When growth optimists such as the wise Richard Berner of Morgan Stanley (not just Roach, their resident long term bear) start talking about a sub-prime and ABX “meltdown”; when the terms “carnage” and “time bomb” are used by mainstream observers to describe the sub-prime and ABX market; and when the same Berner needs to write a long piece to convince you that there will be no “credit crunch” following the sub-prime meltdown you know that some serious trouble may be brewing. The trouble takes the form of three problems:

1. Risk of the subprime "meltdown" becoming contagious to prime mortgages;
2. Risk of the beginning of a broader credit crunch;
3. Risk of the ABX "carnage" leading to more serious losses and implications for credit markets.

Of course last week many investment banks had conference calls to reassure their clients with the message that the subprime meltdown is contained, that other credit spreads are holding in spite of the free fall of the ABX (BBB-) indices, and that there is very little risk of a broader credit crunch.

That optimistic scenario is of course possible and we do not know yet how these credit markets will behave over the next few months. But the same cycle of minimizing the potential risks from the housing fallout has occurred all along since last year: the housing recession was first defined as “housing slowdown” and is now argued to be “bottoming out” based on relatively little evidence; today’s subprime “meltdown” was yesterday’s subprime “correction”; and today’s worries of a “credit crunch” are widely dismissed as unlikely.

But consider the following issues. Normally when a sector like housing or real estate or tech goes into a boom and bust cycle, the “real cycle” precedes the “credit cycle”. In other terms we would have expected that weakness in housing would lead first to large job losses, lower income generation, higher unemployment first (the “real” cycle). Only when the “real” cycle is underway one would usually expect – as in the 1980s S&L fiasco – that a “credit” cycle would be triggered and emerge leading to further real and financial distress.

Instead the most surprising thing about this housing bust and subprime meltdown is how the “credit” cycle started much earlier than the “real” cycle and much more rapidly than anyone would have ever suspected. Now in an economy with still high growth, still high job creation, still very low unemployment rate, still high income generation we are already observing massive increases in subprime defaults and foreclosures, 20 subprime lenders going out of business in two months, the ABX going into free fall and the cost of insuring against the BBB- tranche of the ABX index going to a spread relative to LIBOR of over 1000bps. So, if all this happening in what the consensus terms as a “Goldilocks economy” what would happen if the economy – as likely – will start to slow down more in 2007? How much more carnage can we expect in many sectors and markets when the economy is weaker than in recent months?  

The fact that the downward “credit” cycle has emerged so fast and so sharply in a still “strong” economy is the most important signal that this sub-prime mess cannot be easily dismissed as a niche problem that will have no contagious effects on the rest of the economy and of financial markets.

So let me explain in detail why there are meaningful risks that sub-prime meltdown could infect prime mortgages, why we could be at the beginning of a more serious credit crunch for consumers, and why there is a risk that the ABX carnage could spillover to other credit markets…