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Saturday, 11 August 2007

Subprime fallout draws comparisons to past crises

NEW YORK (Reuters) - The turmoil sweeping the U.S. subprime mortgage market is starting to resemble some of the biggest financial crises of the past 100 years as its fallout infects credit conditions worldwide. While most analysts say it's too soon to hit the panic button, parallels to past crises are starting to fall in place: a domestic credit crunch, contagion to international markets and more volatility, followed by bank intervention.

On Thursday, the European Central Bank pumped a record 94.8 billion euros ($130.6 billion) into Europe's money markets, citing U.S. subprime mortgage problems. The Bank of Canada later injected C$1.455 billion ($1.37 billion) to help with liquidity shortfalls, while the U.S. Treasury said it "remains vigilant."The subprime situation has inspired comparisons to the collapse of Long-Term Capital Management and the Russian sovereign loan default, both in 1998, as well as to the U.S. savings and loans crisis of the 1980's. Some have even found similarities to the early stages of the Great Depression of 1930's.

"This process is a very old and familiar process," says Jack Malvey, chief global fixed income strategist at Lehman Brothers. "These are regular currents in capital markets -- there's a break in the chain from the weakest link and there's a ripple effect." In this case, the "weakest link" are subprime borrowers, those with checkered credit histories who were granted loans during the U.S. housing boom. They were the first group to miss home loan payments or default.

The risk is now widening to so-called Alt-A mortgages, a pool of alternative loans made to A-rated borrowers that could not meet typical prime borrowing terms. As with past crises, the problem is also moving beyond domestic borders to affect global markets. Most view the current situation as a natural adjustment after years of easy money. They say it has not yet reached the stage that LTCM reached in 1998, when the Federal Reserve was forced to initiate a bailout of the hedge fund to stave off a wider financial collapse. Malvey says the current credit squeeze is not necessarily a sign that the financial system is in trouble. What's happening is a washing away of excess that fed an unprecedented binge of leveraged buyouts and lax lending to unqualified borrowers. Like in any great flood, weaker players will get washed away, while stronger players will remain standing.

Malvey says the current squeeze may resemble the so-called Banker's Panic of 1907, exactly a century ago. That crisis started with the failure of New York banks after financial innovation led to excesses. It ultimately triggered wider panic throughout global markets. Similarly, dozens of mortgage lenders have closed or curtailed business in recent months, and a flurry of deals to finance LBOs through debt have been canceled or put on hold due to their exposure to subprime loans. The cap on new bond sales started to loosen on Wednesday, as $15 billion in new debt was sold, the highest daily volume this year, according to Bank of America. Even so, "this isn't over," said Mark Zandi, chief economist at Moody's Economy.com Inc., a unit of Moody's Corp. that provides economic research. "The correction is in full swing and there is the potential that there is another shoe or boot to fall."

A SCALE OF 10

So how does the current environment measure up? In a report this week, Lehman rates the current credit tightening as a "7" on a scale of "1" (minor) to "10" (terrible). Malvey sees room for improvement and advises investors to start buying high-quality debt now. Mortgage-backed securities, asset-backed securities, high-grade corporate bonds are cheap at current levels, according to Lehman. Those debt securities will be more valuable by December 31 than current valuations, Malvey said.

"All credit crises belong to the same species but each has its own DNA," said Malvey, who cites the 1998 Russian default and LTCM crisis; the Middle East War and Arab oil embargo from 1973 to 1975; and the 1981-82 recession as the worst of recent crises. While world economic and corporate fundamentals are far superior in 2007 than was the case during past market upheavals, Malvey concedes that events could get worse. "We're maybe in the third or fourth inning," Malvey said.

WORSE THAN S&L

Josh Rosner, a mortgage expert from Graham Fisher, a New York-based investment research firm, forecasts that losses from deteriorating U.S. subprime loans will surpass the S&L crisis in the 1980s. While most analysts say it is premature to equate the current credit squeeze to past crises, they generally agree that the seeds of financial disruption have been sown. Whether they come to fruition depends on the severity of future mortgage defaults and the ripple effects of those losses. Rosner forecasts more than $200 billion in total losses to investors and homeowners, compared with about $125 billion in losses from the S&L debacle.

"In terms of ultimate losses, it will be worse," Rosner said. "It's a bleeding into the system, a drag on the economy over the life of these mortgages." The worst losses on mortgages originated in 2006 won't even start to have an impact on the market until the end of 2008, Rosner said. "That's all the analysis you need to know things will get worse," he said.

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