subprime loans is that even with six-month Libor at close to 2.6%, we believe that Subprime loans will stillexperience increases in the cost of their mortgages of roughly 50bp

when they adjust to floating, although there is a spike in the margin inlate 2010. The weighted average fixed rate for loans in the 2006-vintageRMBS is 8%. The weighted average margin on top of benchmark for thosemortgages is 6.1%. With six-month Libor at 2.6%, the increase in monthlypayments associated with such a reset is 70 bp. Prior to the falls in short-terminterest rates and Libor, resets were resulting in interest rate increases forSubprime between 300 and 500 bp.


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Interest OnlyWithin the sample, 132 of the 167 Subprime RMBS that were analysedincluded interest-only loans where, for an initial period, the borrower does notrepay the loan but only covers the interest. Roughly three fifths of 2005RMBS and three quarters of 2007 RMBS included interest-only loans in theircollateral pools. And the proportion that interest-only mortgages representedin those RMBS was one third for the 2005-RMBS and two fifths for the 2007deals. Interest-only mortgages made up a substantial minority of the collateralunderlying all three vintages.

For the earlier 2005 and 2006 vintages, interest-only periods tended to befive years in duration with a number of shorter two- and three-year periods.Indeed, more than a third of the interest-only mortgages in the 2005-Subprime RMBS have already begun amortising and by this time next year,roughly 7% of 2006 interest-only mortgages will be paying principal.However, shorter interest-only periods became increasingly uncommon in2007-RMBS: by August 2010, only roughly 0.25% of 2007 Subprime interest-only periods will have expired. In fact, within the 2007-RMBS, 10-yearinterest-only periods started to become more prevalent accounting for 13%.

There are two issues associated with the ending of these interest-onlyperiods. The first is the obvious increase in monthly payments as a result ofneeding to cover both the interest and repayment. This alone could beproblematic given that those most likely to seek interest-only periods arethose least able to afford fully amortizing payments. Second, interest-onlymortgages still have, like the majority of fixed rate mortgages, 30-yearmaturities or less. As a result, the time over which the loan can amortize isreduced by the length of the interest-only period. This puts extra pressure onthe payments when they shift to include principal repayments.


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The average fixed rate for 2005-vintage Subprime loans that reset in thefourth quarter is 7.2%. An interest-only loan will have been making monthlypayments on a $100,000 mortgage of roughly $600. The average marginover the benchmark for these deals is 5.4%, which when added to the currentsix-month Libor of 2.6% gives a rate of 8% and a monthly payment of $670.However, if the reset coincides with the introduction of principal repayments

as well, then for a loan with 25 years remaining would rise to $750, a 26%hike.

This means that the payment shock associated with moving from interest onlyto fully amortising is a more distant prospect for the 2007-RMBS. This offersthe prospect of a solution having been found before those periods expire such as rising wages, rebounding house prices or more refinancing options.On the flip side, longer interest-only periods also mean that if the housingcrisis is not resolved, then the period over which the mortgage must be repaidis shortened further exacerbating the payment shock.

Although, admittedly, amortising a loan over 25 years rather than 27 years

does not lead to a major increase in the monthly payments. If we use thesame 6.1% margin over a six-month Libor rate of 2.6% as above, then themonthly payment on a $100,000 interest-only mortgage is nearly $725,whereas for a 27-year amortising mortgage it is little more than $800 anincrease of 11%.

The volume and range of payment optionality included in Alt-A lending is ifanything even greater than in Subprime ranging from 10-year ARMs mortgages with a fixed interest for 10 years and floating for 20 years tonegative amortising loans where unpaid interest is added to the loan. Thisvariety makes it difficult to know what payment changes borrowers face;when those changes will occur; and finally, how sensitive borrowers are to

the changes. The result is huge uncertainty regarding when mortgage losseswill finally peak and whether they will yet rival the numbers seen in Subprime.And the doubt is acting like an albatross around the neck of the globalfinancial system, frustrating hopes that banks' write downs of mortgageassets have finished and undermining any recovery in the sector.

In short, roughly half of 2005- through 2007-Alt-A mortgages includedinterest-only periods. In the case of negatively amortization, roughly 20%of Alt-A RMBS mortgages allowed borrowers to defer interest paymentsand add that interest to their loans. The ending of those periods will belead to substantial increases in monthly payments as borrowers are nowrequired to repay the principal as well as cover the interest.

