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Sorting Out the Subprime Mess

02/21/2008 12:00 am EST


Neil George

Editor, Profitable Investing

Neil George, editor of Personal Finance, discusses how the subprime lending crisis morphed into a credit crunch, and he speculates about how and when it might end. 

Every decade or so, bankers lose their button-down ways and get lured into the magical, mystical world of financial engineering. This can work long enough for some new rebels to land their own private planes and island retreats, but it never lasts. Eventually the reckoning comes. And those bouts of grandeur tend to end with new sets of rules and regulations (which should have been adopted voluntarily before the reckoning).

We watched the recent ramp-up in the trillion-dollar-plus collateralized debt obligation (CDO) market for years. Initially, much of it was well-constructed and benefited all involved: banks and other financials packaged loans and other receivables to build asset-backed securities for trade on the open market.

It seemed a reasonable means of diversifying risk as well as capitalizing on a broader array of loans. It worked, for a while. But as some of the pieces inside these CDOs began to unravel, market participants weren’t able to get a handle on which CDOs were solid and which were Swiss cheese.

The word quickly got out, signaling a stampede to the CDO exits. And it isn’t over. Some expect at least another $70 billion to $100 billion in losses—or more—for European and US banks.

Lending is now frozen, [and] there’s more credit-crunch trouble in the works: it involves bond or credit insurance as well as credit default swaps (CDS). This has always been a loosely regulated market that, like the CDO market, [has become] an 800-pound gorilla few want to acknowledge. Because default rates on loans and CDOs and other bonds are rising, more CDS buyers face writing huge checks they can’t cash. That’s the next shoe to fall, and it will result in further credit issues.

Here’s how we see this playing out. First, it isn’t a US-specific market mess. The bulk of the CDO and CDS market emanated from Europe.

Next, the Federal Reserve and eventually the European Central Bank, the Bank of England, and others, will lower short-term interest rates. This will enable some floating-rate loans, including mortgages, to reset lower. But just because central banks lower rates doesn’t mean banks will lend.

The deleveraging of the banks will continue. The big money-center banks with piles of CDOs and other debt securities have begun this process. We’re now getting the bad news from the fourth quarter of 2007, and the terrible earnings reports will resume when first quarter 2008 gets under way in the spring.

The next wave will be the regionals and smaller banks. Given that the bulk of regional and local bank assets are mortgages and corporate loans, it’s reasonable to assume there are plenty of nonperforming and/or bad loans that have to be charged off.

We’ll see charges for the regionals and reduced earnings for the first two quarters of 2008. But the deleveraging will result in a return to a certain level of credit normalcy in the second half of the year.

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