Will the Subprime Meltdown Spread to the Rest of the Credit Market?

The well-regarded Nouriel Roubini of RGE Monitor thinks it might. He picks up on the themes we’ve discussed earlier, particularly the severity of the subprime mortgage market contraction (these are loans made to particularly weak borrowers, which therefor e command higher interest rates).

Roubini comments on what he regards as an unusual feature of this credit tightening, namely that it is taking place in a strong economy. Normally, as he points out, the real economy weakens first, and when lenders see that borrowers are looking shaky, they tighten up on terms and availability of financing.

I beg to differ with him. I don’t believe the economy is strong by any stretch of the imagination (and in fairness, the detailed portion of his article is for subscribers only, so he may well be largely in agreement). As has been reported widely, including here, the 4th quarter GDP stats are being revised downwards. Despite the efforts of industry participants to promote the idea that the housing market has bottomed, we’ve just experienced the largest year-to-year price decline in housing prices ever recorded, and a lot of supply has been withdrawn. It’s not at all clear that we have hit bottom, and even if we have, it’s not clear how long it will take to work through the supply overhang. Prices will continue to languish until that process is completed.

But the real untold story of the faux economy is jobs and income. Income gains have occurred only in the top two deciles. Although my evidence is strictly anecdotal, I also believe there is a tremendous amount of un- and underemployment in the 40+ cohort. I know and have heard of a tremendous number of people who are effectively retired, are looking for jobs with no success, or are doing various forms of consulting but are far from fully utilized. These are people in their peak earning years. They are also people who would never apply for unemployment and therefore are not captured statistically.

I also believe there is reporting bias in that most business reporters live in New York. Wall Street and the money management industry is booming, and the local economy is thriving. It’s hard to believe the economy is not doing all that well when the average employee at Goldman is earning over $620,000 a year.

There is also a precedent in the 1999 economy. Most people remember it as a boom time, the last hurrah before the dot-com party came to an end. But it was also a banner year for people in the bankruptcy business. One of my colleagues remarked then, “The second tier of the two-tier economy is hitting the wall.” But that didn’t garner much attention in the mainstream business media.

That is a long-winded way of saying that the near-crisis in the sub-prime mortgage market may well be a harbinger, because the rest of the economy is on comparatively shaky foundations.

From Roubini:

When growth optimists such as the wise Richard Berner of Morgan Stanley (not just Roach, their resident long term bear) start talking about a sub-prime and ABX “meltdown”; when the terms “carnage” and “time bomb” are used by mainstream observers to describe the sub-prime and ABX market; and when the same Berner needs to write a long piece to convince you that there will be no “credit crunch” following the sub-prime meltdown you know that some serious trouble may be brewing. The trouble takes the form of three problems:

1. Risk of the subprime “meltdown” becoming contagious to prime mortgages;
2. Risk of the beginning of a broader credit crunch;
3. Risk of the ABX “carnage” leading to more serious losses and implications for credit markets.

Of course last week many investment banks had conference calls to reassure their clients with the message that the subprime meltdown is contained, that other credit spreads are holding in spite of the free fall of the ABX (BBB-) indices, and that there is very little risk of a broader credit crunch.

That optimistic scenario is of course possible and we do not know yet how these credit markets will behave over the next few months. But the same cycle of minimizing the potential risks from the housing fallout has occurred all along since last year: the housing recession was first defined as “housing slowdown” and is now argued to be “bottoming out” based on relatively little evidence; today’s subprime “meltdown” was yesterday’s subprime “correction”; and today’s worries of a “credit crunch” are widely dismissed as unlikely.

But consider the following issues. Normally when a sector like housing or real estate or tech goes into a boom and bust cycle, the “real cycle” precedes the “credit cycle”. In other terms we would have expected that weakness in housing would lead first to large job losses, lower income generation, higher unemployment first (the “real” cycle). Only when the “real” cycle is underway one would usually expect – as in the 1980s S&L fiasco – that a “credit” cycle would be triggered and emerge leading to further real and financial distress.

Instead the most surprising thing about this housing bust and subprime meltdown is how the “credit” cycle started much earlier than the “real” cycle and much more rapidly than anyone would have ever suspected. Now in an economy with still high growth, still high job creation, still very low unemployment rate, still high income generation we are already observing massive increases in subprime defaults and foreclosures, 20 subprime lenders going out of business in two months, the ABX going into free fall and the cost of insuring against the BBB- tranche of the ABX index going to a spread relative to LIBOR of over 1000bps. So, if all this happening in what the consensus terms as a “Goldilocks economy” what would happen if the economy – as likely – will start to slow down more in 2007? How much more carnage can we expect in many sectors and markets when the economy is weaker than in recent months?

The fact that the downward “credit” cycle has emerged so fast and so sharply in a still “strong” economy is the most important signal that this sub-prime mess cannot be easily dismissed as a niche problem that will have no contagious effects on the rest of the economy and of financial markets.

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