The Subprime Crisis Part II- Recent Events

 This article is a follow up on a previous article titled as “The Subprime Meltdown – An Explanation” Where I described how the subprime problems were created, starting with the lack of due diligence in issuing mortgage loans to how investment banks structured products without taking into account the risks associated with the subprime backed loans as collateral. The article discusses recent events in the media that have been affected by the subprime problem including the housing, economy, credit, stock and foreign exchange market.
It is difficult to tell the exact time when the crisis began but we do know that the main US benchmarks hit their highest point on July 19^th  2007 until they plummeted by around 6.4% compared to the Aug 22^nd 2007 level. In fact between July 19^th to August 22^nd 2007 the CBOE Volatility Index futures rose from a price of $15 a contract to $23. The stock market was predicted to fall for nearly a year, however the market carried on trading it upwards as no one knew the timing of the correction. 

Housing Market

The stock markets downward ride is mainly due to the problems we have with the housing market which is further sinking into the gloom. The problems with the housing market began with the subprime mortgage crisis. For a full explanation of the subprime crisis, see my article “The Subprime Meltdown – An Explanation”. To summarize the article, mortgage brokers used to lend money to subprime borrowers at very high rates of interest without assessing the solvency of the borrower. These mortgage loans were then sold to wholesale mortgage buyers which then soldl them to investment banks who repackage and restructured them into mortgage backed bonds and collateralized debt obligations. The crisis is a combination of subprime borrowers defaulting on loans that then have to reposes their houses, dragging down the overall housing market as well as many of these structured securitized products suffering due to the many defaults in mortgages. Many hedge funds such as Goldman Sachs and two subsidiaries of JP Morgan, which have exposure to these structured products have suffered as a result. 

An article on August 22^nd by USA Today notes that the number of foreclosure filings has jumped over 90% from July 2006 and rose 9% from June. The total number of foreclosure filings in July 2007 was just less than 180,000. This is in contrast to 92,845 fillings in July of 2006. In June 2007 there were over 164’000 filings. This is approximately 1 filing for every 690 households.  

Housing is expected to be the hardest hit sector in the economy this year. New home construction data for July 2007 is at the lowest level in a decade. The price drop in houses is the worst it has been in 16 years. Inventory of unsold homes has been the highest since the National Association of Realtors stated counting them in 1999.

Even expensive houses at the high end market dropped for two reasons. 1. Market psychology created a contagion effect which makes homebuyers generally be pessimistic about the real estate market. 2. Jumbo mortgage rates (mortgages for loans exceeding $417’000) have jumped. The difference between a jumbo rate and a regular mortgage rate has increased another 0.5%. Prior to the change jumbo rates where 0.25% above regular mortgages now they are 0.75% above regular rates. 

In fact when looking at a chart which compares the S&P 500 Index to the S&P 500 Homebuilders Index and the S&P 500 Real Estate Management Index, the S&P 500 has gained 2.7% this year compared to a 10% loss in the Real Estate Management Index and a 40% loss in the S&P 500 Homebuilders Index. If comparing the group ranked returns of the S&P500 for the past month, the Management Index was the worst hit component where it dropped by 22%. The Homebuilding index was the 4^th worst sector this month dropping 17%.

Despite all the worries about the subprime markets, hedge funds and private equity firms like WL Ross who specialize in distressed debt are planning on acquiring subprime loans as they consider the drop in subprime rates as potential bargains. They maintain that there shouldn’t be anything wrong with lending subprime, unless one lends irresponsibly without due diligence. Carlyle Group lent a $100 mil loan to a fund they floated a few month ago. The fund had troubles with margin calls on AAA rated mortgage backed bonds.

Effect on the Credit Industry

The panic created by the subprime crisis created two problems in the credit industry.

1. Consumers are not willing to buy homes. This is because the market for houses is dropping and consumers do not want to loose value on their purchase.
2. Lenders are obligated to improve their due diligence which means that many homebuyers who were previously eligible are not anymore. Furthermore with all the defaults on mortgage backed bonds, investors are not willing to take the risk of purchasing securities which are exposed to mortgages.

These two factors have dried up credit in the economy. Demand for subprime loans have especially gone down in the past 3 months. A survey was done of 16 banks including Countrywide Financial Corp and Washington Mutual. They all reported that demand for mortgages have dropped compared to three month ago. Investors are even fearful to supply credit to sound companies. On August 16^th Countrywide had liquidity issues and had to resort to borrowing $11.5 bill to be able to make loans. This news scared investors even further who saw a number of mortgage lending companies facing bankruptcy.

Novastar Financial Inc the subprime mortgage lender cut its staff by about 37%, costing 500 jobs. They shut down their wholesale lending operation in California and Ohio.

Aegis Mortgage Corp, the Houston subprime lender sought bankruptcy reorganization with 10 of its affiliates.

