Subprime Submerging

Just as Wall Street began to dust itself off from last month’s subprime mess that left Bear Stearns begging for mercy, Standard & Poor's sent the whole stock market running for cover when it threatened to cut the credit rating of more than $12 billion in bonds backed by subprime mortgages.

S&P said it is considering such drastic actions because of evidence of increasing delinquency, default and loss on subprime home loans and the reduction of credit support, which “exceed historical precedent and our initial expectation." S&P shifted some of the blame away from borrowers by saying that loss rates have been partially fueled by “lower underwriting standards and misrepresentations in the mortgage market.”

Also on Tuesday, Moody’s Investors Service downgraded 399 residential mortgage-backed securities that were issued in 2006 and are backed by subprime mortgage loans, and placed an additional 32 under review for downgrade.

Subprime mortgages are home loans made to borrowers with less-than-sterling credit. In 2005 and 2006, toward the end of the housing boom that was fueled by the Federal Reserve's easy-money policies of the early years of this decade, significant numbers of loans were made with adjustable and low teaser rates that are just now beginning to reset. With real estate prices weakening, especially in formerly hot markets like southern Florida and California, borrowers who can't afford their loans are no longer able to get out of them by selling their properties at a profit. That is leading to defaults on home loans from which mortgage-backed securities are made, in turn reducing the credit quality of these bonds.

S&P said that it doesn’t see the poor performance on subprime loans improving and as a result it will change its rating methodology on new and existing mortgage bonds to account for an increased number of defaults and losses.

Total losses on all subprime mortgage-backed bonds issued since the fourth quarter of 2005 is 29 basis points, or 0.29% of face value. That may sound small, but it is up from 7 basis points for similar transactions issued in 2000, which until now had been the worst performing transactions in this decade, the rating agency said.

“We expect that the U.S. housing market, especially the subprime sector will continue to decline before it improves, and home prices will continue to come under stress,” S&P said. “Weakness in the property markets continues to exacerbate losses, with little prospect for improvement in the near term.” S&P said it expects losses to increase as borrowers face rising loan payments.

David Wyss, S&P’s chief economist, predicts that property values will decline 8% from 2006 to 2008.

Contributing to the subprime woes is mortgage fraud. Alleged misrepresentations on credit reports increased in 2006, according to the Mortgage Asset Research Institute. “Data quality is fundamental to our rating analysis,” S&P said. “The loan performance associated with the data to date has been anomalous in a way that calls into question the accuracy of some of the initial data provided to us regarding the loan and borrower characteristics.”

Institutional Risk Analytics’ analyst, Christopher Whalen, said that the deterioration in the subprime mortgage industry “forces everybody to look at the collateral ratings they are currently maintaining on these deals and ask if it’s appropriate.”

In certain cases, investors holding mortgage-backed bonds can sell them back to the issuers if the collateral is found to be faulty.

Mary Ann Hurley, a trader and vice president at D.A. Davidson, said she thinks Tuesday’s announcement by S&P is just the tip of the iceberg. “None of the ramifications are good for the economy and none of them are good for the bondholders or the companies involved because where there’s problems there’s usually bigger problems,” Hurley said. “Many of the people are going to be facing foreclosure. And as you have inventories rise that’s not good for the construction sector of the economy. As you have a glut of unsold homes that’s going to put lower pressure on prices. If you take away credit or make it harder to obtain that’s going to affect consumer spending.”

Indeed, the stock market suffered on Tuesday from reports that retailers such as Home Depot (nyse: HD - news - people ) and Sears Holding (nasdaq: SHLD - news - people ) were suffering from reduced purchases related to weaker housing. (See "Fixer Upper In Home Retailing" and "Sears Overdue For Maintenance" ) Meanwhile, homebuilder D.R. Horton (nyse: DHI - news - people ) cut its sales outlook and said no end to the turmoil was in sight. (See "D.R. Horton Has Subprime Pains")

One area Hurley says will be positively impacted is the Treasury bond market. “As people flee these riskier assets they are going to go into Treasuries,” Hurley said. “And if you have the economy slowing and running into bigger problems than the one it’s currently facing you’re going to have more pressure on the Fed to ease policy." Money did flow into Treasuries on Tuesday, with the yield on the benchmark 10-year issue sliding to 5.04% from 5.16% late on Monday.

Shares of the financial firms that are tied to the mortgage market spiralled at the close on Tuesday. Bear Stearns (nyse: BSC - news - people ) shares tumbled 4.1%, or $5.93, to $137.96, while Lehman Brothers Holdings (nyse: LEH - news - people ) fell 5.0%, or $3.76, to $71.10. Shares of Merrill Lynch (nyse: MER - news - people ) dropped 3.5%, or $3.02, to $82.36 and Morgan Stanley (nyse: MS - news - people ) slid 3.0%, or $2.20, to $70.46. Shares of Citigroup (nyse: C - news - people ) moved downwards 1.2%, or 60 cents, to $51.00.

source:www.forbes.com