Thursday, October 25, 2007

Ouch! $20 Billion????!!!!

Wall Street Takes a US$20 Billion Hit...and Counting
Today's comment is by Mike Burnick, our Senior Editor and Global Markets Analyst, and editor of Market Shock Trader. Dear A-Letter Reader,The hot topic de jour right now is the joint Wall Street/Treasury Department proposal for a "super-fund" to help resurrect the gridlocked credit markets.In my opinion, this initiative amounts to little more than a desperate, self-serving move to bailout Wall Street. The industry players involved are trying to put off the inevitable - another downside market shock in the financial sector.Well according to an article in the New York Times, this financial day of reckoning may be even closer than you think. "Collateralized debt obligations - made up of bonds backed by thousands of sub-prime home loans - are starting to shut off cash payments to investors in lower-rated bonds as credit-rating agencies downgrade the securities they own." Collateralized debt obligations (or CDOs) are just one of the many derivative securities Wall Street created in recent years as they sliced and diced credit risks. CDOs are made up of thousands of individual loans (and other debt). Wall Street then repackages these loans and other debt in shiny triple-A-rated boxes, and sells them off to investors around the world.
Some CDOs May Become "Largely Worthless Overnight"Pension funds, hedge funds, insurance companies and the big banks and investment firms themselves are the biggest holders of CDOs. These companies typically use off-balance sheet entities such as SIVs (see my wealth comment from yesterday), to buy CDOs with lots of leverage.Up until now, investors holding these CDOs have mostly been getting paid on time - but not anymore. "On Friday, Standard & Poor's lowered the ratings on US$22 billion in bonds backed by mortgages made to people with weak credit in 2006," according to the article. What triggered this downgrade? You guessed it; "continued deterioration in the housing market." Another ratings agency Moody's, took the same action in downgrading "a similarly large group of bonds earlier in the month."
When such a downgrade takes place, investors in these CDO securities are forced to markdown the value of their holdings, significantly in some cases. The result: Surprise! Your CDO's are now virtually worthless. The CDO investors that are impacted by downgrades "may be forced to write down mortgage investments beyond the billions they have already written off. Some bonds, for example, may go from being valued at, say, 70 cents on the dollar to becoming largely worthless overnight," according to the Times.
Simple Equation: Higher Rates = More Foreclosures = More Losses for Wall Street As I have been saying since August, the next act of the credit crunch market shock drama is just getting underway. This mess may take longer to play out than the typical three-acts.Home foreclosures recently hit a 35-year high. But even though foreclosure filings have doubled on a year over year basis for the past several months, many more adjustable rate mortgages will reset to higher interest rates next year and beyond. In other words, the worst of the housing recession still lies ahead. Inevitably, this will trigger more foreclosures, leading to even higher mortgage loan losses and more Wall Street write-offs. It's a vicious cycle with no clear end in sight!
We're Still in the "Early Stages" of this Credit Crunch with More Market Shocks AheadHow much worse can it get for Wall Street? Big banks and investment firms wrote-off about US$20 billion worth of CDOs and other bad debt over the last two weeks alone. That's just the tip of the iceberg. "Investment banks issued some US$486 billion in debt obligations linked to mortgages in 2006 and the first half of 2007," according to the Times. So far, only a small fraction of these securities have actually been downgraded by S&P and Moody's. An official at one of the credit ratings agencies said: "It's still the early stages of a very significant stress." Translation: Brace yourself for more credit related market shocks ahead!

No comments: