Credit used to be as free as love in the 1960s. But the days of free credit ended about three weeks ago…and the days of expensive credit arrived. As credit becomes more expensive, asset prices will deflate. And that will not be very much fun for investors.

During this particular credit cycle, investors might suffer even more pain than usual. That's because there was nothing "usual" about this particular credit cycle. In fact, the world has never known anything like it.

In the modern financial system, the ability to create credit extends far beyond the reach of the traditional banking system. A labyrinth of credit contracts and derivatives provides sources of financing that never pass through the door of a traditional bank.

This labyrinth is known as "Securitization."

Every imaginable stream of future cash flow - from car and mortgage payments to the loans that fund private equity deals - can be "securitized" and sold to the highest bidder. Securitization is simply the process whereby a stream of future cash flow becomes pledged to a separate legal entity, which then divvies up the cash flow among different "tranches," or classes, of creditors.

Like everything in life, the securitization revolution has its positives and negatives. One negative consequence is that securitization creates a vast expanse between borrowers and lenders. The two sides never know each other…or care to know each other. But obviously, the further a lender is separated from a borrower, the more potential there is for fraud on the part of the borrower and underestimation of risk on the part of the lender. Very bad loans tend to be made when this is the case, as those who've dabbled in subprime mortgages are discovering. On one end of the lending chain are plenty of fraudulent "liars' loans" yet to default, and on the other are plenty of lenders who don't fully understand the risks they were taking.

Bill Gross, the most accomplished bond fund manager in the world, recently published his views on the subprime debacle. In his July Investment Outlook, Gross acknowledges that securitization and derivatives diversify risk and "direct it away from the banking system into the eventual hands of unknown buyers, but they multiply leverage like the Andromeda strain. When interest rates go up, the Petri dish turns from a benign experiment in financial engineering to a destructive virus because the cost of that leverage ultimately reduces the price of assets…

"The flaw, dear readers, lies in the homes that were financed with cheap and, in some cases, gratuitous money in 2004, 2005, and 2006," Gross concludes. "Because while the Bear [Stearns] hedge funds are now primarily history, those millions and millions of homes are not. They're not going anywhere…except for their mortgages, that is. Mortgage payments are going up, up, and up…and so are delinquencies and defaults. A recent research piece by Bank of America estimates that approximately $500 billion of adjustable-rate mortgages are scheduled to reset skyward in 2007 by an average of over 200 basis points. 2008 holds even more surprises, with nearly $700 billion ARMS subject to reset, nearly three-quarters of which are subprimes…"

The housing market will remain sluggish far longer than most expect. $800 billion of ARM resets can only add to the supply of distressed sellers in 2008. This will further depress an already sluggish housing market that's having enough trouble working through a huge supply overhang. To say the least, this scenario will weaken demand for securities backed by residential housing.

Until now, hedge funds have been creating a great deal of the miraculous "liquidity" sloshing around the globe. By buying the highly leveraged equity and mezzanine tranches of collateralized debt obligations (CDOs), the buyers provided the cash to make new loans and create new CDOs. Liquidity surged; share prices soared; everyone was happy…until homeowners began defaulting on their loans in record numbers. Suddenly, CDOs were not providing the returns the buyers expected. Instead, they were providing the large losses the buyers did not expect. Indigestion resulted.

Indigestion tends to suppress an appetite. That's where we are today - in the indigestion phase. Institutional investors' appetite for mortgage-backed securities is spoiling just as Wall Street tries to serve them heaps of new portions.

Get ready for the days of expensive credit.

Regards,

Dan Amoss
The Daily Reckoning

Dan Amoss, CFA, is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years. Dan brings to Strategic Investment the unique experience of an institutional background and a drive to seek out the most attractive investments within favored "big picture" trends. He develops investment ideas for SI readers with a global network of geopolitical and macroeconomic analysts. Copyright © 2007 Dan Amoss