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August 6, 2007

Subprime Crisis Extending Beyond Credit Markets

The subprime mortgage crisis appears to be spreading beyond the credit markets, dampening not only the U.S. stock market, but also international markets.

Merrill Lynch, in its monthly survey of fund managers, asked them to cite potential risks to economic and stock market stability. Seventy-two percent said credit default risk was above normal, and 44% said interest rates and volatile exchange rates were above normal.

And at the Morningstar conference in June, TCW Group Chief Investment Officer Jeffrey Gundlach said that although a number of mutual funds that hold securities tied to subprime loans or collateralized debt obligations (CDOs) claim their holdings are tied to high-quality debt, Gundlach predicted problems will, nonetheless, spread to other credit markets. In fact, he characterized the subprime crisis as an "unmitigated disaster."

In his July investment outlook report, Bill Gross of PIMCO, said that even single-A rated CDO tranches could "face the grim reaper," adding the resulting upward creep in yields could result in a 5% to 10% correction in stocks. "Both borrowers and lenders may have bitten off more than they can chew, and even those that swallow their hot dogs whole-Nathan's Famous Coney Island style-are having a serious bout of indigestion," Gross wrote.

A recent indication of the spread of the credit crisis was a report on how bank loan mutual funds, which are considered stable, are declining in value and losing assets. Bank loans are loans that banks have given to corporations and resold to institutional investors. Agencies rate them higher than high-yield debt because the interest that corporations pay on them is steady, and in the event of a default, they are scheduled to be paid back ahead of bonds. In the past month, such funds have declined 1.43%, some dropping more than 8%.

Another indication of the growing ripple effect of the subprime crisis in the U.S. is foreign investors', particularly hedge funds', exposure to these securities through asset-backed securities. Many of these investors are reportedly suffering steep losses.

As Yukata Shiraki, senior strategist at Mitsubishi Securities, told Nihon Keizai Shimbun, "The subprime loan issue is a problem for the global financial market as a whole."

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