Why Mortgage-Backed Securities And CDO Problems Are Getting Worse
Thousands of mortgage-backed securities holding subprime loans and related collateralized debt obligations (CDOs) were sold to the public as being far safer investments than they actually were. Over the past few months, securities ratings agencies (Moody’s, S&P and Fitch) have downgraded thousands of these investments, establishing that they were far riskier than originally represented. Unfortunately, the problem will almost certainly get far worse. Investors in these securities need to prepare for this development.
Since the beginning of 2007, the business press has reported extensively on the nature and extent of problems attributable to the subprime mortgage market. These problems have already had a swift and dramatic impact on many investments and losses already run into the billions of dollars.
The problems in the subprime mortgage market will almost certainly get worse for several major reasons.
First, over the next 18 months, the interest rates on hundreds of billions of dollars of adjustable rate first mortgages will reset to higher, in many cases much higher, levels. The higher mortgage payments resulting from these resets will place heavy financial burdens on subprime borrowers who are already financially strapped and will significantly increase the probability of default. The following table shows the approximate amount of first mortgages that will reset to higher interest rates in 2007 and 2008.
| Month | Approximate Amount of Mortgages Resetting to Higher Rates |
| January 2007 | $27,000,000,000 |
| February 2007 | $23,200,000,000 |
| March 2007 | $26,300,000,000 |
| April 2007 | $38,300,000,000 |
| May 2007 | $38,000,000,000 |
| June 2007 | $38,800,000,000 |
| July 2007 | $44,000,000,000 |
| August 2007 | $44,000,000,000 |
| September 2007 | $48,700,000,000 |
| October 2007 | $50,700,000,000 |
| November 2007 | $46,700,000,000 |
| December 2007 | $41,800,000,000 |
| January 2008 | $44,700,000,000 |
| February 2008 | $32,600,000,000 |
| March 2008 | $37,500,000,000 |
| April 2008 | $46,400,000,000 |
| May 2008 | $40,100,000,000 |
| June 2008 | $32,900,000,000 |
| July 2008 | $35,800,000,000 |
| August 2008 | $37,400,000,000 |
| September 2008 | $30,300,000,000 |
| October 2008 | $18,700,000,000 |
| November 2008 | $14,400,000,000 |
| December 2008 | $12,500,000,000 |
Fortune Magazine (9/17/07) has reported that the average increase in monthly payments on the mortgages will be $1,018. The news is even worse for those borrowers who entered into “teaser” adjustable rate mortgages. Those borrowers will experience an average increase on their mortgage payments of $1,825 per month.
Many defaults will occur as these rates reset.
Second, recently the value of homes in many areas of the country has been stagnating or even declining. Further declines in the value of homes are projected to continue through at least 2008. This development significantly restricts the ability of subprime borrowers to refinance their homes or take other action to avoid defaults. In many situations, this development has resulted in houses being worth less than the amount of debt owed by subprime borrowers on the house.
Third, in recent years, many subprime borrowers (and other borrowers) have used second mortgage loans and/or home equity loans to acquire homes or finance other needs. This has resulted in many such borrowers having little or no equity in their houses and has greatly reduced their options of dealing with credit squeezes. In fact, there have been numerous reports of borrowers who owe significantly more on home loans than the value of their homes.These dynamics, along with other factors, have created a “perfect storm” for disaster in the subprime MBS, CDO, SIV and Conduit investment markets. This “perfect storm” will almost certainly continue for the foreseeable future and will result in additional heavy losses for these investments.
Signs that mortgage problems are indeed getting worse:
Losses Are Projected To Be Greater Than Previously Estimated
Economists are now saying that troubles in the mortgage market could cost financial firms and investors up to $400 billion. This is far more than the nearly $240 billion cost (adjusted for inflation) of the savings and loan crisis of the early 1990s. Several economists believe that, depending on how far home prices fall, the loss in total real estate wealth may range from $2 trillion to $4 trillion. Experts caution that these estimates are preliminary and the total costs could be even greater.
Rating Agencies Are Downgrading Bonds With Increasing Frequency
As more and more borrowers default on their subprime mortgages, Moody’s, S&P and Fitch are downgrading bonds backed by pools of these mortgages to “junk” bond status. Many of these bonds were issued in 2006 and 2007 and were rated “investment grade” earlier this year. The number of affected bonds is alarming. In May 2007, Moody’s downgraded -- or was in the process of reviewing for downgrades -- nearly $1 billion in bonds issued in 2006 because of rising losses in the pools of mortgages backing them. In June, Moody’s slashed credit ratings on an additional $3 billion worth of bonds issued last year. In July, Moody’s stated that it was downgrading ratings on nearly 400 more bonds worth over $5 billion. That same month, as a result of mounting delinquencies on the underlying mortgages, S&P announced it was downgrading ratings on over 600 bonds valued at $12 billion.
Trouble in the subprime market has also affected “piggyback loans,” second mortgages typically taken out by borrowers who do not have a 20% down payment to buy their home. Such borrowers take out a first mortgage for 80% of the purchase price and then a second, or piggyback, mortgage for much or all of the remainder. Last July, S&P downgraded over 400 classes of bonds backed primarily by piggyback loans, which were worth $3.8 billion. Eight of these classes included AAA-rated bonds.
The ripple effect of the subprime fallout is also affecting the commercial real estate market. Fitch released a report last July raising cautionary flags and projected rising defaults in the commercial real estate market after years of increasingly lax lending standards, which could adversely affect bonds backed by commercial real estate loans.
In early October, Fitch cut the credit ratings of $18.4 billion of bonds backed by subprime home mortgages issued in 2006 and reduced ratings on $6.6 billion of bonds backed by second subprime mortgages. Moody’s also announced in early October that the shocking number of defaults on subprime mortgage bonds issued in 2006 was being surpassed by those issued during the first half of 2007. According to Moody’s, these bonds include loans that are becoming delinquent at the fastest rate that the ratings company has ever seen. Indeed, data in the Moody’s report suggests that accelerating delinquencies from 2007 bonds are likely to eclipse those issued in 2006, which to date have the dubious distinction of being the worst-performing bonds. In mid-October, Moody’s lowered ratings on an additional $33.4 billion of bonds -- nearly 2,200 securities -- backed by subprime mortgages, the biggest downgrade yet. In late October, Fitch warned that $36.8 billion of CDOs face downgrades. Most alarming is the fact that the majority of these securities carry the highest AAA-rating. In essence, investors are witnessing the transformation of bonds that had been represented and sold to them as high-quality securities into junk almost overnight.
The fact that the rating agencies are downgrading many bonds within a year or so after they were first issued is startling, particularly since these bonds were often sold to investors based on investment-grade A, AA or even AAA ratings. These ratings often led investors to believe that they were safe investments. Although the ratings companies now say they foresaw problems in the subprime market last year, it appears that they were not sufficiently concerned at the time to warn investors of these problems and the risks inherent in these bonds.
Between 2002 and 2006, borrowers obtained $2.3 trillion in subprime home mortgage loans. Unfortunately, it appears almost inevitable that the number and frequency of downgrades in ratings of bonds and CDOs backed by these loans will only get worse.
Page Perry, LLC is a nine-lawyer Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not necessarily indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry attorneys have successfully handled cases involving complex CMO and mortgage-backed securities over the past 20 years and the firm is currently representing investors in various subprime mortgage cases
