Credit crisis far from over despite Bear's collapse


Posted at Jun 14 2008 01:09 AM | Updated as of Jun 14 2008 09:09 AM


NEW YORK - The acute phase of the crisis in financial markets may be over, marked by the near collapse of Bear Stearns, but the fallout leaves the United States vulnerable to recession.

The vicious combination of the banking industry's tighter lending standards, rooted in the monstrous rise in mortgage defaults, and falling American home prices could continue into 2009.

That could eat into already slowing economic growth and push the United States into a recession -- albeit one that might be mild yet last longer than the eight-month-long recession of 2001, speakers at the Reuters Investment Outlook Summit said this week in New York.

"We have fundamental uncertainty about what is going to happen with house prices," Martin Feldstein, head of the influential National Bureau of Economic Research, told the summit.

Those words are hardly comforting.

Earlier this year, Ben Bernanke, chairman of the Federal Reserve, warned that consumers are bearing the brunt of the effects of the current downturn because housing wealth has been tied strongly to spending and their homes are their biggest assets.

Housing headaches to linger

The U.S. housing market's morass has also resulted in more than $300 billion of write-downs at financial institutions globally so far, as banks have been huge holders of risky securities tied to the appreciation or depreciation of housing prices.

This week alone, Lehman Brothers raised $6 billion to bolster its balance sheet, not to mention investor confidence, reflecting the pain that still lies ahead.

"Who would have considered that the Fed (would) aggressively cut rates, and in addition to that, create all these special facilities for the investment and securities industry, and yet we're still in the state that we're in?" Greg Peters, head of global credit strategy at Morgan Stanley in New York, said at the summit this week. "That is nothing short of astounding."

Feldstein said house prices probably need to fall another 15 percent to unwind the frothy gains built up during a bubble in the earlier part of the decade, but there was no guarantee that they would stop falling when they reached that point.

"I don't think that that is an unreasonable proposition to put forward," Tad Rivelle, chief investment officer of Metropolitan West Asset Management, said at the summit, referring to Feldstein's projection. "Housing is not an asset class that is easily deleveraged. It takes a long time."

Making money out of the mess

That said, investors like Rivelle, whose MetWest oversees $27 billion in assets, are finding that various types of mortgage-backed securities are pricing in far more bad news than they should.

"A lot of the subprime mortgage market is very attractively priced if you are talking about top of the capital structure front-end cash flows," he said. "The marketplace has so tarnished the name of 'subprime' that you can find securities that I think under almost any type of condition are going to produce 10 (percent) or 20 percent internal rate of returns."

He's been a purchaser of the safest part of a subprime bond that typically gets paid off in full, even in foreclosure.

"Even if there was a substantial and rapid rise in foreclosures and delinquencies in these deals, the rub is the servicer sells the property and generates some amount of cash in the process," Rivelle said. This cash flow gets directed to these 'AAA' securities, causing them to be repaid at an accelerated rate, he added.

"We're now getting back within normal bands," Goldman Sachs senior global strategist Abby Joseph Cohen commented at the summit. "Not for every asset, not for every market, but we're beginning to see that markets are pricing things in a way that there is demand for them at the new price. And that's an indication that things are un-seizing, things are returning to a more normal phenomenon."

Long healing process

Prominent Wall Street economist Henry Kaufman said the United States is past the halfway mark in the credit cycle.

But "we have a considerable ways to go," Kaufman, president of financial consulting firm Henry Kaufman & Company, told the summit.

Louis Crandall, chief economist at Wrightson ICAP, said, "We are past a couple of points of extreme fragility and risk" in the crisis, but any progression "may not be linear."

Morgan Stanley's Peters agreed: "The first phase in the credit crisis was really a systemic phase. That was, I think, largely ended with the Bear Stearns news of March 17."

But the second phase can be just as rough.

"The turmoil in the credit market and its impact on the financial system, combined with the slowing of the overall economy, is something that most don't fully appreciate or understand," Peters said. "It is different this time, absolutely. I think to get your hands around the depth of what is going on is that much more challenging."