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.
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probably "in the
ballpark". 
