And then this absolutely hilarious explanation:
Subprime
Subprime In A Lighter Vein
My dear friend Mohit sent me this incredible presentation on Subprime.
More Subprime – CDO Insurers Downgrade, Bad Doc Trails and The India Impact
I wrote a long while ago about the Subprime problem in the US, and then followed it up with a few posts on the topic.
Let's see what's happened since my first post.
After the last crisis, things were kinda ok and recovering, until in late Oct and early November, loss reports started to come in. Countrywide reported a $1.2 billion loss, Merrill Lynch took with a $8 billion write down, and Citi had to match it with a $8-11 billion dollar writedown.
After the losses came a revelation of complexity. (Revelation to me, as you understand I am a newbie at this stuff) Turns out these CDOs, which are essentially securities created out of a lot of loans, are rated as tranches - AAA (huge-ass prime), AA (prime), A (prime but just about losing it), BBB (sub-prime) etc. People buy either all tranches or only some etc.
Now if something is rated BBB, why the heck would anyone buy it? Higher rates of course. But some funds weren't allowed to buy BBB. So what happened? These CDO creators got in what are called 'monolines'. These are essentially companies that provide insurance on municipal bonds - idea being if the municipality defaults they pay you instead, and charge you a premium for the exercise. If the municipality does not default they keep their premium. You bought what is called a Credit Default Swap (CDS)on the CDO which is a hi-funda name for "insurance". Now monolines like Ambac, MBIA etc. are hugely capitalised and have the ability to cover the bonds they insure, so they have always got an AAA rating.
So the CDO creators got the monolines to provide insurance for the CDOs, and the monolines greedily did it for all tranches of the CDO. The premium was exciting, but they didn't charge too much - heck, who knew the sub prime problem was around the corner?
If you bought insurance from an AAA entity, you could say you have an AAA security, right? So now you can have a BBB tranche of a CDO, paying a fairly kick ass return (you hope) and that is insured by an AAA monoline. Life could not get any better (in terms of three alphabet ownership at least).
Recently someone at the rating agencies woke up and realised that if these Subprime CDOs fail - and as it seems, even the prime CDOs are going down the drain - these insurers will be exposed to an ENORMOUS amount of liability. That may mean that the monolines are not capitalised enough, which is a signal to re-rate them to say AA or something.
This is treacherous. If the monolines get re-rated downwards, some funds will HAVE to sell the CDOs they hold, since they are mandated to hold only AAA paper. Not just CDOs, but also bond-insurance holders who held sub-prime municipality bonds. (yes, municipalities do go bankrupt in the US, unlike India where they are always bankrupt anyway) The muni-bond market is greater a couple trillion, and the monolines are the major insurers, so a de-rate of the monolines is bound to cripple the bond market - the selling will likely be intense.
If the muni-bond market gets hit badly, holdings on the equity side and maybe the corp-bond side may be ruined and the entire financial sector is hit once more. This time it could be worse than the last bash-up in November.
But why aren't they getting de-rated yet? The rating agencies - firms like Moodys, Fitch and S&P - have a very close relationship with the CDO issuers and insurers. So there will be some under-the-table bailing out (effectively only these guys pay the rating agencies). Now if they do this longer, no one will believe Moodys or Fitch ratings anymore no? Uhm, someone figured that out already - the rating company stocks are down nearly 40% since Jan this year.
Also, there may be capital rescue attempts, like when CIFG's parent company offered it a $1.5 billion of extra capital to ward off a re-rating. My take on that is - $1.5 billion is nice, but it's like dropping a grain of salt in water. You can see it drop and in a few seconds it's gone, and the water doesn't taste a whole lot different either. We need LOTS of the salt.
What's also interesting is: some monolines like ACA have threatened to declare bankruptcy if they are de-rated. What does that mean? Bankruptcy = I don't need to pay my liabilities (or not all of them), so the guys who bought my insurance essentially get less or even zero - meaning, they have no insurance. If that happens, a good part of the CDO portfolio that was assumed to be 'covered' by insurance suddenly takes the hit - and I can't say for sure, but if the equity tranches of the CDOs of these banks have taken multi-billion dollar losses, who knows how much they own that they consider "insured and therefore safe".
