Banks Could Lose $52 Billion From Subprime Investments

Analysts at Credit Suisse estimate that over time banks could lose up to $52 billion from investments in subprime mortgages on the asset-backed market, largely as a result of loans to hedge funds such as the one recently bailed out by Bear Stearns.The losses are anticipated as a result of hedge fund exposure to collateralized debt obligations (CDOs) that invested in the subprime mortgage sector.CDOs consolidate a group of fixed income assets such as high-yield debt or asset-backed securities into a pool which is divided into various tranches: senior (rated AAA), mezzanine (AA to BB), and equity tranches (unrated).As the mortgages underlying the CDO's collateral decline in value, banks and investment funds holding CDOs face difficulty in assigning a precise price to their CDO holdings. Many are recording their CDO assets at par due to the difficulty in pricing CDOs because collateralized debt obligations do not actively trade and mortgage defaults take time to lead to CDO losses.As delinquencies and defaults on subprime mortgages continue to rise to record levels, CDOs backed by significant mezzanine subprime collateral are expected to experience severe rating downgrades and likely losses in the coming months and years.The analysis by Credit Suisse suggests that risks of downgrades by rating agencies and further cooling in the housing market could deteriorate CDO values.Last month, the potential collapse of two hedge funds hit hard by the poor performance of subprime-backed bonds prompted Bear Stearns Cos. to bail one out with $3.2 billion in secured loans.A number of hedge funds reported difficulties since then, including Cheyne Capital's Queens' Walk, Cambridge Place Investment's Caliber Global Investment, and United Capital's Horizon Funds.The troubles left markets deeply nervous about hedge fund losses in subprime mortgages, and many analysts worried about the possibility of broader systemic as a result.The new issue pipeline for CDOs backed by mortgage-backed securities is expected to slow dramatically in the second half of the year, which could ultimately limit the availability of mortgage credit to homeowners. Last year, CDOs helped to support the issuance of nearly $1 trillion in mortgage bonds.Whatever the effect on the mortgage industry, the analysts at Credit Suisse do not believe it will have great effect on the larger global market, where many of the mortgage-backed securities are purchased and traded."Losses in the tens of billions of dollars are clearly a huge problem, but we do not think that they are a systemic one," wrote the analysts.Posted on Tuesday, July 10, 2007 by staff