Anatomy of a credit crisis, from subprime to prime time

The Star-Ledger, August 19th, 2007

The Star-Ledger Archive COPYRIGHT © The Star-Ledger 2007

Date: 2007/08/19 Sunday Page: 001 Section: BUSINESS Edition: FINAL Size: 1934 words


Anyone who lived through the dot-com bust of 2000 knows that when really big bubbles pop, the sticky goo tends to fly everywhere.

Seven years ago, stock investors had to mop up their mess; today, it's the debt and credit markets.

Years of low interest rates and easy access to cheap money are the culprits behind the housing market's boom and bust, which has battered cash-strapped borrowers, led to record defaults on so-called "subprime" mortgages, and roiled financial markets, experts agree.

And now? It's clean-up-the-goo time.

Steven Roach, chief investment strategist for Morgan Stanley, believes there are striking parallels between the dot-com crash and subprime mortgage meltdown. Both were the proverbial needles that ultimately popped much larger "asset bubbles," Roach said.

When the stock market bubble burst in 2000, a handful of Internet stocks were the first to go down. But pretty soon, the carnage widened from the tech-heavy Nasdaq stock market to the broader markets, and before long the rest of the economy was caught in the mudslide.

"This time, it's the U.S. housing bubble that has burst," Roach said, "and the immediate repercussions have been concentrated in a relatively small segment of that market – subprime mortgage debt."

But as the stock market's recent craziness makes clear, the problem is a lot bigger than a handful of risky subprime mortgages gone bad.

Despite assurances from Federal Reserve Chief Ben Bernanke that the subprime mess would not spread, experts say the current global financial turmoil is no longer just a subprime issue confined to a narrow corner of the U.S. mortgage market.

This past week, central bankers around the world infused billions of dollars into the banking system in order to make cash available for lending and restore confidence in the markets. And in a surprise move Friday, the Federal Reserve approved a half-percentage point cut in its discount rate on loans to banks.

For the time being, the abyss down which Wall Street bankers and investors had been peering so tremulously appears to have narrowed.

Now, the riddle facing Wall Street is: What happens next?

"The Federal Reserve's move (Friday) is partially intended to address that psychological issue," said Peter Morici, a professor at the University of Maryland School of Business and former chief economist at the U.S. International Trade Commission. "If markets fail to respond positively . . . and hold those gains through next week, the economy will be in a crisis of confidence that is truly threatening to our prosperity."

Although the Dow on Friday surged 233 points, or 1.8 percent, to 13,079, it is still almost 1,000 points below its record close of 14,000.41 on July 19.

One reason Wall Street bankers and investors will likely remain jittery is that no one knows how deep the subprime sinkhole really is, or how many more sinkholes they need to worry about.

The sad truth is the debt markets are simply not as transparent as the stock market, said Peter Cohan, president of Peter S. Cohan & Associates, a management consulting and venture capital firm.

Everyone knows the bursting of the debt bubble will inflict broad damage – loans will go bad, private-equity deals will be canceled, fortunes will be lost. But nobody knows exactly who is holding what, or how widespread the problem is.

"There is an enormous information vacuum about who owns how much of the alphabet soup of securities backed by mortgages . . . and how much money these securities owners must pay back," Cohan said. "Absent that information, investors have plenty of reason to be jittery."

Cohan noted there are roughly 10,000 hedge funds managing $2.7 trillion in assets. "And not one of them is required to disclose its holdings to regulators," he said. "That's why we can expect the unexpected every day for the foreseeable future until every single hedge fund that's lost money for investors dribbles out its bad news in the form of a leaked letter to clients."


The best way to understand the recent market turmoil is to go back to a simpler time and place and think about the way mortgage lenders used to do business back in the days of the 1946 film "It's a Wonderful Life."

Back then, the home loans that lenders like character George Bailey made from his small savings and loan in the town of Bedford Falls stayed in the bank in Bedford Falls.

But today, when banks lend consumers money to buy homes, they take those loans and sell them to bigger banks, which in turn bundle the loans and sell them to even bigger Wall Street investment banks. These loan bundles are then sliced and diced into smaller pieces, sorted and packaged by degree of risk into debt instruments called mortgage-backed securities, and sold to various investment groups such as hedge funds, insurance companies and mutual funds.

Bill Bonner, founder and editor of the financial newsletter "The Daily Reckoning," likens this entire process to the fate of a pig at a butcher shop.

"After the best lenders have taken the top-grade hams and ribs, there remain many body parts you might show to your daughter only if you wanted to see her make a face and hear her say, 'Eeewww!'" he said. "The low-priced stuff is too disgusting for most people to put directly on the table, so the unidentified scraps are typically run through the grinder. Then they are packaged into old-fashioned, pure-pork, mortgage-backed sausages."

