Hey, if they don't trust each other, why should I trust 'em?

From Reuters :

NEW YORK (Reuters) - The Federal Home Loan Banks said on Monday the amount of loans made to its member banks rose to a record high in the first quarter as a credit crunch crimped other funding sources for banks.

The system of 12 regional FHLB banks, the largest collective source of U.S. home funding, has increased in importance to the housing market since the credit crunch shriveled up other sources of funds for mortgage lenders.

The group makes low-cost loans to its members, which it funds by selling debt in the capital markets.

Advances, or secured loans, rose 4.3 percent to $913 billion in the first quarter, representing 69.0 percent of total assets, FHLBanks said in a statement.

The volume of loans the FHLB provides to members belonging to the network has soared since last summer as lenders such as Countrywide Financial Corp boosted requests for the funding.

FHLBanks on Monday also preliminarily reported a 12.2 percent rise in first-quarter net income to $697 million, from a year earlier.

"The overall profitability of the FHLBanks is going to make people, for now, rest easy," said Jim Vogel, agencies analyst, at FTN Financial Capital Markets in Memphis, Tennessee.

"If you have a check list of the things you are watching out for, you can check off the FHLBanks and move on to the next item on your list after today's report," he said.

FHLBanks, Fannie Mae, Freddie Mac, and the Federal Housing Administration have become favored vehicles of the Bush administration as it makes efforts to stem surging mortgage defaults, falling home prices and rising foreclosures.

In late March, the Federal Housing Finance Board said it would enable banks in the Federal Home Loan Bank System to expand holdings of securities issued by Fannie Mae and Freddie Mac.

Although profitable in the first quarter, combined net income was hampered by a net loss of $78 million at the Federal Home Loan Bank of Chicago.

The FHLB of Chicago in the past decade has been criticized for lax interest-rate risk management, in part due to the growth of a program known as the Mortgage Partnership Finance Program, analysts said. The bank launched the program in the late 1990s to share the risk of managing mortgages with lenders...

From Bloomberg :

Federal Reserve Chairman Ben S. Bernanke may need to step up his effort to unfreeze bank funding markets as a surge in borrowing costs blunts the impact of the cash auctions the central bank introduced in December.

As usual, it is Fitch leading the way. From Bloomberg :

The
market for collateralized debt obligations faces more downgrades as
losses on mortgage-backed securities prompt Fitch Ratings to overhaul
the way it assesses the risk of CDOs based on company debt.

Fitch
will begin next month to affirm or assign new ratings for about 500
CDOs, the New York-based company said in a statement today.

``While
Fitch expects many ratings to be affirmed, downgrades are also
expected, in some cases by several rating notches,'' Fitch said in the
statement.

Rating firms are responding to criticism from
lawmakers and investors for assigning their highest ratings to some
CDOs backed by subprime mortgages
before the market collapsed last year. Moody's Investors Service,
Standard & Poor's and Fitch have cut ratings on portions of CDOs
packaging $482 billion of assets since July, Wachovia Corp. analysts
wrote last week.

I am in the process of creating a macro picture of the banking industry to assist me in consolidating and crystallizing my perspective of the near to moderate term. I will loosely follow the outline below and end up with a list of my personal bearish positions. My analysts initially coined this "Comparison of the S&L and Subprime Crises", but I was quick to remind them that the current crisis is subprime in the media's eyes only. This is, by far, a crisis of the asset securitization system and as I have harped since the beginning of this blog last September, it is the use of other people's money and off balance sheet vehicles that have prompted the abuses that we see today. Even with extremely low interest rates, we would not have seen the carnage that we have witnessed recently if those who originated the mortgages were to be held ultimately responsible for their performance. The first section of the report is historical and plain vanilla. Most who have perused this blog for a while should be quite familiar with it, but I feel it makes plenty of sense to review it in order to remain grounded in factual reality in lieu of what we have seen in the media. See the outline below and the first chapter of the report aftwerwards.

