Subprime mortgage bond risk surges, credit-swap index suggests


By Jody Shenn and Shannon D. Harrington
Bloomberg News Service
Thurdsay, February 8, 2007

NEW YORK -- The perceived risk of owning low-rated subprime mortgage bonds surged today after the two largest U.S. lenders reported growing problems stemming from the loans, an index of credit-default swaps suggests.

An index used to create swaps based on 20 BBB- rated bonds sold in the second half of 2006 and consisting of home loans to the riskiest borrowers fell 2.3 percent to about 88.5 today, the lowest since it was created Jan. 18, according to Deutsche Bank AG. The so-called ABX index was down 10 percent before today.

HSBC Holdings Plc, the world's third-largest bank, late yesterday said more of its U.S. home mortgages were going bad than it expected. Irvine, California-based New Century Financial Corp. said it would post a fourth-quarter loss, restate other 2006 earnings lower and make fewer loans this year.

"People are observing that New Century and HSBC are saying that their loan performance is worse than expected and translating that into a broader statement," said Andrew Chow, who manages $6 billion in asset-backed bonds and their derivatives at SCM Advisors LLC in San Francisco.

Implied premiums for bid prices mean investors must pay about $775,000 per year to protect $10 million of bonds, according to Deutsche Bank. Dealers set premiums on the contracts at $389,000 when launching it last month.

Countrywide Financial Corp., Lehman Brothers Holdings Inc. and RBS Greenwich Capital Markets Inc. last year underwrote the most "home equity" asset-backed securities, which are mainly subprime mortgage bonds, according to newsletter Inside MBS & ABS.

Shares of New Century tumbled 28 percent, the most since October 1998. Shares in rivals such as Fremont General Corp., Accredited Home Lenders Holding Co., Fieldstone Investment Corp. and Novastar Financial Inc. also plunged.

Subprime mortgages, which typically have rates at least 2 or 3 percentage points above safer "prime" loans, are given to people with low credit ratings or high debt. They made up about a fifth of all new mortgages last year and about 13.5 percent of outstanding home loans, up from about 2.5 percent in 1998, according to the Washington-based Mortgage Bankers Association.

Trading volume centered on an index in the previous ABX series linked to 20 BBB- bonds from the first half of 2006, which fell about 2 percent to 86, according to Peter Fitzpatrick, co- head of asset-backed credit-default swap trading at broker GFI Group Inc. in New York

"If it's not the record, it's pretty close," he said.

The ABX market has been driven more by supply and demand issues than the concerns of all bond investors in the past three months, according to traders, investors and analysts including Peter DiMartino at RBS Greenwich in Greenwich, Connecticut.

"There's little you can take from the ABX and infer to the cash market," DiMartino said in a Feb. 7 interview. "Show me where in the housing market prices have declined or depreciated as much as one would infer by looking at the ABX."

Federal Reserve Governor Susan Bies said last month regulators are particularly worried about lenders that added layers of risk by combining low down payments with low documentation, or with interest-only loans that allow borrowers to skip payments and add the sum to the total amount of the loan.

The Fed added a special set of queries on bad loans to its regular quarterly survey of senior loan officers. The Feb. 5 report found half expect credit quality on non-traditional mortgages, such adjustable-rate and interest-only loans, to get worse in 2007. In response, more banks tightened lending standards in the past three months than in any quarter since the early 1990s, the survey said.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on the odds the debt will be repaid. Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.

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