Will subprime woes spill over to stocks?

With Wall Street's two largest debt-rating agencies finally turning sour on subprime mortgages, investors wonder whether housing-market pain will spread to other asset classes, including stocks.

MarketWatch: In-depth global business coverage With Wall Street's two largest debt-rating agencies finally turning sour on subprime mortgages, investors wonder whether housing-market pain will spread to other asset classes, including stocks. "So far, the stock market keeps whistling past the graveyard," said Matt Smith, president and portfolio manager at Smith Affiliated Capital. "But these issues continue to get worse, and eventually they'll impact [mergers and acquisitions] and private-equity activity, which have been the foundations of the stock market." On Tuesday, Standard & Poor's announced that it might downgrade $12 billion in subprime bonds, known as residential-mortgage-backed securities, or RMBS, while rival Moody's Investors Service downgraded 399 such bonds. The Dow Jones Industrial Average fell nearly 150 points Tuesday, while the broad S&P 500 Index, which is heavily influenced by financial stocks, fell even harder. "There are some concerns in regards to the health of the subprime market," said Mike Malone, trading analyst at Cowen & Co. "If it worsens substantially, it could be an issue for the market, even during earnings season." Until recently, the stock-market impact of housing problems has been contained to the builders, subprime mortgage lenders and some of the big Wall Street firms that package and sell residential mortgage-backed securities, or MBSs, in secondary markets. The meltdown in subprime mortgages last month came back to bite two hedge funds owned by Bear Stearns, which were brought nearly to collapse by heavy exposure to subprime MBSs. But the ratings agencies' new stance on subprime mortgages could herald a much broader impact on financial markets, analysts warned. Re-pricing risk Until now, the pricing of risks linked to housing and subprime mortgages remained something of a mystery, as risks remained hidden in the complex world of credit derivatives. But changes in ratings will force a re-pricing of the roughly $800 billion in subprime-mortgage bonds sitting in investment portfolios across the globe. "Whenever you have such a massive growth in derivatives, as we had with housing, it's [used] to hide the losses," said Smith of Smith Affiliated Capital. "Nobody knows the true counterparty risks." So-called subprime mortgages were extended to borrowers with subpar credit histories during the latest housing boom, which ended late in the summer of 2005. Banks and other mortgage lenders mainly resold these risky mortgages to Wall Street firms, which sliced and diced them into mortgage-backed securities and then offered them in the secondary debt markets. Hedge funds, fast-money players and mutual funds searching for higher yields gobbled them up in the hope that the spreading of the risk among different tranches of MBSs - and into larger collateralized-debt obligations, or CDOs - made this a sure bet. They were also reassured by the high grade assigned these securities by the rating agencies. Exotic types of mortgages, such as interest-only and adjustable-rate loans, had helped fuel the housing bubble but, by this year, surging defaults on mortgage payments and the mounting number of homes being foreclosed have caused the prices of these securities to plummet. Rebalancing portfolios Hedge-fund and portfolio managers had been able to let their losses ride to this point. But with the credit-rating agencies now either considering or applying downgrades, the game has changed. Many portfolios that require investment-grade ratings need to be re-balanced by money managers. The immediate impact on stocks was some Tuesday-afternoon liquidation by portfolio managers in order to finance the purchase of risk-free Treasury bonds, which help offset the higher risk of owning lower-grade assets. "They have to go out and buy Treasurys to keep up the ratings," reported Marc Pado, market strategist at Cantor Fitzgerald. Leading lower With the housing market continuing to stumble, financial stocks, which tend to serve as market leaders, were among the worst performers on the S&P 500 during the month of June, losing more than 3.5%. Besides Bear Stearns, investors wonder which of the other large Wall Street firms - such as Goldman Sachs, Lehman Brothers or Merrill Lynch - might be sitting on losses associated with subprime loans. Many large banks, while they have for the most part resold their subprime mortgages as MBSs to Wall Street, also were MBS buyers. Many have also taken countertrades with hedge funds, or lent them money to finance risky bets. "The financial companies that have ridden this wave to high profits