In the sample of 75 Alt-A loans, 59 have prospectuses available, 40 of whichprovide information on the reset timing and margins of adjustable ratemortgages. Twenty seven of the 40 ARM-collateralised RMBS include loanswith interest-only periods and a further nine RMBS collateralised by fixed rateloans also include interest-only periods. We feel that this last detail isnoteworthy, given that it is usually adjustable rate loans that are associatedwith interest only periods.


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In dollar value terms, roughly 55% of mortgages in the 2005- and 2006-Alt-A sample included interest only periods. For the 2007 vintages thatproportion falls marginally to 45%.

As the chart below shows, the most common maturity for these interest-onlyperiods is ten years. Two thirds of mortgages in 2005, three quarters of 2006

and nearly 90% of 2007 Alt-A RMBS permitted borrowers to pay only interestfor the first ten years.

Five-year interest-only periods were also common; accounting for slightly lessthan a quarter of both 2005-and 2006- Alt-A RMBS collateral. For the 2007-vintage deals, the proportion of loans with five-year interest-only periods falls

to less than 10% largely as a result of so many longer-dated interest-onlyperiods.

Although they exist, 15-year interest-only periods represent a tiny percentageof the loans in the Alt-A RMBS we surveyed just 0.2% of 2007-Alt-Amortgages and less than 0.05% of the 2005 and 2006 RMBS.

The 2005 and to a lesser extent 2006 RMBS also include interest-onlyperiods that last for the first three years or less: 4% of 2005- and 1% of the2006-Alt-A mortgages began amortizing within 36 months. Many of theseshorter-maturity periods have already expired for the 2005 deals and the2006 RMBS are now also beginning to see interest-only periods ending.

Further, a much larger number of 2005 Alt-A loans will begin to amortize thistime next year as the first five-year interest-only periods begin to expire.

It is interesting to note, however, that loans with interest-only provisions in the2005 and 2006 RMBS appear to have been repaid at a faster rate than thenon-interest-only loans. For the 2005 RMBS that included loans with interest-only periods, roughly 50% of all principal has been repaid this includesrepayments and prepayments whereas for all of the 2005-RMBS in thesample, the remaining balance is almost 60%. For 2006 RMBS, slightly more


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than a quarter of all loans have been pre-paid compared to nearly a third ofthe collateral for RMBS that include interest-only loans. These prepaymentrates may be even faster than these numbers suggest given that non-interest-only loans will, for the most part, be amortizing and so repaying aswell as prepaying principal. For the most recent 2007 vintage, the proportionsof principal repaid are nearly identical for both RMBS with interest-only loans

as for all RMBS, roughly 13%.

It is possible that the interest-only borrowers who took out mortgages in 2005and 2006 could see the approaching shock of moving onto amortizingmortgages and decided to refinance onto more normal fully amortizingmortgages early. However, this scenario is somewhat unlikely given that suchborrowers are those least able to afford the amortizing payments. It is, wefeel, more likely that interest-only loans were refinanced into new interest-only structures as borrowers sought to push out lower payments andexploiting the longer interest-only periods available in later years.

Although we think the pain could be substantial, 2010 is the earliest that

large numbers of Alt-A interest-only loans will begin to convert roughly a quarter of 2005-vintage RMBS interest-only loans beginamortizing after five years. Further, it is possible that these loans are theones most likely to have been refinanced early.

To understand the volume of loans that may shift from interest-only toamortizing over the coming years, assume that the proportions of loans withinterest-only periods in each of the three vintages in the Alt-A sample are thesame as for all Alt-A RMBS with the same vintages (53% in the 2005, 55% inthe 2006 and 45% in the 2007 RMBS). Second, assume that the percentageof mortgages that remain outstanding in the RMBS in the sample is indicativeof interest-only Alt-A RMBS collateral of the same vintage (58% in the 2005,

73% in the 2006 and 87% in the 2007 RMBS).

By using these numbers and applying them to the interest-only expirations inthe sample we broadly estimate the volume of Alt-A mortgages that will reset


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each quarter in the coming years. It is worth noting that these mayoverestimate the volume of 2005 and 2006 interest-only loans that will expirebecause as noted earlier, 2005 and 2006 RMBS that include interest-onlyloans appear to have been paid down more quickly than those that do notinclude such mortgages.

