This article was written by Minyan Peter, author of other popular articles such as the E-Trade Trade and Discover's Goodwill Hunting.


I was asked recently, “What’s the next shoe to drop?”

At the risk of being indecisive, I believe there are three large systemic risks out there that have yet to be fully appreciated by the market.

The first is home equity credit. Beyond the alarming 16.5% 60 day delinquency statistic reported by Moody’s last week on home equity credit nationwide at the end of June, there is the question of collateral coverage. Generally speaking, home equity loans represent a junior mortgage. In the old days, home equity loans were obtainable for just some portion of the appreciation of home values, but in this credit cycle, home equity lines provided credit up to 110% of a home’s value at peak valuation.

Given the deflation in home values, I believe that many home equity loans today represent at best partially secured credit, if not unsecured credit. To my knowledge, few home equity lines were either underwritten or priced with this in mind. As a result, I believe that home equity loan losses will far exceed even the most current pessimistic forecasts. And not to frighten, but if unsecured credit card losses levels are running close to their 4.00% 60+ day delinquency rates, what does this suggest for home equity loans with their current 16.5% 60+ day delinquency rate? Clearly well above the 1-2% loss levels (and reserves) currently being forecast by banks.

The second risk area I see is municipal credit. Beyond the now well-reported Ambac (ABK) and MBIA (MBI) solvency issues, and the State STIF fund, SIV problems are looming a large property tax shortfall. Whether it is a function of home borrowers’ inability to pay or borrowers’ ability to pay lower taxes due to successful assessment appeals (lower property tax payments due to lower home values), I believe local and state municipalities are in for a very hard time. And without serious, immediate cuts in services, municipal debt ratings are likely to fall (and if AMBAC and MBIA fail, fall hard).

The final risk I see is derivative counterparty risk. Or put differently, how financial institutions can be both right and wrong at the same time. Underlying our financial system today are trillions of dollars of over the counter swaps covering everything from future of interest rates to the future of GMAC debt - where money is owed to one counterparty from another based on what happens in the future.

Since the advent of the swap market in the early 1980’s there has not been a systemic credit crisis anywhere near the proportion of the one we are currently experiencing today. And the biggest question to me is what happens when counterparties begin to default on their swaps. Could, for example, Goldman, which is held out today as being the preeminent risk management firm, be right in its hedges, but wrong in its selection of the counterparties providing them? And then what?

To be clear, I am not saying any or all of this will happen. But before the “all clear” whistle can be blown on our current credit crisis, I believe that each of these major systemic risk issues will be tested, the severity of loss truly understood by all market participants and the related losses ultimately realized.