Are We Living in Subprime Denial?

A common refrain repeated by financial analysts, pundits, business writers and government officials is that the subprime problem is “contained,” and won’t impact the larger economy. The usual "party-line" is that subprime simply can't be a problem because only a minority percentage of all mortgages are subprime and since only a small percentage of those loans are even in default, the “problem” is contained to a small group and only impacts borrowers in a default and a small group of “bad lenders.”

It looks like a good argument on paper, but it only works if you ignore the following:

The U.S. has a larger “mortgage problem,” not just a subprime problem, which is something that many retail banks and mortgage lenders can attest to. In fact, there is even ample evidence that Alt-A, Prime HELOC and Prime ARMs could turn into a bigger problem than subprime. During the last round of quarterly reports many retail banks and mortgage lenders reported losses within their prime portfolios (HELOCs especially), alt-a lenders are experiencing the same problems the subprime lenders had in March, and 1 in 3 homeowners whose initial teaser rate on their ARMs was under 4% will probably go into foreclosure, a fact that crosses all types of borrowers.

The U.S. has a mortgage problem, not a subprime mortgage problem. The subprime borrowers simply got into trouble first, due to being less financial stable than the prime borrowers. Anyone who just talks about “subprime” is only discussing a piece of the puzzle, not the whole puzzle.

Mortgage loans in the U.S. are often financed by institutional investors the world over, who invest in mortgage backed debt securities. Foreign and domestic insurance companies, hedge funds, retail banks, commercial lenders, pension funds, university endowments, etc., all invest in mortgage backed securities and provide the liquidity that fuels the U.S. mortgage market. As the mortgage problem deepens it becomes difficult to sell mortgage securities, which results in less liquidity for the U.S. mortgage lending market, and creates a wide spread problem whose impact extends far beyond subprime borrowers, and lenders.

The mortgage problem with respect to the credit markets, is actually due to institutional investors in mortgage securities not only taking huge losses, but having used improperly valued debt securities as collateral for loans they then used for other investment activities. As a result, you have investors who not only have to deal with huge losses, but are faced with margin calls and liquidity problems as a result of their loan collateral decreasing in value.

As a result of the one-two punch of the above, hundreds (if not thousands) of institutional investors world-wide are dealing with losses due to their subprime investments and mortgage investments in general. When the banking sector of a G-8 nation (Germany) and a continent (Europe) are dealing with investment losses, credit downgrades, margin calls, etc., due to mortgage securities, it’s quite obvious that the problem goes way beyond mortgage lenders and borrowers in default.

Pension Funds and University Endowments have taken large losses due to subprime investments. Harvard lost $250 million dollars due to its investment in Sowood Capital Management, and the State of Massachusetts has lost approximately $80M so far this year. Now, these numbers are relatively small compared to Harvard’s $30 Billion endowment, and Massachusetts’ $50 billion pension fund, still, $250 million would put 1,300 people through four years of Harvard. Furthermore, if we consider the 10s of billions that university endowments and pension funds poured into hedge funds, which were then poured into mortgage debt securities, the losses that Harvard and Massachusetts suffered are probably just the tip of the iceberg.

The U.S. consumer used the proceeds from HELOCs, and real estate speculation, for example, in order to fuel consumer spending. Now that housing is slowing, retail spending has stagnated as well, meaning that the housing slowdown will impact consumer spending significantly.

The U.S. mortgage market, is part of a larger ecosystem of institutional investors who provide the liquidity that make the whole system work. Any pain felt by borrowers and lenders, is also felt by the investors, and that investor pain contributed to the creation of a credit crisis. The European central bank didn’t add liquidity to the European mortgage market because someone in Iowa defaulted on a subprime loan, they added liquidity to the market because European banks are taking huge losses due their investments in debt securities backed by U.S. mortgages.

So, when you hear foolish analysts, pundits, or commentators, say that the subprime problem is “contained,”understand that these people either don’t see the big picture, don’t want to see the big picture or only understand part of the ecosystem.

Comments

[Al Capital:]

I agree with almost everything you write in this post, except for the conclusions. My logic is very simple Markham. When the central banks opened the valves to allow credit to flow where needed, I assume that everyone who needed a loan had lined up for one. Why would anyone wait if they had a chance to meet short term obligations using central bank credit rather than through painful liquidation? So if that is true, then most of the liquidity shortage has already been revealed, its on the order of $400-500 billion, and been nearly satisfied. Again, if that is true, then the central banks have done a great job to avert a wild "fire-sale". For a little more discussion see:

mnrtrading.blogspot.co...

2007 Aug 14 01:05 AM

[Markham Lee_:]

I have to disagree with you because I think the situation is a big more complicated than that. We don't have a liquidity crisis because banks are turning people away and saying: "sorry, we don't have any money to lend you", instead the crisis comes from banks tightening up lending standards due to the sting of previous losses, the crisis comes from other lenders whose collateral has declined in value, having to pay higher rates and/or needing more liquidity to meet margin calls, investors being less willing to purchase risky bonds, etc, etc.

With respect to fire sales, if you're hedge fund, mortgage lender, etc with a liquidity crisis, the issue isn't how much money is floating around the money markets, it's whether you can find someone who is willing to take the risk and lend you more money. When you already owe one lender (or group of investors) money due to not having the collateral to back the loan, other lenders are going to be too keen on lending you money to meet your margin calls AND continue to operate, not without a "Tony Soprano" rate attached anyway. Increased liquidity in the money markets doesn't change that scenario.

If you're a mortgage lender, commercial bank, hedge fund, etc - who has a liquidity problem because the collateral you were using to borrow money with has severely declined in value, the issue is credit worthiness, not available liquidity.

If you're a private equity fund that is having trouble selling the bonds you intend to finance a buyout deal with, the issue is that the potential investors are unsure that they'll be paid back.

If you're a broker and the cost of a credit swap for your bonds increases, or your Bear Stearns and are selling bonds at "Junk" rates, than the lack of money market liquidity isn't the problem, your credit worthiness is.

Injected liquidity can calm fears, but it can't resolve the issue of investors and lenders pulling back liquidity due to fears about not being paid back.

Finally, the fed has pulled back most of the liquidity it injected into the markets, the BOJ has done something similar, pulling back 600 Billion Yen worth of liquidity.

The liquidity crisis cannot be quantified by measuring the amount of added cash the Fed put into the market. Instead, you'd have to quantify the amount by which investors and banks intend to pull back from the markets, either via lending, purchasing bonds, etc. You'd also have to be able to place a number on the amount that various debt securities have depreciated (something that hasn't been done yet) and the corresponding amount of liquidity that would be needed to meet the short-fall...and that's just to scratch the surface.

2007 Aug 14 01:33 AM