On Friday, credit-rating firm Moody's Investors Service slashed ratings on 131 bonds backed by pools of speculative subprime loans because of unusually high rates of defaults and delinquencies among the underlying mortgages. The ratings company also said it is reviewing 247 bonds for downgrades, including 111 whose ratings it had just lowered. All the bonds were issued as recently as last year.
The latest moves by Moody's affected around $3 billion worth of bonds, which represent less than 1% of the over $400 billion in subprime mortgage-backed bonds that were issued in 2006. Still, it was the most aggressive action taken yet by any of the ratings companies -- which some critics say have been slow to address the housing downturn -- and could weigh on the already fragile subprime bond market. Some investors may be forced to sell bonds whose ratings were cut to "junk" from "investment-grade," and some may have to write down the values of the downgraded bonds in their portfolios.
There's good and bad news in this report. The good news is it only effects less than 1% of the sub-prime market. The bad news is this is the first wave of downgrades which is probably going to increase over the coming year.
This move by Moody's may be the start of a second wave of problems in the sub-prime market. The first occurred earlier this year when there was a wave of bankruptcies in the lender section of the sub-prime market. This move by Moody's may be the first shot in a second wave of problems focusing on the investor segment of the sub-prime market.
The index which tracks the sub-prime market is taking a tremendous hit:
On Friday, an index that tracks risky subprime bonds plunged to an all-time low of 60.95. The ABX index was above 97 at the start of this year. In February it dove to a low of 62 before rebounding somewhat to 72 by mid-May.
"Negative sentiment took a firm hold of the [subprime bond] market" this past week, J.P. Morgan analysts said in a report Friday. "We think the weakness in the ABX will continue." The analysts also noted that the recent steep rise in yields on 10-year Treasury bonds, which in turn pushes up long-term mortgage rates, would make it difficult for subprime borrowers to refinance into fixed-rate loans.
Data from the Mortgage Bankers Association last week showed a record number of homeowners entered the foreclosure process during the first quarter. Delinquency rates on subprime loans have soared to 13.77% from 11.5%, and the association's chief economist, Doug Duncan, said delinquencies will peak only later this year, while foreclosures may not peak until next year.
Predictions of a peak in the housing market decline have been very wrong. I tend to think that the problems won't stop even early next year.
The good news here is this is a situation that is ripe for vulture investors -- investors who buy assets that are clearly in trouble with the intention of making a profit further down the line. Right now securities in the sub-prime market are getting cheaper and cheaper. I would guess they would start to make money in say 5 years or more. An investor with that kind of time line and the patience to wait that long is going to find some excellent deals in this market right now. The question then becomes when will these investors start to buy and and at what level.