Real Estate, CDOs, Banks, and the Economy

The story began in June when trouble in the real estate market (which played out first as sub-prime borrowers could not make payments) began spilling over to the banking industry (Bear was the to acknowledge the damage as it took writedowns (and then made loans to) two of its hedge funds as their holdings of CDOs (a type of mortgage backed security) fell sharply.

In recent weeks the problems have continued to mushroom as financial firms big and small have written down billions of dollars of assets. (See CIBC, Wachovia, Merrill, JP Morgan, Bank America, Citi, E-trade, and maybe Barclays, et al). While not enormous as a percentage of value (Citi estimates the losses at about $64B) it is not surprising that bank stocks have suffered.

What is the biggest concern is that this spreads to the overall economy. The line of reasoning is: banks get in trouble, they lend less, and soon the economy suffers. This is one of the things that is worrying Fed Chairman Ben Bernanke. As a result the Fed has lowered the Fed Funds target and reiterated that the discount window is open to any bank that needs it. (which is what they should have done).

No one can say for sure how this will play out, but it seems like everyone has an opinion. For instance:

UPDATE 3-Wachovia, Capital One say credit conditions worsen Bonds News Reuters.com:

"This is now worse than Long-Term Capital (Management),' said Jack Malvey, chief
global fixed-income strategist at Lehman Brothers Inc., referring to the hedge
fund whose 1998 collapse threatened to unhinge global financial markets. 'This
is a painful lesson in financial engineering.'"

Josef Ackermann CEO of Deutsche Bank in Reuters:

"If you go back to the Asian crisis, the Latin American crisis, the Russian
crisis, these were pretty regional," said Ackermann, who also heads global
banking organization the Institute of International Finance.
"(This) is psychologically the worst crisis that I have seen in my 30 years,"

The Economist:

"One worrying lesson for bankers and regulators everywhere to bear in mind is
post-bubble Japan. In the 1990s its leading bankers not only hung onto their
jobs; they also refused to recognise and shed bad debts, in effect keeping
“zombie” loans on their books. That is one reason why the country's economy
stagnated for so long. The quicker bankers are to recognise their losses, to
sell assets that they are hoarding in the vain hope that prices will recover,
and to make markets in such assets for their clients, the quicker the banking
system will get back on its feet."

and finally Business Week:

"Studies have shown that tighter loan standards tend to precede economic
slowdowns. Between July and October, banks tightened their lending criteria
significantly for a variety of business and consumer loans, according to the
Fed's latest survey of senior loan officers. Bankers cited a less favorable,
more uncertain economic outlook, and many pointed to less liquid secondary
markets and greater risk aversion.Sharply tighter standards...will put an added drag on the housing market and consumer spending. And more stringent rules for commercial real estate loans will dampen business outlays for new construction, which has been a key driver of capital spending this year."

So what's next? Who knows? Stay tuned, it will be interesting!

BTW one of the important stories that are coming out is the fact that this is affecting all tranches of the debt as even AAA rated debt is being marked down (which is why the rating agencies are concerned). The San Antonio Express News reminds us that conflicts of interest exist here too.