Two Views On The Subprime Lending Crisis

by: Tim Iacono

Two views on the mortgage mess appear in yesterday's Wall Street Journal (actually there were a few more as the paper now seems to be almost wall-to-wall with news on subprime lending - more than anyone really needs to know, especially about New Century Financial (NEW)).

The first view of contemporary mortgage lending comes in this report($) on the growing distress in securitized debt. It paints a dark picture of what may lie ahead in the weeks and months to come.

For years, an obscure class of Wall Street investment vehicles has acted like a locomotive in the housing-finance business, driving growth by soaking up risky mortgage bonds and parceling them out to investors around the world.

Now, as mortgage problems mount and a wave of mortgage-bond downgrades looms, these investments, known as collateralized debt obligations, are starting to look like a different vehicle -- rockets overloaded with combustible fuel.

Some big investment banks have been wavering when launching new CDO deals because of problems in the subprime mortgage market, which caters to the least credit-worthy borrowers. The problems also have investors demanding much higher returns on the CDOs they buy, which makes them harder to sell and drives down their prices.

CDOs are an integral part of Wall Street's mortgage dicing-and-slicing machine. After mortgages are written, investment banks pool them together and use the cash flows they produce to pay off mortgage-backed bonds, which the investment banks underwrite.

The mortgage bonds, in turn, are often packaged again into CDOs and sold off in slices. Investors can choose to buy the risky pieces of the bonds or purchase slices with less risk.

Until now, credit rating agencies have been slow to react, prompting the question of whether there will be a broad-based tightening of credit.

To date, credit-ratings companies have downgraded less than 1% of subprime bonds issued in 2006.

But some investors say the woes could mount, particularly for CDOs holding the riskiest mortgage bonds.

"The downgrades of subprime bonds are just starting, and they are going to accelerate," says John Cutting, a managing director at MBIA Asset Management, which invests in and manages some mortgage CDOs.

"In time they'll start triggering downgrades in some of the lower-rated classes of CDOs."

The more optimistic take($) on things comes from the editorial page (surprise!) courtesy of Michael Darda, chief economist at MKM Partners, who probably thinks that subprime lending has been getting far too much attention lately.

Some argue that the problems in the sub-prime mortgage market and manufacturing are only the beginning of a much broader and more intense slowdown that is likely to undermine the labor market and stifle consumption. While the problems in the sub-prime mortgage market shouldn't be taken lightly, mortgage resets are estimated at $10 billion to $15 billion during the next two years -- about 0.1% of nominal GDP and 0.02% of aggregate household net worth. Sub-prime borrowers are mostly households in the bottom 20% of the income distribution, which accounts for only about 8% of total consumption spending.

With broad measures of commercial bank credit and household deposits expanding at a 9.8% and 10.3% annual pace, respectively, and global foreign exchange reserves expanding at a 17% year-to-year pace, it hardly seems that a broad-based liquidity squeeze or credit crunch is on the horizon.
As the drags from housing and manufacturing abate sometime later in 2007, it is more likely than not that the economy will return to an above-trend growth rate powered by strong consumption (via a tight labor market), strong global growth (exports) and a pickup in capital spending (thanks to record profits and still-tight credit spreads).

It's probably a safe bet that with Hank Paulson at Treasury and Ben Bernanke at the Federal Reserve, liquidity is not going to be a problem.

Finding qualified borrowers might be.

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