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'