In my last blog post (The Next Market Shock Meltdown on Wall Street: a Tale of M-LECs and SIVs), I explained how a joint Wall Street/Treasury Department “super-fund” is in the works that aims to help resurrect gridlocked credit markets.
In my opinion, this initiative amounts to little more than a desperate, self-serving move to bail-out Wall Street – and try to put off the inevitable – another downside market shock in the financial sector.
Well according to an article in today’s New York Times, this financial day of reckoning may be even closer at hand.
“Collateralized debt obligations — made up of bonds backed by thousands of subprime 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 created in recent years out of Wall Street’s slicing and dicing of credit risks. CDOs are made up of thousands of individual loans (and other debt), repackaged into shiny triple-A-rated boxes, and sold 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 are the biggest buyers of CDOs, typically using off-balance sheet entities such as SIVs (see blog article above), to do the buying using 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 $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 mark-down, the value of their holdings, sometimes significantly. The result: surprise, your CDO’s are now virtually worthless.
Investors that hold the CDOs 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 article.
Simple Equation: Higher Rates = More Foreclosures = More Losses for Wall Street
As I have been saying right along, the next act of the credit crunch market shock drama is just getting underway – and this mess may take longer to play out than the typical three-acts.
Home foreclosures recently hit a 35-year high, but even though the number of foreclosure filings doubled in each of the last few months, many more adjustable rate mortgages will reset to higher interest rates over the next 18 months. 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 Ahead
How much worse can it get for Wall Street? Big banks and investment firms wrote-off about $20 billion worth of CDOs and other bad debt over the last two-weeks alone, but that’s just the tip of the iceberg.
“Investment banks issued some $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 was quoted as saying: “It’s still the early stages of a very significant stress.” Translation: brace yourself for more housing/credit related market shocks ahead!
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