Subprime Securitization: How Much Spillover?

Experts debate the amount of the threat that problems with high-interest debt for homeowners present in other credit-related areas.

As fallout from the subprime mortgage meltdown continues, the securities propped up by homeowners’ debt now sit on wobbly ground. Defaults by homeowners mean that the mortgage repayments they owe — which had been securitized (for the most part, chopped up and sold to new investors as bonds) — must be bought back, straining the securitization market.

Some economists reflexively wonder whether the woes of the subprime housing market will spread among such neighboring sectors as auto loans. And others worry if a similar contagion might eventually infect securitization markets generally.

The Bank of England recently expressed the latter concern in its financial-stability report, which suggests that America’s subprime woes “give insight” into potential problems in markets such as corporate credit and commercial real estate. A strong appetite for securitized assets introduced weaker lending standards into the subprime housing market, and could potentially do the same elsewhere, the report said.

Where else might the subprime crash be replicated?

Larry Fink, CEO of BlackRock, a fund-management group, warned in a recent Financial Times interview that the leveraged loan market could be next. The UK report observed that if asset performance declines, then corporate lending standards could tighten. Higher standards could scare off managers of collateralized debt obligations (CDOs) and hedge funds that bank on the riskier tranches. A subsequent drop in demand would likely make the cheap debt they depend on much more expensive. As bond spreads fell in the past year, highly rated debt became scarce, with junk debt left behind to underwrite riskier deals.

“When you have these types of markets, people tend to get nervous,” says Michael Mascarenhas, vice president and senior analyst in the banking division of the Moody’s Investors Service ratings agency. “The appetite reduces and you see tightening.”

So far, any contagion largely has been contained, although “there are some investors losing money because of these mortgages,” according to Michael Fishman, a finance professor at Northwestern University’s Kellogg School of Management and co-editor of the book A Primer on Securitization.

Subprime lending is only one slice of the housing-loan pie, even though defaults and delinquencies on subprime loans have been occurring at a breakneck pace. In 2006 subprime mortgages comprised nearly 20 percent of new home loans, according to the Mortgage Bankers Association, which represents the real estate finance industry. And of that, 13 percent were delinquent after 12 months, according to rating service Standard & Poor’s. Two-thirds of mortgages are securitized.

And some see little chance of spillover. “It’s a different clientele,” says Brian Harris, senior vice president of real estate finance at Moody’s. “Subprime auto is much different than subprime residential, where the financial strength of the borrower is much lower.” Other securitization markets could be protected because of the abundance of liquidity in the world’s capital markets, in the view of Andrew Davidson, president of Andrew Davidson & Co., an investment-management consultancy. “There’s no shortage of investors right now,” he says.


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