Credit agencies are signalling that problems in the U.S. mortgage-backed securities market could be getting worse.
Standard & Poor's Corp. warned yesterday that it may lower its credit ratings on $12.1-billion (U.S.) of residential mortgage-backed securities (RMBS) backed by U.S. subprime mortgages.
The news prompted a major drop in the benchmark derivative index that measures subprime credit risk, sending it to a record low, and prompted a flight to quality with U.S. Treasuries posting their biggest advance since February.
At least one market watcher early in the day suggested that other rating agencies will follow suit if S&P does downgrade the securities it put on credit watch.
And that did happen. Late yesterday, Moody's Investors Service Inc. cut its ratings on $5.2-billion of RMBS after defaults on the underlying loans came in higher than expected. Moody's lowered its ratings on 399 subprime RMBS issued last year and put another 32 on review for a possible downgrade.
S&P Ratings Services announced that it had put credit ratings on the 612 classes of the RMBS on credit watch with negative implications. The affected classes total about $12.1-billion in rated securities, or about 2.13 per cent of the $565.3-billion in U.S. RMBS rated by S&P between the fourth quarter of 2005 and the final quarter of 2006.
"The [credit watch]actions are being taken at this time because of poor collateral performance, our expectation of increasing losses on the underlying collateral pools, the consequent reduction of credit support, and changes that will be implemented with respect to the methodology for rating new transactions," S&P said in a report.
If S&P goes ahead and cuts its ratings, some bond holders will likely dump the affected securities, because they can only invest in investment grade issues, a move that would exacerbate the problems in that area.
The problems were highlighted recently by heavy losses at two Bear Stearns hedge funds that made bad bets on RMBS backed by subprime loans.
Subprime mortgages are loans made to individuals who might not otherwise have qualified for a mortgage.
The idea behind them was that housing prices would continue to rise, so making the payments should not be a burden.
For several months now, some market observers have worried that the trouble in the subprime mortgage area could spread beyond the housing sector and into the U.S. economy.
The jury on that appears to be still out.
Richard Bernstein, chief investment strategist at Merrill Lynch & Co. Inc., said in report yesterday that he expects the unwinding of the excessive lending that led to the housing bubble will likely be a problem for a long time, but that "as long as the U.S. employment picture remains healthy, the spread of the subprime problems could be slower than most expect."
However, his forecast of U.S. housing prices is likely to heighten worry over the situation.
He suggested in his report that "home prices are unlikely to appreciate from today's valuations over the next 10 years."
Meanwhile, Quincy Tang, senior vice-president, U.S. structured finance RMBS, at Dominion Bond Rating Service, said that his company rates only a relatively small percentage of the U.S. subprime RMBS deals and as such, it can look at each deal it has rated every month.
"We do not follow what other rating agencies have done; we make our decisions based on our own analysis," she said.
S&P also said yesterday that it is reviewing ratings on collateralized debt obligations (CDO) where the underlying portfolios contain any of the RMBS securities on credit watch.
The popularity of the subprime and other low-quality mortgage loans allowed the CDO market to explode in the last few years.
All the concern about the RMBS and CDOs put the skids under U.S. brokerage stocks yesterday as investors fretted that the downgrades on the RMBS securities could hurt the firms' mortgage bond business and lower trading profits.
Lehman Brothers Holdings Inc., the largest underwriter of mortgage bonds, fell the most, dropping $3.76 to $71.10. Bear Stearns, No. 2 in that business, slipped $5.93 to $137.96.
The news also sent the ABX 2007-1 triple-B-minus, a derivative index that refers to the risky residential mortgages written in the second half of 2006, tumbling.
It plummeted four points to 51.42 yesterday, bringing the decline in that index since the start of this year to almost 50 per cent.
Some investors decided yesterday that they preferred the safety of U.S. government issues and pushed the price of the Treasuries up and the yield down. The yield on the benchmark 10-year Treasury slipped 12 basis points to 5.021 per cent.