Hindsight may be 20-20 but Floyd Norris’s latest New York Times column leaves one wondering whether buyers of subprime “piggyback” home loans had any sight at all. Norris nominates a Merrill Lynch offering as candidate for the worst ever mortgage security. Piggyback loans cover the remaining 20% of a home’s purchase price after the original 80% mortgage, allowing the buyer to finance 100% of the purchase.
Would you invest money — at a very low interest rate — to finance mortgage loans made to risky borrowers who put no money down?
What’s interesting about the offering was that not only was it risky, but the yield was low, Norris notes.
“Although market interest rates were low when these mortgages were written, the mortgages had rates averaging 11.2 percent. Yet investors who put up most of the money were willing to accept a floating rate of just 30 basis points — three-tenths of one percentage point — over the London interbank offered rate. At the moment, that gives them a yield of 3.2 percent. ”
“Making the situation worse is the nature of many of the mortgages in the Merrill securitization,” Norris writes. “Fewer than 30 percent of the loans were made to borrowers who provided full documentation of their income and assets. Many of the other borrowers probably lied about their income. Nearly all had borrowed the full appraised value of the home, either for the purchase or for refinancing, and it is possible that some appraisals were unreasonably high even before home prices began to fall.”
Moody’s forecasts that by the time it is wrapped up, so many of the mortgages will have gone bad that 60 percent of the money lent will not be paid back.
Also worth a listen is This American Life’s podcast “The Giant Pool of Money” in which Alex Blumberg and NPR’s Adam Davidson teamed up to look at the mortgage meltdown from the inside out.
Junk bonds are in the spotlight this week with two separate but related posts topping the list of most read at Research Recap. Speculative grade bonds now account for half of all corporate bonds, leading Standard & Poor’s to predict that a
Glut of Junk Bonds Will Boost the Overall Bond Default Rate. Moody’s, meanwhile forecasts a Tripling of Junk Bond Defaults by Year-end.
With oil prices reaching record highs on an almost daily basis, it is no suprise that the IMF’s Speculation Playing “Significant Role” in Oil Price Surge was popular. You know this issue is getting serious when the Financial Times calls for a global oil summit.
Such a summit would have three objectives: to encourage energy efficiency, and so reduce future oil demand; to promote investment in new oil supplies; and to smooth the recycling of billions of dollars in oil revenues from producers back into consuming countries. All three tasks would be easier with international co-operation and there are enough shared interests to make a worthwhile deal possible.
Staying with energy, Freeedonia’ massive Industry Study World Biofuels Demand to Expand 20 percent Annually, drew interest, concluding that ethanol will dominate the industry for some time despite criticism that its is driving up food prices.
Research Recap Quote of the Week:
Maybe working longer is the best answer. After all, the retirement age was set at 65 in 1933, when average life expectancy was 63. With life expectancy today at 78 years, perhaps we should just plan to work until we’re 80.
S&P chief economist David Wyss’s proposed solution for Baby Boomer generation’s projected shortfall in retirement resources.
Oxford Analytica is not persuaded by the Bank of England’s recent suggestion that mark-to-market loss estimates overstate the damage wrought by the subprime crisis.
The BoE’s optimism contrasts with the IMF’s claim that total financial system losses — estimated at $945 billion dollars — remain in excess of writedowns announced so far by banks and other financial intermediaries.
In a new analysis BoE seeks light amid the gloom, OxAn says “it is debatable whether current pricing methods have led to excessively depressed ABS valuations. Mark-to-market pricing, or ‘fair value’ accounting, is strongly endorsed by the accounting profession.”
By arguing that current mark-to-market pricing is overstating financial losses, the Bank of England appears to be seeking to restore confidence in increasingly risk-averse markets, OxAn Says.
However, its contrarian views have called to question its credibility.
“The wide acceptance of ‘fair value’ accounting makes it unlikely to be dropped as common practice. Moreover, the (BoE’s) latest report fails to analyse sufficiently the market for ABCP or the risk of feedback — from a declining economy to the financial system — should present uncertainties be allowed to persist,” OxAn concludes.
