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'Sub-prime Chernobyl': So gold has to be hit hard

Section: Daily Dispatches

Massive Loan Revocations
Expected from U.S. Banks

By Ambrose Evans-Pritchard
The Telegraph, London
Tuesday, June 26, 2007

The United States faces a severe credit crunch as mounting losses on risky forms of debt catch up with the banks and force them to curb lending and call in existing loans, according to a report by Lombard Street Research.

The group said the fast-moving crisis at two Bear Stearns hedge funds had exposed the underlying rot in the US sub-prime mortgage market, and the vast nexus of collateralised debt obligations known as CDOs.

"Excess liquidity in the global system will be slashed," it said. "Banks' capital is about to be decimated, which will require calling in a swathe of loans. This is going to aggravate the US hard landing."

Charles Dumas, the group's global strategist, said the failed auction of assets seized from one of the Bear Stearns funds by Merrill Lynch had revealed the dark secret of the CDO debt market. The sale had to be called off after buyers took just $200 million of the $850 million mix.

"The banks were not prepared to bid over 85 percent of face value for CDOs rated A or better," he said.

"God knows how low the price would have dropped if they had kept on going. We hear buyers were lobbing bids at just 30 percent.

"We don't know what the value of this debt is because the investment banks shut down the market in a cover-up so that nobody would know. There is $750 billion of dubious paper out there in the form of CDOs held by banks that have a total capitalisation of $850 billion."

US property writer Paul Muolo described the Bear Stearns crisis as the "subprime Chernobyl," saying the bank had created a "cone of silence."

Abandoned by fellow banks, Bear Stearns has now put up $3.2 billion of its own money to rescue one of the funds, a quarter of its capital.

This is the biggest bailout since the Long-Term Capital Management crisis in 1998, which Bear Stearns refused to join at the time. Bear Stearns is now alone, a case of rough justice being served.

Lombard Street's warning comes as fresh data from the US National Association of Realtors shows that the glut of unsold homes reached a record of 8.9 months supply in May. Sales of existing homes slid to an annual rate of 5.99 million.

The median price fell for the 10th month in a row to $223,700, down almost 14 percent from its peak in April 2006. This is the steepest drop since the 1930s.

The Mortgage Lender Implode-Meter that tracks the US housing markets claims that 86 major lenders have gone bankrupt or shut their doors since the crash began.

The latest are Aegis Lending, Oak Street Mortgage, and The Mortgage Warehouse.

"There isn't a recovery about to happen," said Ara Hovanian, head of the building group Hovanian Enterprise.

Nouriel Roubini, economics professor at New York University, said there were now concerns about "systemic risk fallout" from the Bear Stearns debacle as investors look more closely at the real value of CDOs.

"These highly illiquid securities have been priced so far on unrealistic and distorted credit ratings as the ratings industry has been complicit," he said.

"They have not been rerated in a way that is consistent with rising subprime default rates," he said. "That is why Wall Street is in a panic. Losses will be massive once these assets are correctly priced to market."

Lombard Street said the Bear Stearns fiasco was the tip of the iceberg. The greatest risk lies in the "toxic tranches" of lower-grade securities held by the banks.

Much-trumpeted claims that banks had shifted off the riskiest credit exposure on to the asset markets was "largely a fiction," said Mr Dumas.

The worst of the US property crisis has yet to hit since there is an overhang of $2,000 billion of mortgages with adjustable rates that have yet to be reset. Many borrowers could see payments jump by half, or even double.

At the same time, a spike in 10-year US bond yields by 0.65 percentage points over the last six weeks has drastically repriced the cost of fixed mortgages, knocking away a key prop for the US housing market.

"With defaults at their highest in the 37 years that records have been kept, it could be a long hot summer," said Mr Dumas.

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