Banks wary of subprime mortgage market "head fake"

NEW YORK (Reuters) - Newfound stability in the $600 billion market for subprime mortgage-backed securities doesn't have anyone jumping for joy.

Prices on mortgages of the riskiest borrowers have improved a little in recent weeks in a respite from the pummeling they took from investors in the four months through March.

The earlier slump in prices followed unexpectedly sharp increases in delinquencies which surprised lenders and investors who underestimated the impact of the cooling housing market.

But executives from the nation's biggest lenders and their Wall Street partners this week were unsure about the state of the market, even though prices on new loans with sounder underwritings have climbed, investors are showing greater interest, and the drama over a widely watched derivative index has subsided.

"Is this a head-fake? That's what worries me," Thomas Neary, an executive vice president for capital markets at Wells Fargo & Co.'s (WFC.N) home mortgage unit said on a Mortgage Bankers Association panel. Capital markets units pool loans and sell them to Wall Street firms that package them into bonds.

Yield premiums on "BBB-" rated bonds, some of the riskiest segments of subprime securities, have narrowed about 250 basis points in the last two weeks to about 450 basis points over the 1-month London Interbank Offered Rate, or LIBOR, according to Credit Suisse. Lower spreads mean investors are demanding less yield to compensate them for potential defaults.

The yield spread on the ABX-HE 06-2 "BBB-" index, that began a free-fall in January, was 1,042 basis points this week, down from 1,446 points in February, after widening from 215 points last fall.

"I thought things were going to get worse than they did before coming back to normal times," Neary said. "I'm not 100 percent convinced that we've seen the end."

Neary and Ted Tozer, a capital markets executive from National City Mortgage Co., a unit of National City Corp. NCC.N, described a tentative market that is still stumbling even though it's easier to sell loans than two months ago.

The National City loans were so-called Alt-A loans, a step above subprime in quality, but including many of the features that brought competitors down, including reduced income documentation.

Tozer said he now sees five to six bidders for each $150 million to $200 million set of loans put up for sale, slightly up from March, but still less than the 11 seen for the average pool in early January. On the bright side, buyers are no longer submitting weak bids designed to fail, he said. But they are still asking for low quality portions of the pools be dropped, or "carved out," he said.

"Liquidity is not back," he said. "But people are starting to put their toes in."

Wells Fargo has soldiered on, seeing an "opportunity" since consumers are still looking for credit, said Stephanie Christie, a senior vice president of the Wells' retail subprime group.

With $5.65 billion produced in the first quarter, Wells Fargo was one of just three top 10 lenders to boost production in the period even as overall volumes fell by a third, according to Inside Mortgage Finance.

Other surviving lenders in the industry this week said they weren't putting too much stock in the stabilization that is mostly due to demand for new, 2007 loans made under tighter underwriting standards and corresponding bonds structured with more protection.

Prices on bonds backed by 2006 loans remain mired, and could worsen as rates on subprime loans made during peak months of the housing boom in late 2005 begin to reset higher later this year, analysts said.

Most subprime loans are so-called 2/28s whose interest rates are fixed for two years and adjustable thereafter. Before the housing boom ended in late 2005, overstretched borrowers relying on house price appreciation could easily refinance ahead of the reset.

The broader housing market is showing mixed signals. The pace of existing home sales fell more than expected in April, leaving inventories of houses for sale to swell, according to the National Association of Realtors today.

The government yesterday reported sales of new homes surged in April, but only after builders slashed prices a record 11 percent.

"This is not the time to be market-share focused," said David Schneider, president of Washington Mutual Inc.'s mortgage division. "We've taken down our market share year over year, and that was done on purpose."

Washington Mutual's (WM.N) subprime unit, Long Beach Mortgage, was the 10th largest subprime lender last quarter with $3.1 billion originated, according to Inside Mortgage Finance. That represents a 51.7 percent drop from a year ago.

Schneider said a rebound would come, however. The exit of dozens of lenders, including former leaders such as New Century Financial Corp., are creating a smaller industry with larger and more stable participants that don't rely on a single business for their bottom line, he said.

On Wall Street, the ultimate arbiter of the subprime market since most loans are packaged into securities, investment banks such as Credit Suisse Group's (CSGN.VX) U.S. unit are biding their time. Investor demand is still too weak to justify a push in originations at the Swiss bank's newly acquired lender, Lime Financial Services, said Michael Marriott, a managing director for Credit Suisse in New York.

"I'm very sure right now that I would not want to be No.1 given where (whole loan prices) and coupons are," he told Reuters ahead of an MBA panel discussion.