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
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
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
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
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
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
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:
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