Housing crises: Besides subprime mortgages, all financial players operating on the US market are dragged into the infernal spiral

For the last six months, LEAP/E2020 has been anticipating in detail the subprime mortgages crisis’ trigger off, making it clear that the end of 2006/beginning of 2007 would signal the explosion of the « realo-financial bubble ». The pace of bankruptcies among US credit companies specialized in this type of loans is now almost daily. The media (and other “regulators”) are astonished to discover that most of these companies had in fact been for months artificially maintained alive by large financial institutions and banks (1) who massively invested in such a juicy sector (2).

For this reason, LEAP/E2020 estimates that the market is only at the beginning of its surprises concerning the size of this subprime mortgage bubble, and above all that it will discover in the coming month two axes of contagion with particularly heavy consequences, namely for the large US (or US based) credit institutions who will be strongly affected by the crisis on three aspects:


a/ Their investments in the subprime mortgage market will turn into large debts: For instance, New Century, whose debt was rated to « default » by Standard&Poor’s (3), means an 8 billion USD shortfall for the lending banks behind them: Morgan Stanley (USD 2.5 billion engaged), Citigroup, Bank of America, Crédit Suisse, Goldman Sachs, Barclays, Ixis Real Estate (4).
Today all investment banks involved in the subprime lending market multiply « margin calls » to protect themselves from the collapsing value of loans traded on financial markets. But most of these high-risk lenders are nothing but empty shells who live on credits granted by those same large banks (5), including investment banks such as Lehman Brothers or Merryl Lynch, or large companies’ financial branches (like General Motors) (6).

b/ Default will spread out of the subprime lending sector solely: Indeed the crisis will spread to the mortgage sector in general, towards credit categories above subprime, on the one hand because the banks will be more careful and make loan refinancing less easy (knowing that the refinancing of USD 2,000 billion worth of mortage loans is expected this year); and on the other hand because a large number of credit companies lent money carelessly, including in the case of lower risk categories such as « narrow subprime », « Alt.A », « near prime » and even « prime » (7). Therefore, contrary to financial media declarations, the subprime crisis will hit about half of all mortgages lent in the US in the past two years (8).

c/ Subprime market woes will drag along one of the financial markets’ favourite vectors in the past years (9): the CDO (Collateralized Debt Obligation – an asset-backed security, namely home equity-backed). In 2006, close to USD 150 billion worth of new mortgage-backed CDOs were absorbed by the US market (with a CDO market today worth around USD 1,000 billion), most of it based on high-risk loans (10). In the past few days, this market started to tumble dragging along the LBO market (Leveraged BuyOut) which fueled the financial markets in the past years (CDOs literally serve to « fuel » this type of operation) (11). On the other hand, the subprime mortgages’ rout entails a return of risk aversion, as anticipated by LEAP/E2020 at the end of 2006. And of course this trend accelerates the ongoing hedge funds crisis (whose health depends on financial derivative products) (12).

In summary, the US financial sector and all operators involved, are sinking into a severe generalised crisis (13), since the very bases of US financial players’ growth are hurt today. Neither Ben Bernanke’s (14) “helicopter drop” of money on an economy already stuck because of easy-money, nor the Plunge Protection Team’s quasi daily moves (cf. GEAB N°8) can reverse the trend in a sustainable way. In this field, US financial authorities are in the same situation than their political and military leaders about Iraq: all remaining options are bad solutions.

LEAP/E2020 will go back on the consequences of this situation in the “Recommendations” (page 15), but for sure this coming quarter is the last one before long to offer perspectives of good results for financial players.

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Notes :

(1) To get an idea of the type of US banks most exposed, read this very interesting article by Philip van Doorn in The Street (14/03/2007): « Banks with most subprime exposure ».

(2) All along the past months, while LEAP/E2020 was anticipating the collapse of the subprime market and related financial operators, the financial media blindly relayed a remarkable investor’s manipulation scheme, reverberating without any distance every positive declarations released by investment banks about these credit institutions, knowing that these investment banks were extensively engaged in the subprime market. The best example may be this MarketWatch/DowJones article dated March 1st, 2007 (« New Century upgraded at Bear Stearns ») announcing that Bear Stearns was upgrading New Century shares, i.e. ten days before the company’s shares trading was suspended and its leaders sued by the State of California. Meanwhile, by completing the purchase of ECC Capitals (a subprime mortage firm, cf. Yahoo Finance, 12/02/2007), Bear Stearns, just like all their colleagues in Wall Street, had become a stakeholder on this market, and therefore highly susceptible of giving partial advice.

(3) Reuters, 12/03/2007

(4) « New Century on bankrutpcy’s doorstep », Reuters, 12/03/2007

(5) “Goldman Sachs warns of ‘dead bodies’ after market rurmoil”, Telegraph, 06/03/2007

(6) “GM may take almost $1 billion charge for mortgages”, Bloomberg, 06/03/2007

(7) « Prime or not so prime : an exploration of US housing finance in the new century », Allen Frankel, Bank of International Settlement, Quarterly Review, March 2006

(8) « Mortgage liquidity du jour: Underestimated no more », Credit Suisse/Narreia, 12/03/2007

(9) For all those with limited command of financial terminology and technicalities, read Wikipedia’s excellent article on « securitization ».

(10) « Mortgage shakeout may roil CDO market », Wall Street Journal, 13/03/2007

(11) « CDO may bring subprime-likebust for LBOs and junk bonds », Bloomberg, 13/07/2007

(12) « Man group drops on key hedge fund’s woes”, MarketWatch/DowJones, 07/03/2007

(13) « Subprime Titanic Hits Iceberg: Wall Street Abandons Ship", Richard Benson, PrudentBear, 22/02/2007

(14) « Speech by Ben Bernanke », US Federal Reserve, 21/11/2002