Credit Crunch to Drag On Despite Efforts by the Fed

Now that Wall Street has gone through its version of “Survivor,” it’s time for a reality check.

The credit crunch is probably far from over and is more likely to play out like a mini-series than as a reality TV show.

From the Federal Reserve to the Treasury to the average economist or analyst, the message is largely the same.

The Fed may have calmed the markets and averted a major crisis by teaming up with JPMorgan Chase to rescue Bear Stearns .

But the root structure of the credit crunch stretches wide and deep. Many of the financial instruments involved are complex, unusual and difficult to value. Asset prices remain in a state of flux and the very players that need to be lending are the ones shoring up their balance sheets.

“There are a series of credit problems, distinct sub markets," says independent banking analyst Bert Ely. “Something could come up tomorrow, an institution, a country, that isn't on anyone’s radar.”

Treasury Secretary Henry Paulson put it a bit more diplomatically earlier Wednesday, telling an audience in China: “I continue to think there will be some more bumps in the road."

The unfolding of the credit crunch – from its inception as a subprime mortgage market problem– has been a series of loud second shoes dropping on Wall Street: Escalating write downs and loan loss provisions in the banking sector, near or actual bankruptcies in the mortgage lending business, the solvency of the bond insurance market and most recently, worries about Bear Stearns, and to a lesser extent Lehman Brothers .

David Resler, chief economist at Nomura International, says Bear Stearns was an example of how the credit crunch could pose an “‘immediate threat to instability in the entire system. The biggest risk has passed.”

Resler is quick to add that people realized the problems were “a lot more systemic than people perceived" and the current “deleveraging has a good way to go.”

“Deleveraging is a process that is painful,” says Resler. “The Fed will make that deleveraging more orderly, but it will not prevent and should not prevent the deleveraging.”

And that’s what happening with the mortgage market as well as the vast derivatives market of securitized debt, from the more conventional mortgage-backed securities to the deceptively simple structured investment vehicles.

The fallout has not been lost on Fed Chairman Ben Bernanke, who explained it to Congress Wednesday.

Economic Data

“The effects of the financial strains on credit cost and availability have become increasingly evident, with some portions of the system that had previously escaped the worst of the turmoil--such as the markets for municipal bonds and student loans--having been affected," said Bernanke in his opening remarks. “Another market that had previously been largely exempt from disruptions was that for mortgage-backed securities (MBS) issued by government agencies.”

The blizzard of exotic debt market derivatives -- some of which are now known as "toxic paper" -- is also part of the problem.

“A lot of people who own this paper, they don't even know they own this paper,” Neuberger Berman portfolio manager and managing director Gary Kaminsky told CNBC. “It will take months for those people who bought these securitized products to actually realize they own these products, to write them down, transfer those losses and actually take them. The process takes a lot longer and will be drawn out.”

The mortgage market, for one, continues to struggle, even though the Fed has cut the federal funds rate three-and-a-quarter points, as lenders remain in a very cautious mode. For example, the spread between a regular, conforming 30-year fixed rate loan and a jumbo one is at 130 basis points, well above the average. Lending for home-equity lines of credit has also tightened.

The complex interplay – some would say vicious circle – between the credit crunch and an economy in slowdown mode – isn’t over either.

Soros on Credit Crisis

In an exclusive interview to be broadcast on CNBC on “Closing Bell” Wednesday, billionaire investor George Soros told Maria Bartiromo that the markets have hit a significant but temporary bottom.

“I don’t think we are halfway through the fallout because to think what happens in the financial markets doesn’t affect the real economy is nonsense,” Soros said.

If this credit crunch, as some have claimed, is indeed the greatest financial crisis since the Great Depression in the 1930s, then Fed will continue to cut interest rates – perhaps to as low as 1 percent. The federal government is probably not though either. Lately, there appears to be a growing inevitability to a broad government bail out of troubled homeowners and even mortgage lenders.  

“A lot of air has been let out of the balloon, but we don't know how much more there is “ says Resler of Nomura International. “This whole crisis underscores the conceit of many in the markets that we can pretend to understand the properties of complex asset structures when they have cyclical sensitivities and we have not experienced those since they were created.”