New foreclosures on US houses at record highs. Late payments for the sub-prime loans reach the highest level in four years. New Century Financial one of the largest sub-prime finance companies in US and the self-proclaimed “new shade of a blue chip” delisted from the New York Stock Exchange as it teeters on the verge of bankruptcy. Suddenly the crisis in the sub-prime loan market has become the biggest story in the world quickly moving from the financial sections of the Wall Street Journal and New York Times to command the top heading on the nightly news.

Since the start of the year more than 30 sub prime lenders have been forced out of business, while large commercial banks such as HSBC have taken a write down of more than $10 billion on their sub-prime portfolio. The situation has become so dire that Angelo Mozilo Chief Executive of Countrywide Financial, the nation’s largest independent mortgage lender, stated yesterday in a CNBC interview, “This is now becoming a liquidity crisis," and "it's going to get uglier." Meanwhile Washington Mutual, the nation's largest savings and loan, told analysts that its sub prime loan portfolio was performing "exceedingly poorly" and would be a drag on its earnings.

The collapse of the sub-prime market is already creating a slowdown in US consumption. Yesterday’s US Retail Sales ex-autos printed at a much weaker then expected -0.1% loss versus forecasts of 0.3% gain. Spending on housing related sectors such as furniture and building materials dropped -1.7% and -1.4% respectively from the month prior.

A Political Problem
If the rate of defaults and delinquencies in the sub-prime loan market continues to escalate as the year progresses, the story will take on political as well as economic ramifications. Faced with the prospect of more than 2 million new foreclosures this year, US politicians are already scrambling to assert control over the situation. Senate Banking Committee Chairman Christopher Dodd, a Democrat from Connecticut said today, "The impact of losing 2.2 million homes I suspect will be in a lot of areas of our cities and towns that are already pretty hard hit, so we clearly want to look at that and legislate,"

A political solution to the crisis in the sub-prime market will likely affect all financial assets but could impact the currency market particularly hard. The only practical solution to stave off further defaults on these loans is to minimize the borrowers debt service costs by lowering interest rates . Over the past decade housing prices in US coastal areas such as California have doubled from approximately 300K in 2000 to peak values of 700K before tapering off a bit to 600K presently. Incomes over the same time barely increased resulting is a massive gap between cost of housing and affordability which was bridged only through the use of Adjustable Rate Mortgages. As $2.5 Trillion of these ARMs have been repriced at higher rates over the past several years, sub-prime borrowers were suddenly faced with monthly payments that were double and in some cases triple of their original cost. Little wonder then that the cycle has turned so violently bearish as new home owners struggle to service these increases.

Will Foreign Capital Leave?
A concerted effort by the Federal government to guarantee the sub-prime credit risk, much like the S&L bailout of the 1990’s, along with the lowering of interest rates by Fed may prevent the massive defaults in the US housing sector, but at a possible cost to the US dollar. After depreciating significantly against the European currencies at the end of 2006, the greenback has essentially tread water for Q1 of 2007 supported in large part by its hefty yield which has attracted massive carry trade flows to the currency. Yet if the sub-prime housing disaster were to force an emergency easing by US monetary authorities, the country will likely see capital outflow and the dollar could decline to new lows against its G-4 counterparts.

Last months woefully low TICS number (which printed at $15 Billion versus $70 Billion projected) may have been an early sign of foreigners’ reluctance to invest into any additional US financial assets. Up to now the market has treated the news as a one-off event, but if this Thursday’s TICS data once again shows very poor capital inflows, all of the fears regarding the structural viability of US finances could return to the market. In light of the collapsing sub-prime market, these concerns could quickly morph into a massive liquidation of dollar longs.

Containing the Crisis
Finally, next week’s Building Permits and Existing House Sales data will be critical in assessing the gravity of the sub-prime situation. "It's true that [US] foreclosures could have a negative impact on the housing market if they continue to increase at this rate," said James Saccacio, CEO of RealtyTrac, recently. "In some of the more problematic local markets they already may be contributing to slowing home price appreciation and a glut of homes for sale. However, most local markets have been able to re-absorb foreclosure homes without seeing any major damage to the local economy."

As long as Mr. Saccacio’s observation holds true, the collapse of America's sub-prime lenders may indeed be contained, leaving the greenback relatively unscathed. However, if like the Asian contagion of 1997 this latest financial problem begins to spread to other sectors of the economy, FX traders should be forewarned. The relatively tranquil currency markets could become as volatile as the today’s global equity markets.

Richard Lee is a Currency Strategist at FXCM.