The breadth of downgrades - and the resulting liquidations and margin calls - upended the U.S. subprime RMBS market in July. But the downgrades are far from over, market participants say, and many expect a repeat of the July experience.
"We had projected prior to the massive subprime rating actions in July that 80% of the 2006 subprime BBB-'s are likely to be downgraded, and I think we are still far from that," said Wen Zhang, an ABS research analyst at Credit Suisse. So far, about 40% of the 2006 subprime BBB-'s were downgraded, according to Zhang's colleague, Xinhui Tang.
Despite harsh criticism from investors about the abundance of simultaneous downgrades and the multitude of rating actions still expected, rating agencies face a difficult challenge of weighing the cumbersome number of downgrades against timing issues. "They don't want to be seen as cherry picking or the opposite of that in this case - attacking the worst yields, slowly bringing that information to the market and maybe being too slow," said Steven Todd, a Wachovia Capital Markets analyst.
Rating agencies typically wait until the collateral is seasoned enough for them to get a sense of how poorly it will perform. Generally, they are looking at 12 to 16 months of seasoning before they can map performance in their loss-timing curve to determine whether the loans are experiencing much higher losses and delinquencies than their models predict, according to Todd. "I wouldn't be surprised if [the rating agencies] repeated [the downgrades in a similar manner as the July announcements] because they are monitoring very closely now, and they are being proactive."
Todd also expected the dollar volume to resemble the wave of July downgrades with the similar structural issues - for instance, the piggyback second-lien loans - that will mostly affect 2006 collateral and some 2007 collateral.
Adding to this expectation are the growing losses for loans originated in the second half of 2006 and into 2007. Average cumulative losses are trending higher for every successive quarter from the beginning of 2005 to the start of 2007, according to a subprime mortgage-market update from Moody's Investors Service published last week.
CDO Challenge
Following the downgrades in U.S. subprime RMBS collateral will be additional downgrades in the affected CDO ratings. The first wave of CDO downgrades in July referenced mainly late 2005 and early 2006 U.S. subprime RMBS collateral. While 2005 CDOs were affected, the 2006 CDOs had a higher concentration of the affected collateral, Todd said, noting that on the upside, the trickle of CDOs that the market has seen as a result of heightened risk aversion will reduce the number of future downgrades.
But the real question is how much these downgrades matter to the market right now. Zhang cited the disconnect between the ratings, the actual performance and how those bonds are being traded.
"While there may be additional pressure or forced selling from future downgrades [either from investors or more likely CDO investors who are generally the predominant holders of BBB' stack subprime ABS, the investors who have been following this market closely will be expecting [these downgrades]," Zhang said. "The market has already priced in the rating downgrades. They are not pricing those bonds at investment-grade ratings if they trade at 35 cents on the dollar."
Furthering these problems is the lack of interest in RMBS products in general and the recent liquidity concerns in the ABCP and SIV sectors. "Investors refuse to buy both good and bad mortgage bonds, which makes the liquidity in that market dry up," said Ajay Rajadhyaksha, co-head of U.S. fixed-income strategy at Barclays Capital on a conference call last week. "Investors need clarity not only about the extent of mark-to-market losses for dealers and other players but also about what CP has exposure and where downgrades could come next."
Indeed, "who holds the risk?" seems to be the question in everyone's mind at the moment, as market players wonder when the liquidity will come back and, on a macroeconomic level, what the Federal Reserve and the U.S. government will do to bail out delinquent borrowers and boost investor confidence.
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