Somehow, “subprime contagion” doesn’t have the same ring as “Asian contagion” did in 1998, but we have the same sort of phenomenon at hand: that panic in one sector of the debt market could lead to a broader rout. Nouriel Roubini in his RGE Monitor quotes extensively from a Bloomberg story that indicates that the panic is spreading to the CDO (collateralized debt obligation) market.
The BBB- rated portions of ABX contracts are “going to zero”…And the “Subprime Carnage” Worsens…
The two panicky statements above (The BBB- rated portions of ABX contracts are “going to zero” and “subprime carnage”) are not mine. The “carnage” metaphor was used today by the usually sober and not panic-prone Wall Street Journal (and used interchangeably in recent days with the “meltdown” term by other mainstream media and analysts). While the former statement comes from the head of a securities brokerage cited today by Bloomberg:
The BBB- rated portions of ABX contracts are “going to zero,” said Peter Schiff, president of Euro Pacific Capital, a securities brokerage in Darien, Connecticut. “It’s a self- perpetuating spiral, where as subprime companies tighten lending standards they create even more defaults” by removing demand from the housing market and hurting home prices, he said.
Taken literally the statement above is an obvious and clear exaggeration as ABX prices are nowehere close to zero. But from a substantial point of view – and as a metaphor of that ABX market – the statement is actually correct as prices of ABX BBB- indices are literally in a free fall. At the current asymptotic rate of fall (see charts here) they could in principle reach zero in a short time….
But you do not need to reach zero to have an sub-prime “carnage” or “meltdown” (the latter term used – among many others – by the smart and still bullish Richard Berner of Morgan Stanley): even at the current price of 72 the cost of insuring against default on the riskiest tranches of subprime mortgages is already literally astronomic, having surged from the 50bps over Libor of a few weeks ago to the 1200bps plus (and rising by the hour) in recent days. To cite Bloomberg:
Subprime Mortgage Derivatives Extend Drop on Moody’s Reviews
By Jody Shenn and Shannon D. Harrington
Feb. 22 (Bloomberg) — The perceived risk of owning low- rated subprime mortgage bonds rose to a record for a fifth day after Moody’s Investors Service said it may cut the loan servicing ratings of five lenders.
An index of credit-default swaps linked to 20 securities rated BBB-, the lowest investment grade, and sold in the second half of 2006 today fell 5.6 percent to 74.2, according to Markit Group Ltd. It’s down 24 percent since being introduced Jan. 18, meaning an investor would pay more than $1.12 million a year to protect $10 million of bonds against default, up from $389,000.
Moody’s said late yesterday that it may cut the so-called servicer ratings for affiliates or units of lenders including Irvine, California-based New Century Financial Corp., the second- largest lender to subprime borrowers. Declines in the ABX-HE-BBB- 07-1 and similar indexes accelerated this month as New Century and HSBC Holdings PLC, the biggest lender, said more of their loans were going bad than they expected. London-based HSBC today said the head of its North American unit stepped down….
“Protection-sellers largely have stepped away until the market settles down,” Peter DiMartino, asset-backed securities strategist at RBS Greenwich Capital, wrote in a note to clients today. “Recent mini-rallies were just a few brave souls hoping they could actually catch the falling knife.”….
The level of delinquencies and defaults on subprime mortgages made last year is the highest ever for such loans at a similar age, according to New York-based Bear Stearns Cos.
`Taken a Hit’
Concern about low-rated subprime mortgage bonds have caused yield premiums to rise on low-rated bonds of so-called collateralized debt obligations backed by the debt. Yields on typical BBB bonds from such CDOs widened 1 percentage point relative to benchmarks in the week ended Feb. 15 to 5.50 percentage points, according to JPMorgan Securities Inc.
“Liquidity has taken a hit as market participants wait for the dust to settle,” Christopher Flanagan, an analyst at New York-based JPMorgan, wrote in a Feb. 20 report. CDOs buy loans, bonds and derivatives, and resell the cash flows in new bonds, some of which have higher credit ratings….
Besides bondholders, stock investors have used ABX contracts as a way to bet on the declining fortunes of subprime mortgage companies or the housing market.
The BBB- rated portions of ABX contracts are “going to zero,” said Peter Schiff, president of Euro Pacific Capital, a securities brokerage in Darien, Connecticut. “It’s a self- perpetuating spiral, where as subprime companies tighten lending standards they create even more defaults” by removing demand from the housing market and hurting home prices, he said.
