So much for the idea that this summer’s credit turmoil is over. Global investors have succumbed to a new bout of jitters, with banks’ exposure to America’s crumbling subprime mortgage market back in the spotlight.
Investors have been reeling from Merrill Lynch’s admission that it is taking $8bn of losses on mortgage-related securities, a write-down twice as large as the group had forecast only a fortnight earlier. A note on Citigroup suggested the bank may have to cut its dividend to shore up its balance sheet, while Citi admitted that it is writing down a further $8bn-$11bn – dwarfing the $3.3bn charge it took at the end of the third quarter – and cannot be sure this sum will be sufficient. A Merrill Lynch note saying UBS could face an additional $8bn write-down this quarter also fuelled fears of further nasty surprises in the months ahead.
America’s Dow Jones index had its worst day since 9 August last Thursday, when US financial stocks, which comprise 20% of the S&P 500, endured a 4.6% sell-off, their sharpest in five years. Both the S&P 500 and the FTSE 100 lost almost 2% last week and kept sliding early this week, with the latter depressed by Barclays hitting a two-year low as investors fretted about its subprime exposure. Uncertainty is rife: “people just don’t know what’s on the balance sheets”, said Brian Gendreau of ING.
The trouble is that there is little consistency in the way banks do their accounting, while derivatives based on mortgages are thinly traded and hard to value. But the outlook for the value of mortgage-backed debt is worsening. The ABX index, which tracks bonds containing subprime mortgage debt (this is packaged into collateralised debt obligations sold worldwide to banks, hedge funds and other financial institutions) is the only tool available to measure sentiment in the subprime world. It shows that even the supposedly safe tranches of subprime-linked mortgage debt, rated AAA and AA, have fallen in value by 20% and 50% respectively, says the FT’s Gillian Tett.
Ratings agencies have been downgrading these securities as the news from the subprime market has grown worse. According to Barclays Capital, 16% of subprime mortgages taken out in January 2006 are in default and 28% are in arrears beyond 30 days. With low introductory interest rates on many subprime mortgage loans expiring after 12-18 months, it’s no wonder a Congressional Report suggests that over two million homes financed by subprime loans will go into foreclosure over the next 18 months. “Take this to the bank,” says John Mauldin on Investorsinsight.com: there will be more bank write-downs “as more and more mortgages go into foreclosure, forcing more downgrades of asset-backed paper”. And as the housing bust intensifies, problems will spread beyond the subprime sector. The housing bust will “hobble” any recovery in the global credit markets for months to come, says Ambrose Evans-Pritchard in The Daily Telegraph.
Mortgages aren’t the only issue bedevilling investors. Companies that insure bonds, such as America’s MBIA and AMBAC, may be hit by the subprime fallout. Many transactions – not just those linked to subprime derivatives – depend on their guarantee, so if their exposure to subprime problems led to their credit rating being downgraded, that would cut the value of bonds they insure, producing a knock-on effect across the credit market. “This panic has ‘contagion’ written all over it,” says Lex in the FT.
More broadly, mounting credit problems at banks imply tighter lending and a slower economy – which is already threatened by consumer retrenchment amid sliding house prices. The crunch has already spurred a sharp tightening in lending criteria for US businesses and households, notes Capital Economics.
Throw in declining US profits and the fact that it’s far from clear that Europe and Asia can offset America’s economic weakness, and the outlook is growing uglier by the day.