The Asset Securitization Crisis – Why using other people’s money has wrecked the banking system and similarities to the S&L crisis of 80s and 90s

The US Credit Crisis: What went wrong?

1. The great housing bull run – creation of asset bubble
2. Declining lending standards, lax underwriting activities increased the bubble – A comparison with the same during the S&L crisis
3. To be Published: Securitization – dissimilarity between the S&L and the Subprime Mortgage crises
4. To be Published: The bursting of housing bubble – declining home prices and rising foreclosure
5. To be Published: Credit rating agencies – an overhaul of the rating mechanism
6. To be Published: US Federal reserve to the rescue
7. To be Published: The counterparty risk analyses – the counterparty failure will open up another Pandora’s box

Now, on to part one of the report...

The spillover from the financial world to the real economic world happened as a result of tightened credit. The banks are not very generous with credit, despite a lower fed funds rate and access to the discount window. Credit availability is what drives business (and consumer) investment, as it has done in excess during the recent boom, and the lack of which will will cause a dearth of business and consumer activity that will prolong the recession.

In addition, the very real threat of higher rates, real or nominal, could very well damage banks even more. It was interest rate volatility that pushed lenders over the edge in the S&L crisis, and the extreme inflation that we are witnessing now could very well force the Feds hand in regards to rates. Volcker's predecessor was forced to push rates to 20% during a slow economy after dropping them too much in an attempt to stave off recession, but instead causing a worse one due to highly inflated prices which Volcker inherited. We shall see what Bernanke does. He surely knows that an increase in rates will quicken many insolvent bank's demise. In the following excerpts, all red font comments and graphics are mine.

From the lastest Federal Reserve Board Senior Loan Officer Opinion Survey on Bank Lending Practices: [We] queried banks about changes in terms on commercial real estate loans during 2007, expected changes in asset quality in 2008, and loss-mitigation strategies on residential mortgage loans. In addition, the survey included a new set of recurring questions regarding revolving home equity lines of credit. This article is based on responses from fifty-six domestic banks and twenty-three foreign banking institutions. In the January survey, domestic and foreign institutions reported having tightened their lending standards and terms for a broad range of loan types over the past three months. Demand for bank loans reportedly had weakened, on net, for both businesses and households over the same period. This tightening covers price and non-price characteristics for commercial and consumer loans over real estate, secured and unsecured lending and credit lines. A very broad spectrum tightening at a time when demand is weakening.

From Wolfgang Münchau at FT.com: "So this crisis is about to end, right? There are two failsafe ways to justify a solid dose of optimism: define the crisis in a sufficiently narrow way; and, even better, look at the wrong crisis. In that spirit I am happy to state my optimism about the prospective end of the subprime crisis. But this would be disingenuous. It is no accident that our multiple crises – property, credit, banking, food and commodities – have been happening at the same time. The simple reason is that they are all part of same overriding narrative. The mother of all these crises is global macroeconomic adjustment – a rare case, incidentally, where the word “crisis” can be used in its Greek meaning of “turning point”.

It is a huge global macroeconomic shock. How long the financial part of the crisis will go on will depend to a large extent on how bad the economic part of the crisis gets. The economic part of the story started more than a decade ago with a liquidity-driven global boom. Property, credit and equity bubbles were all part of this.

If excess liquidity was the ultimate cause of this crisis, the real estate sector was its most important driver. Experience shows that housing cycles are long and symmetrical: downturns last as long as upturns. We also know from the past that house prices undershoot the long-term trend on the way down, just as they overshoot it on the way up. You can see this quite easily when you look at long-run time series of inflation-adjusted house prices for several countries.

The last property downturn in the US and the UK lasted some six years. This is not a prediction of what will happen this time, more like a best-case scenario – because this bubble has not only been more intense than previous ones; it has also bubbled on for longer.

