March 1, 2007
Calm Returns to Market, but Worries Persist Over Subprime Loans
By JENNY ANDERSON and VIKAS BAJAJ
Calm returned to Wall Street yesterday.
Encouraged by comments from Ben S. Bernanke, the chairman of the Federal Reserve, and a bounce-back in the Chinese markets where Tuesday’s global sell-off began, stocks rose modestly in the United States.
The Dow Jones industrial average, which tumbled as much 545 points on Tuesday, closed yesterday up 52.39 points, or 0.4 percent. The Standard & Poor’s 500-stock index closed up 0.56 percent, and the Nasdaq, 0.34 percent. Asian and European markets ended the day lower, but the Shanghai market climbed 3.9 percent. Shanghai opened slightly lower today. [C4]
Yet one important concern — that Wall Street’s bet on home loans to people with weak, or subprime, credit is souring quickly as defaults rise and home prices weaken — has not gone away.
Wall Street executives and analysts acknowledged that the subprime segment of the mortgage business has faltered because of the performance of loans issued in 2006, but many contend that the problems are well contained and do not yet pose a significant threat to investment banks or the broader global financial system.
Cracks have become more visible lately, however. Insurance premiums on the potential default of Wall Street bonds have risen sharply, indicating possible concern among bond traders about potential exposure.
“It is impossible to get a number” on big investment bank’s exposure to subprime loans, said Richard X. Bove, an analyst with Punk Ziegel & Company. “And I don’t think they even know.”
The cost of insurance against potential bond default on Bear Stearns’s debt, for example, increased 40 percent recently, from about 22 basis points in mid-January to more than 31 on Tuesday, according to Lehman Brothers data.
Insurance costs for major firms with exposure to the subprime market, like Lehman Brothers, Morgan Stanley, Goldman Sachs and Merrill Lynch increased similarly. Brad Hintz, an analyst with Sanford Bernstein, said investors are increasingly concerned about Wall Street’s exposure to that market.
Investors, while heartened yesterday by Mr. Bernanke’s prediction of moderate economic growth, have had a revolving list of concerns: a slowing economy, oil prices and accelerating inflation. But now a major concern is whether the problems of subprime lending will spill over into the broader mortgage market, which at $6.5 trillion at the end of 2006 is the biggest bond market.
During the housing boom, Wall Street developed a series of profitable connections to the subprime market that included providing financing to companies that made loans to homeowners, buying finished mortgages, packaging them into bonds and then trading them. Last year, the subprime business generated $600 billion in loans, about 20 percent of all mortgages written, according to Inside Mortgage Finance. While down slightly from 2005, that is up from $120 billion in 2001.
Wall Street now faces risks on two fronts. First, it stands to earn less from originating, packaging and trading mortgage-backed securities. Second, it will have to absorb more of the losses from loans when borrowers are no longer making payments.
In the past, it could demand that mortgage companies buy back defaulted loans, but such large “put back” requests have driven many lenders out of business, and big investment banks are making many more loans through subsidiaries they own. As a result, the banks retain more of the risk in the form of “residual” interest in the loans they bundle into negotiable securities, a process known as securitization.
“The brokerage firms have done something curious: they are not abandoning subprime mortgage origination; they are taking positions,” Mr. Hintz said.
In December, Merrill Lynch completed a $1.3 billion acquisition of First Franklin, which was among the 10 biggest subprime lenders last year, and Morgan Stanley bought Saxon Capital for $706 million.
Bank executives say they anticipated the problems in subprime and they have been buying lenders because they want to better control lending standards in the industry.
“Saxon was a long-term strategic decision,” said Anthony Tufariello, who heads the securitized product group at Morgan Stanley. “And we are happy we made that decision because we bought it as a servicing platform with the expectation that the market would undergo dislocation.”
And the deal-making continues. Citigroup said that it would provide working capital and a credit line to ACC Capital Holdings, which owns Ameriquest and Argent Mortgage. Although the terms were not disclosed, it includes an option for Citigroup to acquire Argent, which lends through mortgage brokers.
