Subprime Issue Refuses to Go Away

I keep posting these things here as this is what the stock market cares about at the moment.

Bloomberg:

Standard & Poor's, Moody's Investors Service and Fitch Ratings are masking burgeoning losses in the market for subprime mortgage bonds by failing to cut the credit ratings on about $200 billion of securities backed by home loans.

The highest default rates on home loans in a decade have reduced prices of some bonds backed by mortgages to people with poor or limited credit by more than 50 cents on the dollar and forced New York-based Bear Stearns Cos. to offer $3.2 billion to bail out a money-losing hedge fund. Almost 65 percent of the bonds in indexes that track subprime mortgage debt don't meet the ratings criteria in place when they were sold, according to data compiled by Bloomberg.

That may just be the beginning. Downgrades by S&P, Moody's and Fitch would force hundreds of investors to sell holdings, roiling the $800 billion market for securities backed by subprime mortgages and $1 trillion of collateralized debt obligations, the fastest growing part of the financial markets.

``You'll see massive losses from banks, insurance companies and pension managers,'' said Joshua Rosner, a managing director at investment research firm Graham Fisher & Co. in New York and co-author of a study last month that said S&P, Moody's and Fitch understate the risks of subprime mortgage bonds. ``The longer they wait, the worse it's going to be.'' [my bolds]

The paper quoted above. Two charts from his paper that show the size of the problem.

The bond market has already downgraded many of the bonds (first chart) and there are a lot of such bonds out there (second chart), but because they are not marked to market, many institutions are holding bonds that are worth 50c on the dollar, yet they are accounted at par. This will result in a lot of forced selling when the actual downgrades hit; this is what Bear Stearns is trying to avoid.

The financial sector is showing notable underperformance of late to the rest of the stock market and it so happens that it is the biggest sector in the stock market and general economy. This was a dead cat bounce on Wednesday and this is how I am playing it on my working vacation. And the Fed yesterday did not help…