Taking Credit's Temperature
Risky home loans run a fever, and the market prays it doesn't spread
Like virologists searching for an outbreak of avian flu or some other highly infectious disease, investors have been carefully monitoring U.S. credit markets the past five months for any sign of financial contagion. Specifically, would the deterioration in the subprime mortgage market that surfaced in February—when HSBC and New Century Financial reported losses from higher-than-expected default rates by less creditworthy borrowers—spread beyond the sector and cause a massive credit crunch? And would that further damage the sickly housing market and perhaps push the broader economy into recession?
But just when some analysts may have been ready to give the all-clear sign, subprime problems seem to be flaring again—and even spreading. Several hedge funds, which used hundreds of millions of dollars in investor capital to borrow billions more for big bets on subprime-backed debt, have been shut down or needed bailing out. Then, Standard & Poor's and Moody's belatedly announced that they were downgrading their credit ratings on over $12 billion worth of subprime-backed bonds, with more reviews to follow. The move rattled the stock market for a day and pushed the index that tracks subprime bonds to an all-time low.
All with good reason, says Robert Rodriguez, chief executive of First Pacific Advisors in Los Angeles. "We're set up for a storm that could be much larger than Long-Term Capital," warns Rodriguez, referring to the hedge fund whose collapse in 1998 led to a brief financial crisis on Wall Street and forced the Federal Reserve to organize a $3.6 billion bailout. "The elements are all there. The tinder is there. The question is: What will be the match to set it off?"
There are a couple of different possibilities. For starters, the broader fallout from Wall Street's bad bets on subprime has yet to be fully accounted for. Between 2004 and 2006, bond investors gobbled up about $1.4 trillion worth of high-yield-but-seemingly-low-risk subprime-backed debt securities. Many also invested in mutual-fund—like mixes of the bonds, known as collateralized debt obligations, or CDOs, which soon became the investment vehicle of choice for hedge fund managers. But then the housing market turned downward. And before long, mortgage default rates that had plunged to their lowest levels in years began to rise again, most recently to about 1 in 7 subprime loans.
Reckoning. But as things stand now, nearly $2 trillion in subprime-backed securities purchased over the past seven years—not only by banks but also by insurance companies and pension funds—still needs to be marked down to reflect the impact of increased defaults on the securities' underlying value. (Unlike widely traded stocks and bonds, for which market values are quoted continuously, many mortgage-backed securities are thinly traded, leaving their holders to determine their exact value at any given time.)
"No one wants to devalue their paper by 20 percent before they have to," says Christopher Cagan, director of research at First American CoreLogic, who closely tracks the subprime mortgage market.
But with the ratings agencies' recent change of heart, the day of reckoning may now be at hand. That's not only because their lower ratings will force many bondholders to remark their values and sell the paper at a loss but also due to a growing tidal wave of interest-rate resets on somewhere north of $300 billion in subprime loans. The rising interest rates will increase borrowers' payments—and consequently defaults—over the next year and a half.
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