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This Credit Crunch Has Bite: Part I


Financial institutions have already incurred losses of over $90 bln.

This article is brought to you by Minyan Satyajit Das, a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall) as well as the author of The Saga of Interbank Banks and Socialism for Wall Street.

2007 may come to be associated with the start of the credit crunch. The sub-prime losses may still morph into a fully-fledged "credit crunch." There are a number of "unresolved" agenda items.

The total level of sub-prime losses is far from clear. Based on current trading levels of ABS indices, estimates of losses range between $150 and 400 bln, not all of which has been written off to date. Interest rates on large volumes of sub-prime mortgages, estimated at around $900 bln, are due to reset by the end of 2008. Interest rates and repayments will rise significantly. The impact on delinquencies and losses are unknown. The rate reset freeze plan and its impact are also still unclear.

As America's mortgage markets began unraveling, economists initially focused on sub-prime mortgages issued to largely low-income, minority and urban borrowers. Closer analysis reveals risky mortgages in nearly every corner of the USA. Analysis by The Wall Street Journal indicates that from 2004 to 2006, when home prices peaked in many parts of the country, more than 2,500 banks, thrifts, credit unions and mortgage companies made a combined $1.5 trln in high-interest-rate, high risk loans. The potential losses on these loans are unknown.

There are also emerging concerns in the $915 bln credit card debt markets. Credit card providers are all boosting loan loss provisions. There is anecdotal evidence that cash strapped mortgagors are using credit cards to make mortgage payments. Analysts expect credit card delinquencies to increase if consumers unable to use home-equity lines of credit to pay off their credit card debt start running up higher card debt.

Financial institutions have already incurred losses of over $90 bln. A substantial volume of assets is likely to return onto bank balance sheets as off-balance sheet structures and hedge funds are forced to sell. The total amount to be re-intermediated by banks may be in the range of $1 to 2 trln. This will make substantial depends on bank liquidity and capital.

There are already signs that the major banks are hoarding liquidity in anticipation of the return of assets. They will also inevitably have to raise substantial amounts of capital. In the second half of 2007 commercial and investment banks raised $83 bln in equity. This was an increase of more than 20% on the corresponding period in 2006.

Hedge funds face substantial redemption requests in the coming months. Asset backed conduit vehicles and SIVs, or Structured Investment Vehicles, may need to sell assets as they breach their rules. This will exacerbate the demands on bank capital and liquidity.

The credit issues have widened beyond banks, investors and hedge funds active in structured credit.

In the conventional mortgage market, Fannie Mae (Federal National Mortgage Association) and Ginnie Mae (Government National Mortgage Association) have recorded losses. This suggests that the problems in the housing market are deep-seated.

Mortgage insurers and monoline insurers have suffered serious collateral damage. A significant downgrade in the rating of insurers will be particularly damaging. It will affect around $2.5 trln of municipal bonds guaranteed by the insurers. It will also affect other bonds wrapped by the insurers. This may trigger further selling pressure and contribute to decline in prices as well as absorbing increasingly scarce liquidity.

The $2 trln of European pfandbrief or covered bond markets have also experienced liquidity problems.

The sub-prime model is also used for leveraged funding in private equity, infrastructure and commercial property financing.

$300 bln of leveraged finance loans made by banks is effectively "orphaned" - they can't be sold off. In late 2007, there were signs that the loan logjam was easing. Underwriters pointed to some sales of risky assets.

Caution is needed in interpreting these developments. Firstly, the sales only related to the less risky tranches and loans. The more risky exposures remain with underwriters for the moment. There are also concerns that some of the sales were not "genuine." The banks had provided the buyers with a variety of favorable terms including the ability to sell the loans back to them at a future date at a guaranteed price. Alternatively, MFN ("most favored nation") clauses mean that the selling bank will need to compensate buyers if loans are sold at lower prices during an agreed time from the initial sale. Current prices indicate steep discounts will be needed to shift the paper to investors.

The crisis shows signs of spilling over into other markets. In Great Britain, Ireland, Spain, Australia and other markets strong house price appreciation similar to the US led to similar growth in mortgage and real estate lending. If economic growth slows and housing prices fall then similar problem may emerge in those economies as well.

There are already signs that there will be significant litigation against the banks. There may also be regulatory investigations and potentially prosecutions. State Street recently provided $279 mln against future litigation claims. The total cost of all this is still unknown.

Click here to read This Credit Crunch Has Bite: Part II
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