"Children's Party Games"

What has been happening in the U.S. mortgage market is reminiscent of 'musical chairs': At the beginning of the game, everyone is very happy and lively, high on jelly and ice cream. Everyone wants to play the game, and they are all confident of success. It is quite easy to begin with - lots of mortgage chairs to sit on, and so the pace is quite sedate. As the music stops for the first time, the daydreaming kid is outsmarted and drops out. Progressively a few chairs are taken away, then the remaining players think that the way to survive is to circulate faster, and stretch out to be near as many chairs as possible (not realising some might have rickety legs). Then another couple of seats are removed and things get yet more frantic. As the game reaches its crescendo, there are inevitably accusations of cheating (mortgage fraud), and a few fisticuffs (involving the lawyers). Furthermore, three of the heaviest juveniles land on the dodgy chair in unison, causing inevitable structural failure of that seat (cue unhappy parents - HSBC?).

Spring is not normally party season for credit, which is prone to underperformance at this time of year (see Credit Note C29 that we published in February). The credit markets are currently watching, and undecided as to whether the sub-prime trauma will be contained or spill over into the wider economy. So they are playing a different game - 'okey cokey': you put your spread in, you put your spread out, you shake it all about ...

At the same time, investors are playing a perverse form of 'pass the parcel' with the BBB tranche of CDO of RMBS. In this version of the game no-one wants to hang on to the package, instead everyone is busy offloading it onto the next in the chain.

The next game will be 'pin the (blame) tail on the donkey'. Blindfold on, do we pin it on the rapacious lenders, the gullible CDO investors, the shifty structurers, the comatose regulators, or, heaven forbid, the delusional borrowers?

Even without a full scale mortgage market meltdown, the seemingly inevitable consequences are tighter consumer lending standards, putting downward pressure on consumer spending. Our models suggest that even without this reining in of credit availability, U.S. retail sales are still headed south (even after this month's disappointing data).

The extent to which business investment can take up the slack is uncertain, but this too is likely to weaken in the second half in response to lower end customer demand. So, back to the party theme: the balloons are bursting and the adult in charge, Uncle Sam, will be singing a different tune - 'It's my party and I'll cry if I want to'.

Bond response - SELL lower rated credit, and buy government bonds in the expectation of lower U.S. economic growth and wider credit spreads.