The Credit Debacle: Brewing a Second Season

This week marks the one year anniversary of the credit crunch, which officially kicked off during the first full week in August when American Home Mortgage shut its doors after an incredibly precipitous decline in its stock.  The result?  This past year’s Fed action has been filled with enough drama to rival the latest season of “Days of Our Lives.”  The Fed slashed interest rates, rolled out a new Fed discount lending program, dramatically rescued Bear Stearns (BSC) in the nick of time, and took swift action with Fannie (FNM) and Freddie (FRE) to avert a financial panic.  Whew!

Soap operas and the financial markets have provided plenty of entertainment, but unfortunately there doesn’t seem to be any sign of relief on either front.  Could Mr. Bernanke be secretly directing the Fed by following NBC’s appetite for cheesy soap operas?  It certainly appears that way.

In 2007, NBC suggested that the over-the-top soap opera "[was] unlikely to continue [on NBC] past 2009," but in a surprise move in 2008, it was announced that NBC has renewed the show until 2010.  Does this sound all that different from Bernanke, who temporarily quelled financial markets by predicting that the subprime debacle would self-resolve by 2008, but at his latest policy meeting claimed that “although downside risks to growth remain, the upside risks to inflation are also a significant concern?”  Importantly, in his June 25th statement, Bernanke chose to drop the language that risks to growth had "diminished somewhat."

There are a number of reasons why the Fed maintains a cautious stance as we approach the last quarter of 2008.

First, Bernanke was confident that the credit crunch was confined to the subprime mortgage market.  He failed to realize that the problems with excessive credit (spurred by Greenspan) involve all aspects of credit, not just subprime.  Near-prime, prime, home-equity loans, commercial loans, credit cards, auto loans, et al. all appear to be fighting over who will star in season two of the credit crunch.

Second, latent losses at major financial institutions are still on the rise.  At the start of the credit debacle, large write-downs at banks were met with rallying share prices, as “bottoms” were thought to have been reached.  This mentality has since diminished, as investors’ appetite for “bottom guessing” has subsided.  Because further decay in bank finances and greater investor losses lie ahead, estimating the overall impact remains a moving target.

Third (not that far unrelated to reason two), approximately one half ($500B to $600B) of sub-prime debt is in the hands of non-institutional investors, such as insurers, hedge funds, pension funds, et al., who have been slower to recognize losses than the large banks.  Given the scale of the total amount, this factor is causing increased anxiety among market pundits.

Finally, Nouriel Roubini, economist and professor at NYU’s Stern School of Business, points out that write-downs and bank failures are far from over.  Just a few weeks ago, IndyMac (NDE), having been bailed out by the Fed, has gobbled up almost 15% of the FDIC’s (Federal Deposit Insurance Corporation) funds.   Mr. Roubini highlights that at least 8% (~700) of banks are in big trouble.  The FDIC is presently watching only nine institutions. "[This] is a joke,” he claims.

Unfortunately, both “Days of Our Lives” and the credit debacle are in the midst of brewing a new season.   Looks like Bernanke got that right: “the possibility of higher energy prices, tighter credit conditions, and a still-deeper contraction in housing markets all represent significant downside risks to the outlook for growth."

Let’s just hope that “season two” of the subprime loan saga doesn’t drag on like terrible soap operas.

Disclosure: I am short XLF & IWM.

Comments

[xsuddensam:]

It's unfortunate and shortsighted that we are treating this sub-prime "saga" as a singular event when in reality it is a symptom of a financial disease.

2008 Aug 11 10:43 AM

[IP Daily:]

...and the cure may be worse than the affliction. And,he false exuberance that exists because of lower energy costs, the brief rise in the dollar or " saga du jour " masks foundational problems that involve systemic risk of unbelievable proportions.

Unfortunately, I don't think we've even seen but the tip of the proverbial iceberg.

2008 Aug 11 11:37 AM

[xsuddensam:]

redruffinsore: "...and the cure may be worse than the affliction."

Ironically, the cure (printing more money) is the affliction.

2008 Aug 11 11:55 AM

[notsosmart:]

sadly,its what i have said for a long while.wall st. has turned into vegas.you lose slower & nobody brings you a drink.you cant believe anybody about anything.the foreclosed house in your neighborhood may soon house the homeless who will claim their family consists of numerous people.the house now owned by the arabs & bought with our gas money.i got this info on this site.how sad.

2008 Aug 11 04:51 PM