The Popping Credit Market and You

Early reports on Friday highlighted the fact that both the European Central Bank and the U.S. Federal Reserve are pumping money into their banking systems to help ease the pain in the credit market. This follows the 2.8% drop in the Dow on Thursday, which stemmed from reports of French bank BNP Paribas freezing redemptions in a few of its investment funds and Goldman Sachs (NYSE: GS  ) taking uncomfortable losses at some of its hedge funds.

While it's obvious that these problems -- which stem from subprime mortgage loans -- are not going to be as contained as was first thought, the full spread of the financial infection remains to be seen.

So ... what exactly are we talking about here?
The loan problems that mortgage lenders face are fairly straightforward. Not only did demand start to dry up as lending standards tightened and the housing market cooled, but the loans that they held on their balance sheets started to deteriorate faster than expected. But now the problems are spreading through channels that are slightly more complex.

One way that subprime exposure has leaked out into the broader market is through the securitization of mortgage loans. In a securitization, a lender like Countrywide (NYSE: CFC  ) will take a whole mess of mortgage loans, create a separate entity to hold those loans, and then have that entity issue securities to investors based on the cash flow expected from the loans. Securitizations can be structured so that there are multiple classes of securities, the top rung of which would appeal to even the most conservative investors.

The securities resulting from securitizations, which are typically referred to as asset backed securities (ABS), can then be bought and sold in the open market. Taking it a step further, all kinds of derivative and synthetic instruments based on the performance and price of these securities can be created and then traded.

As loan defaults continue to exceed what was originally expected, the market is reevaluating what the billions of dollars worth of securities based on these loans are worth.

The pain train at hedge fund station
The big headlines right now are coming from hedge funds. Bear Stearns (NYSE: BSC  ) sent two funds into bankruptcy, and even Goldman Sachs has some funds that have reportedly been doing pretty poorly lately.

The reason the losses have shown up so quickly and drastically for the hedge funds is because many of them took very risky bets in the mortgage market and then highly leveraged their positions. Though the leverage would have translated into bigger gains if they were right, it greatly exacerbated the effects of being wrong. Compounding the situation is the illiquidity of some of the instruments that these funds have taken on. Unlike trading the common stock of, say, Microsoft (Nasdaq: MSFT  ) , in times of volatility it can be very difficult to unload a basket of highly structured derivatives. If you don't believe me, just ask Amaranth.

As partial or full liquidation continues at some hedge funds, it will undoubtedly send ripples that will jostle or even capsize others. However, this doesn't mean that there won't be success stories. Funds on the right side of the issue stand to make a killing, while other funds may be able to step in and buy cheap as everyone else sells.

Next stop ...
The problem wasn't contained to subprime lenders, and it isn't likely to be contained after seeping out to hedge funds either.

The structured products that have spread around exposure to various types of loans have assured that there will be a wide variety of investors feeling effects from the turmoil. Insurers like AIG (NYSE: AIG  ) , for example, hold huge portfolios of fixed-income securities that include many flavors of ABSs.

Still, more conservative investors, such as insurers, will experience much milder symptoms, since they are typically invested in the more senior trenches of the structured debt. Plus, because they don't have highly leveraged holdings or investors calling for redemptions, they won't be under the gun to sell into a troubled market.

Less demand for new structured debt products will affect the investment banks, as will the decline in M&A activity due to the tough market for raising debt for deals. Companies that provide goods and services to the affected industries could take a further hit, as could various consumer goods companies if declining housing prices persuade families to padlock their wallets.

So it's time to sell, right?
Hardly! As a Foolish investor, you're hopefully invested for the long term in high-quality companies that are well run and produce value for their customers and investors alike.

Now and the coming months may be a great time to break out that wish list of yours and start watching for deals. Think Mastercard (NYSE: MA  ) was too expensive? It's down more than 20% from its mid-July peak -- and there's always the chance it could fall further. Even a company right in the crosshairs of the declining housing market like Inside Value recommendation USG (NYSE: USG  ) could be an interesting long-term buy, since it's taken a tumble from its high for the year.

Your best bet right now is to have the long-term picture in mind, keep a sober head on your shoulders, and be on the lookout for bargains.

More financial Foolishness:

Microsoft, Mastercard, and USG are Inside Value recommendations. Take a free 30-day trial and follow all of the newsletter's recommendations.

Fool contributor Matt Koppenheffer owns shares of USG, but does not own shares of any of the other companies mentioned. The Fool has a disclosure policy.


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