Subprime Credit Bubble Yet to Burst

Subprime Credit Bubble Yet to Burst

While politicians and inside analysts are attempting to put a brave face on the current turmoil on the financial markets, commentators are likening the current subprime mortgage crisis to a pyramid scheme.

In a recent CNN interview, Nouriel Roubini pointed out that current Federal Reserve estimates of the problem may be extraordinarily undervalued at $100 billion.

Instead, he points out that minority equity is bundled with debt, which is then leveraged against further higher debts, which can in themselves then be set up as collateral against even yet higher debts.

In his blog entry, Current Market Turmoil: Non-Priceable Knightian “Uncertainty” Rather Than Priceable Market “Risk”, he points out how borrowing has been set simply against interest payments, with each new tier of debt simply funding payments on the one immediately below it.

And at the bottom of all this is the American subprime mortgage market – parcelled, bundled, resold and repackaged – against debt after debt after debt – vastly amplifying the original debt with only minimal real equity:

any wealthy individual can take $1 million and go to a prime broker and leverage this amount three times; then the resulting $4 million ($1 equity and $3 debt) can be invested in a fund of funds that will in turn leverage these $4 millions three or four times and invest them in a hedge fund; then the hedge fund will take these funds and leverage them three or four times and buy some very junior tranche of a CDO that is itself levered nine or ten times.

At the end of this credit chain, the initial $1 million of equity becomes a $100 million investment out of which $99 million is debt (leverage) and only $1 million is equity.

Any loss of value on the original equity value – ie, sub prime mortgages – leaves only debt sustaining debt – a house of cards that we are only beginning to see unravel.

Despite hundreds of billions of dollars having being pumped into them, equities markets around the world have been unable to rally, with the FTSE 100 ending today only 0.9 points higher.

While over 200 points have been added since last Thursday’s fall, the message from the markets is clear – the sheer opaqueness of how these debts have been bundled has been to serve the interests of a minority against the majority.

Already there are calls to hold credit agencies to account for the worthless deals they’ve sanctioned.

But as Ann Pettifor has pointed out, the subprime market has only just begun it’s collapse – and it has a long way to go before all those worthless credit deals are exposed, ripped out of the finance markets, and the extent of those credit holes are finally revealed.

As Roubini adds:

Every day the turmoil is popping out in unexpected institutions and places: by now hedge funds, banks and asset managers in US, France, Germany, UK, Asia, Australia have gone belly up. And every day a different financial market gets into a liquidity crunch and credit crunch: first subprime; then near prime, prime, CDOs, CLOs, LBOs, ABCPs, corporate credit spreads, overnite interbank loans, money market funds, mutual funds. Every day we get a different surprise that adds to the market’s uncertainty and investors’ nervousness.

And he’s right.

Bear Stearns, Goldman Sachs, HSBC, Countrywide, and a whole merry cast of players are all taking hits where it hurts – in the very places they just paid out million-dollar bonuses.

The failure of central banks to shore up the markets should serve as a double warning.

Firstly, it needs to be accepted as the panic action that it is – an attempt to stop a freefall of stocks. It can succeed with that, but it cannot mask the dire situation underlining equity markets, whose bloated over-valuation rests on debt founded on debt without equity.

Secondly, it shows that investors are not going to taken in by showy gestures, and that confidence can only be restored through proper control and regulations taking over trading again. After all, no single investor knows how much market value is founded on empty debt, but the summer bulls all know that they carry huge amounts, and can no longer reallocate it when banks will no longer accept it at face value.

As before, at FM we’ve warned that the markets are on a long down turn. Recent measures to try and prop them up are already failing.

The really serious warning, though, is that the subprime credit bubble hasn’t even begun to impact the markets fully.

When it truly does, the effects will be explosive. It can’t be defused – it simply remains to be seen how controlled the damage will be.


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