I noticed that Moody’s Investor Services has *implied* that the credit ratings of Goldman Sachs, Merrill Lynch and Morgan Stanley were only two levels above “junk” based on the Credit Default Swap (CDS) market. Specifically, prices for credit-default swaps linked to the bonds of Goldman Sachs, Merrill and Morgan Stanley last week traded at levels that equate to debt ratings of Baa2.

This could be because CDS traders are more bearish than bond traders and have been more concerned about the slowdown in the housing (see blog posting) and global equity markets, and therefore Goldman & Co’s exposure to these markets through their massivley successful mortgage securitization businesses (which includes significant exposure to subprime mortgages).

The size of the CDS market is now an enormous $26 trillion (twice the annual economic output of the U.S.)!! According to Bloomberg, Goldman and Morgan Stanley have $171.6 billion and $168.5 billion respectively in bonds outstanding.

But what happens to their credit risk (and revenues) when these markets tank ? Since a Credit Default Swap is an insurance policy on a bond,  the buyer of the insurance pays a premium and gets a nice pay-off if the bond defaults. This is great for financial institutions in an environment of low corporate debt default rates.  Recently, interest-rate spreads above Treasuries on high-yield corporate debt were very low by historical standards. Some of this seemed ok since surging corporate profits have kept default rates on corporate debt very low. But since the credit quality of bond issuers has deteriorated in recent years, clearly the market has been out of sync with reality/history.

So, there are a few problems coming together here to potentially make a mess and really hit bank profits. If the housing market tanks and default rates increase, it is going to cost the banks a lot of money. During the recent sell-off, credit spreads have been widening and so the cost of insuring against corporate bond default (via CDS)  will continue to rise. And, if the actual ratings of these banks do drop to these implied ratings their borrowing costs will rise.

The Subprime and Alt-A markets have been taking a beating recently. Many borrowers took on a lot more risk and have stretched themselves too far such that when interest rates rose, payments increased driving up defaults and delinquencies and high-than-expected repurchases by mortgage lenders.

Not only has this damaged credit ratings of the borrowers and left some without a house, it has hurt the mortgage lenders revenues and cash reserves (which they need to buy back the loans). While originators are trying to sell these loans, they often pass the loan to warehouse lenders such as the big banks. In return they get cash equal to the value of the asset, minus a fee, known as a haircut, which helps to smooth out and cushion against late payments and delinquencies.  These banks are now asking for a larger haircut, also hurting the originators cash reserves.

Statistics

Subprime mortgages are loans taken out by homebuyers with poor or limited credit histories, where the mortgage lender charges rates 2-3% above the “safer” prime-loans. Last year, 13.5% of mortgages in the US were sub-prime (against 2.6% in 200). Overall the subprime market in 2006 was about $600billion, 20% of the $3trillion mortgage market. By the end of 2006, subprime delinquencies more than 60 days jumped to 13% (from 8% in 2005).

Additionally, the “Alt-A” market is adding to the woes of mortgage lenders and investors. Alt-A borrowers are “medium risk” borrowers that fall between the subprime and prime loan markets. Specifically, they meet Fannie Mae and Freddie Mac standards for credit scores but might not meet standard guidelines for documentation requirements, property type, debt ratio or loan-to-value ratio. Of course, they too pay a premium for their loans. “Alt-A”s  defaults are on the rise (now 2%). It is expected that 5% of the 2 million Alt-A mortgages issued in 2006 will foreclose.

Developments

Recently, the Fed has urged Congress to bolster regulation of Fannie Mae and Freddie Mac, the No.1 and No.2 US buyers of home mortgages, by suggesting they limit their holdings to guard against their debt poses to the economy. Freddie Mac correspondingly announced that it would no longer buy certain risky subprime mortgages.

This has forced subprime lenders to either tighten their lending standards or assume the higher risk of keeping these loans on their books. This will include increasing credit score requirements and documentation firming up.They *suggest* that lenders should evaluate the borrower’s ability to repay the debt before offering a loan !!!!

Many of those borrowers have now been effectively shut out of the market as lenders tighten their standards, causing major problem for borrowers wanting to access credit products such as portgages. This will increase delinquencies and foreclosures, causing more credit problems down the road, not to mention that massive impact on the secondary market and overall economy.