are now at risk," said Richard Bove, a banking and brokerage analyst at Punk Ziegel & Co. "Investors in these companies, and the instruments they create, are beginning to understand this risk and have valued the stocks of the companies, at least, appropriately." But "the general market sees no risk and to this point has avoided dealing with the issue," Bove said. "This may not continue." Credit crunch? A bigger problem for the stock market, however, would be a sell-off in credit markets, which would effectively start restricting the availability of funds for both corporations and private-equity firms, which have been going on a buy-out rampage over the past few years. "For their part, lenders may now back further away from extending credit for buyout deals," said Richard Berner, managing director and chief US economist at Morgan Stanley. "In part, that's because even a slight reduction in market liquidity will make it more difficult for lenders and underwriters efficiently to lay off risk, so lending standards will likely tighten." The stock market has continued to advance so far this year, even as economic and earnings growth have slowed, in part due to the big private-equity deals that have removed numerous stocks from the market and have fueled speculation of more takeovers to come. A drying up of the easy money could to an abatement of such deals, removing a central source of recent support for stocks. Enron redux Some market players believe that, with the rating agencies making their moves so late in the game, they're seeing a replay of the Enron and WorldCom debacles, which played significant parts in popping the 1990s stock-market bubble. The rating agencies, then as now, have come under fire for changing their ratings only after the bad news was already out. "The credit agencies are always lagging," said Smith Affiliated Capital's Matt Smith. "But the main difference between now and 2000 is that you could sell stocks quickly; for the real estate market, it takes three or four years to unfold." Both Enron and WorldCom had used "creative" accounting methods to artificially boost earnings, until the bursting of the stock bubble revealed their overwhelming debt was more real than much of their projected revenue. Yet the main credit-rating agencies had kept an investment-grade rating on both companies' debt until days before they went bankrupt. Similarly, some analysts say the housing market bubble was fueled by such home loan categories as interest-only and adjustable-rate mortgages that were extended to borrowers with poor credit. While Wall Street and the banks capitalized on the growth, much of their projected earnings rested on expectations that these loans would, in fact, be paid back. In particular, so-called liar loans, or mortgages that were backed by dubious documentation - if any - from borrowers, still ended up receiving high-grade ratings from the agencies. Peter Schiff, president of Euro Pacific Capital, said the rating agencies' moves this week were too little, too late. He said lenders knowingly relied on inaccurate data. "If the lenders themselves call them liar loans, why should we think they're boy scouts?" Schiff added: "And it's not just people with bad credit that lied on their mortgages." Other analysts, such as Morgan Stanley's Berner, said they believe that, as long as the re-pricing of risk in credit markets remains orderly, a wider credit crunch can be averted. "But I can't rule that out completely," he said. "Credit markets are still tender, and a series of shocks could trigger a much more disorderly re-pricing of risks." Global underpinnings Another key support for the US stock market this year has been global growth, especially from China, whose demand for raw materials and other goods keeps boosting the earnings of many multinationals, well as industrials and materials stocks. One benchmark US industrial stock, General Electric Co., made most of its profits overseas in the first quarter, said Cantor Fitzgerald's Pado. But GE is not completely shielded from subprime issues. According to a report in The Wall Street Journal, the company is expected to take a charge of more than $200 million in the second quarter to cover subprime-related losses suffered by its financing unit. Perhaps more importantly, Chinese and much other global growth is being fueled in large part by exports to the US, where consumers have on average been spending more than they earned - again, thanks to the availability of easy credit. While home-equity loans are already dwindling, tighter lending standards might also start to affect consumption. US job growth, though, remains the true key to consumption, according to Pado. "If we saw unemployment back up to 5%," he said, "that would get the market's attention." MarketWatch: In-depth global business coverage