My evaluation of the subprime mess starts with the premise of the Chaos Theory, which relates to the interconnectedness of everything. That interconnectedness is illustrated by a famous analogy, that of a butterfly flapping its wings in Florida ultimately causing a typhoon in China.
I am not sure if a local US problem caused by ôbutterflyö lending standards will blossom into a full blown financial typhoon, but there is enough evidence for us to be attentive.
I tend to think that the problem began at the beginning of this decade, maybe as a partial consequence of the 9/11 debacle. LetÆs replay the tapes.
In the year 2000, the dot.com meltdown got underway, and billions of dollars went down the proverbial sewer pipe. A lot of people worried that the meltdown could spread to the general economy: after all, the money had to come from somewhere, and now it was not going back.
The overnight millionaires were now just another group of unemployed, over-extended consumers. The banks and investment banks funding dot.coms were now stuck with rafts of duff loans and worthless investments.
The fed funds rate hit 6.75% in mid/late 2000, and then the Federal Reserve began to cut rates, in an attempt to ensure that the dot.com bust did not shove the US economy over a cliff. Then came 9/11, and again, rate cuts became the order of the land, to provide cheap fuel to keep the economy going. More and more rate cuts followed.
The effect of the rate cuts was unbelievably cheap money. Everybody could borrow and everybody did, which resulted in an incredible asset bubble. I don't think there has been a single asset class which hasnÆt exploded in value: stock markets, commodities, real estate, cars, paintings, antiques...you name it, it went up in price.
IÆve been a credit officer long enough to know that bubbles eventually burst. It is hard to predict when, but they cannot defy gravity forever.
The subprime business was a natural outgrowth of extremely cheap money and non-existent credit discipline. Say you donÆt have a job, you donÆt have assets, and you have no income. You could still apply for a mortgage and have banks tripping over themselves to make you a cheap loan to buy real estate. After all, you had no intention to live in the property; you intended to do what all of your friends were doing: flip the property in a few months or a year, make a gain, and then do it again.
You have probably heard about the I/O or interest-only loans (no principle amortisation for several years; you only paid interest in that period); or about the 2/28 mortgages with extremely low interest rates for the first two years, and then ônormalö interest rates for 28 years. Think ætime bombÆ, because the guys who got these loans canÆt pay normal interest rates.
Then there were specialty ARMs, adjustable-rate mortgages, which are very low-interest rate mortgages where the difference between the real interest and what you actually pay is added to principal û in effect accreting loans! Finally, the Alt-A loans, and here you just donÆt disclose much about your finances or payment history. These describe just how insane the banking industry became.
Part of the reason that the banking industry became so insane is because there was so much liquidity around and asset prices were streaking skyward. As long as asset prices keep going up, no credit decision is a bad decision, right?
So what did the banks do with all of these poor yielding and shoddily underwritten loans? The banks sold off the mortgages to the investment banks, which pooled the mortgages, chopped them up, and sold these ôsausageö securities to investors everywhere û spreading the risk, so to speak. So, why do you need to exercise credit discipline if these loans are not going to be on your balance sheet?
It is clear that little credit discipline was exercised in creating the loans. As long as the investment banks would buy, pool, and distribute the sausage assets, the originator banks had no reason to be careful. Just create the loans and pocket the origination fees, then do it all over again, as fast as you possibly can.
The investment banks didnÆt want these things to sit on their balance sheets either, so they ground up the loans, added a bit of spice, and sold them to suckers, aka, investors. But, they didnÆt limit this to residential real estate. They ôsausagedö commercial mortgages, LBOs and other debt and receivables.
So, who would buy instruments that almost no one has the ability to understand or value? Simple, buy a cheap ticket to æHedgiestanÆ, where buyers were eager for yield and any new security was welcome. Little inducement was required to get the hedge funds gorging themselves on the newly pumped out sausages.
But, wait, traditional buyers with loads of cash were competing with Hedgiestan for the right to poison themselves. These included pension funds, municipal authorities, the newly rich Chinese investors, government bodies, and, of course, the Asian banks which have always been ready consumers of toxic waste. Taiwanese and Singaporean banks have already discovered a curious red leak in their corporate boat...Korean banks, a renowned bastion of appetite for poorly underwritten, poorly understood transactions, have yet to admit that they have swallowed hook, line and sinker. But stay tuned!
Back to the tapes. The new head of the Fed started increasing interest rates, alarmed at rising inflation. Oil prices are way up and heading higher. AmericaÆs wars in Iraq and Afghanistan are debt-funded, thanks to central banks in China, Japan and other countries buying tons of US Treasury bonds. As long as the dollar continues to depreciate, there is a risk that these investors could stop buying. The yen carry trade has also injected liquidity into the US economy, but is vulnerable to rising interest rates in Japan.
If the yen appreciates against the dollar, the carry trade will be rapidly unwound. I say rapidly, because the guy who delays will be mauled at the exit. Only the first guys through the door will escape massive injury.
Already, liquidity in the credit markets has dried up. Banks have suddenly found ôcredit disciplineö, so-called covenant-lite loans are a thing of the past and borrowers are being required to submit to a lot more credit scrutiny. Nice idea, but it is seldom useful to secure the barn door once the horses are out.
The big banks, unfortunately, are stuck with some $300 billion in LBO commitments which they were planning to sell off. Now there is no market for these assets, but the commitments still have to be funded. Why do you think the European Central Bank and the Fed flooded the markets with liquidity late last week?
The carnage, in my estimation, has just begun. When there is no market, how do you price a CDO? Whatever the CDOs were worth yesterday, they are worth a lot less today. That is for certain. The rating agencies have just started to downgrade the CDOs, and the pace of the downgrades will certainly pick up. As the CDOs are downgraded, the banks will have to keep a lot more capital against them. Those guys holding the triple-A rated bits have only been keeping $0.56 of capital again a $100 position. When those are downgraded to double-B minus, theyÆll need $52 of capital for a $100 position. There is something just shy of $2 trillion in CDOs out there.
Hedgiestan will be crushed. One of my friends says that a year from now, Hedgiestan will look like the Baghdad Mortuary. As you know, Bear Stearns had to close down three of its hedge funds; BNP took action last Friday. More is expected, and we know a number of the hedgies are in trouble û big trouble, there-is-no-more-tomorrow kind of trouble!
As the stock markets tumble, the margin calls multiply. One analyst estimates that a 10% drop in the equity markets will cause the average hedge fund to take a 50% scalping. ThatÆs enough to put most hedge funds down for good. Be thinking marble slabs and embalming fluids.
For many, it is already too late. So far, at least 80 mortgage lenders have been shuttered, including the 10th biggest mortgage lender in the USA, American Home Mortgage. American Home MortgageÆs problems were not just subprime mortgages. Its failure indicates to me that the contagion has spread beyond the subprime market.
In summary, then, is the subprime debacle the financial butterfly stirring the air that will eventually lead to a financial typhoon? The size of the asset bubble has become immense. The FedÆs ability to control the problem is compromised. Discipline among lenders has been idiotic for far too long. Global credit markets are frozen, while certain asset classes like CDOs are in freefall. The equity markets are correcting and hedge funds, even those run by ôsmart moneyö houses, are treading water to stay afloat. And credit tightness will only grow as the banks are forced to keep more capital against impaired assets for which there is no market. A credit correction is way past due.
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