June 2, 2009

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. 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 (NYSE: FNM) and Freddie Mac (NYSE: FRE), the report examined mortgages of types that represent about one-fifth of the $10 trillion American mortgage pie. Mortgage servicing firms have ramped-up loan renegotiations, lowering rates or even reducing principal, but are finding many borrowers still walking away from severely devalued properties.

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.

Let's 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 (NYSE: TOL), and could domino onto the bottom lines of related material makers like USG (NYSE: USG), further challenge related freight volumes for railroads like Norfolk Southern (NYSE: NSC), and so on.

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 (NYSE: C) and Bank of America (NYSE: BAC) could mount considerably. I kid you not, Fools. The potential ramifications of this mortgage meltdown scenario are that far-reaching ... and then some.

Get ready for 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.

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