New era of defaults on horizon as CDO cuts mount

By Walden Siew - Analysis

NEW YORK (Reuters) - A wave of recent ratings cuts may mark the start of nearly half a trillion dollars in losses for banks and pension funds, as complex securities bring the U.S. subprime mortgage crisis crashing back to Wall Street.

Derivatives once heralded for spreading risk and underpinning the resilience of financial institutions are rapidly deteriorating, threatening to choke lending and driving up the risk of a U.S. recession.

The latest concerns come from collateralized debt obligations, essentially giant bonds that can be backed by subprime mortgages, which are now seeing a trickle of technical defaults.

In the past two weeks ago, more than a dozen such CDOs have suffered a technical default, triggered when the underlying collateral pool falls below a certain ratio, according rating agencies. Now there's increasing worry that default notices may lead to liquidations, pushing down prices of underlying assets and unleashing a cascade of losses.

Standard & Poor's on Wednesday said it may cut four more CDOs, due to even more "Event of Default" notices as write-downs increased for what was perceived to be the safest part of the bonds.

At issue is who may hold onto top AAA bonds that rating companies today are slashing to the lowest junk levels, in some cases in a single rating action, shaking the confidence of investors who scooped up the securities for their perceived safety.

The fear is that a growing list of institutions may be vulnerable, including banks that provide the basic grease to the wheels of the economy, and even top-rated bond insurers.

Fitch Ratings earlier this month said it may cut ratings of bond insurance companies, such as Ambac Financial Group Inc (ABK.N) and Financial Guaranty Insurance Co, whose guarantees of $2.5 trillion of bonds and structured financing make hospital and school building possible for local governments.

"Despite their high initial ratings, even AAA rated securities can be at risk of losing some or their entire principal," according to Jeffrey Rosenberg, head of credit strategy at Bank of America in New York. Write-downs of CDO positions are "increasing fears of the expanding implications of subprime losses to the financial system."

Year-to-date, more than $90 billion worth of structured finance CDOs have been downgraded by the three main raters, according to Barclays Capital.

Tightening credit conditions are spreading the pain, and rating agencies forecast a rising tide of corporate defaults. Moody's Investors Service predicts that the global default rate for high-yield, junk-rated bonds will more than triple to 3.6 percent in a year, from about 1.1 percent.

"Defaults are going up and this is part of what credit markets are going through," said Peter Hooper, chief U.S. economist at Deutsche Bank AG in New York.

Financial stocks are the U.S. market's poorest performers this year, with the Standard & Poor's 500 financials index .GSPF falling more than 16 percent so far in 2007. The sector has borne the brunt of investor anxiety over the subprime mortgage market collapse.

"CDO realized losses are mounting and it will be a significant factor underlying what's happening to values in the financial sector," said Hooper, a confidante of former Federal Reserve Chairman Alan Greenspan, who joined Deutsche Bank this year as a senior advisor.

$480 BILLION