More trouble ahead for credit markets

LONDON (CNNMoney.com) -- The prospect of rating downgrades on complex debt instruments, along with massive writedowns at big banks, are raising fears that the credit crisis may deepen.

Collateralized debt obligations backed by mortgage securities are triggering another wave of worry on Wall Street. Banks have been hard-hit by a decline in the value of these securities, and investors and traders worry that more losses could result if prices fall further.

CDOs are pools of bonds that are sliced into so-called tranches with different levels of credit risk. As delinquencies on home loans given to borrowers with weak credit has risen, rating agencies have started to warn that these securities may not be as creditworthy as they previously thought.

The three major rating companies - Moody's, Standard & Poor's and Fitch - have put an estimated $70 billion worth of collateralized debt obligations, including those with the highest ratings, on review for downgrading.

Fitch said Tuesday that structured finance CDOs it had rated are "clearly underperforming." The agency placed 150 transactions representing about $37 billion on negative rating watch.

Investors are growing increasingly nervous as downgrades have started spreading to high-quality CDOs. One key indicator of the spreading problem is the ABX, an index traders use to track subprime securities. The part of the ABX that tracks AAA-rated mortgage-backed securities issued in early 2007 fell to 82.72 cents on the dollar on Wednesday, a drop of roughly 14 percent in the past month.

More turmoil in the CDO market could result in further losses at Wall Street's leading investment banks. Merrill Lynch & Co. Inc. (Charts, Fortune 500) wrote down $7.9 billion in the third quarter due to losses from subprime loans and collateralized debt obgliations, while Citigroup Inc. (Charts, Fortune 500) reported a $1.56 billion loss related to its CDO positions.

S&P analyst Victoria Wagner said in a conference call on Thursday that bank earnings are likely to remain under pressure through the rest of the year due to further markdowns on loans and mortgage-related securities.

The downgrades of the CDOs come after the ratings firms have already downgraded billions of mortgage-backed securities. On Oct. 11, Moody's said it cut ratings on $33.4 billion of securities backed by subprime home loans.

The big three firms have been at the center of the subprime storm, drawing fire for not forewarning investors about the mortgage mess. The agencies have reevaluated the way they rate mortgage-backed and other complex securities, although some critics say credit ratings have been irreparably undermined as a result of the summer turmoil.