U.S. subprime crisis will get worse - but not as bad as the market has factored, finds new CIBC World Markets report
Unprecedented surge in default rates will still be less than what the markets have priced-in TORONTO, Sept. 20 /CNW/ - CIBC (CM: TSX; NYSE) - While the worst of the U.S. subprime mortgage meltdown is yet to come, the losses will not be as high as what the markets have already priced-in, finds a new report from CIBC World Markets. The report, which looks at the size and scope of the subprime issue, finds that while the rate of mortgage defaults is surging to unprecedented levels, the market has actually overpriced the scope of the problem. CIBC World Markets forecasts the subprime default rate to reach 25 per cent when all is said and done but has found that the market has priced in a rate of about 30 per cent. "It turns out that not only did the barrage of negative headlines of recent months raise the level of market immunity to adverse subprime news, but in fact, even after its recent improvement, the mortgage-backed market is currently pricing in a darker picture than the one likely to emerge when the smoke clears," says Benjamin Tal, Senior Economist with CIBC World Markets. His research finds that roughly $700 billion worth of largely subprime mortgages are due to have their rates adjusted upward by the end of 2008. The vast majority of these mortgages were issued in 2005 and 2006 with a two-year discounted teaser interest rate. The quality of these mortgages has declined every year and subprime borrowers are increasingly finding themselves unable to secure refinancing. The report finds that the biggest fallout from the crisis is yet to come as the overall quality of the mortgages written in 2006 and the first half of 2007 are by far the worst yet due to poor underwriting, reduced prepayment activity and weaker home price appreciation. These mortgages also show a significant jump in mortgage fraud. "Based on recent estimates, as much as 70 per cent of early payment defaults may be linked to misrepresentation of the original loan application," notes Mr. Tal. "This is a clear reflection of the deterioration in underwriting standards and passing on the risks seen in 2006 and early 2007." Compounding the issue is the fact that unlike in previous years, the homes that were financed in 2006 have not appreciated in value - in fact some have declined. Given that most of these mortgages were taken with little to no money down, no less than one-quarter of adjustable rate mortgages originated in 2006 are now in a negative equity position. This number is based on a three per cent year-over-year drop in house prices. Should there be an additional drop of 10 per cent, the negative equity number will jump to 40 per cent. To put things in perspective, Mr. Tal notes that his 25 per cent projected default rate is 35 per cent worse than the losses seen in the 2000 vintage loans from Michigan, Indiana and Ohio - the worst performing vintage and geographic locations to date, and roughly in line with the performance of the 99th percentile of regional default rates in the recessionary vintage of 2000-2001. While these potential losses are reaching unprecedented levels, Mr. Tal believes the market has already over corrected. He found that the prices on the ABX subprime-linked default swap indices suggest cumulative default rates ranging between 28 per cent and 32 per cent producing a weighted average of just over 30 per cent. "Those implied default rates are roughly 20 per cent higher than our projection - suggesting that the market is currently pricing in a much more draconian outcome than our main case scenario suggests. This means opportunities not only in the ABX space but also for the mortgage-backed security and equity markets as a whole, as the subprime default rate will not jump high enough to clear the bar set by the market." The full CIBC World Markets report is available at http://research.cibcwm.com/economic_public/download/ssep07.pdf. CIBC World Markets is the wholesale and corporate banking arm of CIBC, providing a range of integrated credit and capital markets products, investment banking, and merchant banking to clients in key financial markets in North America and around the world. We provide innovative capital solutions and advisory expertise across a wide range of industries as well as top-ranked research for our corporate, government and institutional clients.