"Warsh, Steel Don’t See `Systemic Risk’ From Subprime"

A Fed and Treasury official both said they don’t see the downgrade of some subprime related debt leading to a broader meltdown, but instead see the repricing of credit working itself through in an orderly fashion.

The fact that they felt the need to issue the reassurance in and of itself isn’t a good sign, It says they thought the markets were rattled. And the rating agencies have announced re-ratings that apply to only a small percentage of subprime bonds (the biggest number announced is that S&P is reviewing $12 billion worth of bonds, which is a teeny amount in the bond markets), so their cautious approach means any forced sales should affect only a few issues (although this stuff has been so liliquid, and with the prospect of further downgrades looming, the paper is likely to trade as particularly distressed prices).

But note that an orderly repricing of credit is still a significant event, particularly if it continues, which we anticipate. We’ve had years of overly generous credit terms, which have helped keep housing and indirectly consumer spending aloft. At a minimum, this is a kick in the head to an already weakening housing market.

In addition, this development also comes off a nasty quarter for hedge funds that got there subprime bets wrong (keep in mind that those who got it right like Paulson & Co. made a bundle), and there are rumors of 30 to 50% losses at some funds, and quiet liquidiations underway. And the Fed official ,David Warsh, also remarked that global banks need to make further progress in managing hedge fund related risks, and that the Fed, while hand’s off, won’t be “passive.” It isn’t clear what he means, except perhaps a coded reminder that the Fed would supply liquidity were a real panic to develop. But the markets know that already.

From Bloomberg:

Federal Reserve Governor Kevin Warsh and Robert Steel, the Treasury’s top finance official, said investor losses from subprime-mortgage delinquencies aren’t posing any broader risks to the financial system.

“Our overall view is that there are certainly losses, that we might not be at the bottom of this tumult, but they don’t appear to be raising, to this point, systemic risk issues,” Warsh told the House Financial Services Committee today.

Warsh spoke amid concern that losses on bonds backed by subprime mortgages, made to the riskiest borrowers, will ripple through Wall Street. Bear Stearns Cos., the fifth-biggest U.S. securities firm, last month was forced to lend $1.6 billion to one of its hedge funds to rescue it from immediate collapse following bad bets on subprime mortgages.

The sell-off in subprime securities “does not seem to be a systemic issue,” Steel, the Treasury undersecretary for domestic finance, said at the hearing. The market “is going through an adjustment process,” he added. “It seems to be happening in an orderly way.”

Subprime mortgages are “generating very real losses” for investors, Warsh said without specifically mentioning New York- based Bear Stearns.

Credit Suisse Group analysts this week estimated investors have lost as much as $52 billion amid the sell-off in the $800 billion market for mortgage securities backed by subprime loans. Moody’s Investors Service yesterday lowered the credit ratings on $5.2 billion of bonds backed by subprime mortgages.

`Adequate Cushions’

“The losses that have been felt by hedge funds and other financial intermediaries are certainly forcing them to go back to first principles, revisit their exposures,” Warsh said. “What we’re trying to do in our supervisory capacity is ensure that they still have adequate cushions, that they still have sufficient capital, so that they can operate robustly.”

Philadelphia Fed President Charles Plosser said in London today that most banks remain in “good shape” as subprime losses mount. Referring to the ratings cut by Moody’s, he said in answering questions after a speech today “I don’t think that was entirely unanticipated. Sometimes I buy a stock thinking it will go up and it doesn’t.”

Warsh made his comments in response to questions from Representative Maxine Waters, a California Democrat who chairs the panel’s housing subcommittee.

The hearing’s principal topic was financial-system risks from hedge funds. The private pools of capital that allow managers to share in gains have avoided strict U.S. regulation because they cater to wealthy individuals and pension funds rather than less-affluent investors.

Warsh said in his prepared testimony that said global banks need to make “further progress” in managing risks from hedge funds and that the Fed’s hands-off regulatory stance doesn’t mean the government will be “passive.”

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