But even if we take six years as an estimate of the peak-to-trough period, that means the housing downturn will last until 2012 in the US and a couple of years longer in the UK. It is difficult to see how either of these countries could grow close to trend as long as the housing market is in recession.

When you look at the global macro side, you are looking at similar timescales of adjustment. An important part of the adjustment will be a rise in the US and UK household savings rates. That, too, might take several years to accomplish, during which period economic growth could be below trend.

The really important question about the US economy is not whether the official recession starts in the first or second quarter, but how long this period of economic weakness will last overall. In Japan and Germany macroeconomic adjustment of similar scale took more than 10 years, starting in the 1990s. Even if you believe that the US is structurally stronger, the country will probably not replenish its savings in a couple years.

If global inflation rises, as I expect, this process will become even more difficult. The central banks will have less room for manoeuvre. Fiscal policy is constrained, which leaves the exchange rate as the main tool of adjustment. This would necessitate a weak real exchange rate during the entire period of adjustment.

Obviously inflation would make everything worse, and our future scenarios will depend critically on the inflation outlook. A rise in inflation might alleviate the pressure on some mortgage holders, but is not a good environment for a country to build up savings. If higher inflation were tolerated by the central bank, it would clearly prolong the macroeconomic adjustment process. If it were not tolerated, interest rates would go up and we might experience a re-run of the 1980s. It would get a lot worse before it got better.

Either way, adjustment would take time. Would you really want to predict that under any of those scenarios, the worst was already over for a fragile financial sector? There may be no global financial meltdown. But our multiple crises could easily return with a vengeance, like one of those bloodstained image001.gifvillains in a horror movie who rises to fight his last battle.

It will end at some point, but several pockets of the financial market remain vulnerable in the meantime: US government bonds (under an inflation scenario); US municipal bonds (if the downturn is severe and long); several categories of credit default swap; credit card debt securities among others.

Our macroeconomic adjustment is not going to be as terrible as the Great Depression. But it might last longer. There will be time for optimism, but not just yet.

I had an email discussion with an analyst and blog regular who brought up the topic of inflation and real estate. Academically, inflation is supposed to be good for real estate prices and can actually drive up the price of real estate without driving up the cost of debt, thus allowing the Fed to "infate" certain insolvents out of insolvency. The problem is, too often reality hits. When inflation is rapid and extreme, it actually hurts holders of real estate. For those who hold income producing properties, it drives up the cost of owning and/or maintaining the property faster than rents can be increased, thus puts significant stress on the property holder (think of leases with provisions for 2 and 3 percent annual rent increases while inflation is runnin at that much per month - ala oil and gas prices). This can also work against homeowners who can't keep pace with the inflated costs of homeowner ship, ex. property taxes, heating fuel and other energy (electricity), etc.

From a J P Morgan Research Note: US banks face threat of capital Punishment - The current problem for US banks starts, naturally enough, with a deterioration in loan performance. Noncurrent loans—those delinquent for 90 days or longer—rose to 1.39% of all loans in the fourth quarter of 2007, an increase of 31 basis points from the previous quarter. (All figures cited in this note refer to the universe of all federally guaranteed depository institutions: including banks, thrifts, and credit unions). In historical perspective, the amount of noncurrent loans does not look particularly onerous. However, this conclusion is likely too sanguine for two reasons:

• The increase in delinquencies on real estate loans is probably just getting started. Noncurrent real estate loans were 1.71% of real estate loans last quarter, more than double the figure one year earlier. Given that the decline in real estate prices accelerated into year end, delinquency rates are set to move higher.

• The banking system entered the current episode with a relatively slim cushion of loan loss allowances. In 4Q06, loan loss allowances—a balance sheet item set aside for bad loans—reached a low of 1.07% of loans outstanding, down from over 2% in the mid-1990s. The interaction of these two factors means that banks have been, at best, running to stand still. Even though credit loss provisions—the addition to loan loss allowances—were set aside at the highest pace (relative to assets) since the 1980s, that provisioning did not keep pace with the deterioration in loan quality. The aggregate coverage ratio—the stock of loan loss allowances relative to noncurrent loans—slipped below 100% last quarter for the first time since early in the1990s, meaning that banks have less than $1 in loan loss allowances for every dollar of noncurrent loans.