On this basis, we estimate that in the region of $15 billion worth of resetsare due in 2005-vintage RMBS between now and the end of 2010.In the2006-RMBS, we estimate that from now until the end of 2011 between$25 and 30 billion of interest-only mortgages will begin amortizing.Although these numbers are large, the volumes in the middle to latter part ofthe next decade become truly enormous. In the two years from 2015 and2016, in the region of $80 billion worth of mortgages in the 2006-RMBS willbegin amortizing. And a similar number of mortgages in the 2007-Alt-A willalso see the interest-only periods expire in 2016 and 2017. In the 2005-RMBS, the volume of loans that will begin to require repayments during 2014and 2015 is roughly $40 billion.

Thankfully, the bulk of interest-only loan expiries, those which begin toamortize after 10 years, are at least five and half years off. The paymentshock associated with a move to amortizing payments may by then havebeen reduced by rising wages. If not, then it is likely that refinancings eitherinto newer low-payment mortgages or ordinary 30-year amortizing loans willhave dissipated much of the problem by the start of 2014. At worst, houseprices should hopefully have begun to recover, so that by many borrowerswill be able to sell their houses and repay their debts without facing ashortfall.

Unfortunately the number of interest only loans that have so far reset toamortising is too small to provide us with a meaningful results for how they

affect mortgage payments. However, as long ago as 1978 Vandell wascautioning about the greater default risks of any mortgage in which theamortisation is delayed so as to reduce initial payments "Because equityaccumulation appears to be the dominant factor in determining risk of default,in those situations in which equity is reduced due to lower property values orlower downpayments, larger default risk increases occur and these increasesvary among instruments. They are predicted to be moderate for the floatingrate mortgages and variable rate mortgages, but significant for the graduatedpayment mortgage and the price level adjustment mortgage thoseinstruments in which mortgage amortization is delayed to permit loweredinitial payment levels."

Note, however, that Vandell's model predicts that the reduced equity couldalso be the result of falling house prices which would confirm the theory thatnegative equity can be a driver of default.


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Other Payment Altering Features Negative AmortisationFinally, in addition to interest-only periods, Alt-A adjustable rate mortgagesnot infrequently permitted borrowers to make payments that are insufficient

even to cover the loan'sinterest cost. Thedeferred interest isadded to the principalbalance of the loan,causing the overall sizeof the mortgage to grow

negatively amortize.Such loans are oftenknown as Option ARMs,in that the borrower hasthe option of how muchto pay, or "Pick-a-Pay"loans.

Within the Alt-A sample,11 RMBS include information on negative amortization. Within those deals allof the loans allow for deferred interest to be added to the mortgage, a totalvalue of roughly $12 billion worth. The total collateral of the 59 deals in thesample (which have prospectuses) is $45 billion, suggesting that 15% ofloans allowed for negative amortization. In the 2006 RMBS more than 30% ofloans include Option ARM features: for the 2005 and 2007 RMBS theproportion is slightly more than 10%.

Federal law sets a maximum limit of 125% on the amount such loans cangrow to. In other words, if the original loan to value is 75% on a $100,000property the mortgage can increase to a maximum of $93,750 (1.25 x$75,000). The sample suggests that in practice, lenders usually set the limitbetween 110% and 125% of the original loan. Almost two thirds of loans thatpermit negative amortization are limited to growing to a maximum of 115% ofthe original loan amount and a quarter have a limit of 110%.

Importantly, once an Option ARM hits this limit, the opportunity to underpayceases and the mortgage becomes an ordinary fully amortizing adjustablerate loan. If this occurs, any caps limiting the amount monthly payments canincrease by are ignored, and the payment is calculated purely as thatnecessary to cover the interest and repay the loan by maturity. A 30-yearmortgage with a fixed rate of 7.5%, which gives the borrower the option to

use a minimum rate of 1%, will grow to 110% of the loan's original value after36 months and 115% after 49 months. The minimum monthly payment usesthe 1% interest rate to calculate what payment would be needed to fullyamortize the loan at this interest rate over the 30-year maturity, but deferredinterest accrues at 7.5% of the remaining loan annually. This means that thegreater the difference between the optional minimum payment rate and theaccrual interest rate, the faster the mortgage will grow. Note that this 7.5%accrual interest rate is towards the higher end of mortgages in the Alt-A


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sample and a 1% minimum payment rate is likely aggressively low. As aresult it is unlikely that more than a small number of 2005 Alt-A loans will yetbe forced to recast into a fully amortizing structure. If we use what it probablya somewhat more realistic 7% rate for the mortgage's fixed period and a 2%teaser rate, then the loan will reach 110% of its original size after four years.

