If you've adopted the notion that the worst of the financial crisis is behind us, please think again.
I consider it the height of irony that a sobering wake-up call should come from a ratings agency. After all, I lambasted these agencies repeatedly on my CAPS blog a year ago for failing to warn investors about the risks inherent in mortgage-backed securities and other derivative instruments. Perhaps cognizant of the need to restore credibility, Fitch Ratings delivered a report last Tuesday that -- in the context of the ongoing equity rally -- may represent an uncharacteristically proactive warning to investors about the challenges ahead. If these projections prove correct, then looming mortgage defaults risk sweeping ramifications for the financial system.
Looking at subprime, jumbo, and low-doc home loans that were bundled into mortgage-backed securities between 2005 and 2007, the report focuses on the subset of those loans that have been renegotiated since their origination. While excluding loans backed by Fannie Mae
Fitch Ratings projects that a stunning 55% to 65% of those reworked loans will nevertheless reach the 60-day delinquency stage within 12 months of the loan's alteration. For the subprime mortgages in that group, that expected delinquency rate climbs to 65% to 75%! Echoing the concerns of fellow Fool Alyce Lomax, the report points to falling income and rising unemployment as contributing factors. Even Moody's Economy.com chief economist Mark Zandi, who believes that "the bottom of the housing downturn is within sight," expects a further 11% decline in home prices nationwide.
Pondering the potential consequences
In the scenario implied by this report, however, I believe that both of Zandi's projections would prove overly optimistic. The same conditions seen placing existing loans at risk should also lower the number of able buyers, leading to falling demand and further oversupply concerns. That would significantly prolong the pain for homebuilders like Toll Brothers
This Fool sees a potential link between the report's release and the horrific performance of mortgage-backed securities (MBS) last Wednesday, which drew plenty of comments from CAPS members. Making matters worse, S&P also warned last Tuesday that it may reduce ratings on large portions of commercial MBS. The reverberations from renewed crisis in mortgage-backed securities would further reduce the flow of credit, lead to another spate of asset write-downs, and ultimately herald the unwelcome return of systemic risk to the national lexicon.
As over-extended borrowers default on increasing numbers of credit cards, auto loans, and student loans, overall loan losses for banks like Citigroup
The last domino to fall
The U.S. Treasury and the Federal Reserve have been crystal clear with their actions to date, so their responses to mortgage defaults of a previously unanticipated scale are fairly predictable. Simply stated, I believe that the Fed will absorb additional distressed debt assets onto its balance sheet, offering more crisp dollars in return. While the TALF program presently reports a loan balance of just $15.4 billion, we may yet discover the full range of motivations for the program's expansion from $200 billion to $1 trillion.
Faced with a growing list of insolvent banks, and a stress test process revealed as a joke, I could see Treasury seeking additional TARP-like funds from Congress, and perhaps advocating yet another stimulus package while finding ways to commit capital alongside the Fed in their well-entrenched strategy of countering the deleveraging process with an ever-increasing supply of fiscal intervention. Given the profound discomfort with the U.S. fiscal response already communicated by foreign holders of U.S. debt, like China, I see a failed fiscal response strategy leading this nation's currency down a road to ruin.
I truly hope this report is just as mistaken as the ratings agencies were during the lead-up to this crisis in their investment-grade ratings on what proved to be toxic junk. If, however, this report reflects a ratings industry that is grappling with reality in the aftermath of that failure, then the ultimate stress tests may yet lie ahead.
One simple way for investors to defend themselves against dollar weakness is to look abroad. The Motley Fool Global Gains newsletter team is constantly scouring the globe to identify investment opportunities for Fools who wish to diversify out of the domestic markets, and they're ready to share their findings with you.
Fool contributor Christopher Barker thinks derivatives are a dirty word. He can be found blogging actively and acting Foolishly within the CAPS community under the username TMFSinchiruna. He owns no shares in any of the companies mentioned. The Motley Fool's disclosure policy has zero exposure to derivatives.