What is also troubling is that in the rush to close loans since the 2005 times, people didn't quite do the documentation right and now some foreclosures are getting thrown out the door for not having correct paperwork in place. The cost to do that will have to be borne by the banks, and that is another huge-ass loss. And they've already paid the bonuses, unfortunately. Those who haven't, say they will continue to - because they are afraid to lose people. (No, I don't get it either, but you have to understand that losing most of your staff is a short term nightmare, and no one in this business thinks long term when it comes to bonuses at least) Any Indian company that has outsourced or provided BPO services on such terms is most likely going to get screwed - as the banks are going to say that they messed it up and that the function will have to happen in-house. Why? Because maintaining and managing the doc trail requires a lot of work, training, local contacts and domain knowledge etc. and there are going to be a lot of such professionals in the US who need work (and do it faster as they understand it better)
Let's get to India now, finally. Why do we care? Global liquidity is one of course, and the fact remains that because we don't have loan securitisation (or "factoring") anymore, we don't have the intensity of the problem internally. But we have something, definitely - US home prices started to decline in 2005 - I have personally seen Bangalore real estate prices coming down in 2007. In two years, we are going to see some shake ups if the trend continues - and what will happen then?
Too much supply, too little demand. The market value of a house can become less than the loan outstanding. This can trigger margin calls ("pay up the difference"). High interest rates, and slowing global economy. In India, we can't just walk off with a "foreclosure" and the process takes time, and banks can't securitise and pass off the risks. So the banks will have to take the hit, and perhaps that will drastically reduce their ability to give out more loans, meaning further income losses as well. Where they do foreclose, they will auction and the resulting sales will bring market prices even lower, and there is no organised real estate fund or player to do the buying. (heck, you can't even short right now)
That could lead to further problems with real estate sales, and in turn with higher discretionary spending (as people struggle to pay off mortgages, they cut down on buying high end cars etc.). The overall market decline will take years to undo as it has to run through the cycle.
Note: I am not predicting this will happen. I'm just saying that the problem could progress in this manner. Yes, we could reduce interest rates dramatically - something our RBI will surely do in a crisis. But it may be too little too late - as the RBI already seems to be complaining about too much bad lending. Sticky wickets.
I'm not buying a house right now, for sure. But then, I can't afford to anyway, so call it sour grapes :).
So Exactly How Bad Is The Subprime Problem?
Satyajit Das, who wrote the excellent Traders, Guns and Money, answers this question in an interview[Emphasis mine]:
I started by asking the Calcutta-born Australian whether the credit crisis was in what Americans would call the "third inning." This was pretty amusing, it seemed, judging from the laughter. So I tried again. "Second inning?" More laughter. "First?" Still too optimistic.If Das is right - and I think he knows more than I do - the bear market that will follow will stick around for years. I think we would be kidding ourselves if we think this won't hurt us - but to be honest the first on the line to fall are exports. The fall out will be the financial market, and as a result of that, real estate, cement, auto, etc. will be hit. Some stories like Power, Infrastructure, Oil etc. may not be affected quite as much though.Das, who knows as much about global money flows as anyone in the world, stopped chuckling long enough to suggest that we're actually still in the middle of the national anthem before a game destined to go into extra innings. And it won't end well for the global economy.
Das is pretty droll for a math whiz, but his message is dead serious. He thinks we're on the verge of a bear market of epic proportions.
The subprime crisis is fairly big, but we have to lose interest in it fairly soon so that it can hurt us when we are not looking. If history is a teacher, the lesson has been that markets hurt the most number of players when they are most vulnerable. What the US market is facing now is probably just a small tiny part of the eventual downturn - which could take years to unravel - and eventually we will also need to take some of that damage in our markets.
But does it mean the end of equities? To most of us reading this blog, it might seem like it. And when you come to the conclusion that "equities are dead", my suggestion to you is: think immediately about buying some.
Disclosure: Short Nifty, long RIL and some stocks not mentioned here.
LIBOR is up to 6.45%
It seems the subprime issues have started to affect LIBOR quite a bit. From the Telegraph:
Morgan Stanley said that the recent jump in the benchmark London Interbank Offered Rate, which yesterday rose to just under 6.45pc, was not merely a seasonal blip but a major warning sign of pain ahead.Uhm, weren't a lot of Indian ECBs linked to LIBOR? Last I heard, LIBOR was around 5% or so. If we consider that most Indian ECB Loans are linked to LIBOR and that most were made earlier this year or last, when the LIBOR was about 5.3%, then there is an interesting problem. From RBI, As of March 31, 2007, nearly 72,000 cr. was in ECBs, and between April and June, a further Rs. 34,000 cr. was added. This is a net of Rs. 106,000 cr., which we can consider at a dollar rate of 42 or so, meaning they $25.2 billion. LIBOR on this has gone up 1%, which is an additional interest of $250 million dollars a year, or Rs. 1000 crores. Of course one might imagine that the dollar has reduced in value - but remember that the reduction has already been accounted for as "foreign exchange gains".It came amid further jitters in the banking sector, where many smaller, more indebted banks are struggling to find lenders to keep them afloat.
