Market Insight: US subprime lending market woes

Market Insight: US subprime lending market woes
By Saskia Scholtes
Copyright The Financial Times Limited 2007
Published: February 13 2007 18:56 | Last updated: February 13 2007 18:56


A savage sell-off has swept through the credit derivatives market for sub-prime mortgages since HSBC and New Century Financial delivered a bitter pill to investors last week.

The financial institutions’ warning of difficulties with their portfolios of loans to American borrowers has sent credit derivative investors running for cover. And while the market for credit derivatives on sub-prime mortgages might be small, the extent of the sell-off has raised concerns about the vulnerability of the broader structured finance world.

The cost of buying insurance against default on sub-prime mortgage bonds issued in 2006, as measured by a key index, has soared. The ABX index reflects market views, expressed in basis points, of the general credit risk of the underlying securities.

The ABX index for bonds, rated BBB-, has soared about 300bp higher since last week’s news, reflecting a perceived increase in risk, and pushing the index to a record level above 960bp, signalling an alarming rise in investor concern over the potential losses on 2006 mortgage bonds.

“Liquidity has (temporarily) evaporated from the ABX market and a ferocious sell-off has caught most of the market off-guard,” say Gary Jenkins and Jim Reid, analysts at Deutsche Bank. “This is perhaps evidence that in the world of structured credit and leveraged positions, things can change very quickly if the facts change.”

The Deutsche analysts say that so far the knock-on impact has been limited. But they add the unknown risk is whether any investor in ABX products faces liquidation pressure elsewhere in their portfolios.

“As a minimum, the conclusion we draw from this recent (and so far isolated) event is that we need the US economy to be strong for the leverage in the system not to cause a panic, and that when the next downturn in the economy does come, credit is unlikely to be immune frm this,” they say.

The ABX has undoubtedly become a popular barometer for tracking sentiment in the troubled sub-prime sector in recent months – as one of the few places where investors can express bearish views on the US housing market.

“Shorting sub-prime credit has finally worked for the housing bears, finding its ultimate expression through the ABX index,” says Gyan Sinha, mortgage strategist at Bear Stearns.

However, there are good reasons to believe that the recent extreme price action in the index is more of a knee-jerk reaction to negative headlines, amplified by the illiquidity of an index which sees little trading and there is uncertainty over the fair value of the index.

The problem is, explains Vince Breitenbach, head of US Credit Research at Barclays Capital, “there is a lack of natural long-position interest
in the lower rated tranches of this index.”

What this means is that while there are hedge funds and mortgage originators lining up to take bearish views on the sub-prime mortgage market and on the state of US housing in general, there are very few investors willing to take the other side of the trade.

“As a result, bearish market sentiment on housing has been distilled into this narrow nook of the market,” says Mr Sinha.

Instead, he argues, a considered analysis of the fundamental value of the 20 underlying bonds referenced in the index, shows that much of the price action has been purely sentiment-driven. One indication of this is the mismatch between prices in the derivative index, and prices in the underlying markets for credit default swaps on the individual bonds.

“The current levels of the index are especially intriguing considering that both the cash as well as the single-name CDS markets are trading at much tighter levels versus the index,” says Mr Sinha.

However, Mr Sinha says while the 2006 vintage of mortgages have not been ”the industry’s shining moment”, sophisticated players in the ABS markets have been aware of an increase in subprime delinquencies and defaults for several months.

So while the sub-prime sector may experience some more pain, Mr Sinha argues an overreaction to headline risk could create opportunities for contrarian investors.

At current prices, Mr Sinha estimates those willing to take the other side of the ABX trade and hold on for 10 years could receive an annualised return of 12.92 per cent – not too shoddy for BBB- risk.