Will distress in the sub-prime mortgage sector do great damage to the overall financial system?

Uber-cynic Prof. Nouriel Roubini has a blog post entitled "The Sub-Prime Lending and Borrowing Disaster..and the Broader Risks to the Financial System" in which he continues to argue that distress in sub-prime mortgage lending will soon lead to serious risks and distress in the financial system.

I am not convinced, nor persuaded by his "the sky is falling" arguments. So, in short, my answer to the headline question is simply: No.

I'm sure that some lenders will have significant difficulties or fail, but a larger-scale level of distress does not seem likely either now or in the near future. For one thing, as even Prof. Roubini's "evidence" shows, failing lenders are frequently either closed outright or sold at fire-sale prices. That reduces the overall risk or contagion from sub-prime lenders to the overall financial system.

Prof. Roubini "worries" that the GSEs (Government Sponsored Enterprises, Fannie Mae and Freddie Mac) are at great risk, but he grossly overstates that risk. He has a distinct penchant for referencing worst-case scenarios, but doesn't do a very good job of demonstrating how such scenarios could realistically occur, other than if everything experiences a worst case scenario. Unlike private-sector enterprises, the implicit government backing of Fannie Mae and Freddie Mac gives them the ability to exploit short-term market distress by borrowing at a discount and buying up precisely the distressed securities that weak-willed investors may be dumping.

Simple fact: Not all (100%) of sub-prime mortgages will fail. Even Prof. Roubini's own numbers suggest that defaults for sub-prime mortgages are quite modest in nature: "The problem is especially bad on mortgages originated with less-than-full documentation, which had a 60-day or more delinquency rate of 3.57%. The comparable delinquency rate on fully documented loans originated this year is 2.01%." At 3.57% or 5% or even 10% or even 20%, surely there is a market-clearing price at which Fannie Mae, Freddie Mac, or even investment banks and private investors such as Warren Buffett will find the remaining, more sound mortgages to be financially attractive. Prof. Roubini offers no clue that he understands the nature of a classic "fire sale" and the special ability of the GSEs to exploit such opportunities, if they should ever arise.

I'm not sure if he suffers simply from an inability to see reality and realistically judge risks, or if he has placed investment bets which he is seeking to enhance through the incitement of market volatility.

Simple fact: in a mere three weeks the year 2006 will be completely behind us, and as of even this late date there has been no significant sign of the dire consequences that Prof. Roubini "warned" would have occurred by now.

-- Jack Krupansky