There’s a great debate raging over at Morgan Stanley’s Global Economic Forum
today. Richard
Berner kicks it off:
The long-awaited meltdown in subprime mortgage lending is now underway, and
it likely has further to go. Fears are rising that this so-far idiosyncratic
credit bust will morph into a broader, systemic credit crunch as foreclosures
rise, lenders grow cautious, and Congressional efforts to rein in predatory
lending further choke off supply. A credit crunch occurs when lenders deny
even creditworthy borrowers access to borrowing. What are the risks of such
a scenario?
Worries about a wider credit crunch are dramatically overblown,
in my view. Spreads may widen further and the supply of subprime credit likely
will tighten. But the balance sheets of most lenders are strong, investors
are differentiating among rungs of the mortgage credit ladder, and a limited
incipient spillover into prime loans and other asset classes signals that
a credit crunch is remote.
Stephen Roach, on the other hand, is much less sanguine.
Whether it’s the bursting of the US housing bubble, carnage in sub-prime
mortgage lending, or a slowing of Chinese investment, these events are quickly
labeled as “idiosyncratic” — unique one-off disturbances that
are perceived to pose little or no threat to the larger whole. The longer
a seemingly resilient world withstands such blows, the deeper the conviction
that spillover risk has all but been banished from the scene. Therein
lie the perils of a dangerous complacency…
Like virtually every other credit event that has unfolded in the past several
years — from auto downgrades to the implosion of Amaranth — our credit strategists
have been quick to label the sub-prime mortgage problem as idiosyncratic.
While spreads have blown out in this relatively small segment of the US mortgage
market — with sub-prime loans about 11% of total securitized home loans —
spreads for higher rated mortgage credits have been largely unaffected. Again,
I don’t dispute the facts as they have unfolded so far. My problem comes
in extrapolating this resilience into the future. With resets on floating
rate mortgages likely to put debt service obligations on a rising path for
already overly-indebted US homeowners, the case for increased default rates
and collateral damage on prime mortgage lenders looks increasingly worrisome.
Indeed, as the recent warning from HSBC just indicated, it’s not just
the small specialized lenders that are now being hit. Spillover effects are
quickly moving up the quality scale on the financial side of the post-housing-bubble
shakeout story, and their potential for impacts on the broader economy can
hardly be dismissed out of hand.
No prizes for guessing where Russ
Winter comes down in this debate:
We now know for a fact that the subprime mortgage market is in increasing
disarray. Although not publicized in the mainstream media (MSM) the
cracks are spreading to the midprime arena as well. I am convinced that the
next wave of stories will emerge from the Alt A market. I also strongly
suspect that any market break will come like a thief in the night…
I’m with Berner on this one. As we’ve seen at HSBC, if there are losses in
the subprime mortgage sector, they’re more than outweighed by profts elsewhere
in the subprime sector, let alone profits elsewhere in the mortgage sector.
So long as the lending you’re doing remains profitable, there’s little point
in cutting back on it just because old unprofitable lending turns out to have
been a bad idea. Subprime mortgage underwriting standards have already
tightened up considerably, and I’ll happily bet anybody that the 2007 vintage
of subprime MBSs will perform very well. Yes, there was a period of irrational
exuberance among subprime lenders. But it’s over now, and the broader systemic
risks have passed as well.