UH OH...

We may have a very serious problem due to the sub-prime market collapsing. This is from the BBC:

Mortgage concerns hit US markets
US shares have tumbled amid fears
that problems in the mortgage market
may prompt a global credit crunch.
Friday, 10 August 2007, 02:08 GMT 03:08 UK

The European Central Bank and Japan have both pumped money into the banking market to boost liquidity.

The Japanese central bank injected 1 trillion yen (US$8.4bn, £4.2bn) into markets in an effort to stop further falls on Friday.

The latest trigger for the slump was the announcement by BNP Paribas that it was suspending the three investment funds worth 2bn euros (£1.35bn) because of problems with the US sub-prime mortgage sector.

The worry is that should banks make losses then it would hurt their earnings and their profitability making them less willing to fund the takeovers and buyouts that have underpinned much of the stock markets' recent gains.

...the European Central Bank (ECB) said on Thursday that it had pumped 95bn euros into the eurozone banking market to allay fears about a credit crunch and lack of liquidity.

In the US, the Federal Reserve, also was reported to have taken similar action, pumping about $24bn (£12bn) into the US banking system.

Atrios points us to Roubini who warns that this is also a problem of insolvency, not just temporary illiquidity:

First, you have hundreds of thousands of US households who are insolvent on their mortgages. And this is not just a subprime problem: the same reckless lending practices used in subprime – no downpayment, no verification of income and assets, interest rate only loans, negative amortization, teaser rates – were used for near prime, Alt-A loans, hybrid prime ARMs, home equity loans, piggyback loans. More than 50% of all mortgage originations in 2005 and 2006 had this toxic waste characteristics. That is why you will have hundreds of thousands – perhaps over a million - of subprime, near prime and prime borrowers who will end up in delinquency, default and foreclosure. Lots of insolvent borrowers.

You also have lots of insolvent mortgage lenders – not just the 60 plus subprime ones who have already gone out of business – but also plenty of near prime and prime ones. AHM – that went bankrupt last week – was not exposed mostly to subprime; it was exposed to near prime and prime. Countrywide has reported sharp losses not only on subprime lending but also on prime ones. So on top of insolvent households/mortgage borrowers you have plenty of insolvent mortgage lenders, subprime and - soon enough - near prime and prime.

You will also have – soon enough – plenty of insolvent home builders. Many small ones have gone out of business; now it is likely that some of the larger ones will follow in the next few months. Beazer Homes – a major home builder - last week had to refute rumors of its impending insolvency; but so did AHM a few weeks before its insolvency. With orders for home builders falling 30-40% and cancellation rates above 30% more than a few home builders will become insolvent over the next year or so.

In another post, Roubini also provides a nice explanation of a theory of boom/bust cycles:

Specifically, the crucial macro question that we should ask ourselves today is whether we are at the peak of a Minsky Credit Cycle. Or as the UBS economist George Magnus – an expert of financial instability - put it: “Have we reached a Minsky moment?”

Hyman Minsky was an American economist who died in 1996. His main contribution to economics was a model of asset bubbles driven by credit cycles. In his view periods of economic and financial stability lead to a lowering of investors’ risk aversion and a process of releveraging. Investors start to borrow excessively and push up asset prices excessively high. In this process of releveraging there are three types of investors/borrowers. First, sound or “hedge borrowers” who can meet both interest and principal payments out of their own cash flows. Second, “speculative borrowers” who can only service interest payments out of their cash flows. These speculative borrowers need liquid capital markets that allow them to refinance and roll over their debts as they would not otherwise be able to service the principal of their debts. Finally, there are “Ponzi borrowers” cannot service neither interest or principal payments. They are called “Ponzi borrowers” as they need persistently increasing prices of the assets they invested in to keep on refinancing their debt obligations.

The other important aspect of the Minsky Credit Cycle model is the loosening of credit standards both among supervisors and regulators and among the financial institutions/lenders who, during the credit boom/bubble, find ways to avoid prudential regulations and supervisions.

Roubini suggests that the cheap credit spread to the stock market, accounting for the recent surge in prices:

In the corporate sector given the cheapness - until recently - of credit we observed a massive process of switch from equity to debt that took the form of leveraged buyouts, share buybacks and privatization of formerly public companies. This releveraging fed that equity/asset bubble: as expectations of more LBOs occurred equity valuation of many firms went higher and higher. The excesses took recently the form of premia of 40-50% or higher on the stock price of firms that were a leveraged takeover target. Specifically, CLO demand for corporate debt helped fuel the private equity sponsored LBO wave over the past few years, and thus contributed to the recent bull market in equities.