Further subrime-related ratings bank downgrades are likely to be minimal as global banks have already written down more than 80% of their losses from subprime mortgage assets, Fitch Ratings says in a Special Report.
Fitch estimates total market losses from subprime mortgage assets at $400 billion, though estimates may be as high as $550 billion, depending on the method of calculation used.
Approximately 50% of these losses, $200-275 billion, are held by banks, with the remainder held by financial guarantors, insurance companies, asset managers and hedge funds.
As of May 2008, Fitch estimates disclosed losses by banks on subprime residential mortgage-backed securities (RMBS) or collateralised debt obligations referencing mortgage-backed securities (ABS-CDOs) to be $165bn, or 83% of the banks’ portion of the losses.
As a significant proportion of the losses have been disclosed, further ratings action arising from ABS‐CDO and subprime RMBS exposures is likely to be minimal.
“Subprime mortgage-related losses for the total market vary considerably depending on the methodology used,” says Krishnan Ramadurai, Managing Director in Fitch’s Financial Institutions Group. “Given the problems associated with methods of calculation based on ABX and TABX indices, we believe that Fitch’s internal loss estimate of $400billion is a more appropriate reflection of losses though they are also sensitive to assumptions made on underlying loss rates.”
“To the extent that institutions have effectively hedged their exposures with financially sound counterparties, these loss figures may be over-estimated,” says Gerry Rawcliffe, Managing Director and Group Credit Officer for Fitch’s Financial Institutions Group. “Nevertheless, for those institutions that did not hedge a sufficient portion of their super-senior exposures, mark-to-market losses on these residual exposures have been so large that their capital ratios have come under acute stress.”
The subprime market originated as much as $1.4 trillion of loans in the last three years, Fitch estimates.
Detailed calculations and analysis are available in Subprime Mortgage-Related Losses - A Moving Target.
European venture investors continue to be highly selective as deal activity in the first quarter dropped off considerably while the median amount of capital put into a round shot upward, Dow Jones VentureWire reports.
The number of venture capital investments in Europe fell to 180, the lowest total this decade and the first time it has ever dipped below 200, according to data released today from VentureSource. A year ago, there were 239 deals.
Still, the amount of capital managed to rise slightly to EUR 1.14 billion from EUR 1.12 billion in the year-ago quarter, thanks in part to more money being deployed in later-stage deals. This drove the median amount per round to the highest quarterly total in the decade at EUR 3.23 million, which compared with EUR 2.55 million last year.
The number of deals has dropped each year since 2000, while the amount of investment began to rise in 2004 and hasn’t stopped since.
Indeed, the move by firms to put more money into later-stage deals has had a large effect. In the first quarter, the amount of money invested in later-stage rounds - meaning third round or greater - climbed 8% to EUR 621.6 million from EUR 569.6 million in the year-ago quarter and rose 31% from the fourth quarter total of EUR 469 million. The jump occurred despite there being 29% less deals from a year ago - 58 versus 82.
In a move likely to continue to increase later-stage funding, Index Ventures closed a EUR 400 million growth fund in January. At the time of the fund-raising, Index cited maturing information technology markets and the capital demands of drug-discovery companies preparing to push products to market as spurring the need for the new growth fund, VentureWire said.
The amount of money in seed through second rounds fell 5% to EUR 495.7 million from EUR 520.9 million a year earlier. Likewise the number of these deals fell 23% to 110 from 142.
Information technology took the biggest hit in deal count with 80 deals compared to 142 in the previous quarter and 153 in the first quarter of 2007. The deal count was the lowest since at least 2000.
Junk bonds now account for half of all corporate bonds, likely resulting in an escalating overall default rate, according to Standard & Poor’s. In a Credit Trends report, S &P said 50.41% of firms rated speculative grade at the end of the first quarter of 2008, 3% higher than during the comparable period in 2006 and 12% higher than a decade ago.
