Sub-prime mortgages caught a cold in August, and all but Treasury and Agency debenture issues have checked into a long term care facility.  It has quickly become clear that the so-called "mortgage crisis," which many players have tried desperately to pin exclusively on the perils of investments in sub-prime loans, is a symptom of a much larger malaise.  This malaise is the hangover induced by many consecutive years of global credit expansion and extension that has not been characterized by strong underwriting standards, rigor, and prudence.

 

We suggest that the staggering quarterly losses and write downs announced by several of the world's largest lenders do not qualify as the cliché low-hanging fruit.  Rather, they are windfall apples that have tumbled to the ground, and that there is more to harvest when the accountants get out the ladders and ascend all of the trees in the orchard..

 

Therefore, we believe that the impact of current liquidity and credit conditions will take many, many months to work their way through the system.  Indeed, the magnitude of economic collateral damage may not become obvious for at least six months. 

 

The equity markets, ever hopeful, considered the first wave of warnings and write downs to be the end of the problem, and were soon disappointed in most recent days as several market players doubled or trebled their initial loss and reserve estimates.  The loss and write down figures for many firms are in the high single-digit billions.  Credit market participants should bear in mind that the aptly named "Superfund" for SIVs is only in the discussion phase, with more exciting installments to come. 

 

In addition, the impact of credit and liquidity reality has yet to be factored - or even considered - for some of the more complex holdings, such as retained Beneficial Interests from securitization activities. 

 

In short, this is a big mess, and it will take a long, long time for the participants to manage and for the markets to absorb.

 

There are two outcomes which are highly probable in our estimation:

 

First, a general slowdown and chance of recession seem eerily similar to what became reality precisely twenty years ago, after black Monday in October of 1987, and also after the Dot Com bubble burst at the end of the last decade. 

 

Second, the reach of this credit and liquidity disaster is deep and wide.  The fall out and clean up will serve as a distraction for many market participants, and that could serve to ease some competitive pressures and provide relief for the pricing squeeze on lending. 

 

We believe that, contrary to the experience of the past four years, the yield curve and market conditions may soon pay financial institutions to take measured interest rate risk again. 

 

The FOMC is clearly holding its nose as it cuts market rates, and is engaged in furious sessions of finger-wagging via its published minutes.  However, we opine that the impact of these market interruptions on the economy has been bigger than can be currently measured, and that they will combine with other stultifying market elements - such as the price of oil - to create serious concerns. 

 

The ramifications in 2008 will be huge, and we predict that the Fed will be forced to cut rates again, very early in 2008, but that the committee will drag its feet as long as possible.