A tragedy in three acts


Although in hindsight the clues were there as far back as 2006, to suggest that last year would be a difficult one for the US mortgage market, even the most pessimistic of observers would have been hard pressed to predict the severity of the turmoil in the financial markets in 2007. Losses from residential mortgage-backed securities (RMBSs) and collateralised debt obligations (CDOs) with exposures to subprime mortgages are approaching $60 billion (based on a count of 14 large banks with losses in excess of $1 billion each). Liquidity has dried to a trickle, and interbank lending rates have soared. Even co-ordinated intervention from the world's central banks has done little to turn the tide.

The chart shows index spreads for the iTraxx Europe and CDX North America indexes, which comprise the 125 most liquid credit default swaps (CDSs) on both continents. In the first six months of 2007, CDS spreads remained tight, reflecting strong investor demand for mezzanine tranches of CDOs and abundant liquidity in the financial system.

The first shift in sentiment came in late February as talk of rising delinquencies in the US subprime mortgage market began to spook investors. At the same time, Chinese stock markets plummeted following negative economic data, with the rest of the world following suit. Then, on April 2, California-based real estate investment company New Century Financial filed for bankruptcy, indicating that events in the subprime market were beginning to take their toll.

A period of relative inactivity followed, ending on July 10 with an announcement from the rating agencies that they were downgrading hundreds of CDO and RMBS tranches, sending credit spreads soaring and presenting analysts with profound difficulties in attempting to assess the true value of the subprime exposed securities.

Spreads remained wide through August to mid-September as liquidity evaporated, and other asset classes not directly influenced by events in the mortgage sphere also suffered. Spreads began to tighten in mid-September, although never threatening to reach the levels seen in the first few months of the year. Then, in early October, spreads widened again as hefty third-quarter write-downs were announced by investment banks. Meanwhile, repeated attempts by central banks to inject liquidity into the global banking system failed to lower the cost of interbank borrowing.

By early December, spreads on both sides of the Atlantic were tightening - although it is premature to assume that the worst is over, especially given that interest rate cuts and cash injections by central banks worldwide totalling over a trillion dollars have done nothing to reinvigorate interbank lending. There is also the very real problem of the anticipated two million mortgage foreclosures that the US Congress expects to see before 2009, as well as the emergence of further bank write-downs. CDS dealers who have bet against the market could be in for another good year ahead. For those relying on the markets to go up, it might be a difficult 2008.

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