An increase in both defaults and downgrades and a drop of newly rated entities have affected the ratings distribution during the last quarter, S&P said. “Indeed, the flow of speculative-grade new entrants has been primarily responsible for the downward shift in the ratings distribution over the past few years. With lending conditions tight, however, the impact on the aggregate ratings distribution from newly rated speculative-grade entities has been muted.”
Despite some encouraging news on the earnings front in the first quarter, S&P says indicators of credit quality are negative:
Indeed, negative bias (the percentage of firms with a negative outlook or with ratings on CreditWatch with negative implications) is currently at 29%, and net negative bias (the difference between negative bias and positive bias) is at 17%, both much higher than the long-term averages of 20% and 3%, respectively.
“With profits still at risk within a weaker economic environment, we foresee a continued slide in credit quality, with downgrades outpacing upgrades in both investment grade and high yield, as well as an increase in the trailing-12 month speculative-grade default rate to 4.7% by the end of the first quarter of 2009, from 1.4% at the end of first quarter of 2008.”
The first quarter was the slowest for newly rated issuers since 1991, S&P said. Only the financial, utility, and real estate sectors remain predominantly investment grade. The media and leisure sector has the highest percentage of firms in speculative-grade territory, with 86%, followed by the health care (75%), automotive and capital goods (74%), and telecommunications (73%) sectors.
Further details are available in the S&P report U.S. Ratings Distribution: Glut Of Low-Rated Issuers Could Mean Escalating Default Rate.
2007 was a difficult year for US media companies. Overall advertising revenue did not grow during the year, and the film and television sectors were crippled by the writers’ strike. In a new report, Standard & Poor’s sees only a minor improvement in 2008 thanks to the US elections and the Olympics.
S&P forecasts a 1.7% rise in advertising revenues for the current year, including search engine advertising.
“The radio, newspaper, magazine, and TV segments continue to gradually lose share of total ad spending, propelling asset portfolio restructuring by media firms,” S&P says. “The majority of those that underwent LBOs over the past three years are laboring under onerous debt burdens that were based on expectations of continuous liquidity availability.”
We expect that this will result in another year of media and entertainment downgrades outnumbering upgrades.
Traditional media sectors continue to lose their market share to online advertisements. Print media companies in particular are facing critical questions as to their long term viability. They are not alone in their circumstances, however. Concern over a major Screen Actor’s Guild strike combines with the overall health of the economy to make for a generally negative prognosis for growth of traditional media.
Other key issues addressed in the report:
- Will Political Advertising Save TV Station Groups From Declining Revenues In 2008?
- Radio Station Groups: National Advertising Feels Economic Pressure
- Internet Advertising Continues Its Growth Streak
- Magazines Are Still Trying To Turn The Page On High Credit Risk
- Newspaper Declines Affect Both Investment-Grade And High-Yield Credits
India needs reform its capital and labor markets to meet its growing infrastructure needs, according to the International Monetary Fund. In a commentary published in India’s Business Standard, IMF Senior Advisor Kalpana Kochhar outlines what the Indian government must do in order to meet its goal of investing $500 billion in its infrastructure by 2012.
Over the past three years, India has invested an average of 4½ percent of GDP each year in infrastructure. Getting to the Planning Commission’s target -which is estimated to be the equivalent of 9 percent of GDP in 2011/12- means that infrastructure investment will need to increase by nearly 1 percent of GDP each year between 2007/08 and 20011/12 percent of GDP, Kochar writes.
Where will the resources to finance this additional investment-nearly 5 percentage points of GDP by 2012-come from?
Examining India’s public financial health, Kochar concludes, “From dissavings of around 1 percent of GDP a decade ago, public sector savings shot up to an impressive 3 percent of GDP in 2007/08. But given the pressures from the 6th Pay Commission, the agricultural loan waiver, and continued commodity subsidies it will likely be difficult to increase or even to maintain this level of savings in the absence of substantial improvements in tax revenue collection.”
