Da Counselor: I agree with your assessment, but it largely focuses on this as a market related situation.
If you take a step back, there are other variables at work here that make this a problem with potentially far larger implications. Most of those variables are not within the market (so to speak), but rather impinge on the market (in terms of event triggers) or are peripheral to the market (in terms of compliance or oversight).
Think about this scenario (in terms of cascading effects): S&P downgrades a small section of the sub-prime and begins to scrutinize other portions of the MBS market, including CDO/CDS products backing the MBS market. Concurrent with this, Fannie/Freddie are constrained from further participation as regards purchasing additional risk in the MBS market. The Fed, forced to finally acknowledge the inflationary risk posed by increased core and non-core pricing, raises interest rates another 250bp.
These three events (two fairly small, one fairly significant) would cause a major contraction in credit. Now imagine you’re a distressed homebuyer trying to finance his/her way out of a bad sub-prime product into a better fixed rate product. This loan would be: More expensive (in terms of cost of funds), as well as far more difficult to get (in terms of the lender reselling the loan to Freddie or Fannie).
We have seen some inklings of this in terms of more stringent underwriting guidelines and the new limits placed on state income loans. These events, however, predate the notification about S&P and the potential retrenchment of Fannie/Freddie regarding purchasing MBS risk.
Is it too far out of the realm of imagination to think that this is just round one and there are additional rounds of even greater severity set to come? You mention a chain reaction. I think that is an excellent description of what is about to come.
