http://www.safehaven.com/article-6884.htm
Subprime in Focus:
I've long argued that Unlimited Finance is the Bane of Free-Market Capitalism. Of course, such a notion sounds absurd as the world frolics in a Sea of Global Credit and Liquidity Excess. To most, "bull markets" and various other asset inflations are proof positive of the economic system's underlying soundness.
The subprime mortgage space is only the latest example of the perils of profligate finance. Remembering back to the tech/telecom Bubble, it was a case of massive liquidity excess (certainly including speculative flows) promoting over/mal-investment, profligacy, chicanery and fraud. Yet latent fragility was allowed to compound as an onslaught of late-cycle speculative finance artificially inflated industry profits and cash-flows. The eventual bursting of the speculative technology Bubble then abruptly and radically altered industry liquidity, profits and Credit standing. A system that had so carelessly nurtured companies' dependency to easy access to marketplace finance summarily cut off the lifeline.
Dynamics within the Expansive Mortgage Finance Bubble are thus far - and not surprisingly - amowing a different course, a topic certainly worthy of further attention after this week's announcements from HSBC and New Century Financial. My focus will remain the "big picture" (broader Credit, market and economic impacts), a luxury I'm content with knowing that others (certainly including the great Jim Grant) are doing an most admirable job covering subprime industry developments.
The "blow-off" stage of the Mortgage Finance Bubble led to unprecedented excesses, no doubt about that.
Scores of uninformed borrowers with meager incomes and little savings were enticed into the responsibilities of homeownership by a combination of surging home price inflation and offers of ultra-low "teaser" and/or adjustable-rate mortgages with minimal down-payments (compliments of the Greenspan Fed).
Many loan originators were enticed into lending to poor Credits for the easy profits garnered by selling these loans to Wall Street (for pooling and securitizing). These pool operators were attracted to these suspect mortgages because of the insatiable demand for higher-yielding "structured" products.
Bubble dynamics were driven by the Fed, borrower, originator, Wall Street financial "alchemist," and the speculator/investor community. And I would further argue that the massive recycling of U.S. Current Account Deficits and global dollar liquidity flows back into Treasuries, agencies and investment-grade securities played a decisive role in distorting securities prices and returns, squeezing the speculator community into a self-reinforcing (and ongoing) Bubble in risky Credits.
In the context of Credit system blunders, 2006 was a historic doozy. After several years of increasingly egregious excess, the mortgage industry proceeded to open its arms extra wide. The marketplace welcomed millions to refinance problematic mortgages that were in process of payments resets, in many cases significantly higher. Never have so many atrocious Credit risks been offered such a handsome opportunity (to refinance and/or take our second mortgages). Clearly, many slipshod originators catered to these suspect Credits, and this dynamic helps explain why an extraordinarily large number of these ("bottom of the barrel") new mortgages - "Vintage 2006" - have quickly turned delinquent or fallen into default.
Last year's extreme mortgage Credit system largesse can be explained by a multitude of "Unlimited Finance"-related factors including massive mortgage industry overcapacity, the enormous scope of the leveraged speculating community, overzealousness throughout "structured finance," marketplace mispricing of mortgage risk and, certainly, perceptions that the Bernanke Fed would hastily initiate an easing cycle come the onset of housing market weakness.
I found yesterday's market's reaction to the HSBC and New Century subprime bombshells intriguing. Outside of the subprime lenders and the broader financial sector, the market brushed off the news. Goldman Sachs even trade up on the day, while the Morgan Stanley Retail index closed at an all-time record high. The Bank index was down only slightly from Wednesday's record high. The Utilities closed at a record high, and the Cyclicals were down only fractionally from Wednesday record. The small caps and midcaps closed at an all-time high, while the S&P500 only slightly off its six-year high. Tech stocks posted decent gains during the session.
I think I amow the basis for marketplace complacency. The subprime market is only a small segment of a huge mortgage market, and there is as yet little indication of serious impending mortgage problems outside of the riskiest Credits. And I do agree that there are some key company and industry "specific" issues. For one, subprime had degenerated into the Ultimate Credit Cesspool.
A strapped subprime borrower with payments about to reset higher (and with minimal or negative home equity) is at the mercy of the marketplace to refinance and stay afloat. Akin to the leveraged telecom company in 2001/02, the marketplace closing the loan window is immediately catastrophic for the subprime borrower. Again corresponding to the telecom debt bust, tightening Credit conditions quickly lead to escalating Credit losses and only more Credit tightening and losses.
At the same time, however, the vast majority of the mortgage market operates with risk essentially nationalized (through GSE and govt. guaranties). Notably, benchmark GSE MBS spreads barely budged yesterday from quite narrow levels and ended the week little changed. Employment is strong and incomes are growing robustly, underpinning the capacity of existing borrowers to make payments and new borrowers to sustain inflated home prices.
In contrast to subprime, most "prime" mortgage borrowers are not today at the mercy of the marketplace. The vast majority have not fallen behind on their payments; Credit conditions have not been forced tighter; new "prime" mortgage finance remains readily available; and the mortgage market continues to abound with cheap ("unlimited") finance. For a large portion of the mortgage market, things haven't been much better.
Interestingly, the markets weren't as cavalier today. With Fed Presidents Poole, Pianalto, and Fisher all sporting rather hawkish demeanors and warning of the possibility that the Fed has more work to do, the marketplace was on edge. The specter of heightened consumer Credit and lender problems (on the margin) coupled with upward pressure on market yields is unsettling. This is not the bullish scenario envisioned, but neither is it the conventional bearish view.
The trend that emerged last year - trouble at the fringe of housing and mortgages actually promoting heightened excess in Corporate Credits - is still in play. Junk bond spreads narrowed yesterday and for the week, while risk premiums outside of lower-tier mortgages generally remain near historic lows.
Importantly, mortgage developments so far have been a non-event with regard to general marketplace liquidity. Combined total mortgage, corporate, financial sector and global debt growth remain more than adequate - that is as long as the unfolding subprime crisis doesn't significantly escalate.
Subsequent to this week's developments,
the markets should begin to demonstrate heightened concerned for the financial ramifications of imploding subprime lenders. To this point, failures have been small players with minimal market impact.
If major operators find themselves confronting the traditional subprime liquidity squeeze, this so far isolated Credit event could pose unknown contagion risk.
One or more major failures would likely prove a meaningful blow to the ABS and Credit derivatives market. Additional uncertainty with respect to the degree of leveraged speculator exposure to subprime Credits, Credit indices and other derivatives might also be expected to weigh on the markets.
Any general tightening in the CDO market would likely mark a key inflection point in marketplace liquidity, with major systemic ramifications.
The bottom line is that the markets are now likely facing a bout of heightened uncertainty. The Credit default swap, CDO, and "credit arbitrage" markets have grown tremendously since the last bout of liquidity ambiguity. How these markets will operate in the event of some general financial sector tumult is all too unclear.
That the "liquidity" markets are these days extraordinarily bifurcated between the loose corporate and "prime" mortgage arena and the increasingly tight "non-prime" creates significant uncertainty.
The expectation has been that tightened mortgage Credit conditions would sway the Fed into easing. But today's comments from Fed officials certainly lead one to believe that they are content to focus more on upside liquidity risks, while allowing subprime excesses to, in the words of Mr. Poole, "come home to roost." Hopefully the Fed demonstrates resolve, as the most problematic systemic fragilities are being exacerbated by ongoing Unlimited Finance available throughout markets in corporate Credits, securities leveraging, and for (over)financing asset markets globally.