Libor rates, which indicate how willing banks are to lend to each other, have risen sharply during the past week, after spending almost two months close to the 6.3pc level - a worrying sign since it was Libor's increase in August that signalled the initial impact of the credit crunch.
So who's affected? I don't know, but let me try and guess. Tata Steel for instance has a big loan for Corus, syndicated AFTER Jun 2007. This involves three tranches adding up to a total of 3.7 billion pounds. The effective rate is around LIBOR plus 200 points. For that loan, Tata Corus will end up paying an additional interest next year (if LIBOR stays this way) of about 1% higher - effectively around $80 million, or Rs. 300 cr. This is about 10% of Tata Steel's Net Profits annualized. (Of course if the pound goes down against the rupee further some of the losses may be recovered, but I doubt it will impact it as much as 300 cr.)
Who else? ICICI Bank seems to have a ton of them, according to this article. It has raised about $12.5 billion in the last two years, and these loans are all linked to LIBOR it seems. If LIBOR goes up 1%, their net payment is up about $125 million which is about 500 cr. That's again about 10% of profits.
Now I don't have all the information about how the ECBs are structured but on the face of it the LIBOR rise will affect every single ECB given. Companies like Reliance Industries, Reliance Communications, L&T, Bharti Airtel etc. have also got a lot of ECBs - the only company that will not show a serious loss is Reliance Industries as they have not booked forex gains for the gains in the dollar so far.
Given that with the subprime crisis the LIBOR may stay at this rate or go higher, and the impact may be quite heavy to some Indian companies. But some questions I have are:
- Am I being too simplistic? Is this a valid concern at all?
- Is there something called a fixed rate loan? Or if the loans say LIBOR+something they reset every x months as LIBOR changes?
- Do you know a list of Indian companies with their ECBs, amounts and rates?
Disclosure: Short Nifty.
Calculated Risk – A Brilliant Blog
I've been reading Calculated Risk recently and man is it something. To get a better hold of the U.S. housing fundas, or to simply decipher the plethora of news you seem to hear, I cannot find a better place.
Today's picks from there: Goldman Sachs predicts a $2 trillion cut in future lending. What this means is - there may be a hit to banks' capital, which can take their capital down $200 billion (assuming just half of the total hits their balance sheets). If banks leverage their capital 10 to 1, they are going to stop lending to the extent of $2 trillion.
This is assuming that they can't find the $200 billion to recapitalise, (And $200 billion is not a small amount) and that there is no macho rescue event by the US Fed. And this is perhaps conservative as banks leverage higher than 10 to 1.
Another interesting piece, quoting from a Fed Governor's speech:
First, the bulk of the first interest rate resets for adjustable-rate subprime mortgages are yet to come. On average, from now until the end of 2008, nearly 450,000 subprime mortgages per quarter are scheduled to undergo their first reset, eventually causing a typical monthly payment to rise about $350, or 25 percent. Second, the weakness in house prices and the resulting limit on the build-up of home equity will hinder the ability of subprime borrowers to refinance out of their mortgages into less expensive loans; as a result, more borrowers will be left with a mortgage balance that exceeds the value of the house.Very interesting conclusions further there. Good read.
Some international danger points
Citibank's $11 billion writedown: more to come?
Citi had announced, on Nov 4, a record writedown (read: "money we have lost") of between $8bn to $11 bn, due to CDO losses. A CDO, or "collateralized debt obligations" the concept of putting a lot of loans into a basket, and selling pieces of that basket. Citi still owned a considerable amount of the basket, it turns out. The basket is usually divided into tranches - some part of the tranches are "junk" meaning recovery may not be possible (rated: BB or lower) , and the best tranche is marked "AAA".
Let's now look at the Subprime CDO market - this is marked by the ABX index, (Asset backed securities index). So an index named "ABX-HE-AAA 07-2" meaning the index for Home Equity loans, rated AAA, made in the second half of '07. That's since July 1, 2007.
The index reflects what people are willing to pay for a $100 of the underlying loan. so an index value of 95 means people are willing to pay $95 per $100 worth of loans (the $5 being the return on the risk they take etc.) So lower the value, higher the underlying risk. Most importantly, the CDO issuer probably paid $100, so every bit lower is a value that is a loss.
