U.S. credit crisis escalates as mortgage defaults spread

By Ambrose Evans-Pritchard
The Telegraph, London
Wednesday, February 13, 2008

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/02/13/cnusa1...

Defaults in the US housing market are spreading from sub-prime to the much larger stock of top-grade housing debt, threatening to set off a wave of even bigger losses for banks and investment funds.

The Mortgage Bankers Association says default rates on all outstanding home loans in the US have reached 7.3 percent, the highest level since modern records began in the 1970s.

Arrears on "prime" mortgages have reached a record 4 percent, confounding expectations that middle-class Americans with good credit records would be able to weather the storm.

While sub-prime and close kin "Alt A" total $2,000 billion (L1,019 billion) of debt, the prime market in all its forms is roughly $8,000 billion. If prime default rates rise on their current trajectory, they could ultimately cause huge financial damage.

The grim data comes amid further wild ructions this week on credit markets. The iTraxx Crossover index -- a risk barometer that measures default insurance for Europe's low-grade bonds -- rocketed to a fresh high of 575 yesterday. It is now above the extreme levels seen in August and November.

"We're now at, or close to, historic highs pretty much across the board on the credit indices," said Dr Suki Mann, an expert at Societe Generale.

"There's a vicious spiral as banks are having to protect themselves against these market movements by hedging, and that drives the indices even higher. It's not a crunch as such because companies can still borrow if they need to, but nobody is willing to pay these premiums. The market has shut down," he said.

Willem Sels, a specialist at Dresdner Kleinwort, said investors had been rattled by losses of $4.9 billion at AIG and by the refusal of Standard Chartered to bail out its failed fund Whistlejacket after a $7.15 billion rescue collapsed.

The risk is an avalanche of forced asset sales in the mortgage securities market. "The banks no longer have the luxury to take a long-term view," said Mr Sels. "They themselves face tight liquidity conditions, so they can no longer rescue every single borrower.

"This crisis is not going to stop at mortgages. It is spreading to credit card debt, auto debt, and now student loans. On top of that we think corporate defaults will rise from 1.1 percent to between 5 percent and 9 percent over the next 12 months."

US house prices have fallen by 7.7 percent over the past year, according to the Case-Shiller index of the 20 biggest cities. The slide is likely to gather pace as 2.2 million mortgages taken out at the height of the credit bubble adjust upwards by 250-300 basis points. Goldman Sachs says house prices may fall by as much as 25 percent from peak to trough -- creating the worst slump since the Great Depression.

Over 40 percent of all mortgages issued from late 2005 to early 2007 are on adjustable rates -- a break with the US tradition of fixed-rate borrowing.

Mr Sels said $40 billion to $50 billion would reset each month from now on, reaching peak pain late this year. "Borrowers never expected to pay the new rates. They assumed they could roll over their mortgages when the time came, but that is now impossible," he said.

"There are very similar problems emerging in Britain, Ireland, and Spain. We know from the lending surveys by the Bank of England and the European Central Bank that conditions have tightened a great deal."

Emergency rate cuts by the US Federal Reserve will cushion the blow this year. The federal funds rate has come down from 5.25 to 3 percent since September, and is almost certain to drop further. However, the crisis is now moving with such speed that it may already be too late to avoid a domino effect as one distressed sector topples into the next.

The arrears rate on US auto loans has reached 7.1 percent. Defaults on home equity loans have jumped to 5.7 percent.

The latest concern is paralysis in the $250 billion US market for auction-rate securities (ARS), which fund state governments. A series of deals has failed over the past two weeks. The risk is a slide in ARS prices along the lines of the mortgage debacle, leaving banks with yet another chunk of losses.

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