Subprime

Citigroup Inc., Merrill Lynch & Co. and UBS AG may post losses of $10 billion on bond insurance after MBIA Inc. and Ambac Financial Group Inc. lost their top credit ratings, Oppenheimer & Co. analyst Meredith Whitney said.

MBIA and Ambac, the world's largest bond insurers, had their AAA ratings cut two levels by Standard & Poor's June 5, which trimmed ratings on more than $1 trillion of securities they guaranteed. The downgrades may limit the so-called monoline insurers' ability to write new policies, putting further pressure on earnings, she wrote today in a note to investors.

MBIA and Ambac guarantee phenomenal amounts of muni bonds. The buyers of these bonds buy it on the AAA rating of the insurer rather than the issuer (who aren't given AAA ratings for some obscure reason).

Either S&P and Moodys need to quickly upgrade municipal bonds to AAA or there will be a catastrophe in the muni bond market. Worse, this time the people who are affected are the pension funds, school funds etc. who hold these securities thinking they are AAA - without the AAA they must sell, and chances are that prices are going to be low with so much selling pressure.

Meaning, only people like you and I, in the US, will suffer. Jeezus. I hope there is some salvation and S&P/Moodys decide to quickly upgrade bonds - and if they do, their business is toast. This is the beginning of the end of either the bond insurers (MBIA/Ambac) or the ratings agencies (S&P/Moodys)

Subprime phase 3 is here.

So why this drama now? We already have had two bad shocks, is there a need for a third?

Yes, of course. The shocks need to hurt a lot more than they have. I believe the world has done a lot of financial fine-tuning which will hurt a lot when it unwinds.

Return of the home mortgage problem

Some of you will say it never went away. And you will be right. Foreclosures in the US are at record levels, home inventories are at record levels, commercial real estate is in the dumps, and worse, the highest loan resets are coming up in the next two months.

Citi is aggressively selling whatever it can in other countries - India and Germany I have heard of. Freddie Mac is hiding assets so they don't have to disclose real prices - and indeed, there may be no real prices at all, as no one is currently willing to buy. JP Morgan and a number of banks are firing to keep costs at bay.

Asset backed indices are showing signs of crumbling again (but too early to say). As foreclosures and defaults increase, cities and counties are seeing lower tax revenues and one of them, Vallejo filed for bankruptcy recently. More to follow surely.

Note that this is not just subprime. Subprime reflects the quality of borrower's credit, and referred to the lowest strata. Now the crisis is well spread out with even rich people and companies defaulting. This next edition of the crisis will be a "we are all subprime now" edition, to quote a famous blog.

Bank Failures At least 150 banks will fail in the U.S. in the next two years, says Marketwatch. I suppose this is inevitable, as more and more banks get caught in a spiralling mortgage crisis, which has blown up to become a lending crisis in general.

Commercial real estate is down, home prices are down, lending is tightened due to much more stringent checks, savings rate was never much anyway etc. This is a sign for aggressive banks to tone down - but most small banks can't, because their cost of funds is high and they have to leverage big in order to even make costs.

Indian banks too are going to be in trouble. With the moral hazard associated with a 72k cr. bailout of agri-borrowers, which agri-borrower will ever want to pay. They'll say - "My neighbour didn't pay his loan and got away. If I don't pay a couple years, I'll also get away". The resentment in that is extreme and will hit way too many banks.

At the retail end, loans are in bad shape. ICICI recently bundled personal loan and vehicle loan portfolios and sold them - either as ABS or as portfolios to Arcil. Other banks are surely doing the same, and it's very likely that the loans are at extremely low prices due to default rates rising. NPAs are increasing dramatically. Also credit standards have been tightened (try to apply for a home loan today), and fee income has dramatically reduced after the derivatives fiasco. CRR increases have reduced leverage capabilities (only a little, but still). With interest rates likely to increase if inflation stays this way, bond prices that banks hold will reduce, and hit their treasury and trading income. Lending is down, deposit rates are high but where do you put the funds, NPAs are increasing, treasury is hit - something will give, and some banks will show the white flag.

Politics

If what's required is tightening the Congress isn't going to be up for it. They already forced SBI to withdraw a circular that halted agri-equipment credit (the bank was facing 17% defaults, the moral hazard effect). They've balked at increasing fuel prices as it hurts their voter base. They don't want to raise interest rates anymore as again, voters take loans. They won't use the forex reserves to any good. They won't even take a hit on taxes to ease prices. They will ban futures trading even if it does not help anything. They don't want to do anything that might actually help the economy in order to be in a good position for the elections next year.

This is stupid, because in the process they will create a crisis of epic proportions which, if they get re-voted to power, they have to live with. But the lure of another 4 years of power is too much, I guess.

