Banks: Gauging the Subprime Spillover

S&P Ratings says the rapid falloff of mortgage liquidity is the key risk for financial institutions—and could hurt third-quarter results

by Victoria Wagner and Rodrigo Quintanilla From Standard & Poor's RatingsDirect

What a difference a few weeks can make. Through mid-July, U.S. financial institutions seemed to be weathering the subprime fallout fairly well, broadly speaking. The large, complex bank sector produced strong pretax margins in the second quarter of 2007, powered by robust trading revenues and loan growth. At the big U.S. broker-dealers, mergers-and-acquisitions activity and healthy investment management growth resulted in solid profitability.

The markets, however, changed quickly. Today, Wall Street firms, banks, and investors have almost completely lost their appetite for mortgage-backed assets not backed by agencies like Fannie Mae (FNM) or Freddie Mac (FRE). With the mortgage capital market both capacity- and price-constrained, mortgage lenders' and loan aggregators' overall profitability continues to suffer. Simply put, risk aversion in the mortgage capital markets remains at an all-time high, concern for the potential impact on other asset classes has escalated, and the resulting liquidity crunch is affecting the pricing of all credit, not just mortgages and mortgage-backed securities (MBS).

The correction in the U.S. mortgage market and the accompanying adjustment of risk pricing has reverberated far and wide throughout the global capital markets. Some examples: the leveraged loan market coming to an apparent standstill in August; widening interest-rate spreads negatively affecting the pricing of credit-card securitizations and senior debt issuances at U.S. commercial banks; leveraged hedge funds with large, concentrated holdings of subprime assets continuing to report heavy losses; and the equity and fixed-income markets' wild ride of volatility, which is showing few signs of subsiding.

Third-Quarter Results Likely to Suffer

Global capital markets seem to be having difficulty digesting news surrounding the correction in the U.S. housing and mortgage markets. David Wyss, managing director and chief economist at Standard & Poor's, recently suggested that, after years of optimism regarding risk, investors are now "overreacting in the opposite direction."

In fact, in S&P's Ratings Services' opinion, this current credit cycle is one of the most challenging that financial institutions have ever faced. Until credit spreads and asset pricing fully recalibrate, mortgage liquidity will be constrained. In turn, market prices for all loans—mortgage loans in particular—will remain highly uncertain. Third-quarter operating results for financial institutions will likely reflect the cost of this uncertainty.

Our credit ratings continue to focus on financial institutions' credit fundamentals and their capacity to manage business at both the peak and low points of a mortgage cycle. In addition, because our criteria look "through the cycle," we did not elevate our ratings during the 2003-04 mortgage cycle when mortgage volumes and profit margins were at their peak. Thus the fundamental analysis has room to keep ratings, for the most part, stable in the current environment. As in other areas, we have taken some negative ratings actions on companies without sufficient business or funding diversification, as well when the market hasn't distinguished between asset classes.

A Summary of Ratings Actions

We have responded recently to the weakness in residential mortgage-backed securities (RMBS), closed-end second-lien RMBS, and Alternative A (Alt-A) RMBS. In fact, since the first quarter of 2007, we have downgraded more than $10 billion in subprime first-lien RMBS, closed-end second-lien RMBS, and Alt-A RMBS. We also revised upwards our expectation of future losses on U.S. subprime mortgages.

Mortgage lenders are finding it far more difficult to sell loans off their balance sheets because investors no longer want to buy subprime RMBS or any other structured investment that might include subprime securities, such as asset-backed commercial paper (ABCP). Because the timing for the recovery of the securitization market is uncertain, virtually any company whose profits are tied closely to the mortgage market is vulnerable to these trends. The bottom line is that as banks originate mortgages, a higher proportion will likely end up on their balance sheets, with a resulting impact on capital needs.