For a $100,000 mortgage with these rates, the monthly payment will riseroughly 90% from $330 a month to $630 a month. Unfortunately estimatingthe value of the recasts in any given period is problematic as it requiresmaking assumptions about the extent to which borrowers have been makinguse of low payment options and assumptions about what the minimumpayment rates are.

However, in addition to the negative amortization limit, Option ARMs includescheduled recasts that ensure that the mortgage will be repaid by maturity.These recasts are usually after every 5 or 10 years. Only two of the deals'

prospectuses in the sampleinclude information on

scheduled recasts both2006-vintage RMBS. Inthese two RMBS, twothirds of recasts occur afterfive years and one third

after 10 years.

If we use these scheduled recasts as guides for when Alt-A RMBS OptionArms recast in general, and assume that the proportion of negativelyamortizing mortgages in the RMBS sample by vintage is indicative of all Alt-Asecuritisations, then we estimate that $15 billion dollar worth of mortgages inthe 2005 RMBS will begin to amortize in 2010. For the 2006 and 2007 the

number is roughly $40 billion in 2011 and $15 billion in 2012 respectively.However, we caution against relying heavily on these numbers given thesmall sample with which we have to work with.

Finally, Option ARM loans also shift to a fully amortising schedule if theborrower becomes even 30 days delinquent at any time. This makes itimpossible to predict the timing of these recasts. However, this penaltysystem does mean that the roll rate of borrowers who move from 30-daydelinquent to more serious levels of delinquency is likely to be higher innegative amortisation mortgages than any other kind.


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Testing the dataIf we overlay a chart showing 60-day delinquencies versus the rate resetsthat have so far occurred, there does not appear to be an obviousrelationship at least for the 2006 and 2007 pools.

Although some defence can possibly be made with regards to the 2005mortgages. Delinquencies in the 2005-RMBS have begun to rise again afterfalling since the turn of the year possibly because a large number of resetsoccurred over the summer. Further more, the rise in the latter part of 2007may have been the result of the spike in resets in the summer of that year.Admittedly, it is also possible that the rise in delinquencies is seasonalaround the end of the year as people increase consumption ahead of theholidays and summer seasonal work ends.

With Alt-A loans, the chart below illustrates again just how poorly the twoappear to match. With, if anything, high levels of delinquencies during periodsof no resets.


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It is possible that in the aggregate any relationships become drowned out andat the RMBS pool level a causal link may be more apparent. In order toassess whether there is any persistent change in delinquencies followingpayment changes, a panel data regression analysis was used. Theregressions, which were run on Stata, used a dummy variable indicatingwhether there were any mortgages within the pool resetting in each month("Month has Resets?), the Percentage of Loans Resetting and the Change inMortgage Rate associated with resets as independent variables. Sixty-daydelinquencies were used as the independent variable.

Sixty day delinquencies were used because while many loans that reach thisstage of delinquency may not ultimately default, this category arguably

includes the least noise and should have the most direct link in terms oftiming with any payment shock. Delinquent loans are broken into threecategories 30-, 60- and 90-days and more. It is very frequent to seeborrowers slip into the 30-day bucket because of missed or late payment andthen return to making payments. In this respect, it would possibly be wise touse 90-day delinquencies. However, the 90-day delinquent category includesany mortgages that is delinquent but the lender has not begun foreclosureproceedings. As a result, a backlog of foreclosures or liquidations could swellthis bucket as longer-term delinquent borrowers continue to be included.What's more, because there is a longer time-lag to 90-day delinquency it isless easy to ascertain the cause of the delinquency. For the same reason,neither foreclosure nor REO were used for the dependent variable.

In addition, for the Subprime model, whether there were any interest onlyloans amortising in a given month ("Month has IO?") and the Percentage ofIO Loans Moving to Amortising were included as additional variables.Because of so few resets having yet occurred in Alt-A RMBS, we wereunable to include these variables in the Alt-A analysis.