Now check this out:
Citi probably holds a lot of the 07-2 series (probably, because they wouldn't have been able to sell all of them yet). Now they announced on Nov 4 of their write downs. See what's happened since then - a fall greater than 10%. And this is the AAA tranche. Similar stuff has happened with teh AA, A, and BB/Junk rated ABX!
This will obviously be hitting Citi big time, and probably the rest of the financial world too. They want to take this stuff "off balance sheet" by creating Special Investment Vehicles (SIVs) to fund the purchase of such securities. JP Morgan and bank of America are in on the game. Effectively, they setup another company to buy these securities because no one else will buy them. And the "off balance sheet" means: we'll lose the money anyhow, but we won't tell you how much anymore.
If this gets worse, Citi will be seriously impacted and the entire credit markets will unwind. Heck, they are probably unwinding.
Why do I care? This is the filter through which nearly all the liquidity in the world flows.
And the Yen carry trade is the other big source of liquidity. The yen is at 109.25 to the dollar as I write this, the lowest in about 18 months. People borrow the yen (which is available at ridiculously low interest rates) convert to dollars, and deploy the money in other markets. They earn higher returns, and use the returns to pay high interest.
Example: I borrow 108,000 yen at 1% when $-yen is 120, giving me $900. I then put $100 of my own, and invest the $1000 in say Indian equities, or better still, Indian govt. bonds giving 6%. I make an income of $60. Now I gotta pay back the yen guy 1080 Yen. If the yen rate is constant, That is only $9 - the remaining $51 I can keep for myself - it's a fabulous 51% return on $100 investment!
Okay now what happens if the yen falls to 110? My payment increases by 10% - to about $10 in this example - and my profit comes down to $50.
The example I chose is simplistic because a) people borrow about 20x-50x their investment in yen (i chose 9x) and b) the interest rates depicted have wide spreads. So in reality a lot of guys have much closer spreads and high leverage, meaning that they get affected badly if the Yen appreciates 10%. Till now the Yen stayed above 110, and that seemed to be fine (the last time I heard this was an issue was at 114, but it was no big deal)
But at 110 and below I would see a lot of unwinding. And the Yen should appreciate on each leg of unwinding as people scramble to buy it back. Look at the graphs over the last few days, and you'll see some scrambling.
Who in India has big yen loans? Uhm: ICICI Bank. $1 billion last year and $1.5 billion this year.
The liquidity crunch, yen-carry trade, etc. are all global issues that affect us only in a supplementary manner...and the impact may not be huge. Still, it's worth watching out for.
Commentary that affects the market
Lots of ups, downs, and sideways things happening in the broad market. Some news:
FIIs are selling.
FIIs have sold more than 8500 crores this month, till August 22. They invested around 24,000 cr. in July, so this isn't a panic situation. Yet. In fact,their net investment in 2007, even after these sales, is 34,000 cr.
Why are they selling? I don't know. People say it's the subprime problem, and that some funds have been forced to liquidate their assets. Perhaps they want to go to the US where the market has fallen to what may be attractive levels. The reasons always become apparent much after the fact - and the fact is: FIIs are selling.
The subprime problem is worse than we think.
What is the subprime problem? Here is a step-by-step recipe to create a subprime problem, for a new bank:
- Interest rates are low, and people want to buy houses. But many of them can't get loans because they either don't have known sources of income, or have declared bankruptcy earlier, or have generally had bad credit history. How can we help?
- Okay, let's give them loans at higher interest rates! "Er...but won't they default? They already have bad credit history!".
- No, no, we have the house, right? We'll sell the house and recover our money! Anyhow housing prices are going up and up and up.
- Okay, but they don't have income to pay the principal+interest.
- no problem. Let's give them "interest-only" loans. They will pay only interest for, say 2 years, after which they'll pay back principal also.
- Fantastic. Now we have hajaar loans. Homes are increasing in value, so some customers are selling their houses for 40% more, paying back the loan and taking another loan on a bigger house! Great stuff! But how can we give MORE such loans? We have not got enough capital!
- I have a great idea: We have all these loans no? Let's package them as "mortgage backed securities" and sell them to other companies. They will give us money, which we can use to give more loans. Where they won't buy it, we'll borrow from them. Anyhow interest rates are low.
- Great, now hedge funds have given us hajaar money for our securities and we have also borrowed more money, and are raking in huge amounts of money from the loan payments.
