Some one in Wall Street has written a poem tuned to the Beatles’ song “Yesterday” on the sub-prime loan saga, making light of the recurring nightmare that it is going to be in the months ahead.
Sub-prime, as the term suggests, is something below prime. Sub-prime, therefore, stands for borrowers who are not creditworthy. Sub-prime borrowing constitutes around 10% of all home mortgages in the US. But, it was 20% of mortgages originating in 2006. Many expect the default rate of sub-prime borrowers to be around 20%. It stands at over 13% as of the end of last year. Some commentators have noted that the default rate on sub-prime loans extended by the private sector is about the same as on those extended by government agencies such as the Federal Home administration and the Veterans’ administration, where lending standards are much tighter. It means the default rate on such loans by the private sector could rise further.
There is another potentially destabilising category called Alt-A borrowers. Alt-A or alternative documentation or no documentation borrowers do not satisfy the higher lending standards required by Fannie Mae and Freddie Mac to underwrite housing loans. Interest-only loans or negative amortization loans (where the minimum monthly payment is even below the interest payment) are part of this category. When borrowers fail to meet their interest payments, the difference gets added to their principal and the interest rate is reset higher. Such interest-only or option mortgages made up more than 60% of Alt-A loans originating in 2006. Roughly $300 billion of securitized sub-prime mortgages are likely to see interest rate resets. That could set in motion a chain reaction.
As such defaults rise, lenders begin to go out of business. A website (www.lendingimplode.com) has been set up to track lending houses going bust. The number stands at 39. Lending standards are tightened for remaining borrowers and marginally safe borrowers become sub-prime. A vicious circle thus sets in, in the housing industry. A widely cited recent research report by Credit Suisse (‘Mortgage liquidity du Jour: Underestimated no more’, 12 March 2007) expects 40% of all outstanding home mortgages in the US to be affected by the likely further tightening in regulatory and lending standards in the months ahead. New home sales are expected to drop by 35-45% from peak to trough, compared to their earlier estimate of 25% and the decline of 16% seen so far.
The malaise spreads to the world of finance as most mortgages are securitized and sold off to investors. Even sub-prime mortgages have been securitized into debt obligations with credit ratings ranging from AAA to C. That is, AAA credits have been structured on the foundations of less-than-creditworthy home mortgages. They would then begin to unravel. Compared to the past, the share of loans packaged and sold to other investors down the chain by private lenders has gone up from nearly 10% in 2000 to nearly 30% in six years. Most of these debt obligations collateralized by inferior mortgages have been bought by hedge funds and private investors.
Wall Street believes that spreading the risk across a larger population of investors reduces systemic risk arising from the possible collapse of any large financial entity. On the flip side, more investors may feel the pain, given that the purchasers of securitized mortgages are leveraged hedge funds, whose clients are leveraged funds of hedge funds—whose investors, in turn, are leveraged private clients. The pain threshold would be very low for the last and the weakest link in this chain of leveraged investors when things begin to go wrong. The full consequences of the monopolization of profits at Wall Street and democratization of risk to the main street are yet to be felt, and could be very ugly.
Readers don’t have to speculate on whether this would impact the broader US economy. If it did, it would not only have geo-economic but also geo-political implications. There are a few important mitigating factors in the US economy. The unemployment rate is rather low and wages are rising. Disaster might yet be averted. The important question is if the market would come close to pricing in catastrophic scenarios. The facts presented above suggest precisely such a possibility.
If so, investors are bound to get a nasty attack of the risk-aversion virus. Globally, risky assets (stocks and emerging market assets) would sell off, as would the US dollar. In anticipation, investors should inoculate their portfolios with bond and precious- metal vaccine. According to Merrill Lynch, in recent times, they have been the most uncorrelated to US stocks. Everything else, including emerging market stocks, would fall in sympathy. Some, like India, with a heavier thud.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer (Singapore) Ltd. These are his personal views and do not represent those of his employer. Comments are welcome at email@example.com