July 22, 2007

The subprime storm isn’t blowing over. On July 10, credit-rating agencies Moody’s Investors Service and Standard & Poor’s (like BusinessWeek, a unit of The McGraw-Hill Companies (MHP)) warned of greater-than-expected losses for bonds backed by subprime loans—news that helped send stocks tumbling.

The ratings changes were small. S&P put $7.4 billion worth of mortgage-backed securities, just 1.3% of the total issued from late 2005 through 2006, on watch for downgrades, while Moody’s cut its ratings on just $5.2 billion worth. (S&P originally said the total was $12 billion worth of mortgage-backed securities, but later lowered the figure.) S&P also said mortgage fraud is a bigger problem than it had foreseen and that it’s tightening its rating practices.

But what unnerved investors was the idea that there’s still a lot the ratings agencies don’t—and can’t—know. That’s because, from September through next June, a huge number of borrowers, many with subprime mortgages, will see their adjustable interest rates reset at higher levels. Many will default on their loans; the gnawing question is how many.

In 2006 about 12% of subprime borrowers grappling with interest rate hikes went delinquent or lost their homes. Now, with house prices dropping and lenders toughening standards for new loans, even more defaults are likely. For the next 12 months it’s just going to get worse, says Andrew Lahde, a money manager at Santa Monica (Calif.)-based Lahde Capital Management who is betting mortgage securities will fall in value. Janet Tavakoli, a consultant on mortgage-backed securities, thinks the rating agencies are still too optimistic: No one really knows how many really bad [loans] were put out there, she says. S&P Managing Director Thomas J. Warrack says the agency is in fact being more watchful than in the past because of the unprecedented risks. Says David Teicher, a Moody’s managing director: We call ‘em as we see ‘em.

Investors are bracing for the fallout. Hedge funds have been major buyers of bonds backed by subprime mortgages. Losses in June nearly sank two Bear Stearns & Co. (BSC) funds invested in collateralized debt obligations. All told, losses on CDOs from the subprime mess and Bear Stearns’ troubles could total $52 billion, Credit Suisse Group (CS) recently estimated. Others say the final tally could be double that.

By David Henry and Matthew Goldstein