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 Mortgage Security Bondholders Facing a Cutoff of Interest Payments

October 22, 2007

For all the pain in the mortgage market, investors who hold bonds backed by risky home loans have continued to receive their monthly interest payments — until now.

Collateralized debt obligations — made up of bonds backed by thousands of subprime home loans — are starting to shut off cash payments to investors in lower-rated bonds as credit-rating agencies downgrade the securities they own, according to analysts and industry executives.

Cutting off the cash flow, which is governed by rules and mathematical formulas that vary by security, is expected to accelerate in the months ahead.

Such a cutoff would be the latest blow to financial markets as investors try to anticipate the next problem that might shake confidence.

The stock market, which ended down sharply on Friday across the board, in a week that the Standard & Poor’s 500-stock index dropped 3.92 percent, has been battered by renewed concerns over the credit crisis and about some weak earnings reports.

With such a re-evaluation, owners of collateralized debt obligations — investment banks, hedge funds, insurance companies and public pension funds — may be forced to write down mortgage investments beyond the billions they have already written off. Some bonds, for example, may go from being valued at, say, 70 cents on the dollar to becoming largely worthless overnight, bankers and analysts say.

The adjustment could further erode the availability of credit to consumers and businesses.

Though many people in the mortgage market expect a shut-off of payments, the broader financial market has not focused on it. “At this point, it’s fair to say that everybody expects this shoe will drop,” said Mark Adelson, an independent mortgage securities consultant and analyst. “It’s a foregone conclusion. But when it happens, there will be a market reaction to it.”

From the period since July, the stock market has fallen, then posted several weeks of advances and, most recently, dropped back as investor sentiment about the weakness in housing and its broader effect on the economy waxed and waned.

A re-evaluation of payments by trustees who oversee the debt obligations is part of a long, complex chain reaction that is caused by the surge in mortgage delinquencies and home foreclosures. As more homeowners fall behind on payments and lose their homes, the pressure builds on large pools of mortgages that issue bonds to investors. Many of the riskiest of those mortgage bonds have been bought by the C.D.O.’s, which issue bonds of their own.

On Friday, Standard & Poor’s lowered the ratings on $22 billion in bonds backed by mortgages made to people with weak credit in 2006, citing the continued deterioration in the housing market. Another credit rater, Moody’s Investors Service, lowered a similarly large group of bonds earlier in the month.

It is unclear exactly how many bonds will be affected and how quickly. Investment banks issued some $486 billion in debt obligations linked to mortgages in 2006 and the first half of 2007. A majority of the bonds have high credit ratings, and the trustees of the debt obligations typically shut off lower-rated bonds first to accelerate payments to investors holding higher-rated debt.

When ratings on the bonds directly backed by mortgages are lowered, it forces the trustees to discount the value of their holdings in a calculation performed once a month. Some C.D.O.’s also hold bonds issued by other debt obligations, so it can take months for ratings downgrades to work their way through the system.

“It’s still the early stages of a very significant stress,” said John Schiavetta, a group managing director at Derivative Fitch, which rates the debt obligations.

He noted that C.D.O. deals varied significantly. In some, interest payments continue on all bonds regardless of their rating, which means that higher-rated bonds may be more vulnerable to losses. Fitch has downgraded 30 percent of the debt obligations in its rating portfolio and has put 15 percent more on watch for possible downgrading.

In the last two weeks, leading investment banks have written down about $20 billion, much of it in collateralized debt obligations and mortgage-related securities. Merrill Lynch wrote down $4.5 billion in debt linked to home loans and ousted two senior executives in charge of its bond division. UBS wrote down $3.4 billion and ousted the chief financial officer. Citigroup wrote down $1.3 billion from the deterioration in the value of mortgage-related securities.

Investment banks still hold billions more that could be under threat by the recent downgradings and a continued deteriorating in the mortgage market, said Brad Hintz, an analyst at Sanford C. Bernstein & Company. UBS, for instance, still holds about $20 billion in subprime securities.

But Mr. Hintz said it was difficult to determine how much more of the banks’ portfolios is vulnerable because the institutions have not disclosed many details about their holdings. The size of the recent write-downs surprised many analysts and investors because data provided by the banks earlier in the year suggested there was little to worry about.

“In the case of Merrill Lynch,” Mr. Hintz said, “when you analyzed the financials based on the second-quarter numbers, it didn’t look like they had a lot of exposure. There has been a breakdown in risk management.”

It is unclear what portion of the collateralized debt obligations issued by the investment banks is still on their balance sheets because they could not sell them to other investors. Merrill Lynch was by far the biggest issuer, underwriting $54 billion last year, almost twice as much as in 2005, according to Asset-Backed Alert, a trade publication.

A group of financial enterprises called structured investment vehicles also hold C.D.O.’s, although bankers say that subprime debt makes up only a small percentage of their assets. Problems with these investments has led big banks including Citigroup, Bank of America and JPMorgan Chase to develop a $75 billion rescue fund that could be used to buy risky mortgage securities and other assets from them, a move intended to ease pressure on an important part of the credit markets.

Yet for all the damage that has already been done, the real stress for investors in these securities lies ahead, industry officials say.

Most mortgage securities have not yet had significant losses, which are only recorded when homes are foreclosed and sold. Up to two years can pass between a borrower’s falling behind on payments and an auction. Each mortgage security has a reservoir of excess cash to draw upon to pay bondholders when borrowers do not make monthly payments.

“As far as the security is concerned, it’s only once the property is effectively sold that a loss is recorded,” said Nicholas Weill, chief credit officer at Moody’s. “The process of foreclosure is a long process. It doesn’t just happen overnight.”

Where does that reservoir of excess cash come from?  Hmmmm......

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