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June 26, 2007

What's That Unpleasant Sound?

According to Lombard Street Research, it's a credit crunch.  From the U.K. Telegraph (hat tip, Action Economics):

The United States faces a severe credit crunch as mounting losses on risky forms of debt catch up with the banks and force them to curb lending and call in existing loans, according to a report by Lombard Street Research.

The group said the fast-moving crisis at two Bear Stearns hedge funds had exposed the underlying rot in the US sub-prime mortgage market, and the vast nexus of collateralised debt obligations known as CDOs.

"Excess liquidity in the global system will be slashed," it said. "Banks' capital is about to be decimated, which will require calling in a swathe of loans. This is going to aggravate the US hard landing."...

Lombard Street’s warning comes as fresh data from the US National Association of Realtors shows that the glut of unsold homes reached a record of 8.9 months supply in May. Sales of existing homes slid to an annual rate of 5.99m.

The median price fell for the 10th month in a row to $223,700, down almost 14pc from its peak in April 2006. This is the steepest drop since the 1930s.

The Mortgage Lender Implode-Meter that tracks the US housing markets claims that 86 major lenders have gone bankrupt or shut their doors since the crash began.

The latest are Aegis Lending, Oak Street Mortgage and The Mortgage Warehouse.

It is worth noting that those are specifically mortgage-lending corporations not commercial banks, so I am not clear on the basis of this claim:

Lombard Street said the Bear Stearns fiasco was the tip of the iceberg. The greatest risk lies in the “toxic tranches” of lower grade securities held by the banks.

Much-trumpeted claims that banks had shifted off the riskiest credit exposure on to the asset markets was “largely a fiction”, said [Charles Dumas, the group's global strategist].

In fact, the article contains more assertions than facts.  But I think it is agreed that if there is going to be a really big spillover effect from ongoing housing woes, this is where we'll find it.   

June 26, 2007 in Housing, Interest Rates | Permalink


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I'm highly skeptical of Lombard's position. Banks have used CDOs to lay off credit risk moreso than the other way around. And I don't see the link between poor performance on sub-prime MBS pools and bank loan pools.

I really think the CDO market will prevent a generalized credit crunch, rather than cause it. This is because the risk of poor performing loans is more spread out today than at any time in the past. If many banks/investors suffer small losses, the impact on liquidty system wide will be less than the classic case, where a few banks suffered large losses.

Posted by: TDDG | June 26, 2007 at 12:41 PM


Mortgage-lending companies are dying off because they cannot sell the subprime loans they are originating. With the credit well drying up---and refis becoming a distant memory---, subprime mortgage defaults will inevitably increase, creating large losses for the owners of the lower tranches of MBS and CMOs (hedge funds and banks; what is the difference between a hedge fund and a bank's trading desk these days anyway?).

As losses mount, banks will become ever more cautious, starving even the more creditworthy borrowers (typical credit crunch story). Note that lending standards have recently been tightening even on the prime borrowers. In April Senior Loan Officer Survey, a net 15% of lenders said they have tightened their standards for prime borrower (48% for nontraditional, 56% for subprime borrowers). The tighter standards hurt not only the shaky borrowers but also those who cannot sell their homes due to a dearth of buyers.

We could easily see the problems spread from the toxic products to more traditional loans and higher quality MBS/CMO tranches. If that turns out to be the case, I'd say Lombard is underestimating the problem.

P.S.: Commercial bank/investment bank distinction is no longer all that relevant. Lombard is talking about banks in general, not commercial banks per se.

Posted by: Oracle of Cleveland | June 26, 2007 at 02:41 PM

The article makes it sound like this isn't just subprime: a credit crunch like that would mean it would be difficult for even high FICO borrowers to get a mortgage. If you think housing is in bad shape now, just imagine what that would (will?) be like.

