Sunday, February 18, 2007

Subprime Debt Obligations

Gretchen Morgenson has written a rather complete story about the growing failures in the subprime debt obligation market.

In the last three years, for example, big banks and brokerage firms almost doubled the amount of residential loans they issued, going to $1.1 trillion last year from $586 billion in 2003.

Many of these loans have been packaged into collateralized debt obligations and sold to pension funds, hedge funds, banks and insurance companies. For example, 81 percent of the $249 billion in collateralized debt obligation pools in 2005 consisted of residential mortgage products.

...Mortgage-related activities at the major firms generate an estimated 15 percent of total fixed-income revenue, according to Brad Hintz, an analyst at Sanford Bernstein.

...UBS said that 76 percent of adjustable-rate interest- only loans written in 2006 had low documentation, while 57 percent had loan-to-value ratios greater than 80 percent. No surprise, then, that 3.16 percent of these loans are already delinquent by two months or more.

The exposure to these debt obligations is quite widespread.

In her article, published in International Herald Tribune, Morgenson wonders why the "wreckage" in the subprime segment has not rattled capital markets more than one might expect. While Moody's Investors Service has downgraded only 1 to 2 percent of subprime loans issued from 2001 to 2006, it now appears that more mortgage back securities will be downgraded.

Relying on rating agencies to analyze the risk in collateralized debt obligations may be unwise, however. Back in May 2005, Alan Greenspan noted the complexity of collateralized debt obligations and the challenges they pose to "even the most sophisticated market participants." He warned investors not to rely solely on rating agencies to identify the risks in these securities.

Morgenson concludes with an ominous paragraph:

So far, the pain from subprime defaults has been muted. Market participants are cheered that lenders are finally tightening their loan standards, albeit a bit late. Unfortunately, the damage of the mortgage mania has been done and its effects will be felt. It is only a matter of when.

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