Unless one is actually involved in the credit markets in an institutional way, one is unlikely to appreciate quite how much of the "L" thing, or leverage, is at work in the system. There seems to be a lack of appreciation on this point, particularly among those who inform or decide policy.
Recent characterizations of the credit markets as panicking "irrationally", or needing a "face-slap" moment to break the hold of a fearful mindset strike m* as uninformed about the dynamics of leverage. This is not a panic. To the contrary, the accelerating sell-offs in credit indicies and spreads reflect the most rational and serious behavior: de-leveraging.
Prior to last fall, institutional money was typically levered in loan markets at 10x, levered in asset-backed debt 20x, and brokerage firms doing the lending levered at 30x. By way of contrast, a typical equity hedge fund is levered only 2-3x. As holders of many no down payment to very low down payment sub-prime mortgages have found out, it takes only a hiccup in asset values to create negative equity (for a buy and hold investor) or technical insolvency (for a mark-to-market investor), whether one runs a loan fund, a mortgage fund, a brokerage house, or even a government chartered home mortgage lender (50x in case you were wondering).
Lulled into a false sense of security and extrapolating the trend, the Street gorged at the credit banquet. And it's Risk Management function, more a portfolio optimization scheme for maximizing profits at VaR-ious levels of statistical risk, proved its worth in last summer's quant meltdown - which is to say, not much.
In these conditions then, with asset values having more than hiccup'd, the need for cash and the resultant pressure on the prices of assets most held by the levered players is quite simple. Whether today's rumors of trouble at Bear Stearns "bear out" or not, the potential for a liquidity crisis at a well known name has never been higher. It is likely that this cycle sees major broker failures, or last ditch acquisitions of them on the brink (see BoA/Countrywide). Those who said the problem would be "contained" to the home mortgage sector may have been confused about how far that sector stretched - all the way to Wall Street.
