Subprime America will infect Asia and Europe

Published July 3, 2007

US SUBPRIME FIASCO

Subprime America will infect Asia and Europe

That's because most of the CDOs are owned by investors and institutions in those regions, says DARRYL ROBERT SCHOON


THE collapse of the US housing market will have consequences far beyond the borders of the US - for the majority of America's subprime loans are owned by investors, banks, insurance companies and pension funds in Asia and in Europe.

Over US$1.5 trillion in subprime loans were made to American home buyers who had poor credit records. In retrospect, it wasn't a good idea to loan US$1.5 trillion without asking applicants how much money they had or how much money they made. But the banks did, and this is why: one year after the collapse of the US stock market in 2000, the Nasdaq dropped 80 per cent, and the US government feared a deflationary depression - a no-money, no-demand depression like the 1930s - could happen.

So in 2001 the US government took quick and decisive action and flooded the US with money to prevent a depression from developing; but, in the process they created a real estate bubble and, as the bubble deflates, those who can't pay their bills aren't paying.

Banks aren't in business to loan money to those who can't repay them and they knew that customers who took advantage of subprime mortgages were at high risk of default. So the banks sold their subprime loans.

Now, who would buy a 'subprime' - for example, substandard - loan? Who would buy a subprime steak, a subprime car, a subprime house, a subprime dating service? This is where the genius of Wall Street came into play.

To sell these soon-to-explode debt bombs, Wall Street cleverly bundled them with higher-rated AAA debt and gave them a new name: 'collateralised debt obligations', or CDOs. It then sold trillions of dollars of 30 per cent subprime but AAA-rated CDOs to unsuspecting buyers.

Even if you don't know what a CDO is, CDO sounds a lot better than subprime or substandard. That was the genius of Wall Street. It found a way to sell shaky debt before the fenders fell off. And it worked, at least for Wall Street.

These debt bombs are now embedded far across the global financial landscape, the majority bought by European and Asian investors and institutions seeking downstream revenues; but instead of downstream revenues, they will be absorbing unexpected and significant losses.

Fully 50 per cent of the 2006 earning of HSBC, the world's third largest bank, was wiped out by the subprime losses of its US subsidiary. AXA, a French insurance company, and CommerzBank, a German financial services company, were also major buyers of Wall Street's subprime AAA-rated debt and will suffer the consequences.

But it's not only European and Asian banks, insurance companies, and hedge funds and pension funds that will suffer; wealthy Japanese investors may suffer the greatest losses of all.

Globalisation

It is believed that the highest-yielding but riskiest tranches (risk level) of the subprime CDOs were bought by wealthy individual Japanese investors. The head of structured finance research at Nomura Securities, Mark Adelson, said these investors did not fully understand the risks they were taking, depending instead upon the ratings given by credit agencies such as Moody's or the advice of those managing the security.

'A partial understanding of it is often no better than no understanding,' Mr Adelson said. 'The devil is in the details; if you understand it vaguely, you can get your lights punched out.'

Globalisation has been a wealth builder, perhaps unequally so, but nonetheless wealth has been created. Soon, however, another darker side of globalisation is about to manifest. Risk, as well as money, moves quickly across global highways recently built and made possible by a one-world financial marketplace, and that risk is now about to become apparent.

Global currency flows move quickly and turn on a dime. The Asian liquidity crisis of 1997 was a recent manifestation of this phenomenon; the next crisis will be the US. The subprime losses suffered by the buying of America's bad debts may be the final straw in the diversion of foreign money away from America.

By selling foreign investors its bad debt, America has shot itself in the foot. Because America is now the world's No 1 debtor, because America needs over US$1 trillion in foreign investment capital each year to pay its bills - and because it was foreign investors who were primarily burned by Wall Street's subprime CDOs - the flow of foreign capital to the US may soon be going elsewhere.

Decoupling

In April 2007, a Merrill Lynch survey showed 38 per cent of global money managers believed the best prospects for corporate profits were now in the eurozone; 42 per cent believed the worst prospects were in the US.

