In the News: Recent Developments

July 11, 2007

Subprime Losses Drub Debt Securities as Ratings Drop

By Caroline Salas and Mark Pittman (Bloomberg), Published in Bloomberg News / BusinessWire

— On Wall Street, where the $800 billion market for mortgage securities backed by subprime loans is coming unhinged, traders are belatedly acknowledging what they see isn’t what they get.

As delinquencies on home loans to people with poor or meager credit surged to a 10-year high this year, no one buying, selling or rating the bonds collateralized by these bad debts bothered to quantify the losses. Now the bubble is bursting and there is no agreement on how much money has vanished: $52 billion, according to an estimate from Zurich-based Credit Suisse Group earlier this week that followed a $90 billion assessment from Frankfurt-based Deutsche Bank AG.

Even the world’s second-largest company by market value must “triangulate” the price of an asset-backed bond when it gets bids from traders, said James Palmieri, who helps oversee $197 billion in investments at General Electric Co.’s Stamford, Connecticut-based GE Asset Management Inc.

“We do not foresee the poor performance abating,” Standard & Poor’s said yesterday as it threatened to downgrade $12 billion worth of securities backed by subprime mortgages. Losses “remain in excess of historical precedents and our initial assumptions,” S&P said.

Moody’s Investors Service went further, lowering the ratings on $5.2 billion of subprime-related debt. Moody’s today said it may cut the ratings on $5 billion of collateralized debt obligations backed by subprime debt.

Why Now?

More than a few investors would like to know what took the New York-based rating companies so long to discover a U.S. liability of Iraq-sized proportions.

“I track this market every single day and performance has been a disaster now for months,” said Steven Eisman, who helps manage $6.5 billion at Frontpoint Partners in New York, during a conference call hosted by S&P yesterday. “ I’d like to understand why you made this move now when you could have done this months ago.”

Eisman was referring to the rise in borrowing costs that has forced thousands of Americans to default on their mortgages.

A total of 11 percent of the loan collateral for all subprime mortgage bonds had payments at least 90 days late, were in foreclosure or had the underlying property seized, according to a June 1 report by Friedman, Billings, Ramsey Group Inc., a securities firm in Arlington, Virginia. In May 2005, that amount was 5.4 percent.

Investors depend on guesswork by Wall Street traders for valuing their bonds because there is no centralized trading system or exchange for subprime mortgage securities. Credit rating companies supported high prices because they failed to downgrade the debt as delinquencies accelerated.

Headed Lower

While there’s no consensus on prices, traders agree that the bonds are headed lower. Some of the securities have already declined by more than 50 cents on the dollar in the past few months, according to data compiled by Merrill Lynch & Co.

One subprime mortgage bond, Structured Asset Investment Loan trust 2006-3 M7, was valued at about 91 cents on the dollar to yield 9.5 percent, according to prices posted earlier this week by the securities unit of Wachovia Corp. Charlotte, North Carolina-based Wachovia today valued that security at 76 cents on the dollar for a yield of 15.9 percent, said spokeswoman Amy Jones. Merrill Lynch in New York puts the price of the same security at 67 cents to yield 18 percent.

Bear Stearns Cos., the second-largest underwriter of mortgage bonds, was forced to extend $1.6 billion of loans to its High-Grade Structured Credit Strategies Fund, one of two money- losing hedge funds, last month after bad bets on bonds tied to home loans. New York-based Bear Stearns offered to salvage the fund after creditors including Merrill Lynch seized securities held as collateral and started selling them in auctions.

Shares of Bear Stearns tumbled 4.1 percent yesterday. Lehman Brothers Holdings Inc., the largest underwriter of U.S. mortgage bonds, fell 5 percent.

UBS, United Capital

UBS AG, the biggest money manager for wealthy investors, disbanded the Dillon Read Capital Management LLC hedge fund unit earlier this year at a cost of $300 million after mortgage-bond losses. The Zurich-based company, Europe’s biggest bank, ousted Chief Executive Officer Peter Wuffli last week.

