"Are we always destined to repeat history?"

The current market focus on sub-prime U.S. mortgages is warranted given the extent of the bad lending practices undertaken last year. But is it just another blip in the liquidity induced risk rally or something more serious?

Unless this current shock is big enough to cause a serious decline in economic growth then Goldilocks reigns supreme and investors can stick to their risk taking. Previous scares in the credit markets can be dismissed as one-off events (2005 GM/Ford downgrades, 2006 inflation scare) but things that ultimately cause a recession are the ones to worry about. A quick comparison with the savings and loans (S&L) crisis may be useful in determining the extent of the fallout.

The S&L episode lasted throughout the 1980's. It started in the late 1970's with the Fed raising rates aggressively to fight inflation, and then again from 1986 to 1989. The S&L problems spilled over into the broader economy in the latter quarter of the 1980's and were resolved by the creation of Resolution Trust in 1989. This was not before the problem had added to the chance of a recession in 1990/91.

There are some clear similarities between the current sub-prime meltdown and the previous S&L crisis, which are worth a mention;

S&L - Many were technically insolvent before they ran into real difficulties, as they had to raise rates to attract deposits (as Volker fought inflation) but were limited on the level of rates they were allowed to charge. The Fed's tight monetary policy eventually caused the 1990/91 recession.

Today - CPI inflation is not a concern but one could argue the high level of asset price inflation is. The Fed has not had to respond as aggressively as the Volker Fed, but the inverted curve suggests that for certain parts of the economy monetary policy is tight. 36 originators have gone out of business so far or closed their doors to sub-prime lending. Although this is a drop in the ocean some of them were the biggest players in the sub-prime mortgage market last year (New Century No. 3).

S&L - Through deregulation designed to help them get out of insolvency difficulty; they sold off their loans at discounts and invested the proceeds in risky assets (junk bonds etc). Deregulation also gave them many of the capabilities of banks (without the proper controls and expertise) - issuing credit cards, making commercial loans etc.

Today - No-docs, high loan to value, silent second mortgages, interest only mortgages, teaser rates and sub-prime representing 20% of originations etc. The 2006 origination year will enter textbooks as a good example of how not to run a mortgage industry. 2006 sub-prime originations posted an alarming 94% loan to value on an average price of nearly US$200,000. That being said so far the negative effects on lenders are only apparent in one section of the lending markets. Once 'Alt-A' delinquencies start to rise rapidly then it is clear the problems are going to be felt more broadly.

S&L - The ultimate cost of the crisis is estimated to have totalled around US$150 billion (with US$125 billion coming from the U.S. government). The concomitant slowdown in the finance industry and the real estate market may have been a contributing cause of the 1990-91 recession. Job-losses are the key.

Today - Alt-A has expanded from 5% of originations in 2002 to 20% in 2006. Sub-prime lending has also risen to 20% of originations in 2006.

S&L - was once described as, "The largest and costliest venture in public misfeasance, malfeasance and larceny of all time" (until Enron anyway).

Today - In the scramble for market share in 2006 there are bound to have been some sharp practices; we will only find out later, as most fraud is uncovered once a bubble has burst.

S&L - Swap spreads and high yields spreads widened. It could be argued that it was more to do with the economic slowdown than the S&L crisis, but it was not a good time for credit. U.S. treasury yields peaked in Sep 1987 at +9.60 and then fell (initially helped by a "wobble" in the stock markets) by 290 bases points through to Dec 1991.

There are many similarities - tight monetary policy leading to a weak housing market, which leads to a collapse in a market exposed by bad lending practices, which then spreads to areas of high leverage. As we've already said, previous scares in the credit markets can be dismissed as one-off events, but it's those that lead to recession that are the ones to worry about. Another lesson from the last serious housing market decline is that it takes many years to filter through and to be resolved. If the current concerns are isolated to one section of the lending market (sub-prime) and one origination year (2006) then Goldilocks is back on. If it spreads further to the Alt-A market then it is bound to affect the economy.

Higher equity market volatility will continue to create volatility in credit spreads but until the U.S. economy slips into recession this current period of uncertainty could look just like all the others.

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