According to news reports yesterday and today in both Bloomberg.com and the Financial Times, Standard & Poor’s has lowered its assumptions for the amount of money investors will receive after defaults of subprime mortgage bonds that are part of Collateralized Debt Obligations (CDOs). This is generally regarded as a sign that S&P may be preparing to downgrade even more CDOs. The CDOs covered by this revision are at least 40% invested in subprime mortgage backed bonds.
S&P revealed that, under its new recovery assumptions, any class rated A or lower would likely suffer 100% losses and the losses on AA-rated slices would be 95%. The junior AAA-rated tranches expect to lose 65% and even the riskless super-senior AAA tranches will suffer losses of 40%.
More than 4,000 of these CDOs have been downgraded this year ? amounting to about 90% of all CDO downgrades. Further ratings cuts by S&P ? on top of the $351 billion in cuts over the past year ? may push investment banks such as UBS and Citigroup to sell CDO debt rather than wait for demand to recover. S&P is currently reviewing the ratings of $16.3 billion in CDOs with a “a high likelihood of downgrade.”
S&P expects further downgrades to the CDOs because a lower than expected recovery typically requires a larger cushion against potential losses to receive the same rating as under the old assumptions. More downgrades could force securities firms, banks, and insurance companies to raise more capital, cut dividends, or reduce assets. According to Brian James of Link Global solutions, a structured finance consulting firm, “as recovery value projections continue to deteriorate we are likely to see an increase in secondary market activity as holders are forced to entertain the bid side of the market.”
Morgan Stanley analysts are slashing forecasts for large bank earnings and warning that the credit crunch is only beginning, according to a report on CNBC.com. Morgan Stanley recommended “underweighting” banks with greater exposure to mortgages (Wells Fargo and Wachovia) and Citigroup because of its exposure to risky assets relative to its equity.
It is frightening that such losses are predicted on what had been considered “investment grade” obligations — and the end is not yet in sight. Now add on to these new loss projections the increasing chances that financial firms may soon be embarking on a fire sale of these CDOs, and it appears that any resolution of this credit crunch is still a long way in the future.