Credit Crunch – Increasing Risk

There are increasing signs that the mortgage crisis is traveling up the lending food chain. Recently, banks are drastically increasing rates, and refusing to underwrite Alt-A and other loans. Rates on jumbo loans from a number of institutions are over 8%.
Wells Fargo Raises Rates: Are Homeowners Out In The Cold?
http://www.cnbc.com/id/20107397

Top Lender Sees Mortgage Woes for ‘Good’ Risks
http://www.nytimes.com/2007/07/25/business/25lend.html?_r=1&hp&oref=slogin

The increasing institutional jitter in the mortgage market is spilling over into other debt instruments. Over the past few weeks the overall credit marketplace has become more risky. There is an inability to price and sell debt of any type, and a significant loss of liquidity. This situation is likely to have a significant impact on real estate, lending, and the stock market.

Many recent headlines reflect his concern. Comments from the Bear Stearns CFO regarding the bond market are being generally held responsible for driving the stock market into a selling frenzy late today.

Bond turmoil worse than Internet bubble: Bear CFO
http://biz.yahoo.com/rb/070803/bearstearns_markets.html?.v=1

Other recent articles also reflect the concerns regarding credit and liquidity risk.
Tighter credit could slow U.S. GDP growth
http://www.reuters.com/article/reutersEdge/idUSN0133451220070801

Five Signs That Subprime Infection Is Worsening
http://www.bloomberg.com/apps/news?pid=email_en&refer=home&sid=ageDhNv.n1A4

Stopping the Subprime Crisis
'The subprime crisis has not been averted. In fact, it is still largely ahead of us."
http://select.nytimes.com/gst/abstract.html?res=F70E10FE35590C768EDDAE0894DF404482

It is also startling how quickly some major mortgage companies implode. This problem is no longer constrained to sub-prime. American Home Mortgage specialized in medium-risk "Alt-A" mortgages, and didn't deal in subprime loans. Its recent demise was shockingly rapid, and underlines the expanding credit market mess.
American Home Mortgage to shut down
http://money.cnn.com/2007/08/03/news/companies/american_home.reut/index.htm?postversion=2007080304

Multiple hedge funds have recently revealed to be worthless after losses; including the complete wipeout of two Bear Stearns’ funds and the termination of redemptions on another.
Bear Stearns Halts Redemptions on Third Hedge Fund
http://www.bloomberg.com/apps/news?pid=20601087&sid=aBuz_1cIZ_EQ&refer=home

There is increasing speculation among some market pundits that Bear Stearns may go completely under; imploding in an unprecedented chain of credit derivative failures. If this type of failure occurs, what does it imply for other leading firms involved in the mortgage credit derivative market such as Lehman? Or firms such as JPM with huge general derivative exposures?

Many times when determining risk relative to the market; it is usually best to outline various scenarios and assign probability to each. Define the required investment actions needed to reduce exposure relative to a particular scenario, and then arrive at an overall plan to ease your portfolio risk.

What are the Best, Middle, and Worst cases for the impending Credit Crunch?

The information below outlines some thoughts on the best, middle, and worst case scenarios. Until recently, most analysts believed that we were solidly in the best case scenario. There appears to be increasing risk that the economy is sliding towards the middle case as the credit liquidity problems intensify.

Best Case
The best case scenario is that most real estate markets in the U.S. correct between 3-7% (we are there now) and recover somewhere late in 2008. In this scenario, Wall Street will be very volatile this summer as more bad debt news comes out and there are signs of economic weakening due to mortgage-linked consumer spending problems. Over the short term, the market bounces up and down in a news-driven cycle embedded in an environment reflective of fear and uncertainty. VIX and VXN reach new local highs reflecting the volatility. Risk premium is priced back into the debt market forcing down the prices of lower-grade debt. The stock market shakes off the credit news in the fall timeframe (Sept- Nov) and continues the upward trend. Earnings from corporations remain solid, and mainstream corporate debt reflects solid pricing withstanding any credit concerns. The economy avoids any recession in 2008.

Middle Case
The middle case outlines a situation in which most local real estate markets correct between 7 to 20% and do not recover well into 2009. The U.S. stock market starts to slide deeply over the next few weeks as the bad debt news spreads to prime mortgages, junk corporate debt, and PE/LBO debt. Mortgage rates increase greatly on non-standard fixed rate loans, and lenders refuse to underwrite several types of mortgages. The debt market yields increase and bond values across the board dive. Moody's, S&P, and other rating agencies will be down-grading bonds like mad with pressure from regulators and Wall Street to get ahead of the curve of defaults. Consumer spending weakens and unemployment increases causing the stock market to enter a recessive slide for several months with limited recovery near the end of 2008. After most of the damage is done, the government statisticians come out stating that a recession occurred for a period of time.

Recent articles outlined the increasing expectation of no real estate recovery till 2009, and the contagion of credit concerns to other types of debt. Consumer confidence has been decreasing in recent surveys, and the recent unemployment report showed an increase to 4.6%. Much of the information associated with the “middle case” scenario is more readily apparent in recent news.

Worst Case
The worst case scenario shows 30%+ adjustment in many local real estate markets, and Wall Street panic as the leveraged debt market completely falls apart akin to a feeble house of cards and requires government & banking bail-out. The evils of CDOs is constantly in the news as the "toxic waste" that destroyed the economy. Many major lenders go under. Several hedge funds implode each day taking down pension plans and other institutional entities in droves. The words "death spiral" is readily apparent in articles about consumer spending while politicians debate a solution for the unemployment crisis. The world stock markets re-entrench considerably before the end of this year. The impact would be world-wide as trade and other key economic engines are hit. World debt conditions would remain jittery, reducing the amount of available credit to major corporations and countries, many who start defaulting on loans.

Summary
Until a couple weeks ago, most pundits thought the best case scenario was the most probable. The deteriorating credit conditions over the past two weeks enhance the risk that a scenario resembling the middle case will occur.

What are the key things that an investor should do to ride out a potential storm? First, keep your long-term portfolio properly diversified. In the short term, rotate out of junk bonds, mortgage-focused R.E.I.T.s and other investments that are likely to take significant credit based hits.