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The model's predictive capacity is somewhat underwhelming with an adjustedR-squared of less than 0.04 for the Subprime model and less than 0.02 forthe Alt-A. However, the coefficients appear to be largely statisticallysignificant. In both models, the coefficient for the Month has Resets? variable

suggests that resets reliably coincides with an increase in delinquencies.

However, delinquencies' sensitivity to the Percentage of Loans Resetting isdisappointingly small 0.005 for subprime. This implies that the entire poolwould need to reset in a given month to generate a 0.5% rise indelinquencies. Further, in Alt-A the coefficient is negative: i.e. a largerproportion of resets equates to a lower level of delinquencies. Admittedly,coefficient in Alt-A has a confidence interval of less than 95%.

The model also suggests that Alt-A delinquencies are greater after areduction in rates and lower after a fall. This result is fairly inexplicable. Itcould possibly be argued that it validates Phillips, Rosenblatt and

Vanderhoff's findings that suggest that lower initial teaser rates equate tolower defaults.

In Subprime RMBS, the occurrence of interest-only periods expiring in amonth coincided with an increase in delinquencies of roughly 0.4% twomonths later. But the regression also generated a negative coefficient for thepercentage of interest-only loans resetting, suggesting that as the number ofloans amortizing increased, the delinquencies fall. In other words these twocoefficients contradict one another.

It is possible to greatly increase the capacity of the model by adding in thevintage of the RMBS and the seasoning of the loan pool.


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It appears that the real driver of poorer performance is the vintage, the morerecent the vintage the greater delinquencies are expected to be. Also thedegree of seasoning plays a roll in this respect; however the sensitivity,especially in the case of Subprime is very weak. The other coefficients aresimilar to above

Regressions were also run that incorporated other factors such as thepurpose of the loans, the level of documentation type and the occupancystatus of the property. Adding these variables increased the R-squareds forboth models but not massively.

De-trending the DataHowever, in the above analysis the data for 60-day delinquencies acrosssubprime and RMBS has so far tended to trend higher. A relationshipbetween seasoning and default risk is true for all mortgages (Kothari) but isespecially obvious of Subprime and Alt-A pools where defaults tend to behigher.

As a result it may improve the explanatory power of the model if it is possibleto isolate and remove delinquencies that are a result of ordinary seasoningfrom those that were a result of an increase in the monthly payments. To dothis, averagedelinquency levelsthrough time werecalculated by vintagefor Subprime and Alt-ARMBS that had as yetnot seen any resets. Asthe chart to the rightillustrates, these pre-reset delinquencylevels were calculateduntil the universe ofRMBS that had notexperienced resetsbecome too small to


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produce a meaningful average less than five RMBS of a given vintage.

These averages were used to 'de-trend' delinquencies by vintage. In otherwords these are the delinquencies we would expect to see if there were noendogenous payment-changing features. As such, the appropriate vintagepre-reset level was subtracted from each RMBS's delinquencies.

Unfortunately these changes did nothing to improve the capacity of themodel. In fact the changes ended up reducing the regression's explanatorycapacity and widening the confidence intervals.


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Estimating Negative EquityIf negative equity is a possible driver of mortgage default it is useful tounderstand what proportion of loans are in negative equity and the extent towhich they are in negative equity.

Using the methodology detailed in the appendix, the value of negative equityis estimated in 2005 through 2007 Subprime RMBS to be roughly $46 billionwith an upper limit of $62 billion and a lower limit of $32 billion. This meansthat while the value of securitised 2005 through 2007 Subprime RMBS debt isabout $650 billion the value of the properties those loans are secured againstis closer to $600 billion. In the case of Alt-A RMBS the value of negativeequity is roughly $30 billion with an upper limit of $45 billion and a lower limitof $20 billion. In this case, we estimate there is roughly $600 billion ofsecuritised 2005 2007 Alt-A debt still outstanding backed by propertiesworth closer to $570 billion.

These numbers may seem surprisingly small in comparison to the hugeamounts that are being proposed as possible mortgage losses. However, ifwe consider that the average loan-to-value of a 2006 Subprime mortgagewas 80.5% and house prices according to the Case Shiller National Indexhas fallen roughly 21%, then the average LTV should now be 102% andnegative equity would only be 2%. The actual percentage of negative equityis larger than this because many Subprime and Alt-A loans were extended toborrowers in states with the largest house price declines; notably Californiaand Florida. What's more, those estimates of mortgage losses relate to allmortgages whereas our estimates of negative relate only to recent-vintage,securitised Alt-A and Subprime loans.

