The inevitable next step in the US subprime mortgage turmoil may be very nasty indeed. Investors should not forget about the potential regulatory and prosecutorial backlash emerging from the US subprime mortgage meltdown — this time aimed at credit rating agencies and investment banks, says CLSA’s Christopher Wood, in his weekly client newsletter, Greed & Fear.
Some sources report that the FBI now has 100 agents devoted to investigating mortgage fraud, he says, and Greed & Fear “also heard one US state prosecutor in a TV interview openly accusing credit rating agencies and investment banks of being participants to fraud”.
The conclusion has to be that this whole area “can get a lot worse before it gets better”, says Wood (among many others).
Meanwhile, he reminds us, “the political pressures in America will be to exercise forbearance on subprime borrowers, not to bail out owners of mortgage-backed securities”. Forbearance is, obviously, negative for owners of such securities, he adds.
Indeed, it is abundantly clear that the news surrounding the US housing market and related structured finance continues to get worse, and that “this area represents the main risk for equities for the rest of the year”, says Wood.
In the area of mortgages, he notes, “Moody’s has begun to put tranches of Alt A mortgages on review for possible downgrade. Nearly all of the tranches, or 96 per cent of them, are backed by adjustable-rate mortgages (ARMs)”.
Greed & Fear mentions this “because it is evidence that the mortgage problem will not be confined only to subprime. ARMs that reset form a significant part of the Alt A category that is the ‘middle market’ segment of the mortgage-backed securities market between prime and subprime.
“Clearly, the above problem will go away if house prices start rising again”, says Wood. But this is not Greed & Fear’s view — nor that of many other market watchers.
“All the evidence is that the liquidity flow to the market place is ebbing away as investors become less keen to buy exotic mortgage product, not to mention issuers becoming less keen to issue the stuff”, he says.
“Negative equity is also kicking in, removing the ‘refi’ option. There is also the reality that lenders have tightened underwriting guidelines”. Not to mention the fact that “more than $60bn of subprime loans are due to reset in the next five quarters, with the biggest burden of these resets occurring in the next three quarters.”
All of the above, then, is why Wood says he will be “amazed” if the Fed raises rates this year, though there is scope for a rogue “headline inflation” number to cause a brief inflation scare.
There are several other things that would also “amaze” Greed & Fear: 1) If the 2007 second half does not see more of an economic growth scare relating to the US consumer; 2) If the fallout from the subprime lending crisis and the CDO market “does not contaminate other kinds of leveraged credit, most particularly CLOs”; and 3) If the continuing fallout from structured credit “does not lead to renewed concerns about particular financial institutions”.
Wood says he is not predicting a full-scale systematic crisis, but rather, pointing to concerns about such a crisis.
Greed & Fear is “aware that most equity fund managers cannot short credit spreads”. But they should be making an effort to do so, says Wood, as this remains “by far the most sensible way to hedge an equity portfolio”.
For these are exceptional times, he notes. And that may well mean an “unwinding of a global credit bubble every bit is as insane in its own way as the TMT stock mania in 2000.”
True, the great credit unwind may never hit stocks in 2007. But, then again, it may.
Meanwhile, says Wood, the ABX Index measuring tranches of subprime debt is now at 30.2, down 22 per cent in the past three weeks and down a total of 60 per cent since February 16. As for the spread on the LCDX index, an index of credit default swaps on leveraged loans, it has risen by 174bps to 279bps since the index was launched on May 22 and is up 87bps over the past three weeks.
This, he says, “is evidence of credit contamination”. And possibly (we say), the beginning of an “insane” unwind of the global credit bubble.
