Kass: Finding the Next Shoe to Drop

The Next Shoe to Drop?

With the contagion that started in subprime mortgage lending now spreading to other mortgage tranches, as reported here, the next shoe to drop might well be in the broader securitization market.

Not only will older, less-protected packaged securitizations and other derivatives decline in price in a readjustment, but the entire credit securitization chain will become less profitable to industrial companies, mortgage lenders, banks and brokerages.

Consider what has occurred and is now occurring in subprime. The prices of mortgages are rising as the originations become less profitable for the financial intermediaries that serve the market. In turn, housing affordability worsens, delinquencies and foreclosures rise, housing inventories build further, and home prices drop in the second leg down for residential real estate.

This is the vicious cycle and contagion in credit markets.

Now I am hearing stories of plunging demand for CDO tranches and sponsors taking large fee-haircuts before deals can be sold. It is in the mixed asset class of CDOs where the contagion of subprime might soon spread as buyers recoil from sharper-than-anticipated losses in the mortgage market.

Credit spreads are flying open and the vicious cycle of credit has begun as the evaluation of risk is reassessed.

Given the sheer size and significance of the unregulated credit derivative markets, this is the kind of stuff that capital market crashes are made of.