Just when everyone was wondering if the US Federal Reserve’s 0.50% rate cut would do the trick and start stabilising the crisis-ridden US economy, ratings agency, Standard & Poor’s, delivered a bombshell.

Four hours after the Fed cut its Federal Funds rate from 3.5% to 3%, Standard & Poor’s said it cut or may reduce ratings on $US534 billion of subprime-mortgage securities and collateralized debt obligations.

The Dow turned down sharply near the close of trading to end 37 points lower, after rising more than 100 points in the wake of the rate cut, and news of the S&P move will further shake investors’ confidence.

Bloomberg reports the move could “extend bank losses to more than $US265 billion”.

“The securities represent $US270.1 billion, or 47%, of subprime mortgage bonds rated between January 2006 and June 2007. The New York-based ratings company also said it may cut 572 CDOs valued at $US263.9 billion,” Bloomberg said.

There’s a long list of potential losers, including Citigroup, Merrill Lynch, Morgan Stanley, UBS (which revealed more losses overnight), and banks in France, Germany, Britain, China, Japan and Australia may also be impacted by the downgrades.

Further losses could force banks to seek out more capital, but Citigroup, Merrill Lynch and even UBS might be at the end of the tether so far as investors are concerned after pumping in the best part of $US40 billion in new capital in the past four months.

Bloomberg quoted the ratings agency as saying: “It is difficult to predict the magnitude of any such effect, but we believe it will have implications for trading revenues, general business activity, and liquidity for the banks.”

S&P said it will start reviewing its ratings for some banks, especially those that “are thinly capitalized”.

Bloomberg said that under US accounting rules, many smaller banks haven’t been required to write down their holdings until the credit ratings fell, enabling them to avoid the losses at bigger competitors such as Citigroup and Merrill Lynch.

S&P’s move came a day after RealtyTrac Inc said the number of American homeowners entering foreclosure jumped 75% last year with 405,000 houses foreclosed on by lenders. And house prices in 20 major US metropolitan areas fell 7.7% in November, the 11th consecutive month of declines, according to the S&P/Case-Shiller home-price index released earlier in the week.

But there be another more potentially damaging problem emerging to cause sleepless nights on Wall Street and around the world. The delinquency rate among prime (high quality) mortgages is rising, as reported by Countrywide Financial Services, the biggest US mortgage lender, on Tuesday.

It was also mentioned by the IMF in its surprise World Economic Outlook Update and associated Global Financial System Update issued yesterday:

“A possibly deeper economic downturn in the United States or elsewhere could also serve to widen the crisis beyond the subprime sector, as credit deteriorates more broadly,” it stated.

“Already delinquency rates in 2007 vintages of U.S. prime mortgages (those to the most credit worthy borrowers) are rising faster than in previous years, albeit from low levels, and other forms of consumer credit show signs of deterioration (see chart below).”

US bond insurers are another problem: they are hoping for a government bail out (the irony of the staunchly pro-private enterprise US bailing out failing companies has also slipped past many commentators), but it won’t be enough.

Fitch Ratings has just cut the ratings of the world’s 4th biggest bond insurer in a move that will spark consternation on Wall Street, as Bloomberg reports:

Financial Guaranty Insurance Co., the world’s fourth-largest bond insurer, lost its AAA credit rating at Fitch Ratings after missing a deadline to raise capital. Financial Guaranty, a unit of New York-based FGIC Corp., was cut two levels to AA, New York-based Fitch said today in a statement. The company had been AAA since at least 1991. Moody’s Investors Service and Standard & Poor’s are also reevaluating their ratings.

This means banks, state and local governments and a host of other issuers in the US and around the world face losses and increased borrowing costs. Bond insurers lend their Triple A Ratings (in most cases) to the issuer for a fee, but to generate more profits they started lending it to issuers of corporate and subprime bonds, many of which have gone sour.

The losses are in the tens of billions of dollars for the issuers and other customers if the insurers are not “saved”. The New York State Government has appointed financial advisers to look at raising $US15 billion from banks and other investors to bail out the insurers. Will it be enough?

And what happens if the delinquency rate among good home mortgages continues to rise?

Peter Fray

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