Saturday, August 4, 2007

The Credit Peloton

Let's start out with the peloton (French, meaning a small military group or platoon), which is most notably recognized as "the pack" in the annual Tour de France, cycling's premier race. Friday's troubles in the credit markets reminded me of this year's tour, which was riddled with controversy over doping issues from several lead cyclists (remembering that last year's US tour winner - Floyd Landis - may still be stripped of his title pending further investigation).

There are "to good to be true" mortgage products (along with lead cyclists) that race out ahead of the peloton pushing the limits of stamina, endurance and fatigue to provide the best investments to the secondary (hedge fund) markets. Then, one of two events occur (and has occurred). Either, the drugs wear off and the sprinter can't sustain the pace, burning out during the race and being overtaken by the peloton; or, the drugs don't wear off and the cyclist wins the race, but skeptical officials (the "market") test the cyclist and discover what looked like incredible production is only an artificially enhanced performance that doesn't have the fundamentals to belong in the race. Either eventuality results in disqualification and the peloton is affected. If you weren't paying attention on Friday (8/3/07), jumbo loan buyers just got affected in the credit race.

Friday saw Wells Fargo Jumbo loans jump in rates from 6.78% to 8.00%, as noted on the Housing Bubble Blog:

One said, “If we are going to see credit tightening in the mortgage lending arena, then how can that not affect the rest of our economy as the FED would have us believe. Take crack away from a crack head, cold turkey and you have a problem on your hands.”

A reply, “I don’t think it is a question of ‘if we are going to see credit tightening in the mortgage lending arena,’ we are seeing it. Just how bad did Alt-A get hurt yesterday? Just grazed, or was yesterday really a gut shot like many people think? How long until conforming follows the same path?”

One pointed out. “Wells Fargo just raised the interest rate on their jumbo mortgage to 8% this morning. Last week the rate was 6.78%. The meltdown is in full swing. Hold on the drop is going to be very steep. Ouch!!!!!!!!!!!!”

The sprinters in the credit race got caught "doping" their loans and the market is now faced with "what to do". The first step is the classic "knee jerk" disqualification of the sprinters, slowing the peloton to a crawl as the market continues to correct itself, exposing these loan products for what they are, doped products sold as derivatives in the secondary markets:

The highest rated tranches of The ABX Index, credit-default swaps based on bonds consisting of 20 subprime mortgages , for the 07-2, 07-1 and 06-2 series all settled on their lifetime lows again today (as per Markit). These tranches, AAA, AA and A, are the "most secure" investment series of the subprime mortgage derivatives indices. The lower BBB tranches are off their lifetime lows. Source: Markit.

Housing futures and forwards are showing increasing lower housing prices into 2008 and 2009 in all US metro areas. Of note is that the Miami, Las Vegas, San Diego and Los Angeles futures for May 2008 are 5% to 8% lower from spot index.

As is the case in any housing cycle, the credit peloton ("the pack" of conforming AAA, AA and A loans) will be effected as the market evaluates the pool of "doped" loans and disqualifies them from the race. This credit tightening will effect all buyers' ability to find and obtain credit and all builders' ability to sell inventory.

Banks and securities firms are trimming loans, especially to companies tied to the mortgage market. But it is a balancing act: Cutting back too far could make matters worse by accelerating corporate bankruptcies and causing more turmoil in financial markets.

Banks facing the prospect of taking on billions of dollars in buyout-related debt are starting to trim lending to companies that need to refinance loans or restructure their balance sheets.

As banks rein in riskier lending, companies could find themselves unable to refinance loans coming due or to overhaul their businesses. Some companies may be forced to seek bankruptcy protection, a development that would exacerbate bond-market turbulence.

Timing this cycle is the ultimate question as the credit peloton won't return to a "normal" pace again until the "bad apples" are pulled from race.

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