By some estimates, the potential risks to the big banks are relatively modest. Mr. Hintz, of Sanford Bernstein, calculates that Lehman Brothers had $7.3 billion in residual risks at the end of 2006, $2 billion of it in noninvestment grade mortgages. If the noninvestment grade residuals decline by 20 percent, Lehman’s earnings would decline 3.2 percent after taking into account compensation costs and taxes; Bear Stearns’s income would fall about 4.1 percent.
A Lehman spokeswoman declined to comment on her company’s mortgage business.
Not all analysts are as sanguine.
Guy Moszkowski, an analyst with Merrill Lynch, downgraded Goldman Sachs, Bear Stearns and Lehman based on the erosion of risk appetite among its customers and because he believes the problems of subprime lending are spreading to “Alt-A” mortgages, which fall between subprime and prime and accounted for about 13 percent of loans written last year.
Investment banks entered the subprime market because the loans generated high yields, making them popular among pension funds, insurance companies, hedge funds and foreign investors. On the other side of the food chain, small mortgage companies and brokers stood ready to feed Wall Street with loans. The banks supplied the cash for the loans, and agreed to buy the loans from them.
The business generated multiple lines of income for Wall Street, including underwriting and trading. By 2005, the residential mortgage-backed securities market was generating 15 percent of fixed income revenues, and the subprime sector was bringing in 3 percent to 4 percent of fixed income revenues, Mr. Hintz said.
Lehman, RBS Greenwich Capital Markets, Morgan Stanley and Merrill Lynch were the biggest underwriters of mortgage-backed securities in 2006, with Lehman controlling 10.7 percent of the market and underwriting $51.8 billion worth of mortgage-backed securities, according to Inside Mortgage Finance.
For some analysts, the bigger risk to Wall Street is simply that the spigot has been turned off.
“Does the flow of mortgages to the securitization machine slow?” asked Jeffrey Harte, an analyst with Sandler O’Neill. “That’s what I’m most worried about.”
Volume is falling. Production of nonagency mortgage securities fell almost 50 percent between January and February, according to preliminary numbers compiled by Inside Mortgage Finance. The data indicate that new subprime and Alt-A loans fell significantly in February.
But Wall Street seems to believe it will come out on top, surviving where smaller players lacked the resources. “The economics of the business are moving in favor of well-capitalized entities who don’t have to go outside” for other services, said Gyan Sinha, who heads asset-backed securities research at Bear Stearns.
One gauge of the subprime business is an index that tracks bonds backed by subprime loans, the ABX.HE. The index for loans issued in 2006 has fallen sharply in two months. Its price is used to calculate the cost of insuring the bonds from losses.
On Tuesday, the cost to insure a low-rated, “BBB-” portion of the bonds jumped to nearly $1,983 for $10,000 of bonds, from $1,641 on Monday and $410 at the end of December, according to the Markit and CDS IndexCo. The index, which was little changed yesterday, tracks the performance of 20 mortgage bonds, or pools, and provides a snapshot of complex market.
Each mortgage pool is broken into a number of tranches, which carry different risks and rewards for investors. Portions rated “AAA,” for instance, carry the least risk and provide the smallest return; investors in these pools also get paid off first when borrowers repay their loans. The riskiest portions of the debt, or the residuals, are often held by the mortgage companies that issued the loans or the Wall Street firms that underwrote the bond.
The big banks’ optimism is based in large part on the structure of these bonds. For one thing, most bonds collect more in interest payments than they are obligated to pay out. They also include a cash reserve, or residual, that can be dipped into if interest payments fall short because of defaulting borrowers.
“You can have a pretty long period of stress before you start to see actual write-downs,” said Anthony V. Thompson, who heads research of asset-backed securities at Deutsche Bank Securities.
Much depends on the strength of these bonds’ structure, which is determined largely by agencies like Moody’s Investors Service, Standard & Poor’s and Fitch Ratings.
Skeptics say that Wall Street’s faith in complexity has proved wrong before, most recently in the meltdown of the manufactured housing, or trailer home, market. The business boomed in the early and mid-1990s before collapsing in the late ’90s when many buyers of the homes defaulted.
“These credit corrections are not unexpected,” Mr. Thomson said. “What’s harder to predict is the precise moment when the market decides to reprice the risk.”