The worst Subprime vintage for negative equity is unsurprisingly the 2006RMBS. As of September, 60% of borrowers had some extent of negativeequity with almost 1% facing a more than 40% gap between the value of theirhouse and their debts. Note for the sake of simplicity and because of someinterest-only loans within the pool we have ignored the effect of amortisationon loan pools. However, even for deals originated at the beginning of 2005that are now nearly fours old, the amount of amortisation will be little morethan 1% of the original balance.

If we chart serious delinquencies (90 days delinquent loans plus those inforeclosures) against negative equity for the 2005- 2007-Subprime RMBSthere is little apparent relationship between the two.

In 2005-Subprime RMBS, serious delinquencies have fallen for much of 2008while a significant percentage of borrowers are now facing the prospect ofhouses that are worth 20% or even 30% less than their debts.


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In the 2006 RMBS, serious delinquencies had begun to rise long before

negative equity had started to become a major issue.

Interestingly, the most recent subprime RMBS appear at least to the eye tohave a possible relationship between negative equity and seriousdelinquencies. Although, at 16.3% the level of serious delinquencies remainswell below the proportion of borrowers in negative equity.


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Alt-A RMBS also do not appear to have an obvious relationship between

delinquencies and negative equity in all three vintages. In the 2005 Alt-A,delinquency growth has been reasonably stable with a slight increase sinceJuly of last year, whereas negative equity has only started to becomeapparent since late 2007.


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And in the 2007 deals, delinquencies have if anything slowed since negativeequity growth has accelerated at the start of this year.

If we regress 60-day delinquencies against negative equity for each of the167 subprime RMBS through time, it generates statistically significantcoefficients ranging from 0.03 to 0.06. In other words, the regressionsuggests that 3% of borrowers who have negative equity of more than 10%

subsequently become delinquent on their mortgages, while 6% of borrowerswhose mortgages are more than 30% underwater subsequently becomedelinquent. However, the R-squared from these regressions are fairly low at11% and 2.5% for the 110% and 130% LTVs. And, it should be noted thatboth data series, LTVs and negative equity, trend in the same direction theyhave been getting larger with time. We think it is highly likely that theregression is in reality spurious and are not convinced that this analysisdemonstrates a link between negative equity and default.


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ConclusionUnfortunately by using pool-level data as opposed to loan level data itappears that it is impossible to produce enough granularity to explain thebehaviour of mortgages. This is despite mining data from 167 Subprime and59 Alt-A RMBS, which respectively represent roughly 20% of the 2005through 2007 securitised Subprime universe and 10% of the 2005 through2007 Alt-A universe.

Overlaying the data for 60 days delinquencies on top of that for the ending ofinterest-only periods (see chart below), suggests the possibility of somerelationship between the two, at least, for the 2005 loans. Note the 7% ofloans that began amortising in February of this year coincided with the taxrebate to low-income families that may have slowed delinquencies in all threevintages for the second and third quarters.

But in the case of 2007-RMBS, very few loans have as yet moved frominterest-only to amortising. And yet, the proportion of loans that areseriously delinquent is already higher in the 2007 securitisations thanfor the 2005 or 2006 deals. As such the question remains why, if there hasbeen so little payment shock, are these loans performing so poorly.

It was the 2007-subprime loans that appeared to have at least asuperficial relationship between serious delinquencies and negativeequity. It is possible that the cause of the problems is in fact theoverborrowing inherent in those loans, combined with borrowers'assumptions of either rising house prices or rising salaries that madesuch borrowers very payment sensitive from the outset, even before theresets. And now without the prospect of rising house prices to enablerefinancings, the only option for a large number of those borrowers may be


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default. This dependence on rising house prices may account for thedifference in their behaviour to traditional mortgage defaults.

This account of mortgage default may partially reconcile the research ofPhillips, Rosenblatt & Vanderhoff with more traditional theories of default; thatfalling house prices by themselves do not cause default. In their report,

Phillips, Rosenblatt & Vanderhoff write: "Decreases in income growthincrease the probability of default." In other words unaffordable loans weretaken out on the assumption of rising salaries or rising house prices.

