Thursday, July 12, 2007

Subprime shakeout: questions loom

As the subprime mortgage shakeout continues to ripple through the markets, FT Alphaville looks at two different elements of this story: the macroeconomic perspective, and the contagion effects made possible by financial innovation.

As was pointed out
in these pixels on Wednesday, there are two elements to the subprime mortgage shakeout in the US.

The first, macroeconomic, concerns the extent to which the woes in the subprime sector of the mortgage market spill over into the broader US housing market, and spark a slowdown in overall consumer spending.

The second is a question regarding financial innovation, which has created transmission mechanisms across the wider credit markets, whereby problems can leap between seemingly unrelated markets such as US mortgages and European leveraged loans, which are funding the current buy-out boom.

As Paul J Davies wrote here yesterday: “if contagion between markets is fueled by such mechanisms then the sell-off in credit could be the harbinger for a much broader systemic sell-off of risk across all asset classes - that at least is the most bearish, apocalyptic version of current market concerns.”

The Alphaville post goes on to survey reactions to the subprime fallout from various bloggers and market analysts. While some are expressing little surprise over the current state of things, others are busy making a case for "containment".

But as S&P and Moody's move to cut their ratings on mortgage backed securities (the very securities which they often trumpeted as investment grade), worries over the extent of the damage continues to mount.

Still, there is no time better than the present for some good old-fashioned spin. So with that in mind, let's take a quick look at how the "well-contained" subprime mortgage fiasco has affected investors in other areas of the market.

Minyanville writer Kevin Depew has been chronicling the way in which the subprime "containment has been spreading" for some time, now. Here's a look back at the growing problems in the debt markets from late April, in which Depew observes that a "behavioral contagion" of fear might cause a panic to spread through other portions of the debt markets. Lots of amusing commentary here.

My favorite of all the "containment" statements heard so far (and I'm only a casual observer) is this quote from a recent article that appeared in The Economic Times:

“Risk aversion appears to be mainly contained within credit markets."

The best part about this line is that it's taken from an article entitled, "Subprime woes spread to stocks and dollar". Think about that one for a minute...

For more background perspective on the subprime and mortgage-backed securities market, see our recent roundup entitled, "Not another subprime post?!".