Another Subprime Casualty

Last week everyone was talking about the departure of Merrill Lynch’s CEO, and this weekend it was Citigroup’s Charles Prince. He stepped down as Chairman and CEO after Citi announced losses in the billions of dollars, due to asset price writedowns and credit-related losses. Win Bischoff was appointed interim CEO, until the company finds someone to replace Prince. Robert Rubin, Former Treasury Secretary, was named Chairman of the board. Prince’s tenure was one marked with management experiments, shareholder dissatisfaction and risky strategy – a mixture that didn’t work out well in the end. Citi’s stock trades now at a price 17% lower than where it stood when Prince took over in 2003. Risky bets on subprime mortgage securities may result in $8 to $11 billion in writedowns for the bank, in addition to a $6.5 billion hit it took in Q3.

Banks suffer amid housing woes

Japan’s largest securities company Nomura Holdings Inc. will post a pretax loss of $620 million, its first quarterly loss in four years, caused by troubled residential mortgage-backed securities. It was also announced that Nomura will cut 400 jobs in the U.S. and shut down its residential mortgage-backed securities business. According to CEO Nobuyuki Koga, “the pace of the collapse” was quicker than expected. Japanese banks Mitsubishi UFJ Financial Group Inc. and Mizuho Financial Group Inc. also reported losses on investments in securities backed by subprime mortgages.

In the U.S., Merrill Lynch and UBS expect to report substantial losses with their third-quarter results, related to home-loan investments. Citigroup revealed a 57% drop in third-quarter profit, including higher-than-expected losses of $1.56 billion on mortgage-backed securities. No wonder that no one wants to originate subprime anymore.

FDIC says, cancel interest-rate adjustments

It sounds a little off to me, but that’s the next brilliant bailout idea: modify loans that are about to adjust and “freeze” the interest rates. This is exactly what FDIC’s (Federal Deposit Insurance Corp) Chairman Sheila Bair asked lenders to do. Naturally, the changes should only affect “good” borrowers who occupy their homes, are current on their payments and own adjustable mortgages that haven’t reset yet.

However, surveys show that only a fraction of the ARMs scheduled to adjust in the coming months get modified, partly because of restrictions in the servicing agreements that limit the number of loans that can be modified. Investors who own the loans are unwilling to allow modifications because this will cause mortgages and the securities backed by them to lose value.

OK, ARMs were designed to adjust at some point, that’s their essence. Converting them to fixed home loans is against the rules – after all, they were marketed as a bet against economic fundamentals and market conditions that affect interest rates. And if a large number of ARMs do somehow get modified, who knows what may happen next? More troubled hedge funds? More credit rating downgrades? Elimination of all types of ARMs? I don’t think this is the solution yet.

Bank of America invests in Countrywide

It was announced Wednesday that BofA has invested $2bln in Countrywide preferred stock, which can be converted into common stock at $18 per share. Shares of Countrywide traded at above $25 in after-hour trading, an increase of some 20% on the news. Rumors of a possible acquisition/merger with BofA have been circulating for a whil, but until now none had come to materialize. According to the lender’s CEO Angelo Mozilo, “Bank of America’s investment in Countrywide represents a vote of confidence and strengthens our balance sheet, enabling us to position Countrywide for future growth and success”. For some reason, this sounds like a sigh of relief to me.

Kenneth D. Lewis, BofA’s Chairman and CEO, said that “the stock market has been underestimating the value of Countrywide’s operations and assets” – an interesting thought amid all the turmoil, revaluations and downgrades anything mortgage-related has seen. He also added that “The investment … recognizes the importance of the company in providing home financing across the country”, so would I be right to assume that BofA is making a very risky investment just to bail out Countrywide? I’m probably wrong of course …

American Home Mortgage: another troubled lender?