Nevertheless, despite the inability to demonstrate a statistical relationshipthere is an intuitive argument can be made that the triggering of payment-altering features should have some effect on mortgage performance. As longas mortgage borrowers cannot fully predict their future salaries, consumptionpatterns and emergency spending needs, then a rise in mortgage costs which is largely unpredictable due to floating interest rates should haveincome-shock affect.

Finally, while negative may not the primary driver of default it should at leastprovide us with a ceiling for defaults given that those not in negative equityshould be able to repay the loan by selling the house.

The problem is that if we include LTVs that are greater than 90% to accountfor the possibility of lower house price in a forced sale, the proportion ofborrowers in subprime loans rises to 75% with an upper limit of 82% and forAlt-A the proportion is 60% with an upper limit of 67%. With between threeand four fifths of Alt-A and Subprime borrowers in or close to negative equitythat ceiling provides very little comfort especially given that unemployment isrising rapidly.


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BibliographyCapozza, DR, Kazarian K, Thomson, TA. Mortgage Default in Local Markets.Real Estate Economics 1997 Vol 25. Issue 4. pp 631-655.

Chinloy, P. Privatized Default Risk and Real Estate Recessions: The U.K.Mortgage Market. Real Estate Economics 1995 Vol23 No. 4 pp. 401-420

Davis, M, Lehnert, A, Martin, R. The Rent-Price Ratio for the Aggregate Stockof Owner-Occupied Housing. Department of Real Estate and Urban LandEconomics, University of Wisconsin & Federal Reserve Board of Governors.Dec 2007

Foote, CL, Gerardi, K & Willen, PS. Negative Equity and Foreclosure: Theoryand Evidence. Federal Reserve Bank of Boston Public Policy DiscussionPapers No. 08-3

Kau, J & Keenan, D. An Overview of the Option-Theoretic Pricing ofMortgages. Journal of Housing Research, Fannie Mae 1995 Vol 6 No. 2 pp227-

Kau, J & Kim, T. Waiting to Default: The Value of Delay. Journal of theAmerican Real Estate and Urban Economics Association 1994. Vol 22. No. 3pp. 539-551

Kothari, V. Securitization: The Financial Instrument of the Future. WileyFinance, 2006. ISBN-13:978-0-470-82195-7. pp 265-265

Phillips, RA, Rosenblatt, E, Vanderhoff, J. The Probability of Fixed- andAdjustable-Rate Mortgage Termination. Journal of Real Estate Finance andEconomics 1996, Issue 13:.pp 95-104 (1996)

Vandell, KD. Default Risk Under Alternative Mortgage Instruments: TheJournal of Finance, Vol. 33, No. 5, (Dec., 1978), pp. 1279-1296

For Bibliography on LTV Estimation See LTV Estimation Bibliography


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Appendix I: Estimating LTV Methodology

Subprime and Alt-A RMBS prospectuses include information about the loan-to-values of the mortgages within the pool and the loans' geographicallocation by state. However, they do not provide information about what theloan-to-value of mortgages within each state looks like.

As such we assumed that the distribution of LTVs is the same for each stateas it is for the entire pool. By taking the mid-point of each LTV bucket we thenrecalculated this ratio through time by keeping the loan amount constant andadjusting the house price value.

To determine the house price value for each state we used the Case-ShillerS&P subindices. We think these indices are reasonable proxies for anysubprime and Alt-A house prices located in the 20 cities covered. The Case-Shiller S&P index is a linked transaction-based index and as a result it isconsidered to be skewed towards properties that used subprime and Alt-Amortgages as financing since these dominate sales at the moment. However,unlike the Office of Federal Housing Enterprise Oversight, Case-Shillerincludes non-conforming mortgages, i.e. those not bought and resold byFannie Mae or Freddie Mac. This means the Case-Shiller index shouldrepresent the prices of houses that used Subprime or Alt-A mortgages moreaccurately than the OFHEO index.

However, not everyone within each state lives within the metropolitanstatistical area (US Census Bureau's terminology for cities and major towns)referenced by the Case-Shiller indices. Nor does every state contain a Case-Shiller subindex city. The 20 cities covered by the Case-Shiller indices liewithin 25 different states (including the District of Columbia as a state). Thepopulations of those cities make up 45% of the total urban population ofthose 25 states.


