Debt Market Woes: ARMs Are The Next Shoe To Drop

Includes: BX, CM, FIG, IAI, IYG
by: Mark McQueen

Yesterday, Moody’s and S&P awoke from their summer slumber and swung into action, downgrading (or placing under review, likely for later downgrade) billions of investment grade bonds backed by subprime mortgages.

With 1) delinquency rates above 13% at the end of 2006, and 2) tens billions of $ of currently performing subprime U.S. mortgages about to hit their rate reset date, downgrading seems like an appropriate - if embarrassingly tardy - thing to have done. Some of the downgrades hit bonds backed by mortgages issued by firms (Fremont Investment & Loan and New Century Mortgage Corp., for example) that had gone in the tank months ago.

You’ve got to be a rosy credit analyst to think that a lending firm can go bankrupt due to issues with their loan customers and funders, but that loans provided by the defunct firm aren’t worth a review (see our post “Sub prime market not so sublime“, March 12-07) around the time of the lender’s own tipping point.

The bonds downgraded (or placed under review) by Standard & Poors include three that were previously rated AA, and 88 that were formerly in the A category. More scary for the pension fund crowd are the 366 that were formerly BBB-rated, which in many cases means that the bond in question is no longer “investment grade” if it is dropped two notches (from BBB to BBB minus to BB+). This will ensure that some funds might be forced to sell, by the terms of their investment policy, these formerly BBB-rated bonds once they slide to sub-investment grade status.

How much fun will it be for a Fixed Income portfolio manager to get 60 or 70 cents on the dollar for a higher risk mortgage-backed bond they bought a year or two ago from a U.S. bulge bracket investment bank in the hopes of earning, maybe, an additional 50 bps over what would have been available had they purchased the A-rated product? Moody’s downgraded just 1.2% of the subprime bonds issued (and rated by them) in 2006, for example, so don’t expect total carnage on the fixed income desks just yet. But with billions of BCE bonds underwater, and CDO bonds still to be re-rated, some PMs may well be having a miserable summer.

Here’s the rub; some of the more conservative fixed income desks strive to earn maybe 100 basis points a year above the “risk free” rate on their portfolio of bond investments. If that pool of assets is, say, $2 billion at a smaller pension fund, that’s a target of $20 million of annual profit above what you would have made for your pensioners had every single dollar been invested in government bonds (being the risk free rate).

If you had allocated merely 1.5% of your portfolio ($30 million) to these higher-yielding mortgage bonds, and the bids drop to 70 cents on the bonds that were formerly BBB rated - and are now sub-investment grade - a huge portion of that $20 million of targeted annual yield profit (ie., above the risk free) just got wiped out.

To make matters worse, according to the WSJ, S&P hasn’t yet announced any new ratings on CDOs backed by subprime mortgages. It would be utterly impossible for there not to be more downgrades.

As you’ve read here since we began our corporate blog last September, the debt market has not been pricing for risk across the entire spectrum. The spreads on junk bonds are half what they were a few years ago; not enough has changed in corporate America to warrant such a notional improvement in credit risk. The trend that began a few days ago might be taking hold, as Swift & Co. had to pull their US$600 million leveraged bond offering on Monday due to a lack of market appetite (see prior post “LBO debt spreads widen, PE deals looking rocky“, June 29-07).

If US$50 billion of adjustable rate mortgages are due for 2.0% rate increases this summer, and housing prices are no longer rising (which allowed folks to re-fi, taking out a larger mortgage and use the cash to make their monthly payments), and the cost of living feels like it is going up each day (property taxes, gasoline, etc. are all up in excess of inflation/wages over the past 12 months), where’s the US$1 billion for increased annual servicing costs going to come from for Joe & Jill Homeowner?

And Moody’s has just downgraded merely 1.2% (!) of their 2006 subprime bond ratings, while across town S&P found fault with but 2.13% of the “residential mortgage-backed securities that S&P rated between October 2005 and the end of 2006.”

With billions of more loans going up in price this summer, you’d have to think that more downgrades are coming in both with the CDO and MBS markets.

Who wants to buy a bond fund right now? Not me.

And that’s not the only collateral damage. CIBC (NYSE:CM), for example, strongly denies rumours of a large subprime exposure and still sheds over $500 million of market cap. And that rumour was weeks old before Barrons picked it up last weekend.

This is the reality of the capital markets. Despite all of the positive news in the equity markets, the debt markets are starting to pull them down. It’s as if people are looking for reasons to sell stocks, and few equity securities trade more in sympathy with each other than banks.

Then there are the new plays. Fortress (NYSE:FIG) is down US$5 over the past 3 months and Blackstone’s (NYSE:BX) H/L range is already a remarkable $10 after just a few days of trading: US$38 and US$28.75 (although it recovered a bit to trade above US$29).

What are the odds that financial services stocks will be trading higher on Labour Day than they are right now?