Thursday, December 6, 2007

The Prime Credit Crisis

This was originally published Dec 6, 2007 on

Of late, one cannot read a newspaper article in the financial section and avoid the word subprime. It is everywhere. “Stocks decline on subprime concerns” is a headline used about twice a week when newspaper editors can’t figure out why stocks are going down, but have to report something. However, the average expert or analyst when asked to explain the problem would likely point to a small slice of the economy made up of people who were given loans and didn’t deserve them. As usual, the term is used in a very misleading fashion by those who don’t really understand what is going on. Some will even point to the relatively small proportion of subprime loans among the entire credit market and declare the problem to be ”overblown.”

It helps to know what subprime actually is and where it came from. Most think it is a new phenomenon, when in fact it has been around for decades. Subprime loans were normally given on a refinancing basis only. When people would fall behind on their payments for one reason or another (job change, divorce, medical condition, etc.) but could demonstrate the ability to pay back the loan in the future, they were normally sent to another institution that was willing to take on the risk at a higher interest rate. Once they became current on their payments again, they might have qualified for a prime mortgage with their primary lender. Of course, as the housing bubble in the U.S. started inflating, lenders became less risk averse and started offering these subprime loans on a purchase basis, as second mortgages, or for a variety of other purposes.

Reading the newspapers, one would be led to believe these mortgages were given only to the lower middle-class in the U.S. and that they were the only problem area of the credit markets. Many articles refer to subprime mortgages “infecting” asset backed commercial paper and thus destroying their value. Others point to SIV (Structured Investment Vehicle) bonds being “contaminated” with subprime debt. Such references are derogatory and misinformed. Many affluent people were given subprime mortgages as second mortgages or as consumer loans to be used on boats, vacations, etc. And as lending standards and risk aversion decreased, many other forms of mortgage issuance proliferated even without proper income documentation, a scarred credit history or the standard down payment amount, but still met the bank’s ”prime” requirements for issuance.

Contrary to popular belief, it is the prime mortgage market that is the biggest threat to credit markets and the financial system. And as housing prices decrease, it is of little importance the quality of the borrower, if the price of their home is worth less than what they paid for it. Prime or subprime, they will simply put the keys in an envelope and mail them in. The further prices decline, the more banks are on the hook. And this brings us back to where we are now.

The subprime lending market is now non-existent. 193 lenders have gone out of business in 2007. Most think this is a blessing. But it was actually an integral part of the mortgage market for people who still had the future ability to pay, but had fallen behind on payments. As of now, anyone falling behind on their payments has no recourse and goes straight to foreclosure, further adding supply to the market and further suppressing prices.

The banking mantra since ‘01 has been “borrow short, lend long” and for years it was very profitable. Banks would borrow money in the short term (overnight to three-month) debt markets and use it to lend to individuals and businesses in longer intervals. Subsequently, they would package the loans together and sell them to investors. But as can be evidenced by watching the LIBOR (London Inter-bank Offer Rate), short term rates are rising, making this process less profitable.

But this phenomenon is not exclusive to the subprime lending. Anyone without a pristine credit history, historically stable income and a down payment is being turned away, as they don’t meet the new risk guidelines set out by banks. And even if banks wanted to issue more loans they are not able to resell them to investors, because the investment market for such packaged mortgages is also minimal. The demand is for cash, not lending risk. Banks want cash so they can set aside reserves for loans that go bad. According to a report from the FDIC, loan/loss reserves have doubled in the last quarter alone from all-time low levels. But as a ratio to the percentage of loans that are non-current, those reserves are still lower than they’ve ever been since 1987. And with prices only starting their decline, this need for cash is not going to magically disappear.

So with that as a backdrop, we hear of companies such as E*Trade Financial (NASDAQ: ETFC, Bullboards) on the fringes of bankruptcy. Their portfolio of long-term loans had started to go bad, and as short term lenders became more risk averse, E*Trade was unable to secure cash to write the loans off. As such, they received an emergency cash infusion from a hedge fund (Citadel) that would give them the ability to continue day to day operations. The price? They sold their entire portfolio of Asset Backed Commercial Paper (valued at nearly $4 billion in June) for 26 cents on the dollar. Most interesting is that this portfolio contained 73% prime loans. So if the market is not willing to pay anywhere close to par for even prime loans, what is the implication for the credit markets? Enormous.

Most financial institutions have basically been playing a waiting game. Waiting for “credit markets to normalize” was a popular phrase in Q3 conference calls. As long as nobody sold their securities at a deep discount, the market value they were able to record on the balance sheet remained unchanged. Of course it was only a matter of time before someone had to sell. Now, anyone holding the same securities as E*Trade has also experienced a huge paper loss.

With the enormous amount of leverage taken by lending institutions and investment banks, even a small decline in the portfolio of their assets could render the company insolvent. Indeed, the entire financial system is at risk of going belly-up. And to think less than a year ago, anyone even suggesting a decline in home prices was laughed at.

This is a very simplistic version of how we got to our current situation. But it could be further simplified by stating that lenders and borrowers alike made poor decisions based on their future expectations of asset prices. They made those decisions with an incredible amount of leverage and are now getting a margin call. Unless asset prices miraculously turn around and start rising, we are only witnessing the beginning of this crisis. But simple supply and demand numbers and indicators of future supply and demand state clearly that the chances of that happening are remote. Once a credit cycle rolls over like this one has, and banks begin to become more risk averse, it takes a lot to turn it around. A lot of fundamental changes (price, sentiment), and usually a lot of time (years, not months).

Because the last credit cycle was created by favorable legislation and loose monetary policy, there is a lot of confidence that more of the same is able to ”stem the tide,” ”cushion the blow,” or ”stop the bleeding” and prevent the cycle from going full circle. I believe such confidence to be massively unjustified, and will have more on that later this week.

Best of luck to all in the final month of the year!

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