Signs of a possible credit contraction continue. Doom reader G sent along this Dallas Morning News article  that provides an excellent summary of recent developments with sub-prime lenders, the demise of North Texas based Sebring Capital Partners LP as well as the better known Ownit collapse.
Then K weighed in with an analysis that delves deeply into the guts of the secondary and tertiary markets that consume all that toxic-loan paper. K finds some key quotes (in  and ) that clarify what’s going on with the credit derivatives used to support the sub-prime MBS market. Fasten your seat belts, here we go!
We’ll start off easy. Under a soothing headline, the Los Angeles Times lays out the bare facts.  Basically, two sub-prime lenders have gone down over the last few days, and some dark corner of the financial world seems to be freaking, although with the complexity of what they are doing it’s hard to tell.
G’s find  is worth reading end-to-end. Here’s just a sample.
Seriously delinquent subprime mortgages – loans either in foreclosure or at least 90 days past due – accounted for 6.2 percent of the subprime portfolio as of the end of June, compared with 5.8 percent 12 months earlier. The serious delinquency rate for prime mortgages was 0.8 percent at the end of June, compared with 0.7 percent 12 months earlier.
One source of weakness is the slowing economy. Layoffs and stagnant wages sometimes translate into mortgage loans not being repaid. If the economy slows further next year, the subprime lending industry’s woes could get worse.
Another problem: During the housing boom of the last few years, some customers, perhaps guided by eager salespeople, did indeed sign up for mortgages that they couldn’t afford.
"All those creative loan packages are wonderful for some people," said Bettye Banks, senior vice president for education at Consumer Credit Counseling Service of Greater Dallas. "But they’re not wonderful for everybody."
K now leads us step by step through: 1) problems with one specific sub-prime lender, 2) difficulties in the MBS market supporting lenders in this class, and 3) the effects on the derivatives designed to stabilize that part of the MBS market. All the emphasis is K’s.
- Ownit mortgage company, which originated subprime mortgages, just went bankrupt.
"Ownit would sell loans it originated to Wall Street, which repackaged them as mortgage-backed securities. But, as Dow Jones Newswires reports, the issuers of the MBS can force Ownit to take back loans that go into default. Ownit ran out of cash to repurchase the bad loans for the street, according to industry sources quoted by Dow Jones Newswires." 
- This is indicative of problems in the overall subprime home mortgage bond market.
"The mortgage bond market is beginning to buckle under the weight of the worst U.S. housing slump in six years.
Yields on so-called sub-prime mortgage securities rated BBB have risen to 6.52 percent on average from 6.28 percent on Sept. 5, data compiled by Bank of America Corp. show. The yield premium, or spread above the one-month London interbank offered rate, a lending benchmark, rose to a seven-month high of 1.2 percentage points.
About 3.3 percent of the $160 billion in sub-prime loans made this year through July have payments that are more than two months late, the highest ever for mortgages in their first year, according to New York-based Fitch Ratings."
- Essentially, credit derivatives can be designed to be an insurance policy of sorts on mortgages. Consider those sub-prime securities in 2. (above). A person who holds one of those mortgage pools can buy a credit derivative as something like an insurance policy in case a mortgage in the pool goes bad. The fact that derivatives are increasing in price simply means the perceived risk is increasing.
"The deteriorating conditions for subprime mortgages also have been evident in the relatively opaque market for credit derivatives. The benchmark for these loans is an index known as ABX, which are split into the various sub-indices of varying quality. According to Markit, an online source of valuation for derivatives, the lowest-quality indices, the ABX.HE 06-1 BBB and BBB-minus, recently suffered a ‘credit event.’ Two underlying bonds had interest shortfalls resulting in losses, according to a Nov. 27 release from Markit.
This week, the ABX has taken ‘a pounding,’ according to one mortgage professional, especially in the triple-B-minus indexes. Investors have been trying to get protection by selling this lowest tier of the ABX index. But, according to this pro, the value of the constituent credits in the index may be even lower than implied by the index’s value — because there’s no market for credit protection for the individual names. So still more selling may be ahead. Credit derivatives are a relatively new development in the mortgage market."
That should give Doomers a running start in getting a handle on this ABX stuff. Thanks, G and K!
Notes and References
: "Going gets tough for subprime lenders: Overdue mortgages just one factor affecting high-interest loan firms", by Bendan M. Case, Dallas Morning News, December 10, 2006.
: "Robust job report eases fears, lifts Wall Street: Long-term bond yields jump as employment data dim prospects for an interest rate cut. Key stock indexes record gains for the week.", Los Angeles Times, December 9, 2006. Emphasis here and in  is mine.
[under "other highlights"]
Sub-prime mortgage bonds had their worst week of the year on concern about the failure of two lenders, the slowing housing market and the ability of borrowers to repay the loans, derivatives based on the securities suggest.
An index of credit default swaps based on bonds rated BBB-minus and consisting of sub-prime mortgages made this year fell 2.6% to 95.36. Credit default swaps are financial instruments based on bonds and loans that are used to speculate on the odds the debt will be repaid.
Traders reacted after two sub-prime lenders, Agoura Hills-based Ownit Mortgage Solutions Inc. and Sebring Capital Partners of Carrollton, Texas, closed this week, said Andrew Chow of Seneca Capital Management in San Francisco.
Sub-prime mortgages are made to people with poor or limited credit histories.
: "Cracks in the Mortgage Market are Becoming Visible", by Randall W. Forsyth, Barron’s, December 8, 2006.
Grant’s Interest Rate Observer has been among the first to pick up the warning signs of the trouble in the subprime mortgage market. The current issue, dated Dec. 1, points out that loans made in 2006 already are turning bad. In past cycles, it generally took a few years for borrowers to go bust.
But such have been the excesses
of this housing bubble, and now, bust. Borrowers whose main qualification was the possession of a pulse could avail themselves of an array of new "affordability" products — 45-year, interest-only adjustable-rate option Libor-based loans. That gibberish boiled down to a monthly nut [mortgage payment] that got homebuyers into houses with inflated prices that they really couldn’t afford. Not surprisingly, foreclosures are soaring — up 51% in the three months ended October from a year earlier, according to Realty Trac.
: "Mortgage Bonds Hurt by Delinquencies, Housing Slump", by Darrell Hassler, Bloomberg, December 1, 2006.