Today, the word 'decouple' is increasingly heard where global markets are discussed. No longer referring to freight trains, decoupling refers to the distancing of global economies from the US - the separating of still-healthy economies from the slowing US economic engine.

While it is true the US has been the driver of the global economy, it is no longer. The sobriquet 'has been' is literally correct in this instance; the US share of global economic growth so far in 2007 is 10 per cent.

Global capital flows, like tsunamis, are not something to be taken lightly. If the flow of foreign money to the US slows, the US dollar will collapse and the US will be forced to raise interest rates to continue attracting foreign capital. And, if US interest rates are raised, the US economy will collapse.

America apparently cares little what happens to the primarily foreign investors and institutions who bought its subprime loans. On April 24, Bloomberg reported the head of the US Federal Deposit Insurance Corporation, Sheila Blair, testifying before a congressional committee. 'We should hold the servicers' and the investors' feet to the fire on this,' she said. 'We did not have good market discipline with investors buying all these mortgages.'

It is highly doubtful Ms Blair will exhibit the same attitude should the flow of foreign moneys upon which Mr and Ms Average America depend go elsewhere. Thailand's economy went into apoplectic shock and its currency and stock market fell by 50 per cent in 1997 when international currency flows suddenly changed direction. America may soon be in for the same.

And if America falters and falls, the consequences will be felt around the world. Today, afternoon tea and scotch flow freely in The City, as does dim sum in Hong Kong and Shanghai, and sushi in Tokyo around their respective bourses.

Soon, however, the risks that have lain dormant beneath globalisation's foundation are about to erupt and a reordering of the world's financial geography is about to ensue.

It's the summer of 2007, and the sun is shining. A severe financial crisis, however, is in the offing. But because most don't know a crisis is coming, they will have little chance of survival. This summer, America's subprime CDOs are coming home to roost - and not just to the US.

The writer is a financial commentator and author of the book, 'How To Survive The Crisis And Profit In The Process'

Published July 3, 2007

US SUBPRIME FIASCO

The US$3.6m mortgage solution


SETH Weinstein is not a guy who likes to run a tab. He has only two credit cards - one for his personal use and one for business - and he says he pays them in full each month. He even wrote a cheque the last time he bought a car, a white Volvo convertible.

But Mr Weinstein, who for nearly the last 30 years has developed office buildings and condominiums in the New York area, and who seems to be allergic to the idea of accumulating debt, was approved for a US$3.6 million mortgage last month for the US$4 million condominium he is buying at the Century at 25 Central Park West.

The loan is a two-year floating-rate mortgage that will carry payments of roughly US$24,000 a month at what he estimates will be an interest rate of 8 per cent through the term of the loan. He plans to refinance in two years after making some renovations on the apartment.

Mr Weinstein chose the condominium over a similar co-op apartment, where the limit on his mortgage would have been US$2 million. He said he wanted to use as little of his own money as possible to buy the apartment, preferring to invest it in Connecticut real estate, where he expects the returns to be 25 per cent.

'It's not the case that I'm cavalier about debt,' he said. 'I can make a much better return on that in my business.'

More lenders are targeting overqualified borrowers like Mr Weinstein as the next frontier for growth in the troubled mortgage industry. As the national housing market continues to suffer and lenders grow more cautious about approving mortgages for home buyers with anything less than sterling credit, they are opening their coffers to Manhattan's wealthiest buyers, who might not need any financial help.

High-end buyers, even those who are flush with money from Wall Street bonuses or the real estate boom, are flooding banks with requests for huge mortgages so that they can keep up with the escalating prices for multi-million-dollar apartments.

'I've seen more US$10 million mortgages in the past six months than in the past 10 years,' said Melissa Cohn, president of Manhattan Mortgage Inc. 'We have the new breed of buyers who are buying real estate for investments and consider leverage to be part of that ongoing investment.'

Most of these new borrowers take the mammoth monthly payments in stride because mortgages are now one of the cheapest forms of debt. Keith Kantrowitz, president of Power Express Mortgage Bankers, said that the average mortgage requested by his borrowers in Manhattan has nearly tripled in the last two years to about US$4 million, up from US$1.45 million.