- But interest rates are starting to move up!
- Er...see, we will "reset" their interest rates only after two years, by that time they will be able to sell and give us back all the money.
- Uh oh, the housing market is slowing down.
- It's time for the loans to reset, but the customers can't pay higher rates, and they can't sell their houses.
- Uhm. The default rate has reached 35%! One out of three customers is defaulting because instead of paying our "interest only" loan, they can get a new home for cheaper! How do we account for this now?
- Let's go and get more money from the market.
- Interest rates are too high and nobody wants to buy our mortgage based securities. In fact the people we borrowed from want their money back.
- Uh, oh, the hedge funds who bought our loans can't recover them because of the default rate, and need to pay back their investors, so they are selling what they own - which is things like Indian stocks, Chinese stocks etc.
- Uh, oh, but if we don't give more loans we will make no money! And how do we pay them back? Can we get some money from ANYWHERE?
- ...
The rest is starting to unfold. The Fed and the European banks have already thrown in more than $200 billion of money. The fed has cut rates by 0.5%. They want to save the economy by propping these big banks and funds up - the way they did in 1998 by saving Long Term Capital Management.
You can never really subvert a crisis like this. Eventually the lid will blow. But they can soften it for a few years; so don't go about selling everything, just the basic bits.
How does Subprime affect India?
Short Answer: You will only know after it hits us.
Long Answer:
- IT outsourcers and BPOs can be hit badly if the banks stop giving them business. WNS recently announced a $26 million hit to its profits because they lost First Magnus as a customer.
- Banks in India, which participate in consolidated funding or sourcing, may be hit. ICICI bank for instance takes loans from all over the world to fund its Indian operations.
- If the US market is hit badly, FIIs will swing over, and the move will cause a slump in local markets (temporarily, but still, a hit).
- If that happens the dollar will move up. Companies with ECBs will be forced to report losses on foreign currency gains, which as a line item made their growth seem fantastic this last quarter.
- Subprime loans are in India as well. What we call "personal loans" or "pre-approved loans" are examples. Default rates on homes are moving up, it seems. Both ICICI and SBI have dramatically increased their NPA provisioning, and have both independently announced either slowing of credit growth or increase in defaults. Not good. ICICI, ever the smart financial cookie, has already taken on additional equity of 20,000 cr. and more loans to fight the obviously impending crisis. HDFC and SBI will follow shortly. The rest of the banking pack aren't yet responding.
But interesting things are happening locally. Cement acquisitions: Holcim just bought a 15% stake in Gujarat Ambuja Cement. This may fuel more acquisitions in the Cement segment.
The political stage is also crazy; We may have fresh elections. My feeling is that elections will be good for us, because then we can vote out the Left parties. But if the Congress loses its enthu and pulls back on the Nuclear deal, all future deals will be seriously impacted. Then I will pull out whatever little I have from the markets.
On a personal front, I am still working hard with Kaushik to build Moneyoga. We are getting data on the markets and identifying patterns on them that will give us an idea of how good the odds are to invest in today's markets. We'll soon present that picture to you as well, in a form that is easily understandable.
And of course, it's raining in Bangalore. But before you go buy umbrella company stocks, note that it only rains for half an hour at a time.
The "Subprime" Problem Means All Of Us.
Categories: Commentary, Subprime
The issue now is that subprime borrowers have bolted. The prime borrowers are slowly becoming subprime (home prices are already going down, remember) and when the term "subprime lenders" is slowly getting extinct, they have no refinance option. So the next step: They choose the foreclosure route. Default rates are up.
Read the article. And unlike me, read it slowly because otherwise, like me, you will have to read it again. We are all subprime now.
And what about us Indians? No, we're not the "brown" people mentioned there, but should we care about U.S. Subprime?
I would be kidding myself if I thought this is a U.S. only problem. Note that the European banks have suspended trading in mortgage bonds and China is worried about loss of US exports.
And India? First the software outsourcers have a lot to lose, considering they do a LOT of work with the financial industry all over the world. A dollar decline means a drop in exports so textiles is kaput. Liquidity constraints hit banks which "bank" on their ability to raise cheap money and deploy it for high returns. ECBs become more expensive as spreads abroad widen. Domestic consumption is driven by robust external demand as well, and to that extent asset prices will be hit if there is a global recession of sorts.
Of course I come across as bearish. But this has nothing to do with the stock market. It can continue to flourish, remember, and in the face of such data, it has in the past.
Posted in Commentary, Subprime