That subject line isn't a phrase I invented. It was a phrase used by Deutsche Bank's CEO, Josef Ackermann. He was referring to the coming downgrades of the major bond insurers, which he said was "comparable to subprime".
Bond investors stand to lose $200 billion should MBIA Inc., Ambac Financial Group Inc. and Financial Guaranty Insurance Co. forfeit their AAA grades because of declines in mortgage-backed securities they insure, according to data compiled by Bloomberg.
Since financial institutions have been choking on the $146 Billion of declared losses so far, another $200 Billion is a very big deal.
Where will it all end? How much more is coming?
If you allow me a little latitude, I can tell you that the bond-insurer downgrades are merely the 3rd act of a 7 act play.
And that's assuming that the financial infrastructure holds up under the pressure.
Nearly a year ago I began writing diaries about how the subprime housing bust was going to be a catastrophe on Wall Street. It took another four months before Wall Street came to the same realization.
Eight months ago I warned that the housing bust was going to go global. It took another two months before Europe realized it had a crisis.
Three months ago I warned about the bond insurers, yet only in the last few weeks has Wall Street begun to worry about their fate.
I'm not bragging. After all, all the information I get is written by someone else first. Some insiders on Wall Street have already positioned their investments to take advantage of the coming chaos before I am even aware of an approaching problem.
I am just trying to establish my credentials that when something really big is on the way, I can see it coming.
First they came for the subprimes
The first act of this play was the subprime residential mortgages.
Unless you've been living under a rock this past year you are already fully aware of this crises, so I will not go over this territory again.
The second act was the direct result of the subprime implosion and the weakest link of the Wall Street chain - Structured Investment Vehicles (SIV) and their primary means of doing business - Commercial Paper (aka short-term commercial bonds).
About 6 months ago the financial media was full of stories about how these markets were in a panic. Almost nothing has been written about them in months. Is that because the crises is over? Yes, in a way - almost all of the SIV's have gone bankrupt since then.
When the SIV's went to financial heaven the worldwide commercial paper market stopped shrinking (it declined by nearly 40% in just 6 months), but it hasn't grown significantly since then.
The third act is the current crisis over the monolines.
If a bond insurer gets downgraded, in theory all the securities it has guaranteed have to be downgraded too.
Credit-default swaps tied to MBIA's bonds soared 10 percentage points to 26 percent upfront and 5 percent a year, according to CMA Datavision in New York. That means it would cost $2.6 million initially and $500,000 a year to protect $10 million in MBIA bonds from default for five years.
The price implies that traders are pricing in a 71 percent chance that MBIA will default in the next five years, according to a JPMorgan Chase & Co. valuation model.
Contracts on Ambac, the second-biggest insurer, rose 12 percentage points to 27 percent upfront and 5 percent a year, prices from CMA Datavision in London show.
Ambac's implied chance of default is 73 percent, according to the JPMorgan data.
MBIA is issuing $750 million worth of new stock in order to re-captialize (and by default, screw their current investors by diluting existing equities). However, rating agencies are raising the minimum amount of capital needed by the monolines to maintain their AAA rating. Thus it is a wash.
In fact, traders have already priced in dramatic rating downgrades for the monolines. The rating agencies of Moody's, Standard and Poor, and Fitch are way behind the curve as usual. Remember that these were the same guys that gave Enron an "investment grade" rating just four days before it collapsed. (The complete failure of the rating agencies is a topic that deserves its own diary.)
For the past several weeks there has been much wasted ink concerning a bailout of the monolines. One day it will happen, the next day it won't. If you remember back four months ago the talk was very similar to an SIV bailout. It never happened for the SIV's and it is looking like it won't happen for the monolines either.
An Economic Katrina
Just over a week ago I warned of another threat to the economy that is almost completely under the radar, and therefore is much closer than most people realize - the commercial real estate bust.
"The market is locked up right now because there's a huge overhang of leveraged assets of every type, development deals that won't meet projections made last year when things were rosy," said David Tobin, a principal at New York-based Mission Capital Advisors LLC, which was involved in $5 billion of asset sales last year. "It will end just like the residential housing market."
This impending collapse has been so silent that I have yet to see a single estimate of its size of the problem (the total commercial real estate market is $3.2 Trillion). Of course the original estimates of the subprime bust have already been exceeded four times over, so maybe estimates don't mean much.
Like residential real estate, commercial sales have dropped off a cliff.
US office property sales fell by the largest amount since the September 11 2001 terror attacks in the final three months of last year, raising fears that commercial real estate is heading for a meltdown.
U.S. commercial property prices probably will fall 10 percent in 2008 from last year's peak after rising 60 percent since 2002, said Dan Fasulo, director of market analysis at New York-based research firm Real Capital Analytics Inc.
Delinquencies of securitized commercial mortgages may quadruple in the next 18 months to almost 4 percent, said Kenneth Rosen, an economist at University of California, Berkeley, who runs a real estate hedge fund. About 70 percent of commercial mortgages are pooled into commercial mortgage-backed securities that are sold to investors, Rosen said.
