Stocks regain ground despite credit worries

Published: Thursday, March 1, 2007 at 6:01 a.m.
Last Modified: Thursday, March 1, 2007 at 3:20 a.m.
NEW YORK - Calm returned to Wall Street on Wednesday.
Encouraged by comments from Ben S. Bernanke, the chairman of the Federal Reserve, and a rebound in the Chinese markets where Tuesday's global sell-off began, stocks rose modestly in the United States.
The Dow Jones industrial average, which tumbled as much 545 points on Tuesday, closed Wednesday up 52.39 points, or 0.4 percent.
The Standard & Poor's 500-stock index closed up 0.56 percent, and the Nasdaq, 0.34 percent. Asian and European markets ended the day lower, but the Shanghai market climbed 3.9 percent.
Yet one important concern - that Wall Street's big bet on home loans to people with weak, or subprime, credit is souring quickly as defaults rise and home prices weaken - has not gone away.
Wall Street executives and analysts acknowledge that the subprime segment of the mortgage business has faltered because of the performance of loans issued in 2006, but many contend that the problems are well contained and do not yet pose a significant threat to investment banks or the broader global financial system.
Cracks have become more visible lately, however. Insurance premiums on the potential default of Wall Street bonds have risen sharply, indicating possible concern among bond traders about the potential exposure of the Street.
''It is impossible to get a number'' on big investment bank's exposure to subprime, said Richard X. Bove, an analyst with Punk Ziegel & Co. ''And I don't think they even know.''
The credit default swap spreads on Bear Sterns' debt, for example, widened 40 percent recently, from about 22 basis points in mid-January to more than 31 on Tuesday, according to data from Lehman Brothers. Analysts fear that the exposure could spell trouble.
Spreads on swaps for major firms with exposure to the subprime market, including Lehman Brothers, Morgan Stanley, Goldman Sachs and Merrill Lynch widened similarly. Brad Hintz, an analyst with Sanford Bernstein, said investors are increasingly concerned about Wall Street's exposure to the weakness in that market.
Investors, while heartened by Bernanke's outlook for ''moderate growth,'' have had a list of concerns: a slowing economy, oil prices, accelerating inflation. But now a major concern is whether the problems of subprime lending will spill over into the broader mortgage market.
During the housing boom, Wall Street developed a series of profitable connections to the subprime market that included providing financing to companies that made loans to home owners, buying finished mortgages, packaging them into bonds and then trading them. Wall Street now faces risks on two fronts. First, it stands to earn less revenue from originating, packaging and trading mortgage-backed securities. Second, it will have to absorb more of the losses from loans where borrowers are no longer making payments.
In the past, it could demand that mortgage companies buy back defaulted loans, but such large ''put back'' requests have driven many lenders out of business and big investment banks are making many more loans through subsidiaries they own. As a result, the banks retain more of the risk in the form of ''residual'' interest in the loans they securitize.
''The brokerage firms have done something curious: They are not abandoning subprime mortgage origination, they are taking positions,'' Hintz said.
In December, Merrill Lynch completed a $1.3 billion acquisition of First Franklin, which was among the 10 biggest subprime lenders last year, and Morgan Stanley bought Saxon Capital for $706 million.
Bank executives say they anticipated the problems in subprime and they have been buying lenders because they want to better control lending standards in the industry.
''Saxon was a long-term strategic decision,'' said Anthony Tufariello, who heads the securitized product group at Morgan Stanley. ''And we are happy we made that decision because we bought it as a servicing platform with the expectation that the market would undergo dislocation.''
And the deal making continues. Citigroup said Wednesday that it would provide working capital to and provide a credit line to ACC Capital Holdings, which owns Ameriquest and Argent Mortgage. The deal, terms of which were not disclosed, also includes an option for Citigroup to acquire Argent, which lends through mortgage brokers.
By some estimates the potential risks to the big banks are relatively modest. Hintz, of Sanford Bernstein, calculates that Lehman Brothers had $7.3 billion in residual risks at the end of 2006, $2 billion of it in non-investment grade mortgages. If the non-investment grade residuals decline by 20 percent, Lehman's earnings would decline 3.2 percent after taking into account compensation costs and taxes; Bear Stearns' income would fall about 4.1 percent.
A Lehman spokeswoman declined to comment on the company's mortgage business.
Not all analysts are as sanguine.
Guy Moszkowski, an analyst with Merrill Lynch, on Wednesday downgraded Goldman Sachs, Bear Stearns and Lehman Brothers based on the erosion of risk appetite among its customers and because he believes the problems seen in subprime are spreading to Alt-A mortgages, which fall between subprime and prime and accounted for about 13 percent of loans written last year.
Investment banks got into the subprime market because the loans generated high yields, making them popular among pension funds, insurance companies, hedge funds and foreign investors.
On the other side of the food chain, small mortgage companies and brokers stood ready to feed Wall Street with loans. The banks plied them with cash with which they could make loans and agreements to buy the loans from them.
The business generated multiple lines of income for the Street, including underwriting and trading. By 2005, the residential mortgage-backed securities market was generating 15 percent of fixed income revenues and the subprime sector was bringing in 3 percent to 4 percent of fixed income revenues, according to Hintz.
Lehman Brothers, RBS Greenwich Capital Markets, Morgan Stanley and Merrill Lynch were the biggest underwriters of mortgage-backed securities in 2006, with Lehman controlling 10.7 percent of the market and underwriting $51.8 billion worth of mortgage-backed securities, according to Inside Mortgage Finance.
For some analysts, the bigger risk to Wall Street is simply that the spigot has been turned off.
''Does the flow of mortgages to the securitization machine slow?'' asked Jeffrey Harte, an analyst with Sandler O'Neill. ''That's what I'm most worried about.''
Volume is falling. Production of non-agency mortgage securities fell almost 50 percent between January and February, according to preliminary numbers compiled by Inside Mortgage Finance. The data indicate that originations of subprime and Alt-A fell significantly in February.
Wall Street, however, seems to believe it will come out on top, surviving where smaller players lacked the resources.
''The economics of the business are moving in favor of well-capitalized entities who don't have to go outside'' for other services, said Gyan Sinha, who heads asset backed securities research at Bear Stearns. The big banks' optimism is derived in large part on the basis of these bonds' structure. For one thing, most bonds collect more in interest payments than they are obligated to pay out. They also include a cash reserve, or residual, that can be dipped into if interest payments fall short because of defaulting borrowers.
''You can have a pretty long period of stress before you start to see actual write downs,'' said Anthony V. Thompson, who heads research of asset-backed securities at Deutsche Bank Securities.
Much depends on the strength of these bonds' structure, which is determined to a large degree by ratings agencies like Moody's Investors Service, Standard & Poor's and Fitch Ratings.
Skeptics say that Wall Street's faith in complexity has proven wrong before, most recently in the meltdown of the manufactured housing, or trailer home, market. The business boomed in the early and mid-1990s before collapsing in the late 1990s when many buyers of the homes defaulted on loans.
''These credit corrections are not unexpected,'' Thomson said. ''What's harder to predict is the precise moment when the market decides to reprice the risk.''

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