Scenario 2 on housing and the credit markets

This is a continuation of the short series I started yesterday on potential scenarios that we could see in the housing and housing related credit markets. This scenario is a bit more pessimistic than the Pollyanna scenario I outlined yesterday.

The first large divergence in this scenario is the assumption that the problems which have taken down the subprime lenders and some of the larger Alt-A lenders are systemic problems. Investors believe that there was something funky going on all over the place in the appraisal, loan application, underwriting and approval process up and down the income ladder, up and down the quality ladder and across the country. These problems mean that there are at least a couple and could be a whole lot more than a couple of misvalued securities and bonds still out there that no one really has a clue where they are.

This uncertainty is being removed by the large ratings downgrades that all of the major ratings agencies are issuing for existing bonds. New bonds are being put on hold as investors and issuers know that things need to shake out to revalidate their mark to model systems. However investors are willing to trust the credibility of the ratings agencies and will return to these markets in the next couple of months.

This pause of trust re-verification will knock out a lot of the less than pure mortgage companies and will also take out one or two companies with pristine books as collateral damage. The housing market will also freeze for a couple of months as no one has the cash to lend to new buyers unless that cash is already sitting in the vault. This means there will be an increase in foreclosures and further debt downgrades as marginal borrowers who are having trouble paying back their teaser rate mortgages now will find it extremely difficult to refinance during the next big wave of resets.

However the American consumer as a whole is gaining some extra income in the past couple of months and will see a bit more of summer gas prices should cyclically decrease, so the damage will be real but contained and come next spring, the mortgage market should be in reasonably good shape to start lending some serious money again.