BOCA RATON, FLA. – Home price appreciation and the prevalence of IO loans and ARMs in subprime home equity ABS pools dominated the discussion throughout the Investing in Subordinates investor panel at Information Management Network’s ABS East conference last week.
“The next 12 to 18 months will be a critical period for home prices,” said Michelle Russell-Dowe, a director and portfolio manager at Hyperion Capital Markets. “Appreciation could continue, but a correction is likely coming on.”
IO loans and ARMs have been two of the primary drivers behind the steady increases in home prices, Russell-Dowe added, as these loans have allowed people to move in to larger homes. As rates on these products have yet to reset, the potential for payment shock in this market remains unknown.
“There is a lot of risk in ARMs and hybrid ARMs,” said Tony Lembke, a partner at MKP Capital Management. “If interest rates go up, there is a double risk – IO reset and rate reset risk, and these buyers are not qualified for these rates. It is crucial to figure both of these [factors] into stress scenarios.”
Opinion was divided on whether or not the current trend toward IOs would stand the test of time. “I think they’re here to stay,” Lembke said. “Right now, we’re like guinea pigs in a lab. That’s why I am trying to keep my exposure to 10% or less across the portfolio.”
Panelists predicted that 2004 and 2005 vintage subprime home equity ABS would likely not perform as well as the 2002 and 2003 vintages.
Of particular concern to panelists was California exposure, the region that has experienced the most growth during the boom in housing prices during the past couple of years. One investor noted that in some pools, California comprised upwards of 50% of the collateral, and that the number was still climbing. “There is a high concentration of IO loans in California. What happens when they start to reset?” MKP’s Lembke queried.
MKP is taking a defensive position on home equity ABS, Lembke added. To that end, he is wary of LTVs higher than the mid-80 range, which constitute a high percentage of subprime pools.
John Devaney, president of United Capital Markets, claimed to see little value in new issue subprime home equity offerings. “I am cautious about the triple-Bs that are out there,” Devaney said. “I’m more comfortable with distressed names with five to seven years of seasoning.”
Another investor doubted that the product could weather a rising rate environment, and said that a 300 basis point rise in rates could spell the end for IO loans.
However, there is no way to know the fate of IO loans until the reset dates arrive, panelists said.
Meanwhile, investors are waiting for the rating agencies’ new methodologies for the sector to take effect in November. Hyperion’s Russell-Dowe advised against relying too much on ratings. “Rating agencies only rate to the available funds cap; they don’t even take basis risk into account,” she added.
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