The U.S. is in a similar situation. They won't draw on oil reserves despite this price. They will sign a bill that sues OPEC. (Come on now) They will not reduce subsidies for corn farmers in the ill-framed ethanol policy. (India has a crisis of this sort coming up this year)

The refusal of the powers-that-are to take steps to keep the economy stable will hurt us tremendously.

Oil prices that need to break

We are in the end-game of oil prices. Everyone's predicting it will go up. Everyone's waiting and watching a 10% rise practically every week now! Already, funds in the US have the highest ever allocation to commodities and literally everyone is talking about prices going straight up. $200 in a year, $150 next month and so on.

This is the final build up. Anyone who is short crude oil now is probably hurting like crazy. It's only when the last big short is taken out of business, is when the slide will begin (no downside protection!). That may come when oil is $150, or $200, or wherever, but the question is now at what rate, but when.

But the rise of oil in the interim will precipitate the crisis. As more people get on the platform to "hedge", others will exit stocks and bonds that lose value in a rising inflation, rising interest rate scenario. The crisis will hurt asset prices a lot in the coming few months, which in turn will hurt the crisis. (or help the crisis, depending on how you look at it)

Carry trade unwinding

Earlier this year, the US Dollar briefly went below 100 Yen, a sign of carry trade weakness. (Borrow in yen really cheap, and invest in dollars, which doesn't work if the yen appreciates) Now with an oil crisis and a subprime crisis, the US authorities will have to "appear" like they are doing something, like printing more currency or protecting banks or even trying to lower rates some more or some such.

This will weaken the dollar against the yen. May not be against the Euro because the Euro economies will try to do the same thing. Japan has a different set of problems and can't react like this. Effectively I believe the U.S. dollar will go down against the yen, and destroy whatever is left of the carry trade - and there is far more than you and I are aware of.

Ok. Enough.

That's it for now. These were reasons why I believe there will be a crisis coming up soon, in the next two months.

Now for why I only think one or two months. First, oil is heading down by the end of the year. Second, this crisis will kill a lot of the weak players, and some strong ones, meaning they won't need further protection. Third, most of the political damage will be evident by then, and steps are likely to be taken to reverse them, like India driving the rupee up and so on. This will stem inflation. Then we'll have a period of "nothingness" when nothing seems to happen, some scam may emerge, some financial stuff will make news and then die, and so on. This crisis will hurt much more than the last two, and after it, will keep things down but stable. Sorta like communism - everyone is equally poor.

And in the longer term the U.S. will see a problem of deflation and then rapid inflation - that will be Phase 4 of this crisis. It's a little bit like the 70s, and they will find another Volcker. India is likely to emerge stronger after a few years, unless we have a stupid sort of political coalition again, like with the left parties.

So that's me off the soapbox. I could be absolutely wrong and this may turn out to be the beginning of the biggest economy run ever. In which case, I'm happy to eat my words. (The advantage of writing on the internet is that I can swallow air and say I've eaten my words. Bwahaha.)

Disclosure: Do not trade this in the stock markets. Even if I was 100% right, there is absolutely no way to predict when, at what level, to what level, how etc. So please don't take anything I say and try to take advantage before anything happens. DO NOT predict. React.

I'll explain later about why I think so, because I'm feeling terribly tired today. June-July 2008 should be when it all comes out. Only this time it will not be related only to subprime. This time it will not be related only to the US.

Hints: The usual suspects are oil, inflation and commodities. We have as guerilla warriors US bank further losses from MBS and CDOs, huge foreclosures and loan resets coming up, NPAs in India rising, politics, failure of big-assed companies and banks, and a return of the carry-trade-unwinding.

Coming soon to a theater near you.

Defaults among subprime borrowers and those unable to meet rising payments on adjustable-rate loans drove foreclosure filings to the highest since August and the second-highest since RealtyTrac started keeping records. About $460 billion of adjustable mortgages are scheduled to reset this year, raising minimum payments for borrowers, according to New York-based analysts at Citigroup Inc.

The ABX indices are at their lowest.

MBIA has been let off by S&P, who let them keep AAA - but how? They are in no position to make good on any obligations. Anyways, MBIA is not planning to write mortgage insurance for the next 6 months (who will buy from them anyhow?). They're also planning to split their mortgage and munibond insurance businesses over the next few years.

Ambac is still on negative watch and unless they raise significant capital they're going down, it seems.

Yet, both stocks were hugely up yesterday! The market discounts the immediate future, which seems positive (not yet downgraded) versus the real future which is "bust" for these guys, at least the way they are today.

And in India we couldn't care less. A budget is on the way this week, and the stock markets are low volume and buoyant. Not a good sign this, but it's interesting that the very same factors that were involved a month ago are still existing today, more so than in Jan, and yet, we're looking positive.

If FIIs start another round of selling, we're going to see another big round of damage. Until then we may have a good session going up - but since I won't bet on it, I won't trade it. Waiting for some really good news now - it's been a while!