The fat lady isn’t singing yet, believes finance professor Michael Ehrlich at NJIT’s School of Management. Based on academic research and Ehrlich’s experience working at Bear Stearns and Salomon Brothers, he predicts more financial distress and a new crisis in the municipal bond market.
According to Ehrlich, the sub-prime mortgage crisis is in the open-the financial firms have recognized most losses related to collateralized debt obligations (CDO). In addition, the structured investment vehicle (SIV) crisis has climaxed and there will soon be no SIVs remaining. Plus, the much maligned Master-Liquidity Enhanced Conduit (M-LEC) has finally been put to rest.
Yet despite all those efforts, there’s been spillover to the economy creating a credit crunch, shrinking the economy and more. Credit card debt, which has spiked in recent months, will begin representing new losses for financial firms. American Express has already increased reserves for credit card losses, based on its 2008 outlook. Others may follow.
The worst surprise for most investors is likely to be the municipal bond market. Unfortunately several muni bond insurance companies such as MBIA, Ambac, and FGIC were active participants in the CDO market and insured previously AAA CDO securities that are now in trouble. Losses could exceed their capital levels. Even more significantly, over one trillion dollars of municipal bonds could lose prized AAA ratings.
Ehrlich advises individual long-term investors to review their municipal bond holdings, verifying that they don’t hold bonds insured by troubled insurance companies. Many tax-exempt money market and municipal bond funds have purchased insured municipal bonds. "Individuals and funds that wanted liquidity and solid credits bought the AAA-rated insured securities,” said Ehrlich. “Now they may not know what they own. Some AAA insured bonds are already trading below regular AA rated muni’s and they haven’t been downgraded yet.”
Before joining NJIT, Ehrlich was a government arbitrage trader at Salomon Brothers and senior managing director for fixed income emerging markets at Bear Stearns. He received his bachelor's degree from Yale University and PhD from Princeton University.
Contact: Michael Ehrlich, professor, NJIT’s School of Management, Ehrlich@adm.njit.edu 973-596-5305 (office) or 516-330-5810 (cell).