Posted by: donmihaihai | July 21, 2007

The complexity of the falling US property market.

“The US property market woos has nothing to do with us” is the message that I get when wondering around local newspaper, forums and all kind of reports commonly available in public. Perhaps it is true and even if it got something to do with us in the near future, it is not likely to be huge. But that doesn’t change the significant of the event, the complexity by adding in securitisation, derivative, hedge funds and possible insurance, which totally different from a plain vanilla property, mortgage market where we might never able to see it again. But the stage by stage happening, real life lessons on markets with complexity of spiderweb links is such a valuable lesson is appearing right in front of our eyes because of Internet compare to say 10 years ago. For a keen finance, market learner, this is something that never happens before.

In the good old days, where securitisation is not a common practice among banks or finance firm. Property market was simple, there were just 3 to 4