American Home Mortgage Investment Corp. had to write down the value of its loan and security portfolios due to “unprecedented” disruption in the credit markets, leading to margin calls from its investors. As a result, it is delaying payment of dividends on its common stock, and its preferred shares as well. Keeping cash on hand will allow American Home Mortgage to act quickly when it fully understands “the impact of market conditions on its balance sheet and liquidity”. At this point, it seems, understanding the effect of market disruptions is not as hard as deciding what to do right now and what to do if things get worse. The problem is that economists are having a hard time predicting what will happen next and what happens after that. It is hard to tell whether we’re experiencing a financial “correction” or standing on the verge of a global credit crunch unprecedented in history. So, the “wait and see” strategy no longer works, because credit problems are already affecting investments, retirement accounts and other financial instruments that affect a number of consumers that spans well beyond the circle of Wall Street professionals.

American Home Mortgage, which has little exposure to subprime lending, but worked mostly with prime and Alt-A borrowers, is yet another example of the “subprime contagion” – something corporate executives seemed to deem impossible until recently. If the lender is unable to meet the margin calls, it may have to file for bankruptcy, because it depends on short-term loans from banks to fund the mortgages it issues. It is expected to post a second-quarter loss and possibly “contained” losses for 2007. Stocks closed at $10, 47 on Friday, the lowest since April 2003.

Wells Fargo says goodbye to 2/28 ARMs

Wells Fargo, the fifth-largest bank in the U.S., has stopped offering 2/28 adjustable-rate mortgages effective Monday. The so-called 2/28 ARMs are in fact a hybrid product featuring a fixed interest rate for the first 2 years of the loan which then begins to adjust. This move is prompted by massive downgrades of subprime bonds by rating agencies in the past 2 weeks. Countrywide Financial Corp., Washington Mutual Inc., First Franklin and Option One Mortgage have already stopped offering the product.

Meanwhile Standard & Poor’s announced that it’s placing $1.76 billion in asset-backed securities on CreditWatch with negative implications. S & P said it is continuing its review of CDO ratings, so more downgrades are possible in the near future.

“No value left” in Bear Stearns funds

Bear Stearns estimates that its two troubled hedge funds that invested in securities backed by subprime mortgages are nearly worthless today, after “unprecedented declines” in the value of underlying collateral. The smaller, “enhanced leverage” fund has “effectively no value left” in it while the older High-Grade Structured Credit Strategies Fund has lost 91% of its value. Shares of Bear Stearns dropped $2.47, or 1.8% to $137.44.

As markets watch everything that has “subprime” on it collapse, fears are spreading among consumers who don’t know exactly what their retirement savings are invested in. Now that securities backed by Alt-A loans are getting downgraded, many are beginning to realize how problems in the lending sector could affect nearly everyone. Moody’s, the rating agency which recently started downgrading the securities, says it is not being hired by issuers of commercial mortgage-backed securities. Underwriters are “rating shopping” and the agencies that get hired are the ones most likely to give higher ratings.

I can’t help but wonder if there will be a significant difference between ratings done by Moody’s and other companies. After all, ratings agencies need a good reputation so giving false ratings doesn’t make much sense. It seems that more downgrades are inevitable, so this “rating shopping” trend shouldn’t really last for long. But who knows…

Mortgage-backed securities get downgraded

As troubles in the subprime lending sector are beginning to cause major problems to hedge funds that invested in mortgage-backed securities, rating agencies are now downgrading these papers.

Moody’s announced negative rating actions on 431 securities originated in 2006 with an original face value of $5.2 billion. 399 of these were downgraded and another 32 were placed on review. The rating actions were caused by loan performance deterioration which was due to a slowing home price appreciation and aggressive underwriting practices.

Standard & Poor’s (S&P) announced that it will change the way it evaluates the securities. The full impact of this will be seen in a few months, probably resulting in an increase in interest rates to subprime borrowers and losses for investors. S&P said that 612 classes of mortgage-backed securities, totaling more than $12 billion in debt, have been put on CreditWatch and most of these will be downgraded in the next few days. Ratings of Collateralized Debt Obligations, or CDOs, are also being reviewed.

According to the agency, losses on the mortgages backing these securities exceed anything that’s happened before. I guess we should assume that no one knows what a situation like this will lead to, and, most importantly, how to deal with the problem. It could result in a really big bust for the financial markets, and the dollar is already falling.