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     Nov 16, 2007
Subprime mortgages, subprime currency
By John Lee

Last week, US Federal Reserve chairman Ben Bernanke told the US Congress he would support raising the limit on the size of the individual loans eligible for securitization by the government-sponsored mortgage finance entities from US$417,000 to $1 million, on a temporary basis.

He suggested that Fannie Mae and Freddie Mac could pay insurance premiums on these loans to the federal government, which would "act as guarantor" by taking on some of the credit



risk.

Charles Schumer, the Democratic chairman of the Joint Economic Committee, enthusiastically welcomed the idea and said he would try to insert it into legislation already before Congress.

It came as Bernanke told Congress that estimates that set the total losses from subprime mortgages at about $150 billion were probably "in the ballpark".

Given that the Fed and European Central Bank have already injected well over $150 billion since August, Bernanke obviously lied about his ballpark figure. But just how big is this subprime mess?

To measure subprime losses, we have to first find out the size of the subprime market. Fed data pegs the total US residential value at $20 trillion and the US residential mortgage market at $10 trillion. This number is substantial, as it eclipses the US treasury market of $9 trillion.

Of the $10 trillion mortgage market, government sponsored enterprises (GSEs) like Fannie and Freddie hold about $1.5 trillion, leaving $8.5 trillion in private hands. Within this $8.5 trillion, we have various grades and categories, with grades ranging from AAA, AA, Alt-A, BBB, and categories such as the traditional 30-year fixed, and non-traditional ARM, ARM with teaser rate, interest only, and negative-amortization.

The exact definition of subprime is not clear, with various sources estimating that the total subprime portfolio is between $1.5 trillion to $3 trillion. To precisely break down US$8.5 trillion by categories proves to be difficult. Nonetheless below is our estimate. We have valued the subprime market at $2 trillion. This is in line with an estimate by MSNBC reporter and research firm First American Loan Performance.

So just how much of the $2 trillion subprime position is lost? Various sources including First American Loan Performance estimated a default rate of 15%; this would translate to $300 billion of non-collectable principal and interest.

That in itself is not a big deal, as every year the United States spends well over $100 billion in Iraq and $400 billion on the military outside Iraq. The real concern is how such defaults are affecting the value of the existing outstanding subprime portfolio. In other words, would you eat beef knowing that one in 10 cows is a mad cow?

We follow the ABX index published by Markit.com, which is the basket of derivatives linked to subprime securities. As financial tools go, this index is far from perfect, since it is barely two years old, and tends to be thinly traded. But right now it has the unfortunate distinction of being the only tool easily available to measure sentiment in the opaque subprime securities world. And in the past couple of weeks, the message emerging from this measure has started to look utterly dire, as it shows subprime mortgages are changing hands at 25 cents on the dollar.

As we have shown in the pie chart above, this 80% haircut applies to potentially $2 trillion worth of mortgages if investors of those mortgages were to exit today. The loss is not $150 billion, but more like $1.6 trillion.

What's more, the ABX shows that since September 2007, the value of AAA mortgages has begun to crater, and now trades at a stunning 70 cents on the dollar. This means if all AAA and Alt-A mortgage portfolios were to be marked to market, the loss would amount to another $2 trillion.

Despite the fact that Bernanke and the Fed moved to a neutral balance of risks assessment last week, the market now sees a roughly 55% chance that the central bank will cut rates by another 50 basis points by the close of its January policy meeting, and an additional 15% chance that it will cut by 25 points by then.

And now you understand why Bernanke was so frantic in lowering interest rates and proposing the drastic policy measure of more than doubling the GSE limit to $1 million. In essence Bernanke is trying to increase the share of GSE in the pie and hopes the problem will go away.

The curious mind asks, who holds those trillions of dollars worth of mortgages? Thanks to the genius of the American banking and marketing machine, just about every sizable institution underneath the sun with a fixed income portfolio. From Europeans to Asians, from banks to brokerages, from hedge funds to pension funds, institution to retail, trusts to endowments.

Allow me to quote an FT.com article of November 1:
[T]he experience of living through the Enron scandals earlier this decade means that the audit industry is now terrified that it could face lawsuits if it is perceived to be too lax towards its clients. So some now appear to be demanding that their banking clients reprice their mortgage assets according to the only visible market tool - namely the ABX. It is thus little wonder that some banks have suddenly been forced to increase their writedowns in recent weeks. Indeed, I would wager that the pernicious combination of ABX and the “Enron factor” is a key reason for the recent shocks emanating from Merrill Lynch.

However, the rub is that while auditors at some Wall Street banks are becoming quasi-evangelical about the need to reprice subprime assets, there are still other, vast swathes of the financial system which have not been touched by the full blast of transparency yet. Moreover, many financiers outside the world of Wall Street banks remain very wary of rewriting their mortgage assets to current ABX price levels, due to a lingering hope that the recent ABX slump will remain temporary.
Most of those aforementioned outfits are in a state of shock and have been reluctant to mark their $1 trillion-plus subprime portfolio to market. Every other day there is new revelation of substantial subprime loss. First it was New Century in March, then American Mortgage and Countrywide in September, then it got worse as Wells Fargo, Bank of America, Credit Suisse First Boston, Citibank (albeit with a new CEO now) came out of the woodwork. Last Friday it was Wachovia (US's 4th largest), and on Tuesday it was Etrade. Not one major bank dealing with mortgages was immune. If there is such thing as systemic risk, we are sure looking at it, and therefore expect a lot more skeletons to come out of the closet in the months to come.

How about interest rates? Hiking interest rates on US debts is like giving a discount on mad-cow tainted beef: it’s not going to make a difference or help it sell.

At this juncture, the Fed has no choice but to redeem any and all mortgages at near face value directly, through GSEs or offshore vehicles. The more the Fed redeems, the more dollars they print. When you print $1 trillion (10%) a year, people can reasonably swallow the extra money supply, but when you print $1 trillion in a hurry and in a conspicuous way, you are directly challenging money managers’ intelligence and you will see a squeeze in gold. It’s that simple.

No sane foreign institution is going to finance American home owners, and why should they when they can finance the Brazilians, Canadians, Thais, Russians, Chinese, Indians, with an appreciating currency? The dollar's reserve status is now shattered. Mind you, it’s not that we are against the dollar in particular, we just don’t think any fiat currency deserves to be the world’s reserve currency.

To those who say gold is due for a prolonged correction at $800, you are missing the big picture. To us gold’s run has just started, with the emperor now naked for all to see.

John Lee is a portfolio manager at Mau Capital Management. He is a CFA charter holder and has degrees in economics and engineering from Rice University. He previously studied under James Turk, a renowned authority on the gold market, and is specialized in investing in junior gold and resource companies.

(Copyright 2007 John Lee.)

 


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