Capital ratios under stress - As banks realize losses on their assets, capitalization continues to come under pressure. In our GDW Research note of Nov 30, 2007 (“New data intensify spotlight on US banking sector”), we observed that banks can respond to deteriorating capital in three ways: allow capital ratios to drift lower, raise or retain more equity capital, and shed or slow the growth of assets. To varying degrees, the data show all three responses in play.
• Bank capital ratios generally drifted lower last quarter. Of the four capital ratios that regulators use to determine capital adequacy, three declined last quarter. The fourth, total risk-based capital, increased a touch because some banks issued more subordinated debt. The lower capital ratios fall, the more banks will feel compelled to arrest the decline by raising capital or slowing asset growth. Although most banks are a long way from triggering
regulatory action, they would like to keep it that way.
• Banks have been increasing equity capital. The most visible equity infusions in recent months have been through investments by sovereign wealth funds in US banks. However, banks have also been replenishing capital through more mundane means. Dividend payments (to both individuals and bank holding companies) have fallen sharply. Share buybacks—to be reported in next week’s Flow of Funds report—likely also slowed in 4Q.
• Banks will likely slow asset growth. Data through 4Q show bank balance sheets expanding rapidly. However, much of the acceleration in lending likely reflected prior commitments, such as asset-backed commercial paper, coming back onto balance sheets. Indeed, for commercial and industrial loans (to take one well documented category of lending), around 80% of lending is done under prearranged credit lines. Moreover, an average of about
nine months elapse between the time when contract terms for these loans are set and their actual disbursement. This lag suggests that C&I lending should begin to slow as the tightening of lending standards over the past six months begins to be realized in the data. This will put a significant drag on the real economy as working capital is dried up.

In the published Remarks by John C. Dugan, Comptroller of the Currency, before the Florida Bankers Association in Miami, Florida on
January 31, 2008, I excerpt: "I’m referring to the challenges we face – both community banks and the OCC – from the intersection of two inescapable facts: significant community bank concentrations in commercial real estate loans, and the declining quality of a number of these loans, especially those related to residential construction and development. Today, I’d like to talk briefly about both of these facts, and then turn to our supervisory perspective and expectations.

Looking back to October of last year, I warned of the banks and REOs competing with homebuilders and existing homeowners in pushing housing inventory onto the sales market at highly discounted prices. From my post on

Bubble, Banks and Builders:

Below is a
list of bank REOs. A REO (Real Estate Owned) is property that a banking
(or banking related) institution is forced to hold when a loan that
they either issued, purchased, or became legally responsible for was
foreclosed on and the property held for collateral was taken back .
Generally speaking, an increasing REO inventory indicates increasing
foreclosure activity. Foreclosures are very bad for bank balance sheets
and performance. REOs are worst. If the bank cannot reclaim its full
principle, back interest, and expenses from the sale of the REO, the
amount not reclaimed is a complete loss. In order to move REOs quickly,
banks are willing to take a loss by:

• reducing the price of the REO below that of the P&I outstanding,
• offer
  preferental (below market or flexible term) pricing on loans to the
  buyer of the REO, usually profesional investors or first time
  homebuyers,
• and other such concessions.

If a
significant amount of REOs hits the market, they will compete directly
with other sources of housing supply, namely homebuilders and existing
homeowners looking to sell. REO can very deeply discounted, which makes
them difficult to compete with on a pricing basis, and since they come
with the blessing of a bank, tend to have a "deal you can't refuse"
financing arrangement as well. Banks are willing to get these blights
off of their balance sheets by any means necessary!

