$100B loss in US subprime mortgages – worst yet to come

Friday, July 20th, 2007

Home loans likely to continue recording losses well into next year, say analysts with JPMorgan Chase & Co.


NEW YORK — Subprime mortgage defaults will increase this year and holders of securities linked to those home loans may record losses well into next year, JPMorgan Chase & Co. analysts said.

“ The worst is not over in the subprime mortgage market,” analysts led by Chris Flanagan, head of structured finance strategy at JPMorgan, said in a report Thursday. “ We expect continued deterioration in subprime loan performance through the balance of this year, and it is likely to be well into 2008 before the problems in securitized portfolios begin to abate.”

The report from New York- based JPMorgan comes amid growing warnings of rising defaults on mortgages and losses on securities linked to them. Federal Reserve chairman Ben Bernanke Thursday said there will be “ significant financial losses” from subprime mortgages, pointing to estimates as high as $ 100 billion. Freddie Mac chief executive officer Richard Syron and investors James Chanos and Marc Faber forecast a deepening slide in the subprime market earlier in the week.

“ The credit losses associated with subprime have come to light and they are fairly significant,” Bernanke said in testimony to the Senate banking committee.

Flanagan, in a report titled Subprime Meltdown, the Repricing of Credit and the Impact Across Asset Classes, said home price declines will lead to increases in defaults. Almost half of subprime borrowers won’t be able to refinance their loans when they reset in the next 18 months, JPMorgan predicts. Flanagan described conditions as “ very bleak.”

The increased risk of default prompted Moody’s Investors Service, Standard & Poor’s and Fitch Ratings to begin cutting credit ratings on hundreds of bonds last week. The ratings companies all warned that the housing slump is broadening.

“ Unfortunately I don’t think we have hit bottom” in defaults, Syron, whose company is the second- largest source of money for home loans behind Fannie Mae, said in an interview from McLean, Va. “ Things are going to get worse.”

Mortgage defaults at 10- year highs have reduced prices of some bonds backed by home loans to people with poor or limited credit by more than 50 cents on the dollar.

The extent of the declines in bonds backed by home loans to subprime borrowers is being masked by investors’ reluctance to buy or sell the securities, said Chanos, president of New Yorkbased Kynikos Associates.

Bear Stearns Cos. was forced to extend credit to one of two failed hedge funds after bad bets on subprime mortgage bonds. At the time, “ the banks went out of their way so they didn’t have to liquidate” the bonds and establish a price, Chanos said.

Flanagan, who is based in New York, on June 29 cut his recommendation on collateralized loan obligations without top credit ratings because of higher financing costs linked to the turmoil in similar securities backed by subprime mortgages.

Flanagan reduced his rating on collateralized loan obligations with ratings from S& P or Fitch of AA or lower to “ underweight” from “ neutral” in the report to clients last month. Collateralized loan obligations are pools of loans often used in leveraged buyouts that are divided into bonds with different credit ratings and maturities. Flanagan kept his “ neutral” rating on CLOs with the top AAA rating.

The JPMorgan report said investors should not be optimistic that borrowers will forestall default through loan modifications. “ The difficulties involved in modifying existing mortgages are serious,” the report said. “ Some borrowers may not qualify; for example, if the original loan was based on fraudulent reporting of income and the fraud is discovered when re- qualifying, modification would likely not be an option.”

Loan servicers may not be able to change as many loans as they’d have to in order to prevent a security’s default, the analysts wrote. It may not make sense for servicers to give borrowers a break in housing markets where values are declining so quickly that rapid foreclosure may be the best option, they said.

Some servicers may have sold protection in the credit default swap market and may benefit from foreclosure, JPMorgan said. In other cases, the servicer may own the equity portion of an asset- backed security and have different interests from those of debt holders, the report said.

The temporary stabilization of the ABX mortgage indexes in April and May was an indication of investors’ optimism that servicing would prevent defaults. The ABX indexes are made up of four sets of 20 mortgage pools each designed to allow people to speculate on or hedge exposure to subprime mortgage debt.

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