John Devaney’s United Capital Markets Holdings Inc., which invests in subprime mortgage bonds, halted redemptions in some of its funds last week so it wouldn’t have to dump holdings. The Key Biscayne, Florida-based firm oversaw $620 million in funds on March 31.

The downgrades may force sales, giving investors who have relied on estimates real prices to value their own holdings. That would be novel in the market for asset-backed bonds.

The securities, backed by everything from student loans to auto payments to mortgages, almost doubled to about $9 trillion outstanding since 2000, according to the Securities Industry and Financial Markets Association.

Masking Swings

At least a third of hedge funds that invest in asset-backed bonds pick and choose values for their investment that help mask wide swings in performance, according to a survey of 1,000 funds worldwide by Paris-based Riskdata, a risk management firm for money managers.

“If you have five different brokers you will get five different quotes, so if you don’t have an objective valuation process you can choose the quote which for you is the most interesting,” said Olivier Le Marois, chief executive officer of Riskdata. “There’s no consensus on where the market price is.”

Price transparency came to the corporate bond market in 2002, when the U.S. Securities and Exchange Commission instructed the NASD to require securities firms to report every trade over a computer network called Trace.

Wall Street Benefits

If trades of asset-backed securities were reported on a similar system, more investors could have avoided losses, said Lawrence White, professor of economics at New York University’s Stern School of Business.

“With transparency, changes in value, which will be reflected in changes in the price, will let people know sooner that their value has changed,” White said. Holders will “get taken by surprise less and less often and to a lesser extent.”

Wall Street has benefited from keeping the so-called structured finance market opaque. Securities firms collected $27.4 billion in revenue from underwriting and trading asset- backed securities last year alone, according to Kian Abouhossein, an analyst at JPMorgan Chase & Co. in London.

Investors struggle when they need to set values for subprime and lower-rated debt because the bonds trade infrequently, said Dan Shiffman, vice president at American Century Investment Management in Mountain View, California.

“If it’s a bond that requires a lot of credit work and if that bond hasn’t traded for some time, it’s very difficult to assess,” Shiffman said. American Century manages $5 billion in mortgage-backed and asset-backed bonds.

Increased Confidence

Reporting trades of asset-backed securities on a system similar to Trace may attract more investors, said Joseph Fichera, chief executive officer of New York-based Saber Partners LLC, which has advised governments and utilities on $8 billion of securitizations over the past five years.

It would increase confidence and help the market grow if it became more transparent because we would expand the number of buyers and sellers,” Fichera said. “There would also be less fear of a major repricing, a traumatizing event.

The SEC started tackling the lack of price transparency in the corporate bond market in 1992 because of concern that traders were using inside information to manipulate prices of high-yield, high-risk bonds. Former SEC Chairman Richard Breeden’s probe into junk-bond trading led to the creation of the Fixed Income Pricing Service.

Trace Objections

Arthur Levitt, who succeeded Breeden, wanted a database to collect the prices of trades on all registered corporate bonds after a 1998 review of the debt markets. The SEC concluded that transparency wasn’t an issue for asset-backed securities and didn’t include them in the Trace system. Levitt is a director of Bloomberg LP, the parent of Bloomberg News.

Investment banks objected to Trace. The Bond Market Association, the trade group representing fixed-income underwriters and dealers, said traders wouldn’t be compensated for buying risky bonds because investors adjust their bids and offers after prices are disseminated.

Bonds rated below Baa3 by Moody’s and BBB- by S&P and Fitch are considered below investment grade.


Securities firms missed an opportunity to make the asset- backed market more transparent in 2004, when the NASD proposed changing the definition of securities that would be listed on Trace. The BMA sent a letter to the NASD expressing concerns that the language could include asset-backed bonds and other structured finance products.

The NASD said asset-backed bonds wouldn’t be on Trace. The BMA merged last year to create the Securities Industry and Financial Markets Association, the leading lobbyist of Wall Street firms.

Traders in subprime and low-rated asset-backed securities may resist any move to shine a light on the trades because they benefit from having their moves kept under wraps, said American Century’s Shiffman. “They might get better execution rather than having the bonds flagged all over the market,” he said.

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