The list of
institutions here is far from complete and is meant to represent only
the REO and foreclosure inventory trend for a metropolitan area, not
the absolute REO or foreclosure inventory in a market. Graphs are used
to infer trends*.

Monthly Averages of REOs for Riverside, CA show a 2 and 1/2 times increase in REOs in just five
months. Still not convinced of a problem? To give you an even clearer
picture, here are the numbers for the last 10 weeks.

Image010

Do
you see how steep this incline is, and how much it is increasing week
by week? REOs have nearly doubled in the past 10 weeks. This is not an
anecdotal blurb, look at the longer trend captured above. Things are
getting very bad, very fast. Yet, banks like Citi, Washington Mutual,
et. al. say that the worst is behind them. Someone should email them a
copy of this blog.

Now its Bank vs. Builder vs. Homeowners - Who will win the race to the bottom of the profit ladder?

and from part two of that series in October of last year -

Bubbles, Banks, and Builders, Pt. Deux:

Reprinted from 10/8/07 - In part two of my tabloid series, I will
take a look at the major profit centers of the builders, and take a
look at how the banks (who say the malaise is now behind them) [This post was written 7 months ago, and notice the similarity in the bank's matra "the worst is now behind us" - it wasn't true then and its not true now. The worst will be behind us when real asset prices reach equilibrium and banks come clean with all inventory, marked to market and sold into a liquid and receptive market. That just 'ain't the case' right now, and it looks like it will not be the case any time soon!] that
loaned them money are fairing in those areas. Remember, if home
builders bought their land before the boom, their cost basis will tend
to be relatively low. This is of little consolation to many builders
since the fever hit nearly everybody during the boom, recognized by me
as being from the 2nd half of '00 to '06.

Well, let's jump
straight to the gist of the matter. The biggest money makers for the
builders have now become the biggest busts. Funny, how bubbles work
like that. If I am not mistaken, all of the big public guys bought a
lot of land and developed hard in Las Vegas. How are the banks that
lent to them and their clients fairing? Remember, these numbers are
just for the last 10 weeks. I want to be clear to all how quickly I
perceive things deteriorating. This is not just a short term trend,
either. Look at the 5 month trend in part I of this series.
The next reporting period, assuming we are all honest (which is not
happening all that often these days), should be most revealing.

Builder Profit Center - Las Vegas

Hey, those who are long Countrywide, watch out below!!!

Bloomberg reports: Nomura Posts Record Loss on Bond-Insurance Provisions

Nomura Holdings Inc., Japan's largest securities firm, reported a record quarterly loss after $1.26 billion of provisions for charges related to bond insurers.

The net loss of 153.9 billion yen ($1.5 billion) in the three months ended March 31 compared with profit of 33.1 billion yen a year earlier, the Tokyo-based firm said in a statement today. The loss was 15 times larger than the most pessimistic estimate among six analysts surveyed by Bloomberg. Nomura fell 5 percent to 1582.21 yen in German trading after the announcement.

• From FT.com: Summarized by RGEMonitor.com - Citigroup is allowing
  private equity groups bidding for up to $12bn of its leveraged loans to
  cherry-pick from a wide range of assets with different prices and
  credit ratings. Deutsche Bank has been trying to sell parts of its
  €36bn ($56bn) portfolio in leveraged loans to private equity groups
  since August. Same for Credit Suisse and Goldman Sachs. But wait, it gets worse -the I banks provide vulture funds with financing to buy
  banks' distressed debt--> In its first leveraged loan sale, Deutsche lent the buyers $3 to $4
  – at below market rates – for every $1 of credits they bought. The
  buyers paid full prices for the loan themselves, one buyer says.