The fifth and sixth acts of this play could probably be combined into just one because they both concern subprime borrowers. One element is auto loans.
Auto payment defaults doubled last year and are expected to get worse. It is another financial meltdown waiting to happen similar to the crisis in the home mortgage industry, according to one consumer group. A CBS 5 ConsumerWatch investigation has found consumers locked into cars they cannot afford.
According to Power Information Network, 1.85 of the 9.6 million customers in 2006 who leased or financed a new car were subprime borrowers or consumers with weak credit.
The weak lending standards of real estate mortgages during the bubble spilled out into almost every other type of lending. Subprime consumers lied on their car loans just like they lied on their mortgage loans, and lenders encouraged it (or at last looked the other way). Now the chickens are coming home to roost.
On the flip side of the coin is a more predictable problem - credit cards.
the place that JPMorgan got hit was in credit products – items related to auto loans, home equity loans and credit cards. The bank said credit costs for the company were up 40% from a year ago, as credit card default rates rose.
It isn't just JPMorgan. All the major credit card lenders are suddenly struggling.
In October, credit-card giant Capital One Financial reported that the delinquency rate on credit cards for the third quarter of 2007 was 4.46 percent, up from 3.53 percent in the third quarter of 2006. "Given current loan growth and delinquency trends," Capital One reported, it "expects the U.S. Card charge-off rate to be around 5.25 percent in the fourth quarter."
As housing prices have dropped, families that are already stretched can no longer tap into their home equity (if any still exists). Increasingly they use their credit cards and suffer the usury fees that come with it.
This past summer's subprime meltdown involved about $900 billion in now-suspect securitized debt, reckless lending, and consumers who buckled under the weight of loans they couldn't afford. Now another link in the consumer debt chain - credit cards - is starting to show signs of strain. And the fear that the $915 billion in U.S. credit card debt (an uncannily similar figure) may blow up has major financial institutions like Citigroup, American Express, and Bank of America strapping on their Kevlar vests.
"We are in a heightened state of alert to monitor a potential domino effect," says Michael Mayo, Deutsche Bank's U.S. banking analyst.
Dennis Moroney, an analyst at TowerGroup, expects credit card delinquencies will rise as consumers, who have until now used home-equity lines of credit to pay off their cards, start ratcheting up higher card debt.
...while missed payments are at a historical low, they show signs of an uptick: The quarterly delinquency rate for Capital One, Washington Mutual, Citigroup, J.P. Morgan Chase, and Bank of America rose an average of 13% in the third quarter, compared with a 2% drop in the previous quarter.
Unlike mortgages, credit card debt bonds are unsecured. So a default on this kind of debt means a total loss for investors (as opposed to mortgage debt, where a home auction could at least partially reimburse the bond holder).
The final act of this play is already playing out, but isn't getting reported probably because of laziness in the media or stereotypes.
The problem is the prime sector, and it is starting to show up in the same areas as the economy slows down.
For the past few years, banks that issue credit cards have aggressively wooed affluent customers with lavish perks and fat credit lines. Now, that high-end strategy is coming back to bite the banks: There are growing signs that some of those consumers are having a hard time paying their bills.
While the subprime borrower often exaggerated their income to get into a home they couldn't afford, the prime borrower often took out a risky mortgage to get into a much larger home than they could afford. This is beginning to show up on balance sheets.
Countrywide said 4.56 percent of its prime home-equity loans were delinquent at the end of the quarter, up from 1.77 percent in the year-ago period.
The company said the delinquencies were not due to borrowers struggling with mortgage interest rate resets, as many had expected. Instead, the delinquencies have been largely due to people losing their jobs or similar factors.
"We are experiencing home price depreciation almost like never before, with the exception of the Great Depression."
A common misconception is that every subprime loan was made to someone with sketchy credit. The fact is that many subprime type loans were made to people with good credit, but had overstretched themselves for various reasons.
An analysis for The Wall Street Journal of more than $2.5 trillion in subprime loans made since 2000 shows that as the number of subprime loans mushroomed, an increasing proportion of them went to people with credit scores high enough to often qualify for conventional loans with far better terms.
n 2005, the peak year of the subprime boom, the study says that borrowers with such credit scores got more than half -- 55% -- of all subprime mortgages that were ultimately packaged into securities for sale to investors, as most subprime loans are....
"Every single day ... I saw prime borrowers coming through my desk with 660, 680 [and] 720 credit scores," says Thomas Rudden, a former senior account executive at Mercantile Mortgage Co., a now-defunct subprime lender. Some were taking out loans as speculators, he believes, while in other cases he thinks brokers put borrowers into these loans because they thought it was easier.
It sort of makes sense in a way. It is well known that predatory lenders have targeted the poor for generations because they are often the most honest and responsible with their debt.
While there are plenty of examples of very poor people getting into homes they can't afford, much of the current wave of foreclosures is occurring with homes bought by speculators. Speculators are much more likely to be from somewhere other than the lowest class. But to afford multiple mortgages they would have to take out subprime mortgages, such as interest-only and no-doc loans.
Yet at the end of the day, the poor are the ones that the media blames for the current economic troubles.