Mr Kantrowitz is currently arranging interest-only mortgages for four borrowers in Manhattan, each for US$30 million or more, for two apartments and two town houses they want to buy or refinance.

On the flip side, mortgage brokers say that more banks are increasing the amounts they will lend to Manhattan buyers because apartment prices and sales have remained strong. Jeffrey Appel, a senior vice-president and director of new development financing at the Preferred Empire Mortgage Co, a brokerage based in New York, said he had seen a 20 per cent increase in multi-million mortgages in Manhattan in the past year.

Mr Appel said lenders that are willing to write large mortgages include UBS, Thornburg Mortgage, Countrywide Mortgage and JPMorgan Chase. For some clients, Thornburg will finance up to US$1.8 million on a US$2.25 million apartment and up to US$5.5 million on US$9.2 million houses. Banks that once required buyers to put down half for an US$11 million house now require only US$3.5 million, Mr Appel said.

Depending on a borrower's net worth and financial background, Mr Appel said, lenders are often willing to finance 10-20 per cent more than their guidelines dictate, provided that the mortgage is less than 80 per cent of the house's value. This has resulted in a vast increase in the amount of allowable debt. 'All of these banks are willing to evaluate exceptions on a case-by-case basis,' he said.

Mortgage brokers and psychologists agree that multi-million-dollar mortgages mark a major shift away from the historical stigma that carrying a lot of debt used to hold, especially among the very rich.

'Years ago, financing was looked down upon,' said Mr Kantrowitz. 'A Rockefeller would write a cheque. Now it's accepted.'

Michael Morris, the head of a social intelligence programme at Columbia's business school and a professor in Columbia's psychology department, said that historically, Americans often associated living debt free with economic success and even wholeness.

'In a traditional mindset, there was a moralistic status to having paid off your home,' Prof Morris said. 'It was part of the American dream to have paid off your house.'

No qualms

But David Strause, a mortgage banker in the Manhattan branch of Countrywide Home Loans, a division of the mortgage company, said the wealthy buyers he had seen in the last four months had no qualms about taking out large mortgages. He said such borrowers were typically male, aged 30 to 45, working in finance or real estate and making around US$1 million a year. He has found that buyers in their early 30s borrow most aggressively.

His clients include an investment banker who bought a US$1.94 million apartment on the West Side with a US$1.75 million mortgage; an entrepreneur who bought a US$4 million apartment near Madison Square Park with a US$3.4 million mortgage; and a 32-year-old hedge fund executive who bought a US$1.5 million apartment in the same neighbourhood with a US$1.35 million mortgage.

'They buy the biggest property they can afford, they leverage to the max, and they assume that their careers are on track,' he said. 'A lot of these people tend to think that they are smarter than the banks and they have a better use for the money than put it into real estate.'

But giving the super-rich increased access to borrowed money has raised eyebrows across the rest of the lending market. Robert D Manning, director of the Center for Consumer Financial Services at the Rochester Institute of Technology and the author of Credit Card Nation (Basic Books 2000), points out that it has become far easier in the wake of the subprime crisis for a wealthy Wall Street executive to get a loan than for anyone else in the home-buying market.

'There's no problem with rich people getting loans as long as other people aren't disadvantaged in the process,' he said. 'Are we entering a new Gilded Age where there's just a new set of rules for the rich?'

Larry Goldstone, president of Thornburg Mortgage, a real estate investment trust and jumbo mortgage specialist in Santa Fe, New Mexico, said the average mortgage his company made in Manhattan in the first three months of 2007 was US$1.19 million, compared with US$1 million in 2005. The borrowers are often baby boomers, he said. In fact, Mr Thornburg's average borrower is 47 years old.

'The baby-boomer generation is a generation that is increasingly comfortable with having a mortgage and borrowing money against their real estate,' he said. 'I would much rather have my money in other investments as opposed to paying off my mortgage.'

