Subprime Mess Will Continue Impact on Other Markets

It's just the eye of the storm for the subprime market mess. Count on the crisis impacting many other areas of the market.

As Hurricane Dean ravaged the Caribbean and Mexico, the sub-prime hurricane continued to ravage our industry. Homeowners are defaulting, mortgage originators are failing, fixed-income markets are defibrillating, stocks are tanking, quant models aren't working, hedge funds are closing, investors are panicking and the only thing increasing is volatility.

So how will this play out? While I can't claim clairvoyance, this old dog has lived through a number of these market "challenges," and if the playbook is still valid, I may be able to provide a few insights.

The first play in the downturn playbook is "Stop the Bleeding." In other words, find the exposure and reduce it. This means cutting the money-losing operations, such as sub-prime/high-risk mortgage businesses (e.g., jumbo, no-verification and 100-percent-value loans). Brokers also will begin cutting their asset-backed origination, as well as paring back their high-yield and corporate loan businesses.

In addition, firms with significant losses will look to reduce market exposure. No one likes to lose money, especially shareholders. In times of significant turmoil, brokers reduce their proprietary trading, market making and Value at Risk.

This plays out in several ways: First, firms will need fewer proprietary traders. But more important, the volatility will make firms readjust (read: increase) their cost of capital, making capital provision more expensive. Second, increasing the cost of capital will allow brokers to increase their commission structures as the demand for human services increases and broker capital is reduced. This will be beneficial for agency brokers, which by definition had little exposure to the sub-prime debacle, had few losses to cover and don't extend capital. For these players, an increase in commission rates fills directly to the bottom line.

After the hemorrhaging is stopped, firms will reduce their market data expense. Before sacrificing people or projects, banks will rationalize their market data, as market data licenses are difficult to manage and track -- people move and change responsibilities, and market data licenses and management are slow to respond.

After data, firms will evaluate their initiatives. They will increase their threshold ROI and reexamine whether or not their full slate of initiatives makes sense. As firms abandon initiatives, they will realign project teams, with consultants being the first to go. Without a substantial market improvement, once consulting budgets are slashed, staff reductions follow.

Bad Timing

The timing of this storm is troublesome. The third quarter tends to be a budgeting quarter, and while this downturn will not significantly impact 2008's budgets, 2009's budgets will be significantly impacted. Even if markets return to normal by October '08, budgets will be finished and spending numbers finalized.

Besides the impact to financial institutions, downturns such as this impact private equity and stock valuations as well. Rising interest rates and fewer lenders impact private equity markets, as many of the larger deals are financed by debt. With the market avoiding even top- quality debt, financing for deals becomes tricky if not prohibitively expensive. Without the synthetic floor supporting stock prices for undervalued issues created by private equity, the undervalued will stay undervalued, if not drift further down.

So the bottom line is life is changing again. While the fixed-income side will be harder hit, the equity business will not remain unscathed. Expenses will be cut back, jobs will be lost, capital will become scarce, commissions will rise and stock values will fall. Internal initiatives will be reevaluated and directions modified.

The events of this summer will not be forgotten. It is not just the storm of volatility; it is the storm of change and the storm of retrenchment. Unfortunately, while Hurricane Dean has blown its way out of collective history, the impact of the sub-prime hurricane, like Hurricane Katrina, will haunt us for years to come.

Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio