US bankruptcy code bill rattles the MBS market

US bankruptcy code bill rattles the MBS market By Aline van Duyn in New York Published: January 13 2009 02:00 Last updated: January 13 2009 02:00 The reintroduction last week in the US Senate of a bill aimed at amending the bankruptcy code to allow the modification of mortgage contracts - and its backing by Citigroup - has sent tremors through the market for mortgage-backed securities. The ABX index, which tracks the value of securities linked to subprime mortgages, fell sharply, with the value of triple A rated securities backed by subprime mortgages falling up to 6.5 points. Much of this decline is attributed to the increased chances of so-called bankruptcy cramdown bills passing. Politicians such as Senator Dick Durbin have been proposing such changes for years, but now measures aimed at reducing foreclosures have more support, not least from President-elect Barack Obama. "The bill's passage would be a clear negative for mortgage-backed securities and asset-backed securities holders," said analysts at Barclays Capital. "We fear a massive sell-off that would worsen valuations, threatening further balance sheet write-downs [for financial institutions]." Even if a consumer files for bankruptcy, judges cannot currently change, for example, the size of the outstanding mortgage to allow a new, lower repayment plan. If such powers are given it has long been argued that the potential for changes in contracts would make investors less willing to finance the mortgage sector, or at least require a higher premium to do so. These powers would likely affect mainly risky mortgages such as subprime. These are different to the mortgages backed by government mortgage agencies Fannie Mae and Freddie Mac. Securities backed by these have rallied after the Federal Reserve last week began a $500bn buying plan. Chris Flanagan, analyst at JPMorgan, said the bankruptcy cramdown may reduce foreclosures and stabilise house prices but that higher costs would be passed onto consumers. Increased bankruptcy filings could also increase losses on securities backed by credit cards and other consumer loans, he said. "We are not surprised to see the market react negatively," Mr Flanagan went on. "While lenders have long maintained that [the lack of cramdown] was needed to keep mortgage rates low, that notion ultimately proved to be a farce. To say that now is not a good time to change the bankruptcy code merely echoes the sentiment of the last 30 years, and ignores the facts that [this part] of the mortgage market is shut down anyway." Last week, financial industry groups denounced Citigroup's support of the changes. The bank was bailed out by the US government last year after the value of its mortgage-backed assets collapsed, further increasing the hole in its capital base. The Securities Industry and Financial Markets Association and the American Securitisation Forum said the bankruptcy proposals "would have serious and negative consequences, increasing risk and uncertainty in an already challenging mortgage market and raising mortgage rates for future homeowners at a time when the availability of consumer credit is already severely constrained".