The Great Credit Contraction of 2007

by: Barry Ritholtz

What is the inter-relationship between Housing, LBOs & Stock Buybacks? Last month, I noted 6 reasons why rising yields were a threat to equity prices: Valuation, The M&A/LBO Put, Competition, Profits, Share buybacks, Consumer spending.

As of late, we have seen the threat of two of these issues increase dramatically: The M&A/LBO Put and Share buybacks are being pressured by the increasingly expensive credit. 

Much of this is derived from the mess in Housing: As many of the ARM/liar loans in the Sub-prime and Alt-A mortgage group increase their default rates, the residential mortgage backed securities [RMBS] that were packaged into CDOs have begun to unravel (See WTF is going on in the ABX Markets?). All told, the many variations of these were a prime source of cheap financing. This was what has been driving private equity buying frenzy and many share buybacks. That financing source is rapidly fading. 

How much is the credit drying up?  According Merrill's Richard Bernstein:

"Bloomberg Radio reported this morning that the monthly issuance of Collateralized Debt Obligations (CDOs), or packages of debt instruments bundled together to form a "portfolio" of debt, dropped from $42 billion to $3 billion in the latest month. That 93% drop represents a significant tightening of liquidity that is starting to ripple throughout the credit markets. The fixed-income markets appear to be starting to understand that the days of free-flowing liquidity are likely to be behind us. Most credit spreads are widening."

See Bill Gross latest for further discussion of the great credit contraction of 2007. 

Lastly, for those hoping this marks the bottom of the Housing derived credit crunch, according to the UK Telegraph, "some $2 trillion of subprime and 'Alt A'  mortgage debt is falsely priced on the books of banks and funds worldwide.” 

And to imagine: Some tv pundits -- cretins of the lowest order -- actually have been insisting that the Housing market would have absolutely zero impact on credit, the economy, markets and retail.   What a bunch of tools . . .