Brother, can you spare a sub-prime (insurance policy)?

Derivatives markets are getting roiled by the bad news from the lending industry. How far will it go?

Published February 15, 2007 12:48AM (EST)

Wanna raise hackles on Wall Street? Sneak up behind an investment banker and whisper the words "systemic risk." As in: The miseries currently being experienced by subprime mortgage lenders are causing enough problems in derivatives trading markets so as to send a destabilizing jolt through the entire universe of high finance.

The response most likely will be a snort of derision, but underneath the sneer might lie a shudder, because the way Wall Street works has changed so much, so fast, over the last 10 years that no one really knows what's going to happen when the markets get seriously tested. All anyone can do is look at each new blip in the markets and wonder: Is this the tipping point? Is this the moment we will look back upon and pinpoint as the day it all went to hell?

The latest exercise in uneasiness is amply illustrated by two Financial Times articles today charting the ripple effects of sub-prime woes. First Saskia Scholtes tells us that "a savage sell-off has swept through the credit derivatives market for sub-prime mortgages" this week, in response to the drumbeat of bad news from sub-prime mortgage lenders who are seeing a surge of homeowners defaulting on their mortgages.

What this means is that the price of buying insurance against the possibility of default on sub-prime mortgage bonds is shooting up.

"Liquidity has (temporarily) evaporated ... and a ferocious sell-off has caught most of the market off-guard," say Gary Jenkins and Jim Reid, analysts at Deutsche Bank. "This is perhaps evidence that in the world of structured credit and leveraged positions, things can change very quickly if the facts change."

Which is a very mild way of saying, "Hold on to your hats, boys, it could get windy in here!"

And yet, another article in the Financial Times, which includes the exact same quote from the Deutsche Bank analysts, is titled "Structured finance 'can weather bad debt conditions'" and tells us not to worry.

Duncan Kerr's lead paragraph:

The world's top bond manager has poured cold water on claims that the structured finance market's stability is under threat by a deterioration in the quality of sub-prime, US mortgage-backed bonds, despite worsening debt conditions that led to profits warnings last week...

Kerr then quotes Scott Simon, head of mortgage and asset-backed securities investments at Pimco, as saying, "We don't believe there is any systemic risk at all."

It has been clear for more than a year that Wall Street hedge funds have been betting on trouble coming in mortgage lending markets. Whoever made those bets is probably doing quite well right now. And maybe that's where it will end -- in a perfectly balanced market, someone will profit from someone else's woes, and so it will go, forever more. Some optimists predict that there will be a period of consolidation in the sub-prime mortgage lending industry, the weak players will get eliminated, and the overall market will be stronger in the end.

Or perhaps economic historians will one day look back and trace this sequence of events:

The rise of credit derivatives allowed banks to sell off the risk of being caught holding the bag for bad loans. This emboldened them to move aggressively into riskier and riskier sub-prime loans. But the subsequent collapse of the housing market led all too naturally to a flock of bad credit risks coming home to roost. That, in turn, has made it harder to buy insurance, because there's a chance that the sellers of protection might actually have to pay up, rather than just get fat off their premiums. And so the entire system started to get stressed...

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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