Kass: Ratings Are Subprime's Dirty Secret

But what will happen when the ratings agencies finally downgrade MABS 2006-FRE1? (Which seems inevitable, but late!) Answer: Investors will sell.

Anyone for a 60-bid?

The subprime fungus has only recently been uncovered, and the seriousness of the problem for the sector of housing that has stirred the drink of the residential real estate market has only recently been uncovered in the "see no evil, hear no evil" capital markets of 2007. (Indeed, over on RealMoney, Jim "El Capitan" Cramer argues that the subprime woes are a good thing, because the carnage will contribute to a Fed rate cut. I view this as highly unlikely but consistent with the Cramerica psyche that has inundated the investment community -- good news and bad news are both treated favorably.)

What is astonishing to this observer is the almost universal view that the prime market is in good shape and that the weakness in subprime will be contained.

It will not be isolated, as nearly as half of all the mortgages made over the last 12 months -- even to prime customers -- are nontraditional, creative loans (interest-only, adjustable option ARMS, negative amortization, etc.). These, too, are vulnerable. At the very least, today's lemmings (a.k.a. mortgage lenders) will begin to restrict lending and will dramatically tighten standards. And Katie bar the door if this economy doesn't perform in a Goldilocks fashion.

The subprime mortgage news this week is the first shot across the bow of a boat called Market Optimism. Throughout the balance of 2007 and into 2008, mortgage defaults will accelerate into the prime market (as a result of a moderating economy, too-leveraged mortgage instruments, rising interest rates and ARM resets).

Credit is about to be less plentiful.

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