US: Credit Market

Housing Bust Means At Least Another Year of Pain


It was only nine months ago that pundits, investors and government officials, argued that the U.S. subprime mortgage crisis had been "contained."

So they were wrong.

Home prices continuing to drop.

The implosion of the subprime mortgage market has been rampantly spreading throughout the economy, slamming consumers, banks, investors, even state and local governments to a degree unforeseen by most pundits and analysts and yes, U.S. Federal Reserve officials.

And it ain't over: it could last another 12 months, sucking the life out of lending, driving layoffs, and spurring company bankruptcies and bank failures. Some argue a recession has already begun and it could last for some time.

The depth of the crisis hasn't been hit yet if a new study by several prominent economists is correct concluding that unless financial markets can quickly recapitalize, banks are likely to cut back their lending to consumers and businesses by nearly $1 trillion. That will slash economic growth by more than a percentage point over the next 12 months, said the study by David Greenlaw of Morgan Stanley, Jan Hatzius of Goldman Sachs, Anil Kashyap of the University of Chicago, and Hyun Song Shin of Princeton University, released Friday.

UBS analysts said Friday that losses from the global credit market crisis will likely top $600 billion, of which listed banks and brokers should account for 'only $350 billion.'

Already, mounting home foreclosures, and more than $140 billion of write-downs at banks worldwide with hundreds of billions of dollars more likely, have become the "new normal."

The housing turmoil has spread violently enough that even the municipal bond market, generally viewed as mom and pop's sleepy investment and downright boring, is showing signs of seizing up.

But while the deterioration in housing, triggered by hundreds of thousands of subprime home loans going bad, has been cushioned somewhat by aggressive rate cuts by the Federal Reserve, that won't translate soon into a return to normalcy.

"The housing crisis is the single biggest influence out there on the U.S. economy -- and it is far from over," said Dan Fuss, vice chairman of Loomis Sayles, and widely regarded as one of the best bond fund managers. "You don't see signs of economic strength until later this year," said Fuss of Loomis, which manages $100 billion of fixed-income assets.

This week, Fed chairman Ben Bernanke said as much.

He acknowledged that brewing price pressures at a time when U.S. home prices were falling could make the central bank's job in keeping the economy growing more difficult, especially compared with the last recession in 2001 when the tech-stock bubble burst led to firm's pulling back on investments.

"In this case the consumer is taking the brunt of the effects," of the current downturn because housing wealth has been tied strongly to spending and their homes are their biggest asset, Bernanke said.

He placed a forecast that housing should weigh on the economy "in coming quarters."

Ain't Over Till It's Over

More bombshells could trip up Bernanke's conservative timeline.

Oppenheimer analyst Meredith Whitney, whose prescient call about the scale of subprime problems facing Citigroup led to a worldwide sell-off of banking stocks, said the U.S. bank sector is headed for a credit cycle that will be "the worst in generations."

The scenario includes widespread defaults on subprime mortgages and a range of other debts and a national homes market, which is in its worst downturn since the Great Depression of the 1930s, she added.

But ultra-low interest rates inspired not only a property boom but also financial innovation.

Daisy Chain of Debt (or Risks)

There were hundreds of billions of dollars of subprime residential mortgage-backed securities (RMBS), derivatives on subprime RMBS and collateralized debt obligations (CDOs) that bought subprime RMBS and/or the derivatives on the RMBS. These were packaged and sold to hedge funds, banks, and pension funds who looked to diversify their risks.

Pimco's Bill Gross estimates that there were $500 trillion of these exotic securities and other derivatives that had been hiding in a "shadow banking system," which consists of all the levered investment conduits, vehicles and structures, that are now facing liquidity constraints.

This system includes: SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. 

As the housing market soured, securities losses tied to subprime mortgages were felt by the largest U.S. banks including Merrill Lynch to even a German bank, IKB which had to be bailed out by a consortium of state-backed German banks, as writedowns connected to its revaluation of mortgage-related assets had emerged.

There's more to come. The banks face massive loan losses -- "far more dramatic" than most bank executives and ratings agencies have forecast, said Whitney, an analyst with Oppenheimer.

The crisis has cost the global banking sector well in excess of $100 billion in debt write-downs so far, but losses tied to the credit turmoil will likely top $600 billion, with banks and brokers accounting for more than half of that, UBS said in a note published on Friday.

Tsunami of Credit Eruptions Amid Fed Rate Cuts

Real-estate problems forced banks to tighten credit in the early 1990s, which former Fed chairman Alan Greenspan euphemistically likened to "headwinds" that slowed the economy.

That's easily the case today. "The breadth of the difficulties in the credit markets -- its size and scope - is the worst I have ever seen it," said James Kochan, fixed-income strategist at Wells Fargo Funds Management, in Menomonee Falls, Wisconsin.

A lack of confidence has seized up the markets for lending and curtailed new bond offerings for leverage loans and high-yield "junk" debt, major sources of funding for leveraged buyouts, since last August. But U.S. banks, which have taken losses on exposure in junk and leverage loans, face the "denominator effect" caused from constrained balance sheets and illiquid capital markets that will give way to sharp spikes in loss ratios for banks, said Whitney of Oppenheimer.

Today, investors have lost faith in the liquidity of auction-rate securities, which are issued by municipalities, the safest of all markets. But "munis" also rely on insurance from the so-called monoline companies MBIA and AMBAC for the credit ratings on its bonds.

The tsunami of credit eruptions underscores how the turmoil in the markets is hurting even as the Federal Reserve reduces interest rates.

Whitney said "You don't have a recovery until you have the financial system stabilized."