U.S. subprime crisis will get worse - but not as bad as the market has factored, finds new CIBC World Markets report

Sep 20, 2007


    Unprecedented surge in default rates will still be less than what the
    markets have priced-in

    TORONTO, Sept. 20 /CNW/ - CIBC (CM: TSX; NYSE) - While the worst of the
U.S. subprime mortgage meltdown is yet to come, the losses will not be as high
as what the markets have already priced-in, finds a new report from CIBC World
Markets.
    The report, which looks at the size and scope of the subprime issue,
finds that while the rate of mortgage defaults is surging to unprecedented
levels, the market has actually overpriced the scope of the problem. CIBC
World Markets forecasts the subprime default rate to reach 25 per cent when
all is said and done but has found that the market has priced in a rate of
about 30 per cent.
    "It turns out that not only did the barrage of negative headlines of
recent months raise the level of market immunity to adverse subprime news, but
in fact, even after its recent improvement, the mortgage-backed market is
currently pricing in a darker picture than the one likely to emerge when the
smoke clears," says Benjamin Tal, Senior Economist with CIBC World Markets.
    His research finds that roughly $700 billion worth of largely subprime
mortgages are due to have their rates adjusted upward by the end of 2008. The
vast majority of these mortgages were issued in 2005 and 2006 with a two-year
discounted teaser interest rate. The quality of these mortgages has declined
every year and subprime borrowers are increasingly finding themselves unable
to secure refinancing.
    The report finds that the biggest fallout from the crisis is yet to come
as the overall quality of the mortgages written in 2006 and the first half of
2007 are by far the worst yet due to poor underwriting, reduced prepayment
activity and weaker home price appreciation. These mortgages also show a
significant jump in mortgage fraud.
    "Based on recent estimates, as much as 70 per cent of early payment
defaults may be linked to misrepresentation of the original loan application,"
notes Mr. Tal. "This is a clear reflection of the deterioration in
underwriting standards and passing on the risks seen in 2006 and early 2007."
    Compounding the issue is the fact that unlike in previous years, the
homes that were financed in 2006 have not appreciated in value - in fact some
have declined. Given that most of these mortgages were taken with little to no
money down, no less than one-quarter of adjustable rate mortgages originated
in 2006 are now in a negative equity position. This number is based on a
three per cent year-over-year drop in house prices. Should there be an
additional drop of 10 per cent, the negative equity number will jump to
40 per cent.
    To put things in perspective, Mr. Tal notes that his 25 per cent
projected default rate is 35 per cent worse than the losses seen in the 2000
vintage loans from Michigan, Indiana and Ohio - the worst performing vintage
and geographic locations to date, and roughly in line with the performance of
the 99th percentile of regional default rates in the recessionary vintage of
2000-2001.
    While these potential losses are reaching unprecedented levels, Mr. Tal
believes the market has already over corrected. He found that the prices on
the ABX subprime-linked default swap indices suggest cumulative default rates
ranging between 28 per cent and 32 per cent producing a weighted average of
just over 30 per cent.
    "Those implied default rates are roughly 20 per cent higher than our
projection - suggesting that the market is currently pricing in a much more
draconian outcome than our main case scenario suggests. This means
opportunities not only in the ABX space but also for the mortgage-backed
security and equity markets as a whole, as the subprime default rate will not
jump high enough to clear the bar set by the market."
    The full CIBC World Markets report is available at
http://research.cibcwm.com/economic_public/download/ssep07.pdf.

    CIBC World Markets is the wholesale and corporate banking arm of CIBC,
providing a range of integrated credit and capital markets products,
investment banking, and merchant banking to clients in key financial markets
in North America and around the world. We provide innovative capital solutions
and advisory expertise across a wide range of industries as well as top-ranked
research for our corporate, government and institutional clients.




For further information:

For further information: Benjamin Tal, Senior Economist, CIBC World
Markets at (416) 956-3698, benjamin.tal@cibc.ca; or Kevin Dove,
Communications and Public Affairs at (416) 980-8835, kevin.dove@cibc.ca


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