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.
Indeed, Cagan estimates that about 16 percent of those hapless homeowners—about 140,000—will default annually, and even more if home prices drop by much more than the 1.4 percent decline now predicted by the National Association of Realtors for 2007. The result "will be very ugly," says Cagan. "It won't break the economy. But like Warren Buffett says, 'When the tide goes out, you find out who's been swimming naked. 'And my guess is that it's a lot more people than you might think."
Others warn that even those with their financial swimsuits firmly in place could be exposed if the subprime debacle leads to a wider credit crunch. "The worst case is that all these events cause so much fear that credit begins to flow less freely across the entire market," says Mark Zandi, chief economist at Moody's Economy.com.
Tight. To be sure, demand for subprime-backed securities has all but disintegrated, cutting off financing for many would-be homeowners. Meanwhile, the default scare has also led to tightening credit standards for prime mortgages and is increasingly hampering corporate borrowing, such as the withdrawal of a $600 million bond offering from meat processor Swift & Co. The cause: lack of interest.
But there is also good reason to think that the financial contagion will ultimately be more chickenpox than smallpox. The economy, rather than weakening as it was in February, seems to be strengthening today. After a soft patch, many economists think the economy grew at 3 percent or better in the second quarter. And unemployment is still at a relatively low 4.5 percent.
"For those who thought the weaker economy of last February would surely be tipped into recession by the subprime crisis," argues Donald Luskin, chief investment officer at Trend Macrolytics, "the present reacceleration of growth is a sharp rebuke to their 'housing contagion' theory."
And who knows, the woes in the subprime market may actually have a positive side effect. Many investors who thought subprime debt was a good deal may now seek a safer return in U.S. treasury bonds, pushing U.S. interest rates lower. So in the end, perhaps what doesn't kill the economy will only make it stronger.
With Paul J. Lim and Marianne Lavelle
This story appears in the July 23, 2007 print edition of U.S. News & World Report.