Second Credit Crunch Set For 2008 When $512b in Subprime Loans Reset

“Every election is a sort of advance auction of stolen goods,” wrote H.L. Mencken, an American journalist during the early part of the 20th century. Politics, like prostitution and other vices, hasn’t changed much. If anything, the two have become virtually indistinguishable.

Get ready for six weeks of politicians making promises they can’t possibly keep.

Did you like the original credit crunch? It was an action-packed drama filled with plot twists and suspense. Ultimately, our hero Ben Bernanke saves the world with an audacious double-barrelled interest rate cut to save America’s Empire of Debt from certain financial ruin.

Well, if you liked the original, you’re going to love the sequel. Some US$512 billion in adjustable rate subprime mortgage loans will reset in the first six months of 2008. If the first relatively modest wave of resets was enough to destabilise the global credit market, what do you think the next wave will do?

Major American banks don’t know. But they aren’t taking any chances. The risk to the banks is that a leveraged fund manager facing credit stress will be forced to sell—and not just mortgage-backed securities for which there are very few buyers, but also blue chip stocks…one of the only things a fund manager CAN liquidate to raise cash.

The banks know that another blow-up threatens everyone. So they’ve established a kind of slush fund to bail out distressed players. It’s like a credit vomitorium where the excesses of the boom can be regurgitated in respectable privacy. “Several of the world’s biggest banks,” reports the New York Times, “are in talks to put up about US$75 billion in a backup fund that could be used to buy risky mortgage securities and other assets, a move designed to ease pressure on a crucial part of the credit markets that threatens the broader economy.”

The banks—Citigroup (NYSE:C), Bank of America (NYSE:BAC), and JP Morgan Chase —are putting their heads together at the request of the Federal Reserve. The Fed would rather not do a Bank of England-style Northern Rock, and be forced to lend billions directly to a distressed financial institution.

Besides, it was the lenders who created this mess anyway, extending credit to riskier borrowers and then securitising the loans and slapping a dubious trading value on them, given the credit risk.

The best thing for an economy in the long run is to take the losses. The Austrian school of economics would say that the misallocations of capital have to be liquidated. That’s simply another way of saying the credit crisis won’t well and truly be behind us until the banks have acknowledged their lending mistakes, taken their losses, and moved on. Trouble is, we can’t really move on until another US$1 trillion in ARMs re-set.

In the meantime, prepare for more volatility in bank and brokerage stocks…and in interest rates, bonds, and currency markets.

Dan Denning
The Daily Reckoning Australia

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