Avoiding a Falling Knife in the U.S. Mortgage Market

Is the subprime mortgage crisis really just the tip of the iceberg? Bond ratings agencies seem to be playing catch up and some market participants suggest we have only just glimpsed the rising wave of downgrades poised to wash over the massive MBS and CDO markets.

Josh Rosner, Managing Director at Graham Fisher & Company, and Janet Tavakoli, President of Tavakoli Structured Finance, join Squawk Box at 7:00 a.m. EST to tell CNBC’s Joe Kernen there could be further downside risk for both mortgages and the U.S housing market.

Rosner says to focus on the headline stories this week concerning Bear Stearns’ mortgage-related hedge fund troubles is really to miss the forest for the trees; this is merely one manifestation of a much larger crisis. He points to three crucial components in mortgage crisis at hand:

First, the ratings agencies are not doing their jobs. Many securities still share ratings despite disparate market performance. This should not be the case, he says, and it makes pricing extremely difficult. One important aspect of the crisis at Bear Stearns hedge fund Enhanced Leverage is that no one has a clear idea of what the mortgage-backed securities (MBS) and collateralized debt obligations (CDO) it holds are really worth. Many are illiquid and difficult to mark to market, or price.

Second, we are only at the very front end of the residential mortgage re-rate cycle. In the next month alone we will see $800 million worth of 2/28s, 3/27s and other hybrid adjustable-rate mortgages (ARM) reset higher. These resets will span the subprime, alt-A and prime mortgage markets. Currently, there are about $4 trillion worth of ARMs outstanding in the U.S. Of those, just under $1 trillion will be reset higher by the end of the year.

Third, in February investors were spooked by the rise in early payment defaults on subprime mortgage loans. This type of default occurs when the borrower fails to make payment on a loan during the first 90 days after its origination. Rosner says the upswing in these early defaults may have marked the peak of poor lending standards but it certainly didn’t provide the high water mark for default rates or for trouble in the residential mortgage and MBS markets. Default rates typically peak 24 months after origination and, since the highest volume of mortgage origination came in early 2006 and late 2005, we won’t see the highest default rates until the second quarter of 2008.

According to the Graham & Fisher analyst, people looking to make investments leveraged to the mortgage or housing market now could find themselves catching a falling knife. He says one of the most important takeaways here could be the culpability of the ratings agencies in all this.

Tavakoli also calls the ratings agencies to task, dubbing their recent statements to the public “borderline irresponsible.” She says telling investors higher rated securities will not likely suffer loss of principal only gives them half the story. The consulting firm president points out that investors in all tranches could suffer mark-to-market losses as defaults rise, even if the pools backing their own bonds don’t experience rising defaults.

She says now may be a good time to sell ARM MBS if you own them, even if they have high credit ratings, as we’ll soon see resets in subprime, alt-A and prime mortgages alike.

The bottom line? Things may get uglier, especially since falling prices in the MBS market can cause rates for new mortgage loans to rise. That could, in turn, put further downward pressure on U.S. housing prices.