If the subprime meltdown spreads into higher loan classes, Los Angeles-area lending giants Countrywide Financial Corp. and IndyMac Bancorp Inc. stand to get hit by what one lending expert calls the "law of reverse gravity."
"With bad loan exposure, it's bottom-up instead of top-down," said Keith Corbett, executive vice president for Center for Responsible Lending.
"You got subprime on bottom and prime on top and there's this middle that will be hit, an area where bad loans in the subprime space may lead to not only defaults but tighter underwriting standards for Alt-A loans and perhaps upward."
So-called Alt-A loans are extended to borrowers whose credit scores fall short of prime but are above subprime. Los Angeles County is a center of the Alt-A universe, partly because of its large and diverse population of entrepreneurs, performing artists, independent contractors and others with decent but not-so-steady income. High property prices also push some borrowers who otherwise would be prime borrowers into Alt-A territory.
Both Countrywide and IndyMac are among the very biggest Alt-A lenders in the country. A small but significant portion of the outstanding loan portfolio of Calabasas-based Countrywide, the largest U.S. lender, is Alt-A. IndyMac of Pasadena, which originated $69 billion in Alt-A loans last year, has more than 70 percent of its loan portfolio designated as Alt-A.
"Over the last two years, the distinction between Alt-A and subprime has become even more blurry," said David Liu, mortgage strategy analyst for investment bank UBS AG. "Therefore the same types of problems, such as growing delinquencies, that plagued subprime loans are going to filter into the Alt-A market to a certain extent, and if you're a company in this area, you'll be affected adversely."
Don't call us subprime!
Countrywide and IndyMac recently have seen their stocks slide 21 and 41 percent respectively off their 52-week highs and have responded vehemently to news reports linking them to the subprime market.
Both companies point out that subprime loans are a small part of their respective loan portfolios.
IndyMac has been catching so much flak for being in the "subprime business" that it released a statement March 15 clarifying its "strong position as an Alt-A lender."
"Based on the definition of subprime established by the Office of Thrift Supervision for our regulatory filings," the statement read, "only 3 percent of IndyMac's $90 billion in mortgage loan production in 2006 was subprime."
Analysts thus far have been less than impressed with these explanations.
Robert Lacoursiere, an analyst with Bank of America Securities, recently issued a "sell" rating on both Countrywide and IndyMac. He anticipates increased write-downs and loan-loss provisions.
"We expect a difficult environment going forward for Countrywide and IndyMac," he wrote in a research note, adding that both companies would face continued increases in credit risk in 2007.
Countrywide declined specific comment but said it was watching the market to see the degree to which its Alt-A operations are affected.
Meanwhile, IndyMac Chairman and Chief Executive Michael Perry said via e-mail that it was no fun to have the current level of turmoil in the mortgage business and see IndyMac's earnings and stock price decline, causing stress for employees and shareholders. That said, he added that he thought the industry needed a shakeup in the form of the current "firestorm" to restore rationality and discipline to the industry.
"Clearly, the mortgage market and, in particular, the secondary market for mortgages are in a state of irrational panic right now, making it virtually impossible to predict short-term loan production and sales volumes or earnings with any reasonable precision until things settle down," he said.
Red ink in the gray area?
Alt-A loans skyrocketed from about $85 billion in 2003 to about $400 billion last year.
Default rates for Alt-A mortgages doubled in the past 14 months, partly because the so-called teaser rates temporarily low interest rates for the first few months or years of a mortgage have been expiring at the same time home prices have flatlined. In the past, borrowers simply refinanced or sold when their teaser rates expired, relying on sharply appreciating home prices to bail them out.
Liu of UBS AG said that cumulative losses in the Alt-A sector in the past year are 10 times that of the prime market.
Zach Gast, of the Center for Financial Research, said that if Congress pushes for tougher underwriting standards, a large percentage of borrowers whose loans have already been approved would not qualify after any new standards are put in place.
"And most of the applicants will fall into the Alt-A loan category, which is largest in California," he said.
Before the recent upheaval, a potential borrower could've had a Fair Isaac Co. (FICO) credit score as low as 640 and get an Alt-A loan at a lender's discretion. Today that number is more like 680. IndyMac's new average requirement for Alt-A is 701. Subprime requirements are shooting up from 600 to a low of 670.
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