Top Wall Street credit agencies shook the financial markets yesterday by announcing they are downgrading more than $17 billion of mortgage bonds backed by defaulting subprime loans and changing the way they grade such risky loans in light of increased mortgage fraud that led to the defaults.
The far-reaching actions by Standard & Poor's Corp. and Moody’s Investors Service sent stocks, bonds and the dollar diving, with the greenback hitting a new low against the euro, as investors dumped the dicey mortgage securities and other risky investments in favor of safe havens like Treasury bonds.
The Dow Jones Industrial Average plunged 148 points as investors sold off the stocks of home builders, retailers and financial companies hurt by the imploding housing and mortgage markets. Investment houses and banks like Bear Stearns Cos. and HSBC already have been hurt by the sharp rise in defaults, and the ratings actions further deflate the value of the mortgage investments they underwrite and sell.
“Investors were waiting for the other subprime shoe to drop” after Bear Stearns last month bailed out two hedge funds heavily invested in subprime loans, said Alexander P. Paris, analyst with Barrington Research — and yesterday it did.
The subprime meltdown, which has rankled the markets off and on all year, adds to worries that “the housing correction is nowhere near an end” and consumers, set back by falling home prices and dwindling refinancing opportunities, will rein in their spending, he said.
The actions by the credit agencies add significantly to the borrowing crunch facing consumers and potential home buyers, particularly those who are heavily leveraged with mortgages or have shaky credit histories.
Standard & Poor's said that partly because of fraudulent underwriting practices, default rates among subprime mortgages made from late 2005 through 2006 are the highest ever recorded, even though they have not reached the critical stage where most defaults were expected — when the payments reset at higher levels to reflect higher interest rates and principal payments.
Nearly $500 billion of such subprime mortgages are due to reset in the next year, Standard & Poor's said, so default rates could snowball.
Defaults also will be driven by an expected 8 percent drop in home prices nationwide, the agency said. In areas with high concentrations of subprime loans, prices are expected to drop by 22 percent, leaving many borrowers with loans that have exploding payments they cannot afford at the same time they are unable to refinance because they owe more than the house is worth, it said.
Standard & Poor's came to the conclusion that the much-higher-than-expected incidence of default that recent mortgages are experiencing is due partly to fraud by mortgage brokers and borrowers, such as misrepresenting their incomes or credit standings.
The agency said it is tightening standards for bonds backed by such mortgage securities, requiring lenders to provide additional collateral to receive the best ratings, and it will require safeguards against fraud, “given the level of loosened underwriting … misrepresentation, and speculative borrower behavior reported for the 2006 vintage.”
S&P said it is preparing to lower the ratings on 2.1 percent of $565.3 billion of mortgage bonds it rated last year. Moody’s cut ratings on 399 bonds and said it may reduce rankings on another 32 securities underwritten last year.
While most of the securities being reviewed by S&P have low BBB ratings, some were rated as high as AA. Even before the ratings cuts, prices on some of the mortgage bonds had fallen by 50 percent or more.
The ratings actions could cause a cascade of selling in the mortgage market if they force insurance companies and pension funds to divest securities that get downgraded into junk status. That would potentially drive down prices for as much as $1 trillion of collateralized debt obligations backed by subprime mortgages.
The actions by the ratings agencies is likely to provoke a round of finger-pointing and lawsuits as many investors depended heavily on the opinions of the Wall Street firms in purchasing the securities. Most subprime mortgages were subdivided and packaged into complex derivative securities that were assigned ratings from AAA to BBB depending on their exposure to default. Because they were so complicated and infrequently traded, they would have been difficult to price and sell without the ratings.