Friday, July 06, 2007

Default Overhangs

Bloomberg is reporting that Credit Suisse is anticipating a further increase in defaults and other trouble mortgages in the future.

``It's naïve to assume the worst is past us in the U.S. subprime market,'' Parker said at a bond market conference today in Hong Kong. ``At least over the balance of this year, the subprime default rate will rise.''

The question is whether or not the problems are contained within the subprime market and the related security fields such as the CDOs that kicked Bear Stearns' ass last month, or if the problem is getting larger. Credit Suisse is arguing that the problem is relatively contained in the subprime markets, and we'll see little spillover.

Calculated Risk is linking to an opposing view by Northern Trust in which they believe that the reduction in mortgage equity withdrawals due to the combination of higher/tighter lending standards and less real equity available due to declining prices are squeezing consumers:

Light motor vehicle sales in the U.S. dropped 3.4% month-to-month in June to a seasonally adjusted rate of 15.6 million units. Excluding the Katrina-depressed sales of September 2005, the June 2007 sales rate was the slowest since September 2002. Light motor vehicle sales have declined sequentially for six consecutive months.....

The question the markets and the Fed will be wresting with over the remainder of summer is whether the sharp deceleration in Q2 real consumer spending is a one-off event or something with more longevity. My bet is the latter. The ongoing housing recession is sharply reducing one source of funding for household deficit spending – mortgage equity withdrawal (MEW). The continued decline in home prices and the tightening of mortgage underwriting standards will exacerbate the drying up of MEW. Job growth also is trending lower, which will restrain future consumer spending.

EconPhenom has a handy pointer to a Credit Suisse Report on the timing and size of the debt resets.

Just eyeballing the chart, we are in the middle of a large wave of debt resets. Consumer wages are at best keeping even with inflation, and the labor market is putting up job growth numbers sufficient to track population growth but not significantly increase workforce participation rates. The marginal consumer and marginal borrower is stretched pretty hard right now and there are minimal real wage gains. Interest rates have been increasing in both the short term and intermediate term. Kash at the Street Light has two great graphs that illustrate this point. He is tracking overall US government bond interest rates which sets the risk free rates of return and all other bonds and securities are priced in relationship to the T-bills, and then he has a shorter series on the implied real interest rates which strips out the inflation expectation.

I think that we'll be seeing a continued overflow from the subprime market, as most of the secondary investors who have subprime exposure also have prime and near prime exposure. A mixed portfolio in most circumstances will provide significant protection against a sector specific meltdown but we may be entering an unusual circumstance in which highly leveraged funds are seeing massive meltdowns in their less than stellar credit tranches, and reasonably well performing assets may be liquididated at fire sale prices to cover losses.

Mish Shedlock
has been pulling yeoman's duty in tracking the Bear Stearns asset sales, and the story for the subprime backed CDOs is ugly for everyone involved. The Financial Times reports on the sale of the CDOs:

Vulture funds and others have been quick to bid for holdings in the two funds, but the best bid for Bear Stearns High-Grade Structured Credit Strategies Enhanced Leveraged Fund, the more geared of the two, is just 5 cents on the dollar....

The less-geared Bear Stearns High-Grade Structured Credit Strategies Fund, which the bank has rescued with a $1.6bn loan, is being offered at about 70 cents on the dollar. The fund is only attracting bidders at about 30 cents, according to people who use the system.

Market participants estimate the CDOs the Bear funds held would sell for at least 10 per cent less than the values calculated by lenders. "Where things transact is still many points below where dealers have been marking them," said one manager of CDOs and hedge funds. "That is the big ugly secret of this market."

Yes, this is a fire sale, but basic theory would predict that asset bidders should be bidding at or at least near their expected value for these assets. 70% to 95% discounts from previous face value means these assets are nearly worthless. This sends a signal to other buyers of subprime securities that their assets are overvalued on the books, and that future lending to the same class of borrowers should not occur at current interest rates. If it does occur, either underwriting and credit standards would have to massively improve or interest rates would have to significantly increase to compensate for the 'newly' realized risk.

If that is the case, then the refinance treadmill has been broken, and the scattered bodies of borrowers facing interest rate adjustments will be flying throughout the rest of the year and into next year. Not a pretty picture.

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