FYI | Mar 16 2007
It didn’t take long for global share markets to overcome concerns regarding sub-prime homeloan defaults in the US and pick up the habit of moving north again.
However, the fact that Australian equities failed to keep the momentum going on Friday, as the weekend came in sight, should serve as a clear signal the term sub-prime is not out of fashion just yet.
Many an expert is convinced things will get worse in the US first before they will get better. As one would expect the “cockroach” theory that if you see one in your kitchen there are probably a few dozens more hiding under your fridge has been widely applied to the matter.
Investors better prepare for many more months of sub-prime related news stories.
Of course, every man and his dog have by now felt the need to look into the matter and express an opinion about it. (It has to be noted that the problem of sub prime mortgages has been visible and steadfastly growing throughout 2006 without much notice from the media or investors). Very predictably, most reports conclude the problem has been severely overblown.
To paraphrase one of the many experts who looked into the matter this week: Housing in the US accounts for 5% of GDP. Sub primes represent 5% of housing loans. Delinquencies have run up to 13.3% of total sub primes. So if all delinquencies slip into default mode this will cut US GDP by 0.03%.
Makes one wonder why even a giant such as Lehman Brothers felt compelled to issue an official statement regarding the company’s potential exposure this week.
But, of course, things are never as simple and certainly not as straightforward as suggested in the above calculation. Few people would have feared the US financial system would be under threat because a few mortgagees couldn’t pay the bills at the end of last month.
(Please don’t take “few” too literally as there are in fact quite many people who no longer can pay off their mortgage requirements, but placed in a bigger picture the financial problem is rather peanuts.)
This is not to say the current sub prime problems cannot grow into a much bigger problem. As rightly pointed out by some commentators, recent US retail sales data hardly grew and failed to meet market expectations. It doesn’t take too much imagination to see how daily news stories about mortgagees abandoning the house -or worse having a family member who can tell it to you from first hand experience- could put a dent in US consumption.
Don’t forget the US bond market is already pricing in three rate cuts by the Fed by year end. If US interest rates have to be cut to stimulate the US economy, however, this will not be good news for US shares.
History shows that falling interest rates are usually beneficial for equities as it increases the Price Earnings Ratios (PER) of stocks. However, and this statement needs always to be accompanied by a big however, if the economy is in need of support investors tend to focus on the negative side of things and PE ratios will actually contract and this means lower, not higher share prices.
If you think this is all getting too doomy and gloomy then consider that asset strategists at Wall Street powerhouse JP Morgan have been advising their clients for several months now that cash is king and certainly to be preferred above investments in US equities. They have maintained the advice following the recent sell-offs.
Needless to say JP Morgan does not buy the argument of, for instance, Morgan Stanley strategists that 2007 should see PE ratios inflate. An overall risk reduction will prevent this from happening, JP Morgan believes. Ongoing stories about US sub prime defaults and more of such problems may well strengthen such a reflex among investors.
0.03% of US GDP does not automatically imply 0.03% less risk taking across the globe.
In Australia, JP Morgan strategists do not agree with their colleagues in the US in that Australian equities are still considered a better alternative than cash. But the local strategists are in agreement with the US office that we are not in a PER expansion period.
It won’t surprise anyone the broker has advised its Australian clientele to go Underweight resources.
One commentator pointed out that given we have yet to see the worst of the US housing sector downturn, including sub prime related problems, it is likely global investors will put a higher risk premium on financial institutions in the US.
This then would benefit Australian banks as the Australian economy is widely regarded more solid than the US economy – this view was again strengthened by the fact that RBA Assistant Governor, Malcolm Edey, used a speech on Friday to reiterate the next move in Australian interest rates was more likely up than down.
Australian banks should also experience no such problems as their US peers.
Some of the most intelligent and practical comments on the matter of US sub prime loans has been written by GaveKal and that, may I say, seems to become a recurring theme.
GaveKal believes the most likely scenario to unfold is that so-called vulture funds will end up buying many mortgages on the cheap. After that these funds will sit on their collateral until they can sell it at a profit. GaveKal believes these funds are unlikely going to accelerate foreclosures for properties as there is absolutely no bid for such properties at almost any price, for starters, but also because most sub prime loans are second mortgages, which cannot foreclose without agreement of the first mortgage. (A little knowledge into the matter certainly helps.)
In any case, says GaveKal, second mortgages are usually just 20% of the property value and almost every foreclosure would wipe this out immediately. Thus, sub prime lenders who foreclose today would face immediate 100% write-offs. A better alternative is thus to sell the mortgages for 10 or 15 cents on the dollar to vulture funds which can afford to hold onto the paper for a few years, while house prices stabilise and recover.
This would be the best example available to how modern risk capital, often labeled as devil-ish in the mainstream media, keeps the financial system free from radical disasters.
Something to think about, no doubt.
Till next week!
Your I-apologise-for-delivering-this-week’s-editorial-two-days-late editor,
Rudi Filapek-Vandyck
(As always supported by the Fab Three: Chris, Terry and Greg)