27 March 2007

The lesson's of the subprime meltdown

We see subprime as risk and valuable lesson. This market is in for a rough run. There are sweet dreams of containment; they defy reality. There is no such thing as a subprime neighborhood. Subprime is concentrated more heavily in some areas than others; it is everywhere. Thus broader housing-weakness questions are when and how bad, not if. Hundreds of billions of dollars in loans were made to people who clearly could not repay, absent significant annual house-price appreciation and cash-out refinancing. This means that we made housing loans to create housing-price appreciation on which loan repayment was predicated. Sometimes we are tempted to think that this credit boom has gotten a bit out of control. There is no long-run safe substitute for earnings, savings and income growth when increasing credit. This is not to say there cannot be a lot of money made, valuable financial innovation and long periods of great returns.

The other vital lesson involves our brave world of fully managed risk and nearly perfectly hedged positions. Have other markets and asset classes become dependent on credit growth to drive up asset prices to allow further credit growth? A huge Maginot Line of default defense has been erected to keep loss exposure out. Many valuable and potent new risk-management techniques and products have been developed. Riskier borrowers remain risky to all the various parties that extend credit to them. This showed up fast and furious as the cost of credit-default protection shot up and interest-rate premiums snapped into correlated action with every increase in subprime stress.

The greatest risk may be in thinking that risk has been conquered. It cannot be. It has not been. Risk has simply been redistributed and repriced, downward. As perceived risk fell and sharing grew, new monies were freed up for riskier lending and new, riskier projects. Loans went through and new projects were launched. Default risk continued/continues to grow as credit grows and allocations hunt for return. There is no innovating around this basic reality of financial gravity.

We are looking for periods of contagious fear in credit-risk-reduction markets feeding back and forth with particularly risky asset markets. The real danger slumbers - we hope - so long as massive quantities of cheap credit allow the roll-over financing of future rounds of debt. If this slows sharply, or runs in reverse, US subprime housing turmoil is the tip of the iceberg. There has been a lot of subprime allocation of capital and risk across the past few years. Subprime will either become a heeded warning shot across the bow, or a prelude to violent repricings to come.

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