The US “subprime” mortgage market can still draw a crowd, but these days it is for all the wrong reasons.
A recent briefing at Bear Stearns’ offices in New York filled more than 700 seats in the auditorium, while a further 1,000 people listened over the internet. Those present repeatedly raised concerns over the extent and severity of potential losses for structured financial products resulting from the turmoil in subprime mortgages.
A dramatic increase in late payments and defaults on mortgages made to borrowers with patchy credit histories has sent the stocks of mortgage lenders into a tailspin in recent weeks, resulting in several bankruptcies and a tightening of lending standards. It has also raised the spectre of a more widespread housing downturn.
It has also asked testing questions of one of Wall Street’s most profitable businesses – packaging mortgages into complex securities that are then sold on to investors.
Structurers of collateralised debt obligations (CDOs) – vehicles used to repackage portfolios of other debt – were among the biggest buyers of bonds backed by pools of subprime mortgages in recent years, in turn issuing securities with a range of different credit ratings to investors around the world.
The recent woes of the subprime mortgage market have therefore caused ripples of concern beyond traditional mortgage investment circles about where the risks lie. Some estimates put the value wiped off CDOs in this space at up to $23bn.
“The question is: ‘Who owns all this securitised paper?’,” says Douglas Peta, market strategist at J&W Seligman & Co. If these subprime holdings are concentrated among investors such as pension funds or insurers, “another segment of the market will face a problem”.
Issuance of cash CDOs grew to $486bn last year, up from $212bn in 2005, according to industry publication Creditflux. The biggest category of deals, at 44 per cent, consisted of CDOs backed by asset-backed securities such as those backed by subprime mortgages.
According to CDO data from rating agency Standard & Poor’s, subprime and the slightly less risky Alt-A mortgage-backed securities (MBS) accounted for 55 per cent of the assets underlying these CDOs last year.
More definitive data on the market’s breakdown is difficult to obtain because CDO deals are often private transactions that might not be rated. But these figures suggest that a conservative estimate for subprime mortgage exposure in the CDO market would be about $100bn. And this is before taking any account of subprime exposure in CDO structures built using derivatives of mortgage-backed bonds rather than the actual bonds.
Timothy Geithner, president of the Federal Reserve Bank of New York, said on Friday that recent innovations should make financial markets “more efficient and more resilient”.
But the complexity of new credit instruments could present challenges. “Even the more sophisticated participants in the markets find the risk-management challenges associated with these instruments daunting. This raises the prospect of unanticipated losses.”
Josh Rosner, managing director at investment research firm Graham Fisher & Co, says that understanding CDOs is challenge – even for regulators. “Eeven financial regulators are hampered by the opacity of over-the-counter CDO and MBS markets, where only ‘qualified investors’ may peruse the deal documents and performance reports.”
Even if regulators had a “qualified investor” designation, they would need permission from each issuer to view deal performance data.
Tim Speiss, head of private wealth advisory at accountancy firm Eisner, says some investors are anxious that they may be in the dark about the extent to which the funds could be exposed. “It’s an issue of disclosure, investors really need to get clarity from their fund managers about how much exposure they have to subprime debt.”
Part of the problem for investors trying to gauge the impact of the subprime market’s problems on their CDO investments is that CDO managers generally report the original cost of the portfolio to investors rather than its market value.
This means that, as losses on subprime and Alt-A mortgages have escalated, so the market value of the bonds underlying the CDOs has deteriorated, as has the market value of the CDOs – but their reported portfolio valuations have not.
Analysts at Lehman Brothers estimate that up to $23bn has been wiped off the market value of CDOs backed by structured finance this year, but those losses will not be realised in portfolio valuations unless investors decide to sell.
Bankers say CDOs do not automatically report such losses because the return in most deals depends on cash flows, not on market value of the underlying assets. In principle, CDO returns are only affected by actual defaults, which halt the cash flow used to pay investors.
But there is a fly in this ointment. Large numbers of investors, such as pension funds and insurance companies, are only permitted to hold securities with investment grade ratings.
Mr Rosner says: “Because many buyers of senior CDOs can only hold investment grade assets, they may continue to hold deteriorating, increasingly illiquid assets as long as their ratings have not been downgraded.”
If mortgage market deterioration becomes severe enough to produce downgrades of CDO securities to non-investment grade, these investors could be forced to sell – at much lower prices than many might expect.
Mr Rosner warns that widespread downgrades to junk status could exacerbate losses as large numbers of investors head for the exit at the same time. “Because the market is [privately traded], investors may incorrectly value these assets in their portfolio and be forced to recognise large mark-to-market losses in a fast-moving liquidating market,” he says.
The rating agencies remain relatively calm about the risks of widespread CDO downgrades. Kevin Kendra, head of the CDO group at Fitch Ratings, said most CDOs were well-insulated from subprime problems.
This is because the underlying mortgage-backed securities tend to have built-in protections that are activated when mortgage defaults hit levels that put the security’s cash flows at risk, he says. The CDOs in turn then have similar protections that are activated if the MBS deterioration is more serious.
But a new report from Moody’s Investors Service to be released on Tuesday shows that certain CDOs could be more severely affected.
Moody’s tested how a variety of CDO ratings responded to stress in subprime mortgage-backed securities. The analysts found that the effects were “mild to moderate” for structured finance CDOs with average exposure to subprime mortgage-backed securities – about half of the underlying portfolio – with even riskier layers of the CDO facing downgrades by only a few notches. But the impact could be “severe” for the most heavily exposed deals.
Additional reporting by Michael Mackenzie
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