Last month was the most volatile for the credit markets since the correlation crisis in May 2005. In Europe, the iTraxx credit derivatives indexes registered their largest single-day widening on February 28, while the iTraxx Crossover index regularly traded in a 30-plus basis-point daily range. A glance at the Dow Jones CDX indexes tells a similar story - high volatility and increased volumes.
These movements initially stemmed from weakness in equities and rising delinquencies in US subprime loans, leading to fears of contagion into the broader markets. These concerns now seem to have faded, at least to some extent - yes, there are ongoing concerns about delinquencies in subprime, but most analysts feel there is unlikely to be a wider impact.
For a start, the subprime sector, despite growing rapidly in the past few years, is still a relatively small part of the overall US mortgage market - about 9% of new loan originations in 2006, according to Bear Stearns. It has enabled borrowers with low credit scores to take on mortgages with loan-to-value (LTV) ratios approaching 100%, without providing verification of their income. But now, US regulators are likely to require lenders to tighten underwriting standards. Combined with falling house prices, and the fact that a number of subprime lenders have either gone bankrupt or closed their doors to new business, subprime borrowers may find it increasingly difficult to refinance their loans in the future. That, in turn, could mean delinquencies are set to rise further.
Whether this spreads to other sectors of the mortgage market depends, to some extent, on whether the loose underwriting standards and high LTVs existed among lenders outside the subprime market. Most analysts think not.
Where there could be an ongoing impact is in residential mortgage-backed securities (RMBSs) and collateralised debt obligation of asset-backed securities (CDO of ABSs). Bear Stearns analysts predicted the origination of subprime mortgages will fall by 30% this year, which will affect the volume and mix of RMBSs and CDO of ABSs sold. Current deals are also likely to be affected, with some dealers reporting that several planned CDO of ABSs have been postponed following the volatility of spreads. There have also been rumours that a handful of dealers posted hefty mark-to-market losses on the ABS assets they were warehousing (see pages 42-44).
It may not be the broader credit repricing many traders are expecting, but it has certainly given some food for thought.
Nick Sawyer, Editor