Rising defaults across a range of debt products confirm that credit woes are not just a subprime affair.
Stories in the New York Times and the Financial Times focus on different aspects of this problem. The Times tells us that collateralized debt obligations, complex structured credits that can contain tranches of other structured credit deals, whole loans, or even cash flows from credit default swaps written against other CDOs, are starting to halt payments on their lowest quality tranches as defaults exceed their credit cushions. The Financial Times describes how rising delinquencies and defaults are hitting many retail credit products. Rising financial stress among consumers should come as no surprise; most people will give paying their mortgage higher priority than their credit card or car loan, so if mortgage delinquencies are rising, you can expect a lot of other accounts to be in arrears as well.
First, from the New York Times. Note an inaccuracy in the reporting. The article makes it sound as if CDOs consist entirely of subprimes. While some may consist largely of subprimes, and many subprime loans did wind up in CDOs, those instruments often have heterogeneous assets, including regular residential loans, pieces of collateralized loan obligations (LBO debt), and commercial mortgages. The article also quotes analysts who believe, not surprisingly, that deterioration of credit quality of CDOs has not been fully reflected in the recent financial reports made by investment banks.
Collateralized debt obligations — made up of bonds backed by thousands of subprime home loans — are starting to shut off cash payments to investors in lower-rated bonds as credit-rating agencies downgrade the securities they own, according to analysts and industry executives.
Cutting off the cash flow, which is governed by rules and mathematical formulas that vary by security, is expected to accelerate in the months ahead.
Such a cutoff would be the latest blow to financial markets as investors try to anticipate the next problem that might shake confidence….
With such a re-evaluation, owners of collateralized debt obligations — investment banks, hedge funds, insurance companies and public pension funds — may be forced to write down mortgage investments beyond the billions they have already written off. Some bonds, for example, may go from being valued at, say, 70 cents on the dollar to becoming largely worthless overnight, bankers and analysts say.
The adjustment could further erode the availability of credit to consumers and businesses.
Though many people in the mortgage market expect a shut-off of payments, the broader financial market has not focused on it. “At this point, it’s fair to say that everybody expects this shoe will drop,” said Mark Adelson, an independent mortgage securities consultant and analyst. “It’s a foregone conclusion. But when it happens, there will be a market reaction to it.”…..
A re-evaluation of payments by trustees who oversee the debt obligations is part of a long, complex chain reaction that is caused by the surge in mortgage delinquencies and home foreclosures. As more homeowners fall behind on payments and lose their homes, the pressure builds on large pools of mortgages that issue bonds to investors. Many of the riskiest of those mortgage bonds have been bought by the C.D.O.’s, which issue bonds of their own….
“It’s still the early stages of a very significant stress,” said John Schiavetta, a group managing director at Derivative Fitch, which rates the debt obligations.
He noted that C.D.O. deals varied significantly. In some, interest payments continue on all bonds regardless of their rating, which means that higher-rated bonds may be more vulnerable to losses. Fitch has downgraded 30 percent of the debt obligations in its rating portfolio and has put 15 percent more on watch for possible downgrading.
In the last two weeks, leading investment banks have written down about $20 billion, much of it in collateralized debt obligations and mortgage-related securities. Merrill Lynch wrote down $4.5 billion in debt linked to home loans and ousted two senior executives in charge of its bond division. UBS wrote down $3.4 billion and ousted the chief financial officer. Citigroup wrote down $1.3 billion from the deterioration in the value of mortgage-related securities.
Investment banks still hold billions more that could be under threat by the recent downgradings and a continued deteriorating in the mortgage market, said Brad Hintz, an analyst at Sanford C. Bernstein & Company. UBS, for instance, still holds about $20 billion in subprime securities.
But Mr. Hintz said it was difficult to determine how much more of the banks’ portfolios is vulnerable because the institutions have not disclosed many details about their holdings. The size of the recent write-downs surprised many analysts and investors because data provided by the banks earlier in the year suggested there was little to worry about.
“In the case of Merrill Lynch,” Mr. Hintz said, “when you analyzed the financials based on the second-quarter numbers, it didn’t look like they had a lot of exposure. There has been a breakdown in risk management.”
It is unclear what portion of the collateralized debt obligations issued by the investment banks is still on their balance sheets because they could not sell them to other investors. Merrill Lynch was by far the biggest issuer, underwriting $54 billion last year, almost twice as much as in 2005, according to Asset-Backed Alert, a trade publication.
A group of financial enterprises called structured investment vehicles also hold C.D.O.’s, although bankers say that subprime debt makes up only a small percentage of their assets. Problems with these investments has led big banks including Citigroup, Bank of America and JPMorgan Chase to develop a $75 billion rescue fund that could be used to buy risky mortgage securities and other assets from them, a move intended to ease pressure on an important part of the credit markets.
Yet for all the damage that has already been done, the real stress for investors in these securities lies ahead, industry officials say.
Most mortgage securities have not yet had significant losses, which are only recorded when homes are foreclosed and sold. Up to two years can pass between a borrower’s falling behind on payments and an auction. Each mortgage security has a reservoir of excess cash to draw upon to pay bondholders when borrowers do not make monthly payments.
“As far as the security is concerned, it’s only once the property is effectively sold that a loss is recorded,” said Nicholas Weill, chief credit officer at Moody’s. “The process of foreclosure is a long process. It doesn’t just happen overnight.”
The Financial Times story, by contrast, focuses on the more conventional problem of rising consumer delinquencies:
US banks… are adding to reserves not just for defaults on mortgages, but also on home equity loans, car loans and credit cards.
“What started out merely as a subprime problem has expanded more broadly in the mortgage space and problems are getting worse at a faster pace than many had expected,” said Michael Mayo, Deutsche Bank analyst.
“On top of this, there is an uptick in auto loan problems, which may or may not be seasonal, and there is more body language from the banks that the state of the consumer was somewhat less strong [than thought].”
Dick Bove, analyst at Punk Ziegel, said bank earnings indicated “there are problems with consumer debt that extend beyond the well-known issues in the real estate markets. Auto loans are clearly a new area of concern”. At Wachovia, the fourth largest US bank by assets, credit loss provisions more than doubled from the second quarter to $408m.
Troubled loans that could turn into losses also more than doubled. Ken Thompson, chief executive, said the housing market could remain weak through next year. Wachovia’s poor earnings fuelled a stock market rout on Friday.
Problems can be seen at banks across the US. At KeyCorp, in Cleveland, non-performing assets rose $241m from last year and loan-loss provisions doubled. In Dallas, Comerica’s loan loss provisions tripled from last year to $45m. Net credit losses jumped from $663m last year to $892 at Wells Fargo, in San Francisco, due to home equity and car loan losses. Loans more than 90 days past due and still accruing increased to $5.53bn from $3.66bn last year.
“There has been a fast sea-change in thinking,” said Rick Klingman, interest rate trader at BNP Paribas. “Stocks are showing some real concern about bank earnings and there are worries about credit in general.”