Posted by: TiP | June 26, 2007 at 05:38 PM

I also doubt that banks are big holders of CDO equity tranches. On the other hand: Bloomberg reported this weekend that junk bond buyers are getting pickier about accepting new paper that is very highly levered and/or with weak covenants. And today (June 26) the WSJ discussed the possibility that leveraged loans might become harder to place in CLOs (collateralized loan oblidgations).

Put it all together and we are seeing indications that lenders' appetite for risky paper -- be it from private equity borrowers to finance LBOs (with the hope that the loans be placed in junk debt or CLOs) or from laxly underwritten mortgages (to be repackaged as CDOs) may be on the wane.

At the top of each economic cycle we learn that excess liquidity eventually dries up. I wouldn't be surprised if that is what is starting to occur.

Posted by: JB | June 26, 2007 at 11:04 PM

I see no basis for TDDG's assertion that, "If many banks/investors suffer small losses, the impact on liquidty [sic] system wide will be less than the classic case, where a few banks suffered large losses."

Even if the individual losses experienced by the "many investors" are small relative to those suffered by the "few banks" in the classic case, those losses will not necessarily be small from the viewpoint of those investors, and the degree to which those investors retreat from lending as a result of those losses may be much greater. After all, as they are not banks, they are not "to big to fail", and not supported by the FRB commitments to guaranteed banks profitability by reducing short-term rates below long rates whenever they need to repair their balance sheets.

The dispersal of risk is more likely to increase the impact on liquidity than to decrease it.

Posted by: jm | June 27, 2007 at 03:30 AM

When I said "large" I meant proportionally not absolutely.

Let's say that a large corporation has loans with only 2 banks. If that corporation fails, those two banks may be in trouble. A bank failure surely decreases system-wide liquidity.

Alternatively, let's say that the banks securitized that loan and is now owned in a CDO structure, which is held by dozens of hedge funds. The loss is absorbed by the CDO structure and spread around many investors. Something like that doesn't sour investor appetite for credit risk.

You also have to ask yourself, where is all the liquidity going to go? Drastic oversavings by non-US investors will be invested somehow.

Posted by: TDDG | June 27, 2007 at 11:39 AM

I suspect that we are living in a rather different world of credit intermediation now than in the past. The focus on banks assumes that the risk of financial disintermediation depends on whether banks are will and able to continue lending, A lot larger share of credit flow now goes through non-bank institutions than in the past. If those institutions crack up, then disintermediation becomes a problem even with banks relatively unscathed. Having a sound banking sector means there would be a credit channel to fall back on, but the transition would be painful, if a transition is necessary.

Posted by: kharris | June 27, 2007 at 12:01 PM

One answer, TDDG, is that some of this liquidity will disappear once hundreds of billions of instruments currently carried at face value of the books of many banks and funds are marked to their true values close to zero.

You had better believe that the margin calls on bear's hedge funds will not be the last. The major ratings agencies are finally being forced to revisit their pie-in-the-sky ratings on may such securities, as press reports this week made clear.

No collateral, no loan, goodbye liquidity.

Posted by: Gary | June 27, 2007 at 12:03 PM

That assumes that the problems in sub-prime MBS will leak into other credit products.

Maybe we're arguing semantics, but I wouldn't say that sub-prime consumers experiencing decreased access to funding is tantamount to a liquidity crisis.

Posted by: TDDG | June 27, 2007 at 03:16 PM

One view among the causes of the great depression was a general loss in confidence with the financial system.

The scorecard on the sub-prime meltdown is unsettling. The fact that both the credit ratings given these instruments and the current price are complete fabrications is a much bigger problem.

Should the entities that own this phony paper be allowed to continue the sham ? Or, in the interest of free markets, should they be ordered to revalue immediately ?

What other so called financial markets have been undermined by wall street. Equities ?

This is not just an isolated incident in an obscure security. The problem has ramifications across all free financial markets.

What a dilemna.

Posted by: zinc | June 27, 2007 at 10:55 PM

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