Back on the subprime/housing/credit front . . .

I’m still anticipating it to be worse than generally expected (even now). And, I continue to watch for the event that will drive us to the bottom.

As I described awhile back, I believe the final episode will be triggered when one of the involved parties decides to “make a run for it.” Hedge funds, securities dealers and financial institutions own huge amounts of bonds backed by weak mortgages. No one knows what these bonds are worth on the market because no one is willing to make an offer to buy them. So, the investors carry them on their books at what they claim are justifiable prices. For Merrill Lynch, justifiable prices required a $5 billion write-down earlier this month, but that grew to $8.4 billion this week (per yesterday’s Wall Street Journal).

Today’s estimated prices may, indeed, be reasonable approximations of the true economic value of the bonds if held to maturity. But, not if they aren’t held to maturity. If they were to be sold today, it would have to be at prices much lower than these book values.

And, that’s the risk. If one holder believes that this valuation charade is doomed and the market will soon be flooded with bonds in a sellers’ panic, that holder may decide to get out first -- take the best offer available today, then stand back and watch the rest of the market implode as more and more bonds are written down or actually sold at ever decreasing prices.

All the players, as well as their regulators and bankers, recognize the precariousness of this situation, and are doing all they can to prevent the dreaded sell-off. Mortgage lenders, for instance, are recasting loans to make them less likely to go into default. They’re giving up future income to avoid recognizing a current loss.

The nation’s largest banks are putting together a giant Structured Investment Vehicle (SIV) to buy some of the billions of dollars of bank- and broker-sponsored SIVs that are effectively insolvent due to losses in their holdings of bonds backed by weak mortgages. These premier banks will be putting over-valued, weak assets into a pool that they will carry on their books at full value. That helps?

The Federal Reserve is likely to make another cut in the Fed funds and discount rates – to send a signal that the Fed is there to help (no matter how irresponsible the financial services sector has been . . . again . . . and in spite of the fact that the price of money is not the problem).

Might these efforts succeed? Sure. But, I doubt it. Someone will make a run for it. Some investment pools, in fact, are required by their founding documents to liquidate if their value drops by a certain amount. Others must direct all mortgage payments received to only the senior-level investors once a specified value is breached, leaving the subordinated investors with a non-paying “asset” they might as well dump and get what they can while they can.

So, yes, I still think someone will bolt. Then we can get on with the real clean-up of this very messy situation.