Luminent Mortgage Capital Inc. a publicly traded real estate investment trust which invests in mortgage backed securities has received default notices from creditors. This is a week after failing to gain access to short term debt markets. Lenders have demanded immediate repayment of about $1.6bill under the so called “repurchase agreements” (see my article: The Subprime Meltdown – An Explanation). Luminent last week reported that two lenders defaulted and that there is a significant loss of liquidity in the secondary real estate and mortgage market. They had to cancel its 2^nd quarter dividend as lenders demanded collateral to cover potential losses. Furthermore Luminent is being investigated for making material false statements about its financial position. They claimed that its 2^nd quarter dividend is secure and will not be cancelled. They also claimed that the company had ample liquidity to manage its business. The stock plunged approximately 90% in the past month. Many other publicly traded companies which have heavy exposure to mortgage loans are facing lawsuits for misleading investors and making up false allegations of liquidity.

The problem with the credit squeeze is that it wouldn’t only remain in the housing market. The contagion will spread to consumer loans and such as auto loans and credit card loans. Investors are even fearful to supply credit to sound companies.

Institutional investors have shifted away money from money market funds that hold risky corporate debt to funds that invest primarily in ultra safe government issued securities like treasury bills and bonds. Treasury bonds are considered a safe haven for investments in times of financial crisis.

The Economy and the Fed

To alleviate the problems with the credit squeeze the Fed dropped the discount rate on loans to banks to 5.75% and pumped in $38 bill of its own reserves on Aug 10^th to keep short term interest rates from surging. Initially the Fed was reluctant to cut rates because of the problems with inflation but they knew that except for the cost of energy, prices are generally stable.

Initially the markets rebounded after the drop in discount rate, this hasn’t stopped investors from panicking, even with the Fed pumping in billions of dollars. Furthermore the economy which has grown to 3.4% annualized between April-June is expected to slow to below 2% in the coming quarters of this year. Currently economists are estimating the probability of a recession to be 1/4 this year and 1/5 next year. If investors keep on panicking the probability will increase to 1/3. Furthermore the unemployment rate moved to 4.6% in the month of July and many are forecasting that it could even rise to as high as 5% by the end of this year. If this will materialize it will create another dent in confidence.

It is important to note that the rate cut that the Fed made on Aug 10^th was a lowering of the discount rate. This is the rate that the Fed lends to banks and does not have much benefit for the non financial sectors in the economy. Wall Street however is clamoring for a cut in the Fed funds rate which has a more direct effect for consumers and businesses. On August 22^nd USA Today reported that the majority of economists do not believe that the Fed will cut rates until September and by no more than 25 basis points. The current rate is at 5.25% since June 2006.

The Stock Market

As mentioned above, the stock market dropped 6.4% from its high in July 19^th 2007 and even went as far down as 10%. The Volatility Index Future (VIX) rose from $15 a contract to $23. This has raised anxiety on Wall Street as the stock market was expected to burst for a year now. The stock market got hit by a rapidly spreading credit crisis triggered by subprime defaults. Now the problem is spreading to other borrowers.  

Last week the markets rose after the Fed lowered the discount rate for banks, pumped in cash into the economy and gave hints that it will lower the Fed Funds Target rate and will use “all tools to restore stability in the financial markets”. Moody’s reported that the subprime housing market doesn’t pose a risk for banks. 

Henry Paulson and George W. Bush claim that there will be a soft landing, but many believe that they are stating this to calm the markets. Mark Faber, the Swiss economist believes that the US stock market is at the beginning of a bear market and expects benchmark indices to fall more than 30%. He believes that the mortgage losses are not contained or easily solvable even with interest rate cuts. Furthermore housing created a lot of ancillary economic activity which will feel the effect of the crisis. 

Others however disagree and believe that the problems in the economy are to a very large extent subprime and in general companies will rebound because of strong profit growth. They believe that the fundamentals in companies haven’t changed and global growth will translate into higher stock prices in the US.   

The Foreign Exchange Market  

A very important effect the subprime crisis has on the FX market is on the Yen carry trade. The Yen carry trade is a trade where an investor is taking advantage of the very low interest rates in Japan. Here the investor will borrow funds in Yen, pay a very low interest rate and invest it in a higher yielding currency like the US dollar. If the exchange rate does not move he will earn the difference in the rate of interest rates. For example let’s say that US interest rates are at 5.25% and Japanese are at 0.25%. The Yen carry trader will earn 5.0% yield if exchange rates do not change.

With the subprime crisis many are expecting the Fed to drop interest rates. This will have an effect of unwinding the carry trade because the difference in yield will go down. Unwinding the carry trade means investors will buyback their Yen and sell Dollars. This will strengthen the Yen and weaken the dollar. For example by the end of June 2007 JPY/USD was trading as high as 124. The exchange rate has gone as low as 114, loosing 8.1%. Within the past week the exchange rate jumped because the lowering of interest rates caused the equity markets in the US to rise which in turn created demand for the USD, pushing the exchange rate to just below 116.  

Conclusion

Like all financial crises there will be a period where markets will face a downward momentum, probably reaching below where the equilibrium correction level should be.

This is mainly because of the panic as well as some of the damages the crisis created, such as bankruptcies and sell offs. The crisis is mainly due to the housing bubble as well as subprime loans. Other sectors in the economy however are growing, especially with earnings announcements being positive. This should limit the negative downward movement in the markets. This is the first crisis due to subprime loans in the US within the past 30 years and the economy learned important lessons such as the due diligence mortgage brokers need to take in originating loans as well as credit rating agencies understanding how to evaluate risks of structured products such as CDO’s.    

AUGUST, 2007