  By
  selling the loans at full prices, Deutsche was able to avoid marking
  down its positions. The deal offers Deutsche additional protection
  because if the price of the loans drops, the buyers would have to put
  up more collateral, the loan buyer says. For the private equity
  firms, the key to the deal is the low-cost leverage, which gives them a
  chance to boost potential profits even though they paid a full price
  for the loans themselves. May I comment. The banks are trying to get $50 B of bad loans off of its balance sheet. So it makes $40 B of loans (under priced which should be market do market) to move these other bad loans that are guaranteed to drop in price. Are we supposed to believe that Deutsche Bank truly transferred risk from the balance sheet, or just transferred the assets? OK, I guess I'm just stupid and don't get it.

• European banks biding time, mark to market losses will soon convert to operating and credit losses. Fitch sugar coats it: The issue of credit performance now becomes central to the outlook for leveraged credit as medium‐term refinancing risk remains pervasive throughout the market. With banks arguing that any recovery in the primary market remains dependent on recovery in the secondary market, constituents have no choice other than to anxiously bide their time as financial system stresses continu to be worked out and the inevitable contagion to the broader European economy approaches. Indeed, leveraged credit market constituents are left with little more than hope that outstanding credits continue to perform in time for an economic and credit market recovery that will provide the refinancing and exit options necessary to avoid widespread defaults. That hope may be justified as, ironically, the excess that accompanied the wind‐up in financial system leverage, particularly in regard to loose covenants and back‐ended debt maturity profiles, has insulated the leveraged credit market from the spike in defaults normally associated with a credit crisis.
• Altman, whose Z score analysis I have used in this blog for the homebuilding industry chimes in on what happens when the excess liquidity from the non-traditional lenders dries up. I have state repeatedely that the historically low default rates will soon skyrocket, further distressing banks and the economy. Well,,, according to S&P/Res.recap blog: U.S. distressed debt ratio up sharply from
  less than 1% during past five months to 3% in August. The first sectors to succumb are the usual suspects:
  consumer products, retail/restaurants, and finance companies. Covenant "none" debt delay the inevitable defaulting through avoidance of technical triggers.
• FT:
  Expect legal arbitrage rather than distress renegotiations with
  short-term oriented hedge funds; Geithner: Untangling complex web of
  OTC contracts in case of default like "unscrambling eggs"
• Hu/Black;
  BofA: Distress renegotiations less likely with HF than with PE due to
  short-term focus. Also: these who buy credit protection in general bet
  on default, not restructuring. However: Physical bond settlement favors
  default because protection buyer receives face value (i.e. the
  underlying bond); cash settlement on the other hand includes
  substantial hair cut and protection buyer might be better off
  restructuring.

This is part of my continuing diatribe on the state of the US and global banking system. As a backgrounder, and to get caught up on where I am coming from, see:

• Banks, Brokers, & Bullsh1+ part 1
• Banks, Brokers, & Bullsh1+ part 2
• Banks, Brokers & Bullsh!t part 3 - Shenanigans at Morgan and Lehman
• I know who's holding the $119 billion dollar bag!
• Is this the Breaking of the Bear?
• The worst is behind us, unless massive bank failure is considered a bad thing
• Reggie Middleton on the Street's Riskiest Bank - Update

In my most recent post, I admitted to being disappointed in myself for allowing volatility drop my personal investment results below my internal 110% annualized return goal. This volatility stemmed from financials and the broad market rallying due to the "alleged and percieved mollification of systemic financial system failure". Now, I never believed we were at risk of systemic failure. That was just the fodder of tabloidal media outlets. Asset securitization and OTC counterparty credit risk management is on the verge of systemic failure, though, and these are significant portions of our financial system. I don't think these failures will bring the whole financial system down, just the portions that need it. We were, and still are, at risk of a correction where the excesses of the past will be shaken out and weaknesses in our system will break and then be eliminated, bringing down the players that were overly reliant on those weaknesses. Examples of these weak points are:

• the lack of propert due diligence and credit risk management in the credit default swap markets,
• the monoline cum multiline industry,
• excessively leveraged structured products written on top of a real asset bubble,
• poorly underwritten, covenant none leveraged and high yield loans,
• poorly underwritten consumer debt,
• the peak passing and return to the trough of the most recent business profit cycle (banks and financial institutions in particular),
• the return to mean of real asset prices.

