Dallas Fed President Fisher: Dead Wrong On Subprime Woes Not Spreading

Includes: AGG, DIA, SPY
by: Michael Panzner

Almost one month ago to the day, Federal Reserve Bank of Dallas President Richard Fisher suggested to an audience of Texas mortgage bankers that the fallout from the meltdown in the subprime finance sector would remain "contained," according to the Wall Street Journal. Unfortunately, based on the flurry of reports that hit the newswires over the last 48 hours, Mr. Fisher may eventually regret having giving the impression, at least, that he is somewhat out of touch with reality. Among the more notable developments:

"GM Quarterly Profit Plunges 90% on Mortgage Losses"  (via Bloomberg):

General Motors Corp. said first-quarter profit plunged 90 percent, dragged down by bad loans at the GMAC LLC finance unit and continued automotive losses in North America.

Net income dropped to $62 million from $602 million a year earlier, the Detroit-based automaker said today. Revenue declined 16 percent to $43.9 billion, largely reflecting the November sale of a majority of GMAC. GM shares fell the most in almost seven months and its bonds also declined.

GM's going to have to pay very close attention to this housing market because that's obviously a big drain on their profits,'' said Bradley Rubin, an analyst with BNP Paribas in New York. "The restructuring program did seem to help, but GM should be making money in North America by now."

"UBS Scraps Costas's Hedge Fund After Mortgage Losses," (via Bloomberg):

UBS AG, the world's biggest asset manager, is winding down John Costas's hedge-fund unit after 11 months of trading and returning client money because of losses attributed to the U.S. mortgage market.

UBS will close Dillon Read Capital Management LLC amid losses of 150 million Swiss francs ($124 million). Costas, 50, who previously ran the bank's securities unit for almost four years, gained control of the hedge fund in June 2005 as an incentive to stay. Trading started a year later. Costas will stay as an adviser to the executive board, UBS said today in a statement.

"It's been an embarrassment," Christopher Wheeler, an analyst at Bear Stearns Cos. in London, said of Dillon Read. "They never raised enough money for it to do more than break even."

UBS has been hurt by hedge funds before, losing about $700 million in 1998 when Long-Term Capital Management LP collapsed. Dillon Read was slow to start the fund and raise capital, and its challenges culminated with a shakeout in the subprime lending market, Costas said today in an interview. More than 50 lenders to the riskiest mortgage borrowers have gone bankrupt or sought buyers since early 2006, according to Bloomberg data.

"Bond Investors' Lament Fallout as Moody's, S&P Cut Ratings on Issues Tied to Subprime Loans" (via the Wall Street Journal):

More challenges are hitting bond investors who own securities backed by risky mortgages.

Over the past two weeks, Moody's Investors Service cut credit ratings on more than 30 bonds that were issued in 2006 and backed by pools of "subprime" mortgages, home loans made to consumers with troubled or sketchy credit histories. The downgrades came as more borrowers defaulted on their mortgages and caused losses to spike among the pools.

More than half the bonds that were downgraded were originally rated "investment grade" but were cut to "junk" status, because they now are viewed as much more likely to lose money. A few bonds with weak ratings already have been eroded by losses, which means investors in those bonds probably won't be repaid.

"It's unusual to see downgrades in subprime deals so soon after they were issued," said Jay Guo, a director of asset-backed securities research at Credit Suisse Group. "This is not a normal phenomenon and is a cause of concern."

The downgrades also are focusing attention on the role of credit-rating companies in the subprime downturn. Their ratings play an important part in the process of creating the bonds and in how they are valued by investors.

"It's embarrassing for a ratings company to downgrade bonds so quickly" after the bonds were issued, said Paul Ullman, chief executive of HFH Group, a New York hedge fund active in the mortgage market. "It reflects poorly on all parties in the underwriting process and their judgment of the credit-worthiness of the bonds."

The recent downgrades affected mostly bonds that were backed by speculative mortgage loans known as "second liens," including some that were made by units of troubled lenders Fremont General Corp. and New Century Financial Corp and were packaged and sold by Wall Street firms.

These second mortgages, which are taken out on properties that already have a first mortgage, are often used by borrowers to buy homes with little or no money down. Such loans are seeing high delinquencies because many people stretched themselves financially to take them out or were speculators betting on a rise in home prices. Lending standards were also especially loose last year.

Moody's Investors Service, a unit of Moody's Corp., is reviewing 81 bonds for potential downgrade, including a few with double-A and triple-A ratings, where risk was supposed to have been minimal. The ratings company lowered a handful of ratings on 2006 bonds earlier in the year, but the recent series of downgrades and reviews has affected many more bonds and has been more severe.

Standard & Poor's, a unit of McGraw-Hill Cos., has downgraded 43 bonds backed by subprime mortgage loans from last year and is reviewing more than 60 for downgrades.

Susan Barnes, a managing director in S&P's residential mortgage-backed securities group, said most of the bonds affected by her firm's downgrades were initially assigned "junk" ratings. She said S&P has been trying to be more proactive about issuing downgrades and reviews as it sees conditions in the subprime market worsen.

Brian Clarkson, chief operating officer at Moody's Corp., said his company is committed to having "the most accurate opinions out there at all times," and the recent downgrades reflect that. "When we assigned the ratings originally, we made an assessment about how we thought they would perform going forward based on the information we had," he said. "At the end of the day, it's a credit opinion and not a guarantee of how the bonds would perform."

In all, nearly $1 billion in bonds issued in 2006 have been downgraded or are being reviewed for downgrades because losses have risen in the pools of mortgages backing them. That still is a small portion of the roughly $483 billion of bonds that Wall Street created from subprime mortgage loans last year, according to data from Inside Mortgage Finance, an industry newsletter. Around $36.5 billion in bonds backed by second-lien mortgages were issued in 2006.

The ratings companies say they foresaw subprime problems last year, and around midyear began requiring larger loss-absorbing cushions for newer bonds they rated. That could limit future downgrades. They also say the majority of investment-grade bonds rated "A" and higher -- which constitute more than 90% of all subprime bonds -- should be adequately cushioned from losses.

"A Third of US Homebuilders May Be Downgraded -S&P" (via Reuters):

More than a third of all U.S. home builders are vulnerable to rating downgrades over the next two years as a downturn in the housing market lingers, data released by Standard & Poor's this week showed.

"The sector is now about one and a half years into what we believe may be a roughly three-year downturn," S&P said in a report. "Our home-builder rating bias is emphatically negative, as the sector is in the midst of an inventory correction of uncertain -- and potentially protracted -- duration."

About 13 percent of U.S. home builders were on review for a possible downgrade by S&P at the end of the first quarter, while 22 percent had negative outlooks, meaning a downgrade is likely over the next two years.

Ratings weakness is concentrated in junk-rated home builders; all eight investment-grade home builders have stable outlooks, S&P noted.

While investment-grade home builders appear to have adequate liquidity, "we will be looking for these companies to pare their inventory and demonstrate an ability to operate profitably at lower volumes," S&P said.

The U.S. housing market has been cooling off as home finance costs climb and subprime borrowers struggle to keep up with payments, raising foreclosure rates.

Pending sales of existing U.S. homes fell in March to a four-year low as a decline in subprime lending took its toll, data from the National Association of Realtors showed on Tuesday.

Maybe Mr. Fisher was only kidding, right? I can't wait to hear his next speech on the topic.