The Beginning of the End?

We’ve commented from time to time on loose credit conditions (see our “Rising Tide of Liquidity“, plus Part 2 and Part 3 on the same topic) and indifference to risk (“Where Has the (Perception of) Risk Gone?“).

The tide may be turning. Today, the New York Times had a lengthy, well researched article, “Tremors at the Door,” on the reversal of fortune in the subprime mortgage market. Defaults by borrowers have risen to a level where the lenders themselves are increasingly in jeopardy:

Wall Street’s big bet on risky mortgages may be souring a lot faster than had been previously thought.

The once booming market for home loans to people with weak credit — known as subprime mortgages and made largely to minorities, the poor and first-time buyers stretching to afford a home — is coming under greater pressure….Now, Wall Street firms, which had helped fuel the growth in the market by bankrolling and investing in subprime mortgage lenders, have begun to pinch off the money spigot.

Several mortgage lenders have recently collapsed. While the failures so far are small in number, some industry officials are concerned that they could be the first in a wave. The subprime sector, which produced loans worth more than $500 billion in the first nine months of last year, could shrink significantly.

A sharp contraction in subprime mortgages would have ripple effects, reducing consumers’ access to credit and affecting investors like foreign central banks, pensions and mutual funds that have been big buyers of mortgage-backed securities….

“Pick a company — small, medium or large — they all have the same problem: capital,” said Marc A. Geredes, who runs a small mortgage company, LownHome Financial, in San Jose, Calif. “The economics of the business do not make sense right now.”….

Across the industry, 2.6 percent of the subprime loans securitized in the second quarter of 2006 had been foreclosed on or repossessed within six months. That is up from 1 percent for loans securitized in the second quarter of 2005, according to Moody’s Investors Service, the ratings agency.

The article mentions in passing that subprime mortgage paper is widely dispersed and its holders include hedge funds, mutual funds, and foreign institutions, including central banks. One of the beliefs about the way things are done now is that the widespread syndication of various credits means that institutions are better protected from risk, since they hold a more diversified portfolio of credits than was possible previously. That may be true, but we have also seen that there has been tremendous hunger for income and yield, and some old greybeards believe that risky credits have been underpriced.

Because subprime and other high-risk assets are now widely held, as those instruments go sour, it’s possible that dispersed, and seemingly diverse investors will all take note of their subprime losses and will pull in their horns as far as speculative (or even not-so-speculative) investments are concerned. In other words, the widespread syndication of risky loans could produce herd behavior in a contraction just as it did in the expansion.

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