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2 Subprime and the biggest risk of
all By Max Fraad
Wolff
The
subprime mortgage market is in a state of flux.
Risk reduction and risk sharing financial products
are being stress-tested and the results are
unclear.
Recent announcements by
HSBC, New Century and others
have rattled volatility-complacent investors.
Rapid downward repricing has occurred and global
contagion has emerged. A few weeks out, some smiles
are evident as indices have whipsawed and
jawboning has reassured investors. Others see catastrophe on the
horizon. We are in neither camp.
Estimates
are that there is about US$1.5 trillion in
subprime housing loans in the US market. Slowing
house-price appreciation
calls into question repayment
on some of these loans. The greater risks and
lessons are symbolic. The subprime boom and the
risks from a rapid deterioration in the market are
much bigger than subprime. Questionable loans and
the misallocating credit models that generated
them are everywhere. Trillions of dollars in
managed speculative wealth seeks returns greater
than traditional low-risk assets offer.
Global deregulation and consolidation of
banks and financial intermediaries creates a world
of opportunity. New risk and asset securitization
innovations enable products to arise to meet the
ravenous hunger that fuels a global credit boom.
Risk redistribution and repricing derivatives
proliferate to "offset" and safeguard the rising
exposure required. We may be on the brink of
testing our new portfolio and solvency safety
equipment.
Lehman Brothers and Bear
Stearns base cases call for subprime national
defaults of $200 billion to $250 billion over the
next two years. This would translate into 1
million to 2 million residential-unit defaults.
The next 22 months will see nearly $1 trillion in
adjustable-rate mortgages resetting, with $650
billion in subprime. Industry base cases assume
average house prices will be flat to 2% down
across the next two years. Given the scope and
size of recent house-price appreciation, the
projected housing-market correction is very
modest. Confidence derives from many questionable
assumptions. Default risk and hedging products must
turn in stellar performances, fear must not grip
markets, and contagion must be limited. This is
possible and has happened before. This best case
requires us to thread the needle.
Risks must be measured against private US
housing stock valued at $20.6 trillion on January 1
and total mortgage debt of $9.7 trillion on the
same date. The sheer size and recent growth
of household net worth is constantly and
impressively invoked to sooth. Household
real-estate assets increased by 50%, or $6.857
trillion, from 2002-07. During the same period,
the Federal Reserve Z1 Flow of Funds records an
increase of $3.708 trillion, 62%, in mortgage
liability. Disposable personal income increased by
$1.851 trillion or 24% over the period. Net worth
grew by $16.829 trillion, or 43%. It has been a
crazy few years. All this growth of wealth and
debt amid asset inflation is made possible by new
markets, methods and innovation in risk hedging
and sharing.
The rise of collateralized
debt obligations, credit-linked notes,
over-the-counter finance and custom derivative
products are the enablers. The subprime situation,
credit quality, hedging techniques and products
must all be considered together. Across the past
three years there has been a steady decline in the
quality of mortgages written and creditworthiness
generally in the system. Credit-default protection
has been extended to lower credit-quality-rated
debt.
Massive international capital
flows and global financial deregulation have
grown exponentially over the past decade. Cross-border
capital movements have increased more than
threefold to more than $7 trillion since 1996.
This has made far more credit available at much
lower cost. For riskier borrowers - subprime -
this has meant a maiden voyage deep into debt. The
securitization and sharing of default risk has
allowed issuers to share loss risk and markets to
grow.
The sheer mass of managed wealth has
reduced the returns to traditional safe investment
grade assets. Thus supply and demand are generated
by the same forces. These forces include rising
risk/return appetite, global upward distribution
of wealth, financial deregulation and financial
innovation. Risk-management
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