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.
While we believed that credit losses would revert to more normal levels, which would result in lower earnings, profitability pressure on mortgage lenders also has resulted from increasing funding costs, due to the seizing up of the ABCP markets. Our recent rating actions on financial institutions reflect a tipping point, with liquidity concerns outweighing credit quality concerns. This development was at the heart of our negative rating actions on Countrywide Financial (CFC) and Thornburg Mortgage (TMA).
Needed: Strong Funding and Liquidity
In our view, the rapid curtailment of mortgage liquidity is the key risk for financial institutions in the near term. For example, this lack of liquidity is forcing many companies to dramatically downsize their mortgage operations. Most recently, Capital One Financial (COF) announced the closing of its Alt-A mortgage unit, GreenPoint Mortgage Funding, and Lehman Brothers Holdings (LEH) announced it was closing its subprime mortgage unit, BNC Mortgage.
In our opinion, the two factors that will sustain financial institutions through this crisis are strong funding and liquidity—both predominantly featured in our long-term ratings criteria. The majority of our rated institutions have either been affirmed or downgraded modestly. An orderly unfolding of the credit cycle is already reflected in the ratings and, generally, our assumptions account for losses in one financial quarter.
The market consensus is that the broader economy remains quite sound and the corporate credit sector is showing stable performance. Inevitably, some are benefiting from the market turmoil. Hedge funds that shorted the mortgage markets have outperformed their peers. And, while subprime mortgage volume is much lower for most lenders, business at some of the largest mortgage originators has increased as they fill market need created by those exiting the business.
Watching the Key Indicators
The overhang of subprime stress in the mortgage markets and its impact on the broader credit markets was addressed by President Bush in a speech given in the last week of August. The White House argued that pending modernization of the Federal Housing Administration, legislation should be passed and that the tax code should be altered so those who are refinancing their homes will not be penalized.
Should key economic indicators such as unemployment rates, gross-domestic-product growth, or interest rates take a negative turn, however, financial institutions' problems likely would be compounded. In fact, if the market dislocation continues for an extended period at the pace we have observed to date, or if the economy starts to head toward a hard landing, further rating changes on financial institutions are likely. Companies vulnerable to a downgrade in the current environment include the following institutions, each of which is on CreditWatch Negative: Thornburg Mortgage, Residential Capital, H&R Block (HRB), and Countrywide Financial.
On the other hand, the large majority of our rated financial institutions hold stable ratings outlooks. We expect even those with significant mortgage exposure, as long as they are sufficiently diversified, to manage through the current turmoil. This list includes, among others, HSBC (HBC), Wells Fargo (WFC), and Wachovia (WB). A third group comprises organizations entering the third quarter with strong capital positions, diversified funding sources, and a track record of credit discipline. Our recent upgrades of Morgan Stanley (MS) and Deutsche Bank (DB) put these organizations, among others, firmly in that category.