Alt-A Mortgage Class the Next Shoe to Drop?

For credit rating purposes, the class above subprime is known as "Alt-A". It is likely Alt-A bonds is the next shoe to drop… that is if it hasn't already.

Issuances of Alt-A mortgages has tumbled, according to a Dow Jones report, however, "the mortgages still made up 28 percent of all mortgages originated in the quarter, the same level as two years earlier." The lending industry's continued appetite for these loans is still alarmingly high considering Alt-A delinquencies are rising at a rapid pace:

After 18 months, Alt-A loans originated in 2006 had a delinquency rate of 4.71 percent, versus 1.97 percent for such loans from 2005 and 1.07 percent for 2004. The trend for 2007 loans is even worse than 2006, suggesting last year could be "the worse ever for the Alt-A market," S&P said.

This is terrible news for hedge funds, fund-of-funds and individual investors that have billions invested in Alt-A bonds. In 2006 alone $400 billion Alt-A loans were originated and likely sold to investors.

The fall-out of a collapse in this market will likely mirror that of the subprime loan market. Amidst the subprime rubble, allegations of hidden risks and omissions have been commonplace as well as accusations that Wall Street unloaded toxic subprime debt on unsuspecting investors. We could see a similar legal landscape in the near future.

According to our sources, Alt-A investments were pitched in a comparable fashion as subprime. Brokers and managers told clients Alt-A investments were backed by secure assets and were steady gainers, unlike tech stocks of the late 90s. Alt-A securitized investments in reality are backed by loans requiring little documentation regarding salary and other assets that would determine a consumer's credit worthiness. The phrasing is interesting: "Alt-A mortgages typically got to borrowers whose credit is deemed good enough to forgo proof of claimed assets or income."

Analysts are also eyeing the Alt-A market suspiciously. In a Marketwatch story from earlier this month, Mark Adelson, head of structured finance research at Nomura Securities International, calls "Alt-B" products:

"The Alt-A market has absorbed and disguised a portion of the subprime space," he said. "You can debate how to define these loans, but many have ended up being an Alt-A product with subprime deficiencies…"In the past few years, Alt-A loans were made to weaker and weaker borrowers and the sector expanded downward along credit spectrum," he said. "In doing that, you draw up into the Alt-A space some of the problems that are affecting the subprime space."

In other words, "Alt-A" isn't simply the next subprime, it could be subprime.

My Subprime Litigation Speech

As previously posted about, I just wrapped up a speaking engagement sponsored by Bloomberg and Eversheds. To see my full remarks, click here.

The Impending Subprime Litigation Tsunami

Tomorrow I will be participating in a panel discussion hosted by Bloomberg News and Eversheds, one of the world's largest law firms. The conference is entitled "Sup-prime and global credit symposium: What will happen in 2008". Other participants include Matthew Allen, partner in the insurance and reinsurance group at Eversheds, Dr. Andrew Hilton, director of the Centre for the Study of Financial Innovation, Rolf Tolle, Franchise Performance Director at Lloyd's of London, Michael Fallon, MP for Sevenoaks and member of the Treasury Select Committee and Mark Gilbert, a Bloomberg news financial columnist.

I was asked to provide a view of the potential litigation. Here's what I will tell them:

The world is in for an unprecedented litigation tsunami. Subprime isn't the new dot-com, it's in a whole other class altogether. Wrongdoing is likely much more pervasive and egregious and claims will reach into the multi-billion dollar range. Already there are over 32 class actions filed against mortgage lenders, originators, and Wall Street brokerages alone and multiple civil and criminal probes.

There is one thing in common with the tech-bubble: investors were left holding the bag. I'll be posting my full remarks later this week.

Moody's Finds Religion: Too Little Too Late

It was announced that Moody's is weighing a new 21-point scale for rating structured finance securities. The firm is also considering adding a warning label that acknowledges the ratings' limitations. While I welcome any reforms that can prevent another subprime collapse, this to me falls into the too-little-too-late category.

Furthermore, the market for securitized financial instruments has all but dried up, so it's unclear to me what benefit the new system will have. In reading the news, I couldn't help but recall the asbestos litigation and subsequent regulation which required certain buildings to contain the phrase. CAUTION: ASBESTOS. HAZARDOUS. DO NOT DISTURB WITHOUT PROPER TRAINING AND EQUIPMENT.

My suggestion for the ratings agencies: "CAUTION: PURCHASING THIS SECURITY COULD GREATLY REDUCE YOUR PORTFOLIO."

Harvey Pitt on Individual Investors: Let Them Eat Cake

Former SEC chairman Harvey Pitt was no champion of individual investors. Pitt was in charge of the agency when the former New York Attorney General put the SEC to shame and took the lead in exposing Wall Street's conflicted research. Pitt was also among the regulators who signed off on Spitzer's wrist-slapping $1.4 billion global settlement.

So I guessed I should not have been surprised to hear Mr. Pitt tell CNBC viewers today that the Supreme Court's recent Stoneridge decision, which prevents investors from suing all parties involved in a fraudulent transaction and not just those who directly initiated it, would have no bearing on investors seeking legal recourse relating to the subprime mortgage meltdown. Mr. Pitt said that there were already enough primary violators to sue.

Mr. Pitt is badly mistaken. The Stoneridge decision will adversely affect the legal recourse available to subprime investors, as many potential avenues for discovery – where "smoking guns" are often discovered &ndash are now closed. My guess is that if CNBC had also asked Mr. Pitt about the Supreme Court's Tellabs decision, which requires "a strong inference of fraud" before a class action suit can be certified, he wouldn't have had any issues with that ruling either.

Credit Mr. Pitt at least for one thing: at least the regulatory lightweight's longstanding indifference to the issues and concerns of individual investors remains intact.

FBI's Subprime Investigation and Cuomo's "Martin" Move

If the legal departments at our nation's major financial services firms weren't nervous before, they certainly are now. According to news reports, the FBI is looking into potential subprime crimes by 14 companies as part of a wide ranging investigation into the troubled mortgage industry. Apparently they have been doing so since the Spring of 2007. Reading through the tea leaves, the FBI might find that risk disclosures were hid from investors and ratings agencies as well as mortgage lenders and brokers falsifying information on loan applications, among other potential wrongdoings.

The FBI inquiry is extremely important because rather than pursuing these cases civilly through the SEC, we could see federal criminal indictments and jail time. The Feds were successful in prosecuting corporate criminals at Enron, WorldCom, and Adelphia and they have the requisite knowledge and experience to pursue wrongdoing in the subprime mortgage arena.

This is in stark contrast to Eliot Spitzer's strategy who was content to use photo-ops and wrist slaps and call it justice. Mr. Spitzer's performance will hopefully not serve as a case study for the current New York Attorney General, Andrew Cuomo. This is not to say he didn't learn anything from Mr. Spitzer. Attorney General Cuomo apparently is threatening to use The Martin Act to aggressively pursue a case against Wall Street, which also was Mr. Spitzer's legal club of choice.

This is an important development. The Martin Act is quite broad in its scope and can be used to indict a company for virtually anything. No Wall Street firm has ever survived an indictment, so Cuomo will likely garner some settlements. Let's hope that unlike Mr. Spitzer, Mr. Cuomo is hell bent on truly reforming Wall Street and that any settlements involve penalties that might actually serve as painful deterrents to future wrongdoings.