My Diary 362 --- Section (2) Sth is more than subprime

 

My Diary 362 --- Section (2) Sth is more than subprime, Everybody gets hurt, The Vampire story, The Cost of confidence

 

December 7, 2007

The real concern over recent credit crisis is not housing bubble burst, but more over consumer spending which is a multiple of Housing/Exports in the weighting of GDP. The key macroeconomic function of banks and government-backed mortgage agencies has been to serve as a highly effective engine for creating credit from base money to move the American US economy.

However, when subprime mortgage losses surfaced in February and again over the summer, everybody suffered write-downs on their balance sheets including banks, insurers, hedge funds, and even money market funds.  The “unexpected” consequence is it turns banks into Vampire……A scary story to begin with…..

Section (II) Credit and Liquidity Conditions

Sth is more than subprime

The subprime problems are clearly spreading to markets far beyond the subprime world. Looking back, it is clear now that a perfect economic environment has not only allowed the Wall Street rocket scientists in high finance to apply massive amounts of leverage on low quality, securitized mortgages, but also simultaneously prevented the system from being tested. Now, when the first signs of softening in housing prices surfaced, the markets learned that investors had taken on far more risk than anyone realized, and losses could not be contained.

A fundamental question now is should a recession expose weakness in credit fundamentals? To a large extent, the answer is YES. When the real economy no longer cooperates, the subprime music will be stopped in the markets, and financial institutions throughout the world are left holding the dirty bag. What we have seen is that --- as subprime mortgage pools created in 2006 and 2007 manifested high rates of early delinquency, the expectation of losses and subsequent rating agency downgrades triggered widespread sales. The consequent collapse in CDO valuations then threatened to provoke a forced unwind of leveraged structures whose stability depended on a mortgage payment experience that resembled those of the past…… In the investment world, a simple but easy-to-forget lesson is the past does not represent the future!

Interestingly, some extremely optimists still hold the view that, with current default rates around 1% and the lowest since 1981, a consumer recession or business slowdown so far are little more than the fairy of bearish economists. What I want to add some flavor here is that – there are a large amount of high-yield paper at low rates with weak covenants is already out in the marketplace and worth far less than their book values. In each year since 2004, more than 40% of all new debt held ratings below investment grade. More specifically, the proportion of new paper of such poor quality issued in each of the last four years far exceeded the proportion of such issuances in any year since the late 1980s…… When the cycle turns and defaults rise, the stage is set for the drama to unfold,

Everybody gets hurt

When subprime mortgage losses surfaced in February and again over the summer, the success of structured finance in dispersing risk was more than offset by the exceedingly high degree of risk taken across the globe. Not only did direct participants like subprime mortgage originators meet their demise, but also US I-banks, EU insurers, Chinese SOEs, hedge funds, and even money market funds suffered write-downs on their balance sheets.

Unfortunately, for today’s global financial system, the magnitude of credit risk is a multiple of that in subprime mortgages. Each sinking CDO and a commensurate leverage unwind could trigger a vicious cycle of financial losses. An[Quote] …”we simply don't know how the enormous growing role that credit derivative products play in the global financial architecture has altered the fundamental correlation assumptions upon which the entire world is built….. By that implication, the problems that might ensue could make the subprime mortgage problem look like a walk in the park. In addition, what I learned the most from the past 6 months is that -- risk is we don't know what will happen.

The Vampire story

Since the middle of the summer, the hungry for liquidity has turned European and US markets in to Vampires, particularly the inter-bank funding markets, while Asian markets remained liquid.  From the end of October, conditions have deteriorated rapidly with the spread between LIBOR and benchmark policy rates widening and swap spreads rising across the curve to new all-time highs, both signs of the return of interbank lending concerns. Meanwhile, there has been a flight to quality as government bond markets have rallied strongly and credit spreads have widened, especially for financial institutions.

The root cause was the huge losses in sub-prime, and other structured credit-related, instruments. Even though sub-prime had been known for some time to be a potential problem, it had not been foreseen, by the market as a whole that the housing market and the related mortgage-backed securities would deteriorate so far, so quickly.  This week we’ve seen the FT on November 28 report that the estimates around lossesaused by subprime may rise to as high as US$700 billion from US$200-$500 billion. Where all those losses actually reside is still unknown. The increase in losses is a reflection of higher charge-offs in credit card and auto loans. This is even before taking into account the potential for corporate losses given the view from the rating agencies of rising default rates going into 2008.  That uncertainty led to a collapse in confidence in inter-bank counterparties and the funding markets seized up, despite central banks providing liquidity and the Fed cutting rates.

The second cause is the return of fears over further losses at financial institutions. Despite some huge write-offs there still seems more to come, especially considering the huge rise in Level-3 assets on the balance sheets of the US banks in particular. FAS157 rules introduced on 17 November will make it much harder for banks to put unrealistic prices on these assets going forward. As we discussed in the section (1), the key question is how much that will constrain banks’ ability to lend. It will ultimately depend on how much the write offs will eat into banks’ equity capital, the possibilities of ‘deep pockets’ investors being able and allowed to inject capital into these banks and the response of regulators. Abu Dhabi Investment Authority’s capital injection of US$7.5bn into Citibank to raise its Tier 1 capital level shows how liquidity can be crucial in the cleaning up of banks’ balance sheets.

The Cost of confidence

The Ahu Dhabi deal reflects the cost for the market to restore some confidence. In addition, there was a Fed vice chairman suggesting that there may be a rate cut in December. A theme we have remained fixated on for some time now is that liquidity has become very precious in current market conditions. Interestingly, both actions were more than sufficient to overcome the stream of negative economic data that continues to hit the headlines and other “ironic” scenarios that both Lawrence Summers and Bill Gross painted for the economy and financial markets in the Financial Times on November 27 and 28, respectively.

What really caught my eyeballs is that although Asian liquidity conditions remain relatively good, reflecting the massive balance of payments surpluses and the robust economic and financial markets situation, some markets (HK, Korean) are now starting to see a shortage of US Dollar and illiquidity and distortions arising. Today, in the most liquid Hong Kong market, 3M EF Bill is trading at -0.05% for primary tendering price. Thus, the danger for markets now is that going into year-end these liquidity conditions could deteriorate further leading to severe market volatility.

Good night, my dear friends!