The subprime situation having an uneven impact on the mortgage REIT sector, depending on a company's exposure to subprime loans and securities backed by subprime loans, but now also on the uncertainties posed by the credit crunch. Portfolio spoke with John Kriz, managing director, Moody's Investors Service; Steven Marks, managing director, Fitch Ratings; and Ernest Napier, managing director, Standard & Poor's about the impact of the subprime situation and what is next for the Mortgage sector.

John Kriz

Steven marks

Ernest Napier

Portfolio: What would you say is next for the entire mortgage sector?
John Kriz: Most of the challenges are going to continue to be in the subprime sector, but not exclusively. On the origination side, there's a limited amount they can do. If industry volumes are down, individual originator volume will be down too. Losses due to early payment defaults (EPD) are going to continue.

Steven Marks: The effect, especially the indirect effect on commercial mortgage REITs, will be temporary. Some investors didn't understand the lack of correlation between subprime and the other kinds of mortgage REITs, and that's driven a lot of the decline in stock prices recently. For some investors, it has presented a good entry point—a chance to catch a stock price at a potential bottoming.

Portfolio: Are commercial mortgage REITs benefiting from strong real estate fundamentals?
Marks: Yes. The underlying fundamentals of the commercial mortgage REIT follow commercial real estate, and that has performed quite well in recent years. In terms of priority, first and second mortgages on the cash flows generated by these properties are first in line.

Kriz: Still, in the subprime space, the 2006 vintage was a tough one because of EPDs. If I own an asset as part of a security that's been downgraded, or been impaired in value somehow, I need to write down that asset or increase my loan-loss provision to absorb that loss. That puts pressure on earnings.

Ernest Napier: A lot of companies are going to have to mark down their residual values. They were making certain assumptions about credit losses in those residuals, and the extend to which credit losses have exceeded expectation, the amount that's going to come back to them at the end of the structured transaction will be less. So yes, it will have a direct impact on residual values going forward because in most cases credit losses are more than anticipated.

Portfolio: Could the subprime situation have been anticipated and prevented?
Kriz: The subprime business is cyclical. The potential for swings in asset quality and for funding issues is inherent in subprime. We're simply going through one of those times. The question is how long it will last. I'd say we're looking at the end of 2007 and into 2008—this isn't a short-term phenomenon.

Napier: Last summer, the market was already showing some signs of turning down, so I think there was some anticipation. For example, Saxon was purchased by Morgan Stanley last summer, and that was great timing. They got a better value than they would have a couple of months later.