In: Root » » Loans and mortgages
Back to the Future As this is being written, about a year after the subprime financial shock hit, the worst of the crisis appears to be over. The financial turmoil reached an apex in mid-March, when the Federal Reserve stepped in to engineer the sale of Bear Stearns then on the brink of collapse to JPMorgan Chase. While conditions have improved since then, the shock continues to reverberate: House prices are still declining, foreclosures continue to mount, the economy hasn't found its footing, and the financial system remains unsettled. Falling house prices are particularly unnerving. With no clear bottom in site for the residential real-estate market, financial institutions remain unsure of their losses on mortgage loans and securities. Many have already written down their portfolios by large amounts, subtracting from their balance sheets both the estimated losses from defaults and declines in the market value of their remaining loans and securities. Some institutions believe the market has grown overly pessimistic and that those securities will eventually rise again in value; thus the write-downs might simply reflect a temporary hysteria from the subprime shock. Whether this ultimately proves correct depends on how far house prices eventually fall. The same applies to the fate of the monoline insurers, who are still trying to raise enough capital to maintain their Aaa-ratings and thus survive. Another wave of financial turmoil looms if they cannot. It is also disconcerting to find many banks without enough capital to withstand the credit losses that were still to come. The nation's community and regional banks appear especially vulnerable, as credit problems spread from residential mortgages to other types of lending. There have never been so many auto repossessions, and credit card and student loan delinquencies are rising quickly. Banks also have loans out to troubled home builders and have sizable commercial loan portfolios that could soon face problems from weakening rents and falling commercial property prices. The big banks continue to suffer from indigestion, even as the rest of the cash-strapped financial system relies on them for credit. The shadow banking system made up of asset-backed conduits, structured investment vehicles, finance companies, broker-dealers, and so on continues to have difficulty funding itself and has turned to banks for help. This means that assets that had been deliberately kept off banks' balance sheets are moving back on them. Combined with the banks' own massive write-downs, this will sorely strain banks' available capital. Even with sovereign wealth funds offering billions in new equity capital, banks still don't have the resources necessary to both backstop the entire financial system and also provide enough credit to their own household and business customers. It is also possible that previously unaffected parts of the financial system will soon feel the widening ripples of the subprime shock. One likely candidate is the mammoth market for credit default swaps. While CDS on mortgage-related securities are relatively well understood, a much larger portion of the market involves default swaps on corporate bonds. These have been unaffected thus far because corporate bonds have experienced relatively few credit problems. However, if corporate bond defaults rise (which seems likely) the default-swaps market will surely be tested. That could set off a new and more powerful shock to the financial system. There are other potential new shocks as well, but it remains unclear which pose the greatest threats and to which institutions. Financial markets remain disturbingly opaque, making it hard for financial players to identify or prepare for additional threats. If financial institutions are worried and uncertain, they will remain cautious and restrict credit and raise its cost for nearly everyone, good borrowers and bad. Until credit flows more freely and cheaply, the economy will not get its groove back.
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