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Wednesday, August 15, 2007


what is the potential scope?

recent market events have been labeled "the subprime crisis" in spite of the fact that mortgage securites backed from the alt-a and jumbo prime universe are also participating in accelerated default rates and leveraged buyout bridge-cum-pier loans are a key element. but if the crisis involves more than subprime, how much more is it? and what can one expect.

the difficult answer from nouriel roubini:

[W]e have no idea of what the subprime and other mortgage losses will be: $50 billion, $100 billion, $200 billion? They could be as large as $500 billion if the US enters in a recession and we have a systemic banking and financial crisis. The uncertainty about these losses depends on the fact that we have no idea of how deep and protracted the housing recession will be and how much will home prices will fall. If home prices were to fall – as my research suggests as likely – more than 10% in the next year or so, the subprime carnage will massively expand to near prime mortgages and prime mortgages. There is already plenty of evidence that the delinquencies are not limited to subprime mortgages as a number of near prime and prime lenders are now bankrupt or in trouble (AHM, Countrywide just to cite two examples). The worse the housing recession will be the worse these now uncertain losses.

as roubini goes on to explain, the incredible complexity and opacity of the derivatives market and the private unregulated funds that trade in them make the consequences of this crunch unforeseeable. but what is truly fearsome is the leverage that the financial engineering of recent years has built into the system.

[T]oday any wealthy individual can take $1 million and go to a prime broker and leverage this amount three times; then the resulting $4 million ($1 equity and $3 debt) can be invested in a fund of funds that will in turn leverage these $4 millions three or four times and invest them in a hedge fund; then the hedge fund will take these funds and leverage them three or four times and buy some very junior tranche of a CDO that is itself levered nine or ten times. At the end of this credit chain, the initial $1 million of equity becomes a $100 million investment out of which $99 million is debt (leverage) and only $1 million is equity. So we got an overall leverage ratio of 100 to 1. Then, even a small 1% fall in the price of the final investment (CDO) wipes out the initial capital and creates a chain of margin calls that unravel this debt house of cards. This unraveling of a Minskian Ponzi credit scheme is exactly what is happening right now in financial markets.

i can't say exactly where this ends. the market sold off hard into the close again today, meaning the bottom probably isn't here yet. things are hysterical enough that merrill proposed bankruptcy for countrywide, the largest mortgage lender in the country.

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