Tuesday, July 17, 2007

Fiscal Containment???

One of the stories that housing bubble worriers and watchers tell about how the unsustainable run up in home housing prices will cause significant damage in the rest of the economy is a simple story with a basic assumption that too many loans were packaged at too high of a credit rating.

During the bubble years, people who should never have gotten a loan were being put into exotic subprimes, and we have covered that story with the subprime implosion of this winter. People who under normal underwriting circumstances should have received subprime loans Alt-A loans, and people who should have been categorized as Alt-A were receiving Prime A ratings. If there are not that many miscategorizations, this is not a problem, but underwriting and credit ratings of these mortgages were crap. The reason for the low quality underwriting can be a combination of inexperience on the underwriting, perverse incentives, fraud, and a couple of other things. So loans were going to market sliced, diced and then rebundled to look really good while the underlying loans were actually really weak for the rating that they received when compared to the historical time series.

At first people thought this problem was contained in the subprime market as that is the Wild West. There might have been minor leak through into the A and Alt-A market but the GSEs would make sure that standards were upheld. No need to worry, the system is punishing the people who took out the loans that no one should have gotten, especially them. Everyone else is fine. Or at least that has been a significant part of the financial world's take.

But there is a potential large problem as someone(s) with some serious money is thinking that there is a potential large scale contamination of mortgages:

But higher-quality tranches of the ABX also took an ugly haircut today — the AAA-rated section of the index fell to 95 from about 100, while the AA-rated tranche fell to 88 from 100, according to Markit. The A-rated tranche is down to 70 from 90 a month ago, Andrew Lahde, managing partner of Lahde Capital Management, a hedge fund in Santa Monica, Calif., told Dow Jones Newswires.

And all of this happened without any news to drive the market.....

Worries about subprime lending drove the riskiest tranche of the closely-watched subprime ABX derivative index to a record low of 44 cents on the dollar today — understandable, given everything that’s gone on in the subprime sector.

People are starting to price in some very significant potential for losses among the best rated mortgage backed securities. If this continues to happen, credit will start drying up at CURRENT INTEREST RATES, which means rates either need to increase, or the cheap money that is sloshing through the system will stop sloshing.

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