July 26, 2007
It Never Was Just Subprime
So now the dissecting of today's market jitters begins, and there is no shortage of diagnoses. Today's data releases -- described here, here, and here, for example -- were certainly not great, but the most popular explanation seems to be that market players have developed a newly found sense that the world is a risky place. Barry Ritholtz sums it up nicely:
The Dow is off 395 points as I type this. There will be some short covering shortly, and a rally attempt. But what I want to address is the change that has taken place:
What has changed? What is different today than yesterday? Are the prospects of the economy and/or corporate profits so different today than they were merely a week ago?
What has changed is Credit: Risk appetite for anything less than AAA -- and that includes the ABX stretched definition of AAA (see WTF is going on in the ABX Markets?) -- has waned considerably.
The tinder, if not the spark, for the flare-up of credit concerns was this week's revelation from the mortgage lender Countrywide Financial that loan problems extend well beyond the subprime borrower. From the Wall Street Journal (page C1 of the July 25 print edition):
By laying the blame for its earnings shortfall on rising defaults of prime home-equity loans -- many taken out by people who were straining to afford a house and didn't fully document their income -- Countrywide undermined the popular notion that only subprime borrowers are falling behind. And that could have a broad, negative impact on lenders' stocks.
And from from Joanna Ossinger's column at the WSJ Online:
Credit-market woes are partially rooted in the subprime-mortgage sector, which has been a source of market angst for months. But recently the problems have become more acute, as hedge funds invested in mortgage-backed securities have struggled and as default rates have risen, even among prime borrowers. Banks have been hurt by having to take loans onto their balance sheets instead of passing them on to outside investors. And major private-equity acquisitions have struggled to find financing, possibly removing one long-standing support for the market.
It "all goes back to weakness in the mortgages," said Larry Peruzzi, equity trader at Boston Company Asset Management.
But a closer look at the Countrywide development is instructive, as it reveals that the source of the problem is, not surprisingly, non-conventional types of loans. Again from the WSJ article:
Many of the home-equity loans that are going bad are "piggyback" loans to borrowers who took out a second mortgage because they couldn't afford a large down payment and didn't want to pay for mortgage insurance.
Now, with home prices falling in many areas, some borrowers owe more than their houses are worth. That is forcing Countrywide and others to increase provisions against losses.
Another concern is the $27.78 billion of pay option adjustable-rate mortgages held on the books of Countrywide's banking arm. These loans allow borrowers to pay no principal or less than full interest each month. If they choose that option, their loan balance grows. Payments are now overdue on 5.7% of these loans held by Countrywide, up from 1.6% a year earlier.
But here's the thing -- we surely have known for a while now that the building stress in mortgage markets is not a prime vs. subprime thing, but conventional-loan vs. non-conventional loan thing:
What seems like fresher news to me is the growing skittishness in credit markets that are not so clearly associated with the housing sector. From the Financial Times:
Stock prices plunged on Thursday amid a flight from risky credits and fears about banks’ growing exposure to leveraged buy-out debts...
Investment bank stocks led the market lower on worries that they will have to use their balance sheets to fund private equity deals. The S&P investment bank index was down 5.3 per cent.
Concerns about the possibility of a credit contraction were exacerbated this week when banks gave up attempts to sell to investors $20bn of debt for the leveraged buy-outs of Chrysler and Alliance Boots, the UK retailer.
A Financial Times analysis shows that in recent weeks, bank balance sheets have absorbed more than $40bn of high-yield debt for buy-out deals that was meant to be sold to investors.
So you have your pick -- weak economic news, a broadening of housing market woes, a fading corporate debt market. Or just choose all of the above and keep your fingers crossed that it's only a bad week and not a perfect storm.
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