Subprime meltdown? What subprime meltdown?


You might have heard somewhere about “the subprime lending and borrowing disaster” – today there’s another article on the subject in the WSJ, from Gregory Zuckerman and Michael Hudson. Their thesis is that the the subprime meltdown is unlikely to spread into debt markets more broadly.

ByFelix Salmon

But reading the article, the evidence of a subprime meltdown seems to be pretty thin. One James Melcher is quoted saying that “the emperor is naked, the quality of mortgages has been deteriorating and default rates are rising sharply” – but then it turns out he’s a hedge fund manager who is long protection on subprime mortgages, and is therefore basically just talking his book.

Meanwhile, at the end of the article, a chart shows the share prices of three mortgage lenders, all of which are up significantly on the year, and all of which have been on a steady upwards climb since late August.

And here’s the reporters’ evidence that the market in subprime mortgages is suffering at all:

The cost of insuring against default on some mortgage-backed bonds shows the impact. An index of these costs — the 2006 ABX Series Two index, which tracks 20 pools of thousands of BBB-minus-rated mortgage bonds — traded at 95.5 yesterday, according to, down 5% in a week.
It corresponds with a yield on subprime mortgage bonds that is about 3.8 percentage points higher than the comparable yield on a benchmark interest rate for investors, the London interbank offered rate, or Libor. Two weeks ago, the yield was 2.4 percentage points higher than Libor.
Prices on subprime bonds themselves, which don’t trade as actively as this index, haven’t moved much, traders say. Overall mortgage-backed securities, which are higher-rated, also haven’t moved much either.

In other words, speculators such as James Melcher have bid up the price of credit protection on subprime mortgages – but the mortgages themselves “haven’t moved much”. If there was a real basis for the move in the CDS market, one might expect the spread on securitized subprime mortgages to have gapped out to 380bp over Libor from 240bp over Libor, like the CDS contracts have done – but it hasn’t. In fact, seeing as how according to the article the actual bonds are more illiquid than the CDS contracts, the spread would probably have gapped out even more, due to that illiquidity.

Seems like the dog not barking to me.


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