(cont)
The process of transforming risky mortgage loans into coveted perceived safe and liquid (“money”-like) Credit instruments has broken down on several fronts. Not only is the risk intermediation community impaired, marketplace confidence and trust in the quality, safety, and liquidity of mortgage (and mortgage-related) securities is being shattered. There are apparently serious problems developing throughout the massive marketplace for (“repo”) financing MBS. And it is precisely the market for financing the top-rated mortgage securitizations – where the perceived risk was minimal – where I suspect the greatest abuses of leverage occurred. The marketplace is now experiencing forced de-leveraging and a liquidity Dislocation – with major systemic ramifications.
I mostly downplayed the marketplace liquidity and economic impact of the housing downturn last fall and the subprime implosion this past February. For the system as a whole, the Credit spigot remained wide open. My view of current developments is markedly different. I cannot this evening overstate the dire ramifications for the unfolding Credit Market Dislocation. There is today serious risk of U.S. financial markets – distorted by years of accumulated leverage and derivative-related risk distortions – of “seizing up.” A system so highly leveraged is acutely vulnerable to speculative de-leveraging and a catastrophic “run” from risk markets. At the same time, the Bubble Economy and inflated asset markets – by their nature – require uninterrupted abundant liquidity. The backdrop could not be more conducive to a historic crisis, yet most maintain unwavering confidence that underlying fundamentals are sound.
I am this evening unclear how the enormous ongoing demand for new California mortgage Credit will be financed going forward. With the market having lost all appetite for “jumbo” MBS, mortgages must now be priced generally in accordance with the standards of increasingly cautious loan officers willing to live with these loans on their banks’ balance sheets (a radical departure from pricing set by originators selling loans immediately in an overheated MBS market). And, let there be no doubt, the prospective Credit tightening will hit grossly inflated and highly susceptible “Golden State” housing prices hard – a scenario that will force lenders to incorporate significantly higher Credit losses into their loan pricing terms (perhaps Cramer was speaking to CA homeowners when he jingled house keys in front of the camera during Wednesday’s show and suggested it was perfectly rational to mail your keys to the bank). Furthermore, I expect the pricing and availability of Credit required to refinance millions of rate-reset mortgages in California and elsewhere to turn prohibitive for many. And the home equity well is about to run dry – from a combination of sharply tightened Credit conditions and accelerating home price declines.
A severe tightening in mortgage Credit is in itself sufficient to pierce a vulnerable U.S. Bubble Economy. But there is as well an abruptly brutal tightening in corporate Credit. The junk bond market has basically closed for business. The leveraged loan marketplace is in turmoil and scores (46 – see WSJ above) of debt deals have been pulled. And, more ominously, the previously booming ABS and CDO markets have slowed to a crawl. Perhaps not immediately, but it will not be long before the economy succumbs to recession.
Credit Market Dislocation now dictates the assumption that Federal Reserve liqudity assurances and rates cuts are on the near horizon. And while they will likely incite the expected knee jerk response in the equities market, I don’t expect they will have much lasting effect on our impaired Credit system. Current issues are much more complex and serious than ’87, ’98, 2000, or 2002. The dilemma today is that confidence in “Wall Street finance” has been shattered. The manic Bubble in Credit insurance, derivatives, and guarantees is bursting. The manic Bubble in leveraged speculation is in serious jeopardy. The currency markets are a derivative accident in waiting. Fed rates cuts risk a dollar dislocation and/or a further destabilizing (for spreads) Treasury melt-up.
