And now for the main event

Now that the sideshow of plummeting Chinese markets is all but forgotten its time to turn to the main event. Sub prime mortgage lenders are coming under increased pressure as creditors make calls and defaults increase. Here is a roundup of the latest:

New Century Financial Corp (NEW), whose shares have been suspended from trading, made an error of $500m in reporting their debt obligations. Whoops we actually owe $500m more than we thought - the level of incompetence is staggering. Add to that NEW has received notices of default and reservation of rights from Barclays, Guaranty Bank, Morgan Stanley, State Street Global Markets and UBS Real Estate Securities. Won't be long until New Century is filing for Chapter 11.

Accredited Home Lenders (LEND) plunged 65.6% after it said it's seeking more capital and exploring strategic options after paying about $190 million in margin calls since Jan. 1. Chapter 11 sounds like the most probable strategic option for LEND.

Countrywide Financial Corp. America's largest US mortgage lender, told its brokers on Friday to stop offering borrowers the option of a "no-money-down home loan". Wise decision to tighten lending controls however I fear the damage has already been done. Banks will no doubt see more missed payments and foreclosures in the coming months as consumers with weak credit histories begin to face higher monthly mortgage payments. As the Fed's top banking official Susan Bies said last friday

"This is not the end, this is the beginning".

Outside the strictly subprime arena General Electric Co's WMC Mortgage arm is sacking more than 450 staff members and also stopped lending home loans to borrowers who can't or don't make a deposit. WMC contributed 28% of GE Money's $US163.39 billion in revenue last year. Expect the 2007 year P&L to take a hit.

Bies also said that problems in the mortgage market are well-contained in a very narrow segment (the subprime sector.) An opinion echoed by the Treasury secretary Henry Paulson.

"If, as I think the case, the housing correction has bottomed, it shouldn't be a surprise to anyone if there is some fallout in the subprime mortgage market. I believe there are going to be dislocations. It is painful to some mortgage holders. It is going to be painful to some lenders, but it is largely contained."

What do these distinguished officals mean by contained and exactly how contained is it? In financial markets major events rarely happen in a vacuum - in fact such events are usually highly contagious. A report from the US Mortgage Bankers Association showed foreclosures are rising on loans to borrowers with the best credit ratings, as well as subprime borrowers. Overdue payments on all types of loans rose to 4.95% in 4Q06 from 4.67% in 3Q06 the highest since the second quarter of 2003.

This article contains implications for the Mortgage backed securites (MBS) market. The riskiest portion of MBS's is obviously the sub-prime portion. Enter collateralized debt obligations (CDO's) which have been the major buyer of the riskier end of MBS offerings and in doing so helped underpin the residential mortage boom of the last 3 years. It is estimated that 40% of the collateral of CDO's is residential MBS's of which 75% is sub-prime and home equity loans. The CDO market is estimated at $500 billion.

What does this all mean? If CDO's decide that the writing is on the wall for the residential mortgage market and exit for greener pastures liquidity in the MBS market will dry up making it difficult for mortgage originators to onsell their loans. Availability of home loans for subprime borrowers will dry up (already underway) leading to higher interest rates for borrowers with good credit.

People who had committed to buy homes from failed lenders such as New Century will now find it extremely diffficult, if not impossible to refinance. Those looking to refinance after the honeymoon rate on subprime mortgages is over will need to stump up cash they haven't got because the new lender will demand a deposit or need to find more equity in the home they are tyring to refinance - a tough call in an environment of falling house prices.

The Contrary Investor has been harping on for some time now about the extent to which US household consumption has been financed by dipping into rising home equity values. You don't have to be a genius to see what happens to this trend when house prices start to fall. Have we seen evidence of this already? US retail sales for February were up a lacklustre 0.1%, excluding gasoline and car sales they were down 0.3% - the lowest level since April 2004. A robust emplyment market seems to be about the only thing stopping the US falling head first into a recession.

While some of the above is hypothetical I find it difficult to buy into the containment argument just yet. Economic figures due out over the next few months will be very interesting. The volatility seen in financial markets in the last two weeks is set to continue - enjoy the ride.