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If we include metropolitan areas that are conjoined to those 20 cities and thesurrounding exurbia for example San Berdino or Inland Empire and LosAngeles then the proportion rises to 54%. This 54% is as a percentage ofthe total US urban population plus the 10 million people that The BrookingsInstitution estimates live in exurbia. Estimates for the exurban populationssurrounding each Case Shiller city were provided by the Ohio State

University's The Exurban Change Program.

In our base case we think that the price declines indicated by the Case-Shillerindex for a given city are relevant for the connected urban, suburban andexurban subprime and Alt-A properties. Research by David Stiff, ChiefEconomist at Fiserv Lending Solutions suggests that the largest house pricedeclines have been experienced by the neighbourhoods furthest from the citycentre (Housing Bubbles Collapse Inward). And so we feel applying a city'sprice decline to outlying communities is not unreasonable.

However, the Case-Shiller Indices are likely to be of diminishing relevance asthe location of the property became less connected to the city. For example in

Texas, Houston, San Antonio and Austin have combined populationsapproaching half of the state's total urban population. The Case-Shiller priceindex for Dallas may be of less relevance for subprime and Alt-A houseprices in these cities. For populations in such cities we have used theaverage of the Case-Shiller Index and the appropriate OFHEO regionalindex. Both indices use a repeat-transactions methodology whereby for atransaction to be included, the same property must have been purchased (inthe case of the OFHEO index an appraised value is used if the property isrefinanced), more than once, the change in price then contributing to thechange in the index. We feel this composite price change reflects the mixtureof the regional and local economics.

Finally for states that do not contain a Case-Shiller Subindex city we haveused a composite of the Case-Shiller national index (which covers more than100 metropolitan areas) and the OFHEO regional index to once again reflectthe regional economy and national pressure on house prices.

Admittedly, this may underestimate the house price declines since theOFHEO index has experienced smaller falls than Case-Shiller indices. TheOFHEO indices have deviated from the Case-Shiller indices and haverecently experienced far less dramatic falls. Research by OFHEO(Differences between the OFHEO and S&P/Case-Shiller) suggests that partof the difference is largely as a result of the OFHEO index covering a largerpercentage of transactions from a wider geographical area. But more recent

research (Revisiting the Differences) suggests the difference is also a lack ofsubprime and Alt-A properties in the index

To try to resolve the issue of Case-Shiller Indices being less relevant tohouse prices of subprime- and Alt-A-financed properties in cities with noCase-Shiller index we have added a best and worst case scenario of houseprices.


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In the best-case scenario, for properties located not in a city covered by theCase-Shiller index but close to one, then the average of the appropriateCase-Shiller and OFHEO regional indices was used. For other propertieslocated in those states, the appropriate OFHEO index was used and for non-Case-Shiller states the OFHEO regional index was used.

In the worst-case scenario, the Case-Shiller sub index is applied to allproperties in that state. For properties in non-Case-Shiller states the Case-Shiller national index is applied.

Using these state-by-state house price changes a current loan-to-value iscalculated quarterly since each deals' origination. By multiplying the originalloan to value by the house price level relevant to that state in that quarter wegenerate an original loan value. This state loan value is then divided by theappropriate house price index quarterly until the current period.

LTV Estimation Bibliography

Berube, A, Singer, A, Wilson, JH, Frey, WH. Finding Exurbia: America's Fast-Growing Communities at the Metropolitan Fringe. The Brookings Institution.Living Cities Census Series. October 2006.

Calhoun, CA. OFHEO House Price Indexes: HPI Technical Description.

Office of Federal Housing Enterprise Oversight. March 1996

Leventis, A. A Note on the Differences between the OFHEO and S&P/Case-Shiller House Price Indexes. Office of Federal Housing Enterprise Oversight,July 25, 2007 (Originally Published June 22, 2007)

Leventis, A. Revisiting the Differences between the OFHEO and S&P/Case-Shiller House Price Indexes: New Explanations. Office of Federal HousingEnterprise Oversight. January 2008

Stiff, D. Housing Bubbles Collapse Inward. Fiserv Lending Solutions.http://www2.standardandpoors.com/spf/pdf/index/052708_Housing_bubbles_

collapse.pdf

summer project - what is driving subprime & alt-a borrowers to default on their mortgages

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