Monday, August 13, 2007

Subprime Meltdown, the Repricing of Credit, and the Impact Across Asset Classes

Currently $ 25 Billion of ARM's are experiencing their first interest rate uptick each month. That will increase to $ 50 Billion per month and continue at that rate for 12 to 15 months.

The securities created from these mortgages will continue to be marked to market for at least that long. If the U.S. goes into recession, even more people will default on their mortgages, including formerly prime borrowers.

The knock on effect of reduced imports from China could send that country into depression. This is big. This is serious and this isn't going away. The money the U.S. Fed injected last week was only three day repos., with some prime CMO's and other securities used as collateral. It bought some breathing room, that's all. The FED and the ECB are going to have to figure out a longer term plan by tomorrow.
The rate of increase in greenhouse gas emissions should slow down.

This report is a good overview, from J.P. Morgan:

This comprehensive report provides the views of JPMorgan strategists across relevant asset classes. It also includes the recommendations of our Equity Research Bank Financial Institutions analysts from the US, Europe and Asia.

• The worst is not over in the subprime mortgage market. Problems to date have been related largely to poor underwriting or weak housing prices. Credit stress related to resets of subprime mortgages will not become significant until later this year. We expect continued deterioration in
subprime loan performance well into 2008.

• We think investors are overly optimistic about the potential for loan modification to prevent default. There are serious obstacles to loan modification, and in markets with falling home prices modification may not be in the interest of lenders or investors.

• Home price declines such as we expect would lead to substantial increases in subprime mortgage defaults and losses. This in turn would have significant negative implications for pricing and ratings of subprime securities and the asset-backed indices (ABX).

• Although a worsening subprime market will put some spread pressures on CLOs and therefore on leveraged loans, the net impact should be contained and relatively modest. The issues facing subprime and those facing other credit markets are not substantially interrelated.

• In equities, we think increasing defaults and delinquencies in subprime mortgages are negative for the homebuilding, banking, and retailing sectors. We are more concerned with some mid-cap and small-cap banks than largecap financials.

• In the US high yield market, spreads are likely to remain range-bound over the next several months. With a sizeable supply backlog capping meaningful upside, but with fundamentals strong, we believe high yield bonds could trade in a range of 300 bps to 350 bps over Treasuries.

• In the US high grade market, we anticipate risk remains at elevated levels with spreads as wide as the 105 area. LBO activity could decrease modestly while strategic M&A, as well as recapitalizations and other forms of shareholder-enhancing transactions will likely increase.

• In the European credit markets, spreads continue to trade near their wides; we are of the opinion that spreads could rally, but not to their historic tights.

• In the loan market, investors may be concerned about the parallels in the subprime and corporate loan markets, and we think wider LCDX pricing at the moment reflects some of those concerns.