18 March 2007

Subprime Contagion Effects:

Doug Nolan:

The Mortgage Finance Bubble should have burst last year, taking the lead from housing market dynamics. But the extraordinary dynamism associated with global Credit, speculative and liquidity excesses proved overpowering. The global leveraged speculating community was in aggressive expansion mode; Bubble excesses were going to reckless extremes throughout "Credit arbitrage;" the M&A and corporate debt Bubbles were in full bloom; and securities leveraging was taking the entire world by storm.

The resulting global liquidity cataclysm ensured insatiable demand for higher-yielding instruments, in large part satisfied by Wall Street's unprecedented CDO (collateralized debt obligations) issuance boom. Despite the turn in U.S. housing, the unprecedented deluge in speculative finance created rapacious demand for riskier loans, certainly including subprime mortgages - vulnerable housing markets notwithstanding. Readily available mortgage finance empowered subprime originators to accommodate throngs of simply terrible Credits (many borrowers content to submit fraudulent loan applications) desperate to refinance problematic mortgages with payments about to reset significantly higher. When Wall Street pool operators recognized the unfolding disaster - and began rigorously scouring portfolios for problem loans and imperfect applications to return to the originators ("early payment defaults") - the subprime Bubble was brought to a screeching halt.

That the Mortgage Finance Bubble did not succumb last year only ensured the peril associated with a protracted period of terminal blow-off excesses. Excesses included unprecedented speculation in Credit derivatives (including a Trillion or two of new CDOs), equities Bubbles spanning the globe, and only greater Bubble distortions and imbalances in U.S. and global economies. The exponential growth in risky lending, in the leveraged speculating community, in the derivatives markets, and in speculative flows to global asset markets were accommodated another year. Wall Street finance became an only more imposing source of global "money," Credit and marketplace liquidity, operating with the type of power and control central banks could only dream of.

Reading through this week's Wall Street earnings releases and listening to their conference calls left me with the sense that these firms and their clients are especially poorly positioned for an abrupt change in the market environment. Everyone is quick to state that their subprime exposure is small and that they have successfully "hedged." We are also told that market tumult has been isolated in the subprime marketplace, and that marketplace liquidity remains extraordinarily abundant. All of this may be true for now, but it does not alter the reality that the subprime collapse may very well mark a key (historic?) inflection point for the U.S. Mortgage Finance Bubble and intertwined global risk markets generally.

Clearly, the subprime collapse has quickly imposed dramatically tighter Credit standards and Availability for risky borrowers. I would expect this to speed housing price declines in some areas, with mounting Credit losses ushering in the ugly downside of Credit cycle. To be sure, this has provided a belated wakeup call regarding the latent Acute Financial Fragility of Ponzi Finance Units. Importantly, the flow (deluge) of speculative finance played a critical role in the subprime boom, and its abrupt reversal has instigated almost immediate collapse.

The bulls argue that subprime amounts to only a small portion of mortgage debt - and thus will have only minimal economic impact. More discerning analysis would instead focus on the Financial Sphere Ramifications Associated with the Hasty Reversal of Speculative Flows from Risky Mortgage Instruments. Is the flight out of subprime mortgages, securitizations and other derivatives a harbinger of things to come for the entire mortgage marketplace? Does the move toward Risk Aversion (position liquidation and/or hedging operations) in this sector mark a momentous marketplace shift from Risk Embracement to Risk Aversion?

In analyzing potential Subprime Contagion Effects, we must begin with a critical question: Is the general backdrop characterized by soundness and stability or is it more a case of excess, weak debt structures, and general fragility. Again, subprime collapsed so abruptly because of the acute fragility associated with Ponzi Finance. Unfortunately, analysis of general mortgage market vulnerability leaves me quite uneasy.

The entire Mortgage Finance Bubble is today especially susceptible to Subprime Contagion Effects. For starters, lending standards should be expected to tightened significantly throughout the "Alt-A," "jumbo," and prime "exotic" mortgage marketplace. This will likely pose a greater dilemma than subprime restraint for vulnerable high-priced housing across the country, with all eyes on California. For years now, the "Golden State" has been at the epicenter of mortgage lending excesses. I suspect the state has also been the leader in mortgage fraud. Going forward, I fully expect California to lead the nation in Credit losses and mortgage/housing angst.

Throughout the boom, the securitization of mortgage Credit provided endless finance for homebuyers and speculators, as well as endless profits for the holders of these instruments. As long as home prices were inflating, there was little concern whether the underlying collateral was a reasonably valued home in, say, Texas or a highly inflated property in the San Francisco Bay Area. Now, with Credit conditions beginning to tighten, I expect holders of MBS, ABS, CDOs, etc. to take a more keen interest in the type and location of underlying collateral. This Contagion Effect will mark a significant reversal in speculative flows from the mortgage arena.

For some time it has been my belief that a California housing bust would bring an end to the GSEs as we presently know them. Never in my wildest imagination did I contemplate the median price for the entire state inflating to $560,000. A bust would now likely take down the GSEs, the mortgage insurers, scores of banks, and wreak bloody havoc throughout the entire securitization and derivatives marketplaces. While few will today subscribe to such a scenario, I certainly expect the marketplace to begin contemplating and gravitating away from such risks. And I don't think it would take that much for the marketplace to start nervously totaling up the capital and reserves available for future Credit losses from the thinly capitalized guarantors of the so far pristine "AAA" agency securities marketplace. Again, there are now reasons to ponder various Contagion Effects that together could foster a major and self-reinforcing reversal of speculative flows.

Ominously, renewed dollar weakness has been an early Subprime Contagion Effect. Sure, the market now perceives the Fed will in the not too distant future cut rates and narrow rate differentials. But I also believe more may be at work. The transformation of risky Credits into perceived "money-like" instruments - that foreigners have been happy to accumulate - has lent great support to the dollar over these past few years of massive Current Account Deficits. A bursting Mortgage Finance Bubble and what it could mean for the securitization markets and risk intermediaries create the potential for Subprime Contagion Effects to precipitate a real problem for the dollar.

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