It is now totally clear that there is a severe credit crunch in the subprime segment of the mortgage market. We have now over 30 subprime lenders out of business (the last one being New Century – the second largest subprime lender – that is now on the verge of bankruptcy); many more lenders are losing massively on their subprime operations; lending standard have been sharply tightened by lenders; regulators are starting to crack down after being asleep at the wheel; Congress is making noises about predatory lending; many near prime and prime mortgages had the same “monstrous” features as subprime ones; the current disruption of the CDO market is starting to affect the RMBS market . Thus, we have certainly a serious credit crunch in the subprime market that even mainstream analysts are recognizing. But, as I will argue below, we also have the beginning of a much broader credit crunch among many other mortgages that could have severe macroeconomic effects.

Regarding the credit crunch in the subprime market, let us start with what the Wall Street Journal reported in its lead article today:

"The last couple of weeks have been almost catastrophic," said Armand Cosenza, a mortgage broker in Cleveland. Mr. Cosenza said he turned down eight loan applicants on Wednesday because he couldn't get them a mortgage. At least five of them would have qualified for a loan six months ago, he said.George Hanzimanolis, a mortgage broker in Tannersville, Pa., says his office has turned away 30 to 40 people in the past week because of tighter lending standards. "It's scary how quickly these very large lenders are just...imploding," he says. "The situation will get uglier before it gets better."Many economists say that the subprime crunch won't cause big problems for the U.S. economy. But economists at Goldman Sachs in New York said in a report this week that the tightening of subprime credit could cut annual demand for new homes by 200,000 units, or about a fifth of new-home sales last year."This credit tightening potentially will create another leg down in housing," said Ivy Zelman, a Cleveland-based housing analyst for Credit Suisse Group.[bold added]

Words such as “catastrophic”, “imploding”, “scary” and such coming from market participants cited by the WSJ are worth pondering. One could of course provide more formal data and analytics to prove this serious credit crunch in the subprime segment of the mortgage market: many investment banks – GS, JPM, MS, Citi - are now doing that in their research this week; see also my recent paper with Christian Menegatti and my recent blogs.

But I would argue that the quotations above from the WSJ – as well as Mr. Tomnitz of DR Horton statement this week that housing will “suck” every month of calendar 2007 – should be sufficient to prove the existence of a serious credit crunch to any reasonable person who follows the simpler “smell test” or “duck test” or “obscenity test” (to paraphrase Justice Stewart definition) to prove an argument: “if it walks, quacks, ducks, looks and stinks like a rotten duck it is a rotten duck”. And subprime looks and stinks in every way and shape like a rotten duck.

Since the credit crunch in subprime is now finally not under question any more - as it was two months ago when most mainstream analysts were barely starting to become aware of the subprime “meltdown” or “carnage” - it is worth doing a little more numerical work and figure out how bad things could be if we end up in a generalized credit crunch (rather than a sub-prime credit crunch alone) or in an economy-wide recession, rather than just the current deep housing recession. It is also important to consider the likelihood of a generalized credit crunch. Thus, here are a few crucial question that are worth considering

First, are the growing distress, defaults and foreclosures only a problem among subprime mortgages or will they become soon a big problem among a wider range of mortgages?

Second, will the current subprime credit crunch become a generalized credit crunch that will hit a much large fraction of mortgage lenders and borrowers?

Third, what is the role of a possible disruption in the CDO market in transmitting the subprime carnage and credit crunch to a broader range of mortgage credit risks (see ABX and TABX) and to the overall RMBS market?  I.e. could the RMBS market end up in a seizure if the CDO market is disrupted?

The current mainstream “consensus” answers to these questions is as follows. First, the subprime carnage is a niche problem; other mortgages are not problematic in terms of actual or expected distress and default rates. Second, there may be a credit crunch in subprime but there is no evidence of a general credit crunch in most mortgages. Third, there may some losses among CDO investors, sellers of protection in the ABX market and other investors in a variety of housing products; but there is not much evidence of serious problems in mortgages related credit derivatives (excluding subprime) or in corporate credit risks.

But why should be believe the conventional wisdom when – since last summer – the consensus altogether missed the boat on every single developing problem in housing, mortgages and the economy? Note that: 

In early December no subprime lender had gone out of business; now over 30 have shut down operations (including today the second largest one) and many more have serious losses and/or are in trouble. A few concerned analysts – including yours truly – started to warn about serious subprime problems last summer when mainstream analysts were simply ignoring and denying the existence of any problem. 

In early December the ABX indices – even the BBB- ones – were priced near par value of 100; now they have collapsed and are fluctuating between the low 60s and 70 with massive daily volatility. While some warned about this problem early on, most analysts started to discover the existence of the ABX indices – and to write about it - only when they had plunged into a free fall. 

In early December, mainstream analysts were barely talking about “subprime problems” and arguing that such problems were minor; now – too late - they talk daily about subprime “carnage” and “meltdown” while arguing that this is only a niche “subprime” problem that will not affect any other mortgage.  

In early December the conventional wisdom was that the housing recession was close to “bottoming out” (and last summer the conventional wisdom even denied the existence of a housing “recession” hiding behind the “housing correction” spin). Now, after 14-16% plunges in housing starts and new home sales in January alone and after Mr. Tomnitz declared that housing will “suck” all of calendar 2007, few have the chutzpah to speak about a bottom of the housing market. 

Now, after all this mess the conventional wisdom - that was altogether wrong and missed the boat on the housing recession, on the subprime mess, on the ABX collapse, on the subprime credit crunch - is telling us today that subprime is a niche problem and that other mortgages are fine, that there is only a minor credit crunch in subprime that will have no effect on other mortgages, that there is no problem in the CDO and RMBS market, that the macro effects of the subprime disaster will be between tiny and non-existent, that the economy will have a happy soft landing.  Since the conventional wisdom completely missed the boat since the last summer on all the main developing disasters why should we believe it now that it has lost all credibility?  

Since last summer I argued against the conventional wisdom consensus; and now I do not find the new current optimistic consensus about the future any more convincing. But let me flesh out now in more detail why my answers to the three questions above are very different from consensus and why the risks ahead of a general credit crunch and of a seizure of the mortgage market are high...