Subprime market faces further setbacks

The stricken US subprime mortgage market is likely to suffer further setbacks in the coming months as $500bn of risky home loans sold with initial low “teaser” interest rates are reset at much higher levels, analysts warn.

“It’s like an onion, as you peel back another layer it just smells worse,” said William Strazzullo, chief market strategist at BellCurve Trading.

Over the next 18 months, adjustable-rate home loans sold at the peak of the high-risk lending boom in 2005 and 2006 will be reset. Given a recent tightening of lending standards as banks try to rein in their mortgage exposures, this raises the prospect of further serious losses. Christopher Flanagan, strategist at JPMorgan, estimates up to 45 per cent of borrowers facing resets will not meet criteria to refinance into new home loans.

The mounting problems could force ratings agencies to downgrade billions of dollars of mortgage securities below investment grade, a move that would in turn force many investors to sell their holdings and exacerbate the spiral of losses.

“The potential repercussions are quite serious,” said Andrew Lo, professor at MIT’s Sloane School of Management. “There are hundreds of hedge funds and proprietary desks that are involved in these instruments and have used leverage.”

Part of the problem, said Mr Lo, was such complex debt instruments were hard to value and rarely traded, making it difficult for investors to gauge how much further prices could fall. “Once the ratings agencies adjust their ratings, you will see a massive sell-off by institutional investors, and the repercussions could be extraordinary,” he said.

Ratings agency downgrades of subprime-related securities have already gained momentum in recent weeks, helping to push a key derivatives index tracking such securities to record lows. The ABX index tracking 2006-issued subprime bonds rated BBB- fell to a record low of 41 cents on the dollar on Friday, down more than 50 per cent since January.

“There is a possibility that one or two money centre banks and dealers could be a casualty along with hedge funds and institutional investors,” said Mr Lo. Even higher-rated securities were unlikely to be immune from losses, Mr Flanagan said. “Losses are going to move up the capital structure to the higher-rated pieces. Hedge funds will continue to feel the pain,” he said.

Fresh worries about US subprime mortgages cast a shadow over financial markets last week as Ben Bernanke, US Federal Reserve chairman told Congress that losses from mortgages could total $50bn-$100bn. That came after Bear Stearns said on Tuesday that subprime mortgage-related assets held by two of its hedge funds were virtually worthless. Bear’s stock is down 17.1 per cent for the year.

JPMorgan, Citigroup and Bank of America increased future loss provisions for bad loans in their second-quarter earnings reports.

The concerns triggered acute weakness in financial stocks last week, a health warning for the overall markets. The S&P investment bank and brokerage sub-index slumped 7.2 per cent and was at its lowest level since early April.