That's just the way Mr Weinstein, the developer, sees it. He watched his parents, who grew up during the Depression, approach buying homes far more conservatively, putting down as much cash as possible.

'My parents were concerned about debt,' he said. 'I could afford to put down more money, and I could afford to pay off the mortgage at any time I choose. My cash has more value to me to invest in my company than to let sit fallow in a home.' - NYT

Published July 3, 2007

More victims of housing bubble

Many investors who bought bonds backed by subprime mortgages didn't realise what they were getting into

By PAUL KRUGMAN


WHAT do you get when you cross a Mafia don with a bond salesman? A dealer in collateralised debt obligations (CDOs) - someone who makes you an offer you don't understand.

Seriously, it's starting to look as if CDOs were to this decade's housing bubble what Enron-style accounting was to the stock bubble of the 1990s. Both made investors think they were getting a much better deal than they really were.

And the new scandal raises two obvious questions: Why were the bond-rating agencies taken in (again), and where were the regulators? To understand the fuss over CDOs, you first have to realise that in the later stages of the great 2000-2005 housing boom, banks were making a lot of dubious loans. In particular, there was an explosion of subprime lending - home loans offered to people who wouldn't normally have been considered qualified borrowers. For a while, the risks of subprime loans were masked by the housing bubble itself: As long as prices kept going up, troubled borrowers could raise more cash by borrowing against their rising home equity.

But once the bubble burst - and the housing bust is turning out to be every bit as nasty as the pessimists predicted - many of these loans were bound to go bad.

Yet the banks making the loans weren't stupid: They passed the buck to other people. Subprime mortgages and other risky loans were securitised - that is, banks issued bonds backed by home loans, in effect handing off the risk to the bond buyers.

In principle, securitisation should reduce risk: Even if a particular loan goes bad, the loss is spread among many investors, none of whom takes a major hit. But with the collapse of the US$800 billion market in bonds backed by subprime mortgages - the price of a basket of these bonds has lost almost 40 per cent of its value since January - it's now clear that many investors who bought these securities didn't realise what they were getting into. And it's also becoming clear that in addition to failing to appreciate the risks of subprime loans, many investors were fooled by fancy financial engineering - those collateralised debt obligations - into believing they had protected themselves against risk, when they had actually done no such thing. The details of CDOs are complicated, but basically they're supposed to transfer most of the risk of bad loans to a small group of sophisticated investors, who are compensated for that risk with a high rate of return, while leaving other investors with a 'synthetic' asset that is, well, safe as houses.

S&P, Moody's and Fitch, the bond-rating agencies, have gone along with the premise, telling investors that the synthetic assets created by CDOs are equivalent to high-quality corporate bonds.

And investors have, in the words of a recent Bloomberg story, 'snapped up' these securities 'because they typically yield more than bonds with the same credit ratings'. But the securities were never as safe as advertised, because the risk transfer wasn't anywhere near big enough to protect investors from the consequences of a burst housing bubble.

It's not quite the metaphor I would have come up with, but here's what the legendary bond investor Bill Gross had to say about CDOs in Pimco's latest Investment Outlook: 'AAA? You were wooed Mr Moody's and Mr Poor's by the makeup, those six-inch hooker heels and a 'tramp stamp'. Many of these good-looking girls are not high-class assets worth 100 cents on the dollar.'

Now, we're looking at huge losses to investors who thought they were playing it safe. Estimates of the likely losses on CDOs range from US$125 billion to US$250 billion, with some analysts warning that a wave of distress selling will deepen the housing slump even further.

Now, you might have thought that S&P and Moody's, which gave Thailand an investment-grade rating until five months after the start of the Asian financial crisis, and gave Enron an investment-grade rating until days before it went bankrupt, would by now have learned to be a bit suspicious. And you would think that the regulators, in particular the Federal Reserve, would have learned from the stock bubble and the wave of corporate malfeasance that went with it to keep a watchful eye on overheated markets. But apparently not. And the housing bubble, like the stock bubble before it, is claiming a growing number of innocent victims. -- NYT

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