Not surprisingly, the IMF argues that the government can not afford to invest adequately in its infrastructure without foreign capital, and that foreign capital can not be acquired without a significant re-tooling of India’s financial and labor markets.
India needs to rethink its capital account framework in the light of the need for $500 billion in infrastructure investment.
Specifically, Kochar reccommends, “refraining from ad hoc changes in capital controls in the name of macroeconomic management, and quickly expanding the country’s real and financial absorptive capacity.
In particular, there is an urgent need for an expedited and time-bound plan to develop the corporate bond market, including by raising the limits on foreigners’ participation in this market, permitting greater capital outflows, creating fiscal space to finance infrastructure investment by curbing wasteful spending, and implementing structural reforms of labor and product markets.
Moody’s expects the default rate on junk bonds to triple by the end of the year, reaching 5.7% in the U.S. and 5.0% worldwide.
In a new report, Moody’s said the global speculative-grade default rate increased to 1.7% in April from 1.5% in March, and from 1.6% a year ago. The US speculative-grade default rate also edged higher in April to 2.1% from a revised level of 1.8% in March and from 1.5% in April 2007.
We expect continued upward pressure on default rates over the next year as issuers increasingly feel the effects of slower economic growth and reduced access to credit markets.
Moody’s default rate forecasting model now predicts that the global speculative-grade default rate will rise sharply to 5.0 % by the end of this year. It is expected to increase further to 6.1% a year from now. For U.S. speculative grade issuers, Moody’s forecasting model foresees default rates increasing to 5.7% by the end of this year.
Moody’sexpects that the Construction & Building sector will be the most troubled industry in the U.S. and the Durable Consumer Goods sector will have the highest default rate in Europe.
Moody’s speculative-grade corporate distress index- which measures the percentage of rated issuers that have debt trading at distressed levels- edged lower from 24.5% in March to 21.3% in April. This is the first time that the index has declined since last summer. Nevertheless, the current level is much higher than the level of 1.3% in June 2007, Moody’s said.
There were signs of improvement in the commercial real estate market in the first quarter as sales prices rose slightly, though demand continued to decline, according to MIT’s Transaction Based Index.
Results for the 1st quarter of 2008 show a 2.1% capital return for the properties sold in the National Council of Real Estate Investment Fiduciaries database, MIT said.
The demand-side index continued to fall, by 4.6 percent, which is the third straight quarterly drop, for a cumulative decline of more than 14 percent versus the mid-2007 peak.
However, the supply side of the market raised its reservation prices by 9.2 percent in the first quarter.
The NCREIF Property Index (NPI) showed a total return of 1.6% in the first quarter, comprised of 1.26 percent income and 0.3 percent capital appreciation.
Standard & Poor’s says the slowing of commercial real estate lending among regional banks may be problematic for some financial institutions’ performance, but is unlikely to result in widespread rating actions on those with the highest exposures.
In a new report, Cracks Are Emerging In Commercial Real Estate For U.S. Banks, S&P says it believes that “certain issuers concentrated in builder-related segments with certain geographic and loan exposures could see negative ratings actions depending on credit quality losses and their profitability outlook.”
We expect that credit quality within most CRE segments will remain sound, with the exception of construction, which has shown considerable credit deterioration in recent quarters.
Residential construction and development loans are currently experiencing a significant downturn, in particular in markets where home price appreciation outpaced the industry, such as Florida, Georgia, Arizona, Nevada, and California, according to the report. While nonperforming asset levels and net charge-offs have increased, they are off a low base. As banks increase their loan-loss provisions to build reserves for potential losses, however, earnings are diminishing for CRE lending.
CRE segments, such as retail or hospitality, will likely weaken in the face of low consumer spending, but Standard & Poor’s doesn’t expect credit losses to outpace its expectations for a normal cyclical downturn. Overall, it expects CRE valuations to decline from elevated levels during the next two years because of a difficult financing landscape and economic weakness.
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