A quick perusal of this weeks news and analysis pretty much reveals what I thought to be the case - this bear market sucker's rally will probably end in a deep downturn and entrance (continuation of) a prolonged bear market. These wide swings are the cause and source of the volatility that has now forced me to implement return robbing dampeners to quell these wide swings. I am also in a quandary. Should I allow the volatility to persist, for the aggregate risk adjusted return is still way above most other's efforts and alpha is being generated over both broad market and hedge fund indices, or should I spend the time and money to dampen both volatility and return to make everything look pretty and ease my own stomach? The answer really relies on who sees my returns and what kind of observers they happen to be. I think that too many investors are trying to mimic the steady fixed income-like and large cap returns that are the bread and butter of many institutions. The problem with that is that it actually reduces returns over the long run and introduces risk. I don't have time to get into this now, but it will definitely be on the table for a future blog posting.

Now, back to this week's events:

I hear many bank CEOs saying they believe the worst is behind us. I am not a banking exec, and I am not on the street, but I definitely disagree. Bank of America has missed estimates by about 44%, and has increased credit loss reserves by 500% to over $6 billion dollars, net income drops 77% amid write-downs, and it is forecasting a best case scenario of minimal GDP growth for the balance of 2008. 2007 was the year these same execs were forecasting no recession and a pick up in the following year. This is the same company that says it will buy Countrywide, which has a severe credit and NPA problem - and has nearly as many assets in REOs and repossessions as it had in actual performing mortgages. Does this sound like the worst is behind us? Let's take a look at some more banks.

The Bank of England has decided to just go forward and bailout it's banks, "American Style": BOE Aims to
Jump-Start Lending - The Bank of England launched a plan to allow banks to
temporarily swap $100 billion of mortgage-backed and other securities for U.K.
Treasury bills, in a bid to ease the current credit crunch. (Statement) Of course, I query (like the bloke I've been known to be), why dump a $100 billion into the market where the worst is behind us? That's a lot of money, considering they've probably pumped much more than that into the market for liquidity's sake over the last few months.

From Fitch's latest report :

As the U.S. housing crisis continued to deepen in 2007, Fitch’s global
structured finance rating actions took a decidedly negative turn, driven
overwhelmingly by the unprecedented credit deterioration in the U.S.
subprime mortgage sector. By year’s end, U.S. subprime-related
downgrades affected 3,529 tranches, or 77% of the year’s 4,570 global
structured finance downgrades. Total downgrades readily topped upgrades
of 1,790, the first year in recent history to see such a trend in structured
finance. However, the nonmortgage ABS and CMBS sectors reported
more upgrades than downgrades in 2007.

The subprime mortgage sector downturn also pushed up the global
structured finance default rate in 2007 to 1.19% from 0.37% in 2006. The
average annual global structured finance default rate over the 17-year
period ending in 2007 subsequently moved up to 0.77% from 0.68% in
2006...

In reviewing 2007 global structured finance rating
activity, it is important to note that credit quality
continued to deteriorate in the subprime mortgage
and CDO sectors in early 2008, resulting in
additional and significant negative rating migration.

Highlights
• Fitch’s global structured finance rating activity
turned net negative in 2007, with downgrades at
least 2.5 times more frequent than upgrades and
a record 14% of structured finance tranches
experiencing negative rating actions over the
course of the year, compared with 6%
experiencing positive rating actions. This
produced an upgrade-to-downgrade ratio of 0.39
to one in 2007, a stark contrast to the 4.54 to one
ratio reported in 2006.
• Despite weak performance in the U.S. subprime
mortgage securitization and CDO sectors, 80%
of global structured finance ratings remained the
same in 2007. However, this is down from an
85% stability rate in 2006.