Explaining the Global Credit Crunch

An Economics PhD isn't necessary to understand the global credit crunch now in full bloom since last Thursday. As a real estate professional, it's important to understand how to
simply explain this latest permutation on the capital markets to your clients:

Why the credit crunch?
No institutions want to purchase any securitized loans (called CDOs - collateralized debt obligations ) that are tainted with the subprime loans now experiencing high rates of defaults.

Last Thursday and Friday, France's BNP Paribas and Countrywide, the US's leading mortgage lender, sent up red flags that were unexpected - just one week ago both institutions posted press releases reassuring financial stability. So many warning signals have implicated financial institutions with potentially risky holdings (and that includes many of them) as categorically suspect.... globally.

Wall Street investors "shoot first and ask questions later". Since money managers have no idea which institutions are exposed to the subprime risk, they simply stop buying any CDOs. Interbank lending came to a standstill.

Why are hedge funds so integral to this credit crunch?
Hedge funds are non-public investment funds that now manage $1.7 trillion in assets and are generally rewarded for high yield performance. Many hedge funds were attracted to the high yields offered by subprime collateralized CDOs.  Institutional investors like banks, pension and insurance companies invest in hedge funds, and are thus exposed to subprime risk. Hedge funds are also collapsing along with mortgage companies and no one knows how exposed institutions are to subprime risk because the hedge funds don't disclose their portfolios.

Explaining how the world's Central Banks are keeping the credit markets from "locking up"
The Central Banks globally are providing liquidity to the credit markets by pumping funds into short term repo markets over the past two trading days. A repo is a short term (normally 1-3 days) capital market instrument where securities are traded for (made liquid) cash so that institutions can move money around and avoid the domino effect that happens when one failed cash payment causes a chain reaction of more failed payments. The Central Banks will likely continue this infusion this week, probably as long as it takes to calm the market.

Why this credit crunch may be just temporary
The unity shown by the Central Banks was last seen after September 11, 2001 and it works because it says the world's financial systems are united in trying to slay a dragon... the hope is the markets will have time to figure out which institutions are risky and return to some form of status quo.

Many money managers see this liquidity crisis as an over reaction to the black box (Pandora's box?) of limited data about where all these subprime loans are. Some are slightly positive or making buying recommendations.

Why this credit crunch may be deadly
Bit of News provides succinct background on a 1998 hedge fund credit crunch caused by the failure of Long Term Capital Management, how it established the precedent that the Fed will bail out companies that will potentially cause massive fallout. It goes on to say that the subprime crisis has such huge fallout implications (it's not just one hedge fund now...), a bailout will essentially force the Fed to "print money" with potential hyperinflationary consequences.

Subprime contagion is spreading - Rising foreclosures affect Main Street...

Marc Faber of Boom Gloom Doom and David Chapman of Union Securities predict start of bear market with 20-30% drops in stock prices.

As a real estate professional, this is what you're hoping for
Liquid lenders return to the market with realistically priced loan products that aren't corrupted by the disproportionate mortgage rate jumps happening last week.

Now, buyers are spooked, particularly those contemplating purchases of properties that fit the subprime default profile - lower income neighborhoods, significant investor activity. If the Fed does lower interest rates to stem the credit crisis, it won't fix the underlying problems of subprime defaults now and in the future, nor would it make more borrowers eligible. On the other hand, A-clients will benefit from a new window of opportunity of lower interest rates and their associated mortgage rates... and that will help lubricate a residential market where there are both sellers and buyers.

As always, appreciations to Mr. Ritholtz at Big Picture, who monitors market developments exquisitely - he provides a linkfest for the liquidity crisis's upcoming week - and John and Patrick who stay on top of relevant press developments.

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  • 8/12/2007 9:49 PM Alexander J Wilkas wrote:
    A great summery of the current state of affairs, the best thing for now is to wait and see what shakes out. That's what we are telling our clients.
    Reply to this

  • 8/13/2007 6:17 AM Ginger Wilcox wrote:
    Great summary and explanation Pat. This is something every agent needs to understand.
    Reply to this

  • 8/13/2007 10:09 AM Athol Kay wrote:
    Great post Pat. Seems clearer now.
    Reply to this

  • 8/18/2007 4:50 AM ronconnor wrote:
    thanks pat, great to see someone in our industry talking facts!! and explaining the connection to the credit crisis. every single agent i have spoken to in my area ( informal survey of at least 20 agents this week) does not understand 10% of this.
    helping out clients get a mortgage or making sure our sellers accept an offer with a viable mort approv is going to be the main theme next year.
    i think you are over optimistic in your outline of what practitioners should be hoping for. the mortgage landscape will change drasically, many potenial buyers will be out of the market till they have enough downpayment, etc etc
    at my blog i give a brief summary of what expect in the fall. wish i had your writing chops - i'd write more
    Reply to this

  • 8/19/2007 11:16 AM Nigel Swaby wrote:

    Good summary of what's going on. There is one little bit of information you missed. The reason the hedge funds won't buy CDOs is not because they are subprime, it's because they don't know how much subprime is involved with their holdings. Many CDOs have been rated AAA when they actually carry a bunch of subprime or BBB paper. Until all the fallout occurs nobody is going to buy CDOs unless they know the true risk.

    This article from today's WP offers a good analysis: http://www.washingtonpost.com/wp-dyn/content/article/2007/08/17/AR2007081701710.html?nav=rss_opinions/outlook?nav=slate
    Reply to this
    1. 8/20/2007 6:30 AM Pat Kitano wrote:
      Thanks Nigel... I try to condense the information for the laymen. I did imply the fact that no one is buying because no one knows which CDOs are suspect to risk and you clarified how the bond rating agencies were complicit in getting institutions to purchase subprime-laden CDOs by overrating them.

      Reply to this

  • 10/20/2008 10:10 PM Bad Credit Loans wrote:
    This is great explanation and summary. I fully understand now what is happening in just one page explanation.
    Reply to this

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