Hundreds of billions of dollars worth of these "mortgage-backed sausages" have been sold on the secondary market.

But it's not just mortgages any longer. These days, any illiquid asset that produces cash flow, including credit-card debt, auto loans, even health-club memberships, can be turned into a tradable piece of paper, priced and sold.

Ironically, while the idea behind this financial alchemy is to spread risk, securitization has the perverse effect of tethering lenders, borrowers and investors from all over the world to the same mess when things blow up, experts said.

That's why so many people, from borrowers to stock investors to hedge fund managers, are feeling the pain of the subprime blow-up.

Some of these low-grade pork scraps have turned out to be spoiled rotten, experts say. William Gross, managing director of Pimco, the biggest bond fund in the world, has alternately referred to these mortgage-backed securities as "sub-slime" and "toxic waste."

A lot of investors have gotten sick, and now nobody wants to buy anything vaguely resembling a sausage.

That's why the credit markets have essentially ground to a halt. And this is being felt throughout the global economy.

"That growing lack of confidence . . . has frozen future lending and backed up the market for high-yield new issues such that it resembles a constipated owl," Gross said. "Absolutely nothing is moving." The result: Money, the fuel that powers the economy, is becoming more scarce and expensive to borrow.

It's the reason Countrywide Financial, the nation's largest mortgage lender, is now gasping for air, the reason American Home Mortgage recently went belly up, and why so many smaller lenders have gone out of business – 122 since the end of 2006, according to Mortgage Lender Implode-O-Meter, a Web site that tracks failing lenders.

Ordinary borrowers are also feeling the pinch.

"A mortgage is getting harder to get, especially for those who cannot qualify for prime loans," said Patrick Newport, U.S. economist for Global Insight. "Home buyers in California, New York, and in places where houses are expensive will be especially hurt, because a large share of homes in these markets is financed with jumbo and non-prime loans. Even borrowers with a solid credit history are feeling the pinch."


Alarm bells first started sounding in mid-July, when credit rating agencies such as Standard & Poor's, Moody's Investors Service and Fitch Ratings began downgrading the creditworthiness of billions of dollars worth of mortgage-backed securities.

The move – which Michael Youngblood, managing director of asset-backed securities research at Friedman Billings Ramsey, likened to Pearl Harbor – drove down the value of mortgage-backed securities, forced investors to absorb huge losses and sent a chill through the debt markets.

"One bright Monday morning, (the credit rating agencies) decided to bomb our fleet sitting in the harbor," Youngblood said. "That is what set off the event."

While the ratings downgrades centered on subprime mortgage-backed securities, it didn't take long for fear to start spreading to other assets.

"To be blunt, (investors) seem to be thinking that if Moody's and Standard & Poor's have done such a lousy job of rating subprime structures, how can the market have confidence that they're not repeating the same structural, formulaic mistakes" with other types of debt, Gross said.

Some analysts believe the problems will only get worse as more homeowners fall behind on their monthly mortgage payments.

Bank of America estimates approximately $500 billion of adjustable-rate mortgages are scheduled to reset higher in 2007 by an average of 2 percentage points. And in 2008, nearly $700 billion worth of ARMs – many of them subprime – are expected to reset higher.

"It is understandable that the problems would appear first in the subprime market, since these are buyers who generally have little or no financial cushion," said Dean Baker, an economist and co-director of the Center for Economic and Policy Research. "However, it is almost inevitable that the problems will spill over into the rest of the market."

The optimistic view is that the bond market is witnessing a long-overdue adjustment that has brought interest rates back up to historical norms.

"Simply put, we have been living in a period of low global interest rates and cheap money that have let consumers and companies borrow money cheaply," said Charles Gradante, co-founder of Hennessee Group, an adviser to hedge-fund investors. "When the subprime program began, everyone started to re-assess risk, and what you are seeing is a fear factor entering into the bond market. The whole banking system is now repricing risk."

A good way to measure risk in the bond market is to look at "the spread," or yield difference, between 10-year Treasury bonds and junk bonds, which are corporate bonds with ratings below investment grade, Gradante said. The higher rates for junk bonds is what investors demand as an enticement to purchase this type of high-risk debt instead of much safer Treasury bonds.

Throughout the second quarter of 2007, the spread stayed below 3 percentage points, getting as low as 2.41 percentage points back in June, Gradante said. But since mid-July, the spread on the Merrill Lynch High Yield Index widened from 2.9 percent to 4.1 percent.

On a percentage basis, that's a huge leap – nearly 40 percent. But Gradante notes the spread is still below the long-term average of 4.8 points.

"We're still under the historic average, so this is a natural swing back," Gradante said. "We had too much liquidity and people got too complacent about risk. This is a reality check."

Sam Ali may be reached at or (973) 392-4188.

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