Juggling Dynamite

Sorry to keep harping about the looming fall-out from mortgage defaults, but the issue is inevitably key to the health of all other asset markets at present.  When the foundation is rotten, and world liquidity has been built up on that foundation, all other structures are at risk of major damage. The problem is that mortgage bonds are the world's biggest debt markets (Securities Industry Financial Markets Association).  And mortgage bonds have some serious problems at present.

See S&P, Moody's Hide Risk on $200 Billion of Mortgage Bonds for an excellent summary of some of the key issues and players in this mess to date:

“You'll see massive losses from banks, insurance companies and pension managers,” said Joshua Rosner, a managing director at investment research firm Graham Fisher & Co. in New York and co-author of a study last month that said S&P, Moody's and Fitch understate the risks of subprime mortgage bonds. “The longer they wait, the worse it's going to be.”

Interesting to note the collusion between various participants in this fiasco.  As banker/underwriters are scrambling to try and keep subprime portfolios from being priced on the open market, pretending that these bonds are still worth their inflated book values.  This morning, a south Florida newspaper reported that realtors in various parts of the country have been failing to submit recent sales data in hard-hit areas as another effort to prevent real market prices from coming fully into public view.

Comment:  the truth is going to get out eventually.  This problem is too big and too wide for any group to conceal.  The quicker we all come clean and admit the shocking extent of the credit abuse beast this cycle, the quicker we can get on with clean up and recovery.

This week the BCA reports that Bank Worries Continue to Mount:

“The bank index continues to spiral downward in relative performance terms. Concerns about loan quality are steadily building, a natural by-product of the freewheeling lending boom in recent years. Banks have been lowering their exposure to mortgage backed securities in order to fund lending for M&A deals, but exposure to U.S. housing remains sufficiently large to deliver a blow to profitability should the sector continue to sour.”

At the same time the Wall Street Journal points out the positive correlation between the fate of big bank profits and the enormous leverage they have been so instrumental in creating during this cycle.  When the leverage was positive the banks profited handsomely, but now that the wide scale risk re-pricing is upon world debt markets, the risks to the downside also fall squarely upon them:

“A sudden retrenchment in debt markets is likely to nip at profits at the big banks that have been financing the leveraged-buyout boom around the globe.”

Bottom Line:  Banks are about to see the down side of the up they have enjoyed this cycle.

Today the UK Telegraph quotes a Lombard Street Research report warning that the US faces a severe credit crunch as mounting losses on risky forms of debt catch up with the banks and force them to curb lending and call in existing loans:

The group said the fast-moving crisis at two Bear Stearns hedge funds had exposed the underlying rot in the US sub-prime mortgage market, and the vast nexus of collateralised debt obligations known as CDOs.”Excess liquidity in the global system will be slashed,” it said. “Banks' capital is about to be decimated, which will require calling in a swathe of loans. This is going to aggravate the US hard landing.”

US property writer Paul Muolo described the Bear Sterns crisis as the “subprime Chernobyl.”