As pressure mounts on rating agencies to proactively evaluate risky bonds, downgrades will continue to  creep up the credit spectrum.

Prime loans make up almost 80% of the massive mortgage market, and delinquencies are quickly deviating from historical averages. While subprime mortgages continue to make headlines, data from the latest MBA survey on delinquencies for 3Q '07 shows a disturbing trend:

• Prime serious delinquencies (+90 days) are up 14% from 2Q '07
• Subprime serious delinquencies (+90 days) are up 10% from 2Q '07
• Prime ARM foreclosure starts are up 65% from 2Q '07
• Subprime ARM foreclosure starts are up 23% from 2Q '07
  

Note this is a quarter-on-quarter comparison and a snapshot before the credit crunch began to materially impact the broader economy. Overall prime delinquencies measured 3.1% compared to historical levels of 2.4% and are increasing at a faster rate than subprime delinquencies.

To understand the implications of this shift and explain why many of the new mortgage vulture funds want to buy CDO securities backed by subprime rather than prime mortgages, we turn again to the nuances of structured finance.

Mortgage backed securities are structured with a cushion, or subordination, to protect buyers of the deal's senior bonds. Investors buying these riskier securities are rewarded with a higher return because they are first in line for losses if the deal goes bad.

This excellent graphical depiction courtesy of Urban Digs shows how lower rated bonds and deal equity (labeled "Unrated" on the chart) protect higher rated bonds as losses occur.


Click to enlarge image

Underwriters such as Bear Stearns (BSC) and Merrill Lynch (MER) profit from structuring fees as well as the excess spread between interest collected on loans in the pool and the coupon paid to bondholders. In plain English, if the mortgages in a deal average an interest rate of 8% and the bonds have an average coupon of 6%, underwriters earn the difference between the two, or 2%.

Rating agencies Moody's (MCO), S&P and Fitch rate the various bonds using statistical models that predict how pools of loans will behave. As expected, subprime loans have a much higher loss severity and frequency than prime loans, so underwriters must build lots of cushion into subprime deals to allow for greater losses. The rates charged on subprime loans help provide extra cash to pay subordinate bondholders that demand a higher return for their increased risk.

Prime securities, on the other hand, are structured with very little cushion, since historical prime loan performance has been so good. Prime loans carry a low interest rate so there is less margin available to pay investors in the lower rated bonds.

Problems for mortgage backed securities are not caused by absolute default rates or even by absolute drops in house prices. Models break down and deals lose value when loan performance and home values deviate from what the models expect. Prime loan performance has historically been very good and home prices have never fallen on a wide scale, therefore prime securitizations are structured with razor thin subordination.

Getting back to the vulture funds, the problems with subprime securities are widely known and not getting any better, but subprime AAA bonds began with more cushion and can be picked up in the marketplace at bargain prices. Prime securities on the other hand, have a much smaller margin of error, and even a small uptick in prime delinquencies puts highly rated bonds at significant risk.

Although Washington cannot change the underwriting standards of the 2005 and 2006 vintages of prime mortgages, its doing everything it can to support home prices. The recent bill that will raise the limits for Fannie Mae (FNM) and Freddie Mac (FRE) is directly aimed at propping up values in jumbo (prime) regions.

The subprime debacle and its ripple effects have shown what happens when a small piece of the structured credit market breaks down. The prime market is four times as big as subprime, and the implications are far greater since banks and insurance companies hold such huge amounts of prime securities on their balance sheets.