How The Bad News Could Get Worse

If delinquencies lead to downgrades of mortgage-backed securities, ripples could become waves

With the Dow Jones industrial average once again setting records, it's tempting to think the subprime mortgage mess that roiled stock and bond markets in February and March is over. But late in the evening of Friday, Apr. 20, came a jarring sign that things may be getting worse, not better. Credit experts at Moody's Investors Service (MCO ) projected that average losses on pools of subprime mortgages from 2006 would be as much as 8%, one-third higher than what they expected just six weeks before.

The report was a reminder that no one will know for some time how big the losses on bad mortgages will be. That includes the credit-rating agencies, whose grades on mortgage-backed securities and other instruments play a big role in determining how easy it is for everyone from homeowners to private equity firms to borrow money. Moody's executives acknowledge that they've underestimated delinquencies so far and say they won't know if their new estimates are right until several things become clearer, such as how many borrowers are able to work out new repayment terms. Fitch Ratings Ltd. also has raised its loss estimates recently. Standard & Poor's says it hasn't changed its estimates but notes that they were higher than its rivals' to begin with. (s&p, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP ).)

The stock market lost ground on the Monday following the announcement but gained it back quickly. Perhaps that's because investors have already sorted through most of the possibilities and decided the odds are against worse trouble unfolding.

But some experts caution that there's a possible scenario that's worth mulling, even if it's unlikely. It's not the familiar threat of foreclosed homes depressing house prices and hurting the economy by deep-freezing consumer spending and construction. Rather, it's a disease that would spread through the channels of modern finance, starting with unprecedented delinquencies on subprime and other adjustable-rate mortgages. That would force the rating agencies to issue widespread downgrades of mortgage-backed securities, and that would set off downgrades of the collateralized debt obligations (CDOs) that bought those securities. The downgrades and subsequent losses could prompt investors to back away from the broader debt market, slowing corporate loans and leveraged buyouts—a big support for stocks in the past few years. "It could force a fairly significant leverage unwinding [and even] some degree of global liquidity crunch," says Christian Stracke, a senior analyst at CreditSights Ltd., a research service for institutional investors.

While Stracke isn't predicting this will come to pass, he argues that it's possible because credit ratings on mortgage-backed securities are based on historical patterns. Yet history has never seen a time with mortgage debt so high relative to the national economy, with house prices having gone up so much amid rampant speculation, with so many risky mortgages, and with delinquencies surging at a time when jobs are plentiful. "This is a significant issue that's going to play out in a matter of months," says credit market strategist Jeffrey A. Rosenberg of Banc of America Securities (BAC ). "Investors should be paying attention."

Moody's has updated its rating methods in at least three ways to deal with the changes in lending over the past few years. But Brian M. Clarkson, Moody's co-chief operating officer for global structured finance, doesn't share Stracke's larger concerns. He says he has seen three distinct subprime waves before and that adjustable-rate mortgages with payment options and ultra-risky no-documentation loans aren't new, either. Clarkson doesn't foresee a wave of mortgage defaults setting off a broad downturn in available credit. "In my opinion," he says, "it is a very remote possibility. But it is a possibility."

By David Henry

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