Some 40% of US mortgages have piggybacks - second mortgage “home equity” loans on top of the first mortgage. The 80/20 - a first mortgage at 80% and a second for the remaining 20% of the purchase price has been a favorite way of implementing 100% financing. That way the first mortgage avoids the need for PMI. Then the risk is somewhat focused into the second mortgage.

It is these second mortgages where the credit quality deterioration is becoming more and more marked. At least one major lender (Fremont) appears to have stopped subprime 80/20 lending. The ABX indices show continued deterioration in credit quality for the 2006 loans. One wonders how well the older tranches are doing, unfortunately there is no public data that I’m aware of.

Don Coxe always taks about the “Page 16″ stories as being key to succesful investing. By the time a story reaches Page 1, it is old news and discounted in the marketplace, and most of the money has been made. This in my view is a story about to move onto Page 16 on its way to the front page. New Century Financial Corp, one of the largest subprime lenders, has apparently issued instructions that borrowers with credit scores less than 580 must be qualified at the fully indexed rate on adjustable loans, that is about 12%. This is clearly a significant credit tightening.

Max Fraad Wolff in the Asia Times: “In 1999, total outstanding household debt was $6.4 trillion. As of the end of the second quarter of 2006 total outstanding household debt was $12.3 trillion.

“Household debt has increased by almost as much since 1999 as the sum total of all debt accumulated by all households across the preceding 220-year history of the [United States]. In 1999, household mortgage debt stood at $4.4 trillion. At the close of the second quarter of 2006 it had more than doubled to $9.33 trillion. In 1999, consumer credit outstanding was measured at $1.6 trillion.

“Today, this stands at approximately $2.4 trillion dollars, signaling a 50% increase in less than seven years. This is usually soft pedaled and talked down by comparison to skyrocketing housing values. Household assets held as real estate increased by $9 trillion from 2000-2006. This might be called the mother of all modern bubbles. Yet household net worth struggled up by a mere $1.2 trillion. Net worth badly lags housing values because of waves of cashing out. When these waves crash ashore it will be with massive destructive force.”

At Markit you can track a set of indices that measure the cost of credit default “insurance” for asset-backed securities. Right now, the set that is available covers bonds backed by home equity loans, hence ABX-HE. There are plans for others in the future. The series covers various tranches of the bonds, which range in credit quality from AAA through BBB- and were issued in 2006. Hence ABX-HE-BBB- 06.  There is a January series (06-1) and a July series (06-2). As I read the documentation (I’m not an expert on this) for each credit quality, there is a basic fixed rate for insurance which was the rate at when the securities were issued. In the case of the lowest quality (BBB- 06-2) tranche, this was 242 basis points. Then there is a floating rate, which is the difference between 100 and the current price. Today, the lowest quality tranche has a price of 92.99, so the floating rate is 701 basis points. This is, in essence, the amount by which the price of insurance has gone up based on the actual default experience and/or expectation. So as I read it, the total cost of credit insurance for the lowest quality tranche is now 943 bps. Nearly 10%. This index covers securities which were issued in the first half of 2006 and shows a marked deterioration in credit quality when compared to the earlier 06-1 series. Markit seems to have gone to some trouble to ensure that the securities included in the index were representative. This seems to validate the various comments about difficulties in placing subprime debt. With such a high cost of insurance, the yield would have to be huge to cover the credit risk.

If I’m not reading this right, please comment.

I guess “Secured Funding” didn’t:

Dear Valued Customers,

Based upon market conditions and limited product availability, we are ceasing wholesale operations. We have stopped accepting new applications, and will have until the 12th of January to fund out the pipeline. We appreciate your patience as we undergo this transition.

Thank you for your support

1000 employees. The beat goes on. Rumors that there are a couple more hanging by a thread. A subscriber’s email on Bill Fleckenstein’s site claimed that this week Merrill Lynch exercised their option to put defaulting loans back to a top 50 (but not top 20) subprime originator worth over four times the originator’s total capital, and furthermore did not renew the company’s warehouse line.

Much-maligned Michael Milken made a fortune in the 70’s and 80’s by observing that the yield on junk bonds was much higher than necessary to compensate for the additional risk of default. In the succeeding years, credit spreads have collapsed and it would appear that we are now in the reverse situation - credit risk has been way underpriced and now is biting back.

I don’t subscribe to the service, but I have heard good things about sentimentrader.com. A daytrading site that I occasionally read is showing a chart from sentimentrader.com that points out that many sentiment indicators are bearish. FWIW.