Hypothesis on the subprime market issues & its impacts on other financial instruments (REVIEW)

Wrote this short prediction back in 6th July, 2007 (2 months before the subprime crisis imploded). I thought it's time to dig it out and see if my prediction correlates with what is happening right now. Major predictions will be worded in RED, and the explanation that follows will be in BLUE:

'Introduction: Subprime market refers to the housing loans that are below normal credit ratings issued to home buyers with lower income. When the market interest rate is low, it makes sense for banks to make the loans as it offers substantially higher return over interbank rates, and the default rate will be low as the borrowers are more likely to be able to service the loan payments. However, when the market interest rate gets higher, there will be more defaults, simply because the borrowers are not able to service the loans.

Typically, bank & mortgage lenders partially issue securities such as bonds (normal & tranche) backed by the future loan payments, known as collateralized debt obligations (CDO), in order to get advance payments to re-invest in. These bonds are tradable, and the price depends on the market yield as well as the default rate. As default rate rises, these bonds will become cheaper as the future loan payments from the borrowers are not secured. As these bonds are bought by large financial institutions such as investment banks for its high yield, a collapse of the bond prices backed by the subprime market will result in high losses, inadvertently affecting its investors negatively.

Explanation: A largely correct prediction. Debts are currently priced at 20-30 cents on the dollar for the junk CDOs, and even prime loans to affluent customers are being traded at just 70-80 cents on the dollar. This situation extends even to corporate loans to major companies in the Fortune 500, suggesting that the credit crisis has extended to the corporate sector.

The impact of the subprime market can’t be discounted easily. Housing mortgages is a huge part of the US economy (50-60% of GDP), and the subprime market is a sizable part of it, accounting for between 12% - 15% of the total housing mortgages (year 2001). Already, Bear Stearns has made a loss of USD 1.6 billion dollar related to the subprime market collapse, and more revelation of losses will follow from other institutions as well as mortgage lenders overexposed to the subprime market, triggering a meltdown in the financial market sector.

Explanation: the losses that was revealed by Bear Stearns at that time (USD 1.6 billion) turns out to be a drop in the bucket of losses that has since unravelled. Currently the figure stands at around USD 1.04 trillion, and with many well-known Wall Street and European banks still bleeding profusely, the figure would eventually reach USD 2 trillion all up. For example, Merrill Lynch, which was taken over by BoA, announced losses of USD 15 billion in the 4th quarter of 2008. It still has USD 110 billion of toxic assets on its books, prompting BoA to seek further infusion of capital from the government, and also requested the government to guarantee up to 90% of the potential losses from Merrill before they conclude the takeover. Looking at this scenario, there is still much potential losses that hasn't been fully unravelled yet.

Although subprime in itself is a small portion of the housing mortgage sector, the frantic sell-down after losses are exposed will cause the market to plunge deeper than it should, a phenomenon called applied reflexivity first proposed by George Soros. Given that consumers who have defaulted on debt are declared bankrupts, they would spend less for day-to-day purchases, therefore bringing down the profits of corporations, hence dragging down the stock market as a whole. In particular, businesses that focus on serving the lower-end market are going to be the most affected.

Explanation: This part of the prediction has missed out on a crucial point: even though the subprime crisis originated from the lower end of the market based on indiscriminate lending from the mortgage houses and banks, it is the AFFLUENT CUSTOMERS that finally ended up with these CDOs after Wall Street repackaged these loans for sale. Hence, instead of the drag in the lower end of the market, it is these MIDDLE UPPER CLASS that are trading down to lower end market. Those that are already in the lower end market initially still had to shop for essentials, and coupled with the middle class that are trading down, businesses that serves the lower end market will instead do BETTER as there are now more people shopping for only essentials. The best proof of this will be the increasing profitability of WalMart even when other businesses are doing badly.

Effect on the loan market

Perhaps, the most worrying effect will be on the loan market. With the current buying spree by the private equity outfits growing larger than ever, funded by cheap credits and also investors’ willingness to accept haphazard terms on loans made, there is every chance they will freak out if the subprime market collapses dramatically, raising doubts on the quality of the loans used in the LBOs by the private equity firms. After all, LBOs are highly risky ventures that depend on cash flows to service the loan payments, and when interest rate rises, the cash flow might not be enough to handle the increase, and hence making the business illiquid, and ultimately defaulting on payments.

Since the private equity takeovers are growing larger & larger in size, if the cash flow to loan ratio of these companies are not large enough, there is every possibility that many may become insolvent, and as they are large companies, there will be reverberation effect in the whole market.

Explanation: This past year has seen many firms funded by high LBOs (almost) go out of business. Cerberus's Chrysler & Sam Zell's Tribune Co. are just 2 high profile victims of the credit crisis. The problem is 2-fold: Firstly, the current downturn doesn't allow them to generate enough cash flow to make the interest payment, and secondly, it is not possible to roll over their loans as majority of their assets are either sold or already serving as collateral to the banks for the initial LBO fund. Since refinancing is not possible, banks will recall the loans once the term is due, hence causing illiquidity. Firms associated with these LBOs, whether as suppliers or customers, would be severely affected as well, hence dragging down the economy as a whole as bad debts increase.

As can be seen from the explanations above, many of the predictions have already been realised. The question now is, what are the terms for recovery, and when is that going to happen? I will cover these points in the next post!