Credit Market Contagion: Dan Amoss / August 2, 2007

Global markets are taking yet another dive this morning on fear that the “subprime” meltdown is not contained to a manageable little box. Investors in funds without any exposure to subprime paper are redeeming their funds en masse. They aren’t going to wait and see if their “prime” mortgage backed securities will keep paying interest and principal as expected. So they are forcing fund managers to liquid portfolios full of illiquid securities.

As I wrote in the August issue of Strategic Investment, Wall Street’s mortgage machine is set to work in reverse, cutting off credit for many who face devastating ARM resets in the coming months. These fund redemptions will exact a real toll on the economy precisely because these same people were fueling the credit bubble in their shortsighted reach for yield.

Mortgage-based funds located everywhere from Australia to Germany are exploding, another Bear Stearns fund is in trouble, and American Home Mortgage, a supposedly higher-quality “Alt-A” version of New Century Financial, crashed yesterday. For an autopsy on New Century, see my Whiskey & Gunpowder article "Leverage Blackens a Blue Chip".

A “crisis of confidence is at the root of both American Home’s and Bear’s current woes,” reports the Wall Street Journal.

“In American Home’s case, banks including UBS AG, Bear Stearns and J.P. Morgan Chase & Co. said they wouldn’t extend the company any more funds. Some lenders have demanded the return of money already lent. As for the latest Bear hedge fund to run into trouble, investors began demanding their money back even though the fund wasn’t heavily exposed to subprime mortgages…

“Investor and lender skittishness can feed on itself. The funds being hit by investors’ redemption demands or their banks’ margin calls -- requests for additional cash or collateral -- can be forced to sell their holdings at reduced prices, further lowering the market value of these assets. That in turn hurts other investors who hold similar assets.”

Batten down the hatches, and by all means, avoid financial stocks -- even if they look cheap. — Dan Amoss

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