underestimating the credit crunch?

I was thinking over the weekend about the subprime crisis. Why is it imploding now? And what does that mean for the overall economic picture?

Then I came across Susan Bies' comments about the coming wave of subprime defaults. The picture started to make sense to me. The subprime crisis really started in 2003 and we are just seeing the tip of the iceberg as asset prices come in. Its easy to loan people money to buy assets that keep rising in value, even if they have no income. But when they stop rising, the cracks show.

I believe that this is the beginning of the end of the liquidity glut that pushed risk spreads to historically low levels. We will probably see something of an overcorrection, which means that consumer debt will be harder to get for some time in the future. Mortgages and car loans have been fueling the consumer for some time. If we see rising risk premia for even marginal consumers it could have a severe impact on growth.

I doubt that a subprime implosion will have much of an impact on balance sheets, but I think this could put our expansion at some risk. We're already looking like we're in the latter part of the cycle. This credit crunch slowdown is probably what the inverted yield curve has been pricing in for the past 18 months.

A vigilant Fed could bring the consumer back with a couple of quick rate cuts. I think we'll need to show some more cracks before Bernanke can act. I am staying defensive here.