Downgrade avalanche stings risk-takers

NEW YORK (Reuters) - Investors got another wake-up call on risk-taking on Tuesday after two leading credit rating agencies weighed in with dire warnings on over $17 billion of debt tied to risky mortgages.

In recent weeks, nervous investors have shunned or even dumped numerous holdings related to subprime mortgages and speculative securities like junk bonds from their portfolios. That has sent bond yields jumping in those sectors, increasing the cost of capital for Corporate America.

Recent risk-taking has been fueled by easy financial conditions and a seemingly unquenchable thirst for high yielding investments. But the red flags waved by Standard & Poor's and Moody's Investors Service on Tuesday punctuate a reassessment of risk.

"The incremental risk aversion now evident in the financial markets seems to us to be a sign that the financial liquidity spigot is starting to tighten," said Merrill Lynch & Co. chief investment strategist Richard Bernstein.

S&P said it may soon cut 612 residential mortgage-backed securities totaling $12.1 billion, which represent 2.13 percent of the $565.3 billion U.S. subprime market.

Most of the mortgage-backed bonds were packed into collateralized debt obligations. CDOs, in turn, have been a rapidly growing class of securities created by packaging together bonds, including risky subprime loans, junk or high-yield bonds, and high-grade debt, to help diversify risk.

If that weren't enough, rival credit-rating agency Moody's slashed its ratings on 399 mortgage-backed securities and may cut ratings of another 32, affecting a total of $5.2 billion of securities, citing higher-than-expected delinquencies in the underlying home loans.

"We are way below normal levels in our exposure to junk bonds, the lowest we've been since ... I can't tell you when," said Dan Fuss, co-manager of the $12.7 billion Loomis Sayles Bond Fund. Fuss defied the market consensus when he invested heavily and successfully in junk bonds in 2002 when others shunned the sector.

Andrew Harding, chief investment officer of fixed-income at Allegiant Asset Management in Cleveland, said, "Opportunistic buying? I still think this is a buyer beware market.

Major stock indexes dropped more than 1 percent on Tuesday.

"Markets should not be surprised by S&P's warning, but rather investors should be angry with both S&P and Moody's for not having a more rigorous modeling effort that measure the risk structured product from a top down and bottom up approach," said Tom Sowanick, chief investment officer at Clearbrook Financial LLC in Princeton, New Jersey.

For the time being, many investors are running for cover into safer securities.

"I'm officially buying Treasuries," said Fuss. "I have seen this play before of different versions and this one is the leverage version of a speculative market which coincided with the monstrous growth of new financial technology."

Bill Gross, the widely followed chief investment officer at Pacific Investment Management Co., has expressed similar concerns.

In an investment outlook report earlier this year, Gross said banks created exotic derivative products, which included subprime mortgages, that were rated triple-A by the ratings agencies.

Then the banks leveraged the new securities up to 15 times to generate higher returns.

While investors' insatiable hunt for yield has led many to buy these triple-A rated pools of debt assets, they are "subject to numerous (more numerous than usual) subjective assumptions on the part of the rating services and in turn vulnerable to quicker downgrades than your normal triple-A General Electric credit rating," Gross warned.

INVESTORS HAMMER JUNK AND STOCKS

Investors aren't waiting for the day of reckoning by the rating agencies. AMG Data Service in Arcata, California, said that in the latest week, investors pulled $223 million out of mutual funds that invest in junk bonds.

That's the fourth consecutive week of outflows totaling $1.6 billion and the highest outflow for the year, added AMG's Bob Adler.

The blood bath won't stop anytime soon. "If in fact, the agencies downgrade these issues, it is an admission that they got it wrong -- big time -- and you will see forced selling from many investors," said Greg Peters, chief U.S. credit strategist at Morgan Stanley.

Equity investors, too, are assessing their appetite for risk. Adding to worries about housing, home- and consumer-related shares were punished after Home Depot (HD.N), the world's largest home-improvement retail chain, warned on Tuesday its earnings will decline this year more than previously expected because of weak conditions in the housing market and the sale of its wholesale distribution business.

"The slowdown in housing is, to some degree, having a contagion effect across all markets," said Peters. "This issue isn't going away anytime soon."