Sub-prime Crisis Keeps Pulling Me Back In

Writing as frequently as I have in recent months about the ongoing Wall Street credit crunch saga makes me feel a bit like the “Godfather”, Michael Corleone: Just when I thought that I was done they pull me back in!

But the fact that the sub-prime induced credit crunch is perhaps the biggest financial story in decades helps provide lots of material for me. Also, the standard Wall Street/Washington approach to this crisis has followed the usual pattern: First, ignore the problem; second, dismiss the problem as largely irrelevant; third, deny the problem will have any lasting impact on the economy.

Treasury’s Paulson Provides Dire Sub-prime Forecast for 2008

It’s deliciously entertaining in such circumstances to point out the truth; that the sub-prime crisis has become much worse than anyone thought just a few months ago, and it will continue to impact financial markets for quite some time to come.

Just in the past few days in fact, Wall Street firms have begun to turn on each other, as I mentioned in yesterday’s blog (The Sharks are Circling on Wall Street... Looking for a Year-End Meal). After first denying that the credit crunch would have any meaningful impact on banks’ bottom line profits, analysts are now stumbling over one another to issue the direst forecasts of expected sub-prime loan losses and assets write-offs.

In a recent interview with the Wall Street Journal, even Treasury Secretary (and former Goldman Sachs alum) Henry Paulson had a somber outlook on sub-prime, the emphasis is mine: “We'll watch carefully mortgages that will be reset. The quality [of the 2008 resets] will be lower, when you think about it. Of the 2005 ones, roughly 10% of those end in default; the others refinance. The nature of the problem will be significantly bigger next year because 2006 [mortgages] had lower underwriting standards, no amortization, and no down payments.” Yikes!

Industry Bellwether Freddie Mac Takes a $2 Billion Hit

I have been writing for some time about the peak in overall sub-prime mortgage resets won’t even be reached until the spring of 2008. And we will not see a significant decline in reset activity until late next year and moving into 2009. Meanwhile, the process for Wall Street to clear all of these bad loans off their books will last even longer; well into 2009 and perhaps not until 2010.

Yesterday, mortgage giant Freddie Mac reported a much larger than expected $2 billion loss related to credit crunch fallout. The government-charted Freddie, along with it’s twin Fannie Mae are expected to provide stability to the home mortgage market in times of crisis, buying and guaranteeing mortgages against default.

Instead, Freddie revealed yesterday that it has recently “been forced to sell mortgages to ease its financial woes,” according to the Wall Street Journal. The company actually sold off about $20 billion of mortgage loans in September, followed by another $25 billion in October. Freddie says it was forced to take such actions due to its dwindling capital margins, but the effect is to destabilize the mortgage market, rather than providing a backstop.

Freddie’s Outlook: Expect Loan Losses to Triple in 2008 and Brace for a Dividend Cut

In fact, losses at Freddie Mac and expectations for more red-ink this quarter “put the company in jeopardy of falling below minimum capital levels” as required by regulators.  As a result, Freddie is seriously considering the unthinkable possibility (for a blue-chip financial firm) of slashing its dividend by 50% in the fourth-quarter to preserve about $646 million in cash.

Even worse was Freddie’s outlook. Since the firm is such an industry bellwether, it’s forward-looking guidance can be a key barometer for where the entire financial sector is headed. And the forecast from Freddie was NOT reassuring.

“Freddie estimated that its losses related to defaults on single-family homes will grow to $1.5 billion in 2008 and $2.1 billion in 2009 from an estimated $493 million for all of 2007. That forecast assumed that home prices at the depth of the downturn would be down 5% from their peak.”

So by Freddie Mac’s own estimates, loan losses will triple next year from 2007 levels – and quadruple in 2009! But Freddie may still be far underestimating the depth of its troubles assuming only a 5% slide in home prices. On a nationwide basis, home prices are already down about 5% over the past 12 months, with many economists predicting declines of 15% to 20% before it’s over.