RSSCredit Crunch Returns
The credit crunch has reappeared again and has already forced the Federal Reserve Board to make an emergency 0.75% cut in the federal funds rate. Other central banks will likely take similar action. This was done to keep credit available for normal business loans, including construction financing. This round of the financial crisis was set off by two inevitable events.
First, the obscure firms that provide bond insurance, a promise to make principal and interest payments on time in the event of default, are collapsing under the weight of massive defaults on collaterized debt obligations (CDOs), the bonds backed by subprime mortgages. ACA, a small bond insurer, has had it own credit rating belatedly reduced to junk bond status. The credit rating of two larger firms, Ambac and MBIA has been downgraded from AAA.
The consequence is that the credit ratings of the insured bonds have been similarly reduced. Some CDOs, bought as AAA rated, are now worthless. Others will have to be marked to a lower value, consistent with their now lower credit rating. This will require further capital write-offs, reducing the capital available for loans. Expect an immediate spike in the interest rate for jumbo residential and for commercial mortgages which both rely heavily on capital raised ion the CDO market.
Also, municipal bonds, many of which fund construction projects, are caught in this mess because issuers bough bond insurance from the same companies to enhance the credit rating of their bonds and lower their interest payments. The rating declines now underway for existing municipal bonds will reduce their value and hence raise the interest rate for new municipal bonds. At a minimum, this will cause a brief delay in issuing construction bonds and marginally raise the interest rate for construction bonds.
Second, the bloated stock market indexes in other countries have abruptly dropped 5-8% and will likely fall further. Partly this reflected belated recognition of subprime mortgager losses. Partly, this is due to the diminished prospects foreign suppliers now have for export sales to the weaker US economy.
In some developing countries, the amount of capital in public companies is very small and the stock indexes have more in common with the World Poker Tour than rational investing. What ever happens top these indexes will have little consequence for the US construction Market.
However, the sharp declines in major European and Asian indexes will produce parallel drops in US stock Indexes. Confidence will be depressed. Everyone’s pension fund will be reduced. And capital for construction loans will be more expensive and harder to get.
Quick action by central banks should contain this crisis. The format of the intervention will temporarily lower interest rates. But there will be cost. Postponing the recognition of subprime mortgage losses only stretches out the time required before lending returns to “normal” and economic growth can resume.
The good news is that the collapse of foreign stock market bubbles and the bond insurance firms will force investors to move more quickly to recognize their losses and repair their own credit ratings so that they can again make loan commitments, confident that they can draw on other capital sources as needed for the funds to cover the commitments.
