A crisis avoided?

Subprime home loan problems were back in the news recently. A couple of leveraged hedge funds that were heavily invested in subprime mortgage-backed bonds nearly folded when losses on those bonds erased most of the thin margin of equity in the funds. But, the funds ultimately were kept afloat . . . with more loans.

The original lenders to these funds strongly considered liquidating the funds – selling off the subprime mortgage-backed bonds and other assets, using the proceeds to pay off their loans, and then paying any remaining proceeds out to the funds’ investors. But, I suspect they soon realized that this might not raise enough to pay off the loans, much less return anything to investors. Putting a long list of low-quality bonds on the market would hammer the already suffering subprime mortgage-backed bond market as well as bring down the prices of other bonds, possibly starting a downward spiral throughout the investment markets.

So, they just lent the funds more money to keep them in business. For awhile at least.

This illustrates the type of concerns behind my statement of March 28, when Wall Street was saying we had seen the worst of the subprime crisis: “I believe it will have a broader and more negative impact on the economy than is currently reflected in the stock and bond markets.”

I still believe this. The growing impact may be confined to the areas of the financial markets tied most directly to housing. But, as more and more home mortgage loans reset to higher interest rates over the next twelve months, and the mandated higher lending standards prevent many marginal borrowers from refinancing, more and more mortgage-backed bonds will see declines in value, and more and more investors in those bonds will be looking to get out.

Crisis avoided? I’d say more like challenges deferred.