The Persistent Credit Crunch

Months after the market began feeling the ill effects of subprime "garbage loans," things still look terrible. Is there light at the end of the tunnel?

Call it a relapse, or maybe the troubled credit markets never really recovered from their summertime crunch. In any case, three months after a financial crisis spooked fixed-income investors, the debt markets are back in critical condition.

Investors still won't touch risky debt with a 10-foot pole. They're so scared they've shifted huge amounts of money into ultrasafe U.S. Treasuries, sending the yields on government debt back to low levels not seen since September.

Treasury Yields Bottom Out

Bad news from Merrill Lynch (MER) and Citigroup (C) on Nov. 5 heightened the fear factor. "There is still a real discomfort in the credit markets that the subprime problems have not yet become evident," says Ward McCarthy of Stone & McCarthy Research.

The worry remains that large financial institutions are sitting on top of big losses from bad mortgage debt. That's not unreasonable given Citigroup's announcement that it will report losses of an extra $8 billion to $11 billion just weeks after reporting a $2.2 billion hit.

"Everyone is being very risk-averse," says Bill Larkin, fixed-income portfolio manager at Cabot Money Management, who notes Treasury bond prices are so high they offer "ridiculously low yields." Taking inflation into account, they barely offer any real return at all, he says. After the summer's financial crisis, yields on the 10-year Treasury note hit a low of 4.3% in early September. They recovered a bit after the Federal Reserve cut interest rates later in the month, but now they're back down again, trading at around 4.3% on Nov. 5.

No Resolution in Sight

At the beginning of the 2007 financial crisis, many observers were making analogies to previous crises in 1987 or 1998. Those financial meltdowns threatened to slow down the economy but seemed to blow over quickly.

This crisis is exactly the opposite, McCarthy says. It started in the real economy and then spread to the financial markets. Subprime borrowers have been unable to make mortgage payments on their homes, and housing prices are falling fast. "This is a real fundamental problem in the economy that has become a contagion on the financial side," McCarthy says. That makes the crisis much more stubborn. "This is a problem we're going to have to contend with for a long period of time," he says.

Investors continue to worry that problems with mortgage-backed securities will spread to other forms of debt. Commercial paper—short-term funding for companies—still faces trouble.

Municipal Bond Market Concerns

There are also worries about municipal bonds, which in most cases are a very safe investment. Few think cities and towns won't be able to pay back the money they've borrowed—though municipalities may face extra stress from the decline in real estate prices. Instead, the worry is over the companies that insure municipal bonds, thereby raising the bonds' credit ratings. Analysts say those insurers, including Ambac Financial Group (ABK) and MBIA (MBI) are probably still in good shape. But losses from toxic debt on their balance sheets could threaten their creditworthiness, causing problems for the mortgage market as a whole.

PIMCO Chief Investment Officer Bill Gross, the so-called bond king, warned of possible problems in the municipal bond market on CNBC on Nov. 5. He also called the market's difficulties with "garbage loans" a "trillion-dollar problem" that could result in $250 billion in defaults.

"We've only begun to see the pain for the homeowner," Gross said. He expects the Federal Reserve, which already has lowered interest rates 0.75 points, to lower its federal funds rate, now at 4.5%, to 3.5% by the time the crisis is over.

Foreclosures Still Mounting

The big worry, say Gross and others, is home values. The overheated real estate market already created a housing bubble, pushing prices to unsustainable levels. Now, with subprime mortgage defaults, experts expect a wave of foreclosed homes to go up for sale at bargain prices. An analysis by Bear Stearns (BSC) says annual foreclosures could reach 1.8 million by the end of 2008, up from an average of 660,000 before 2006.

The result of all this foreclosure-driven supply? "Total home-price declines in the 15% to 20% range are not unreasonable in a scenario of disorderly liquidation," wrote Dale Westhoff, head of mortgage-backed securities fixed-income research at Bear Stearns.

The Fed will likely do everything it can to prevent such a scenario. "The Fed can't afford to let home values fall 10% to 15%," Gross said, mostly because of the devastating effects on the economy. Federal Reserve Chairman Ben Bernanke testifies before Congress on Nov. 8. He's likely to be grilled about what can be down to slow housing's slide or prevent an economic slowdown.

A Grim Outlook

Credit market worries aren't likely to end soon. The first problem, says Avery Shenfeld, senior economist at CIBC World Markets (CM), is all the uncertainty. Every day more rumors appear about another major financial institution in trouble. "The markets may calm down once the unknown is better known," Shenfeld says. He thinks this may happen in the next couple of months, as the end of the year gives financial institutions a chance to come clean about their subprime exposure.

Second, the markets may need some reassurance that the fundamental problem—worries about mortgage debt and falling housing prices—have stabilized. "The first sign that a broader healing is happening would be…some stability in home prices," McCarthy says. However, he adds, "There are really no encouraging signs on that point."

Cabot's Larkin thinks the government may need to help troubled borrowers stay in their homes. But any such move would take months, if not years, to show effects, and no one in authority has proposed such an ambitious effort yet.

For many investors, whatever light was visible at the end of the credit-crunch tunnel appears to have dimmed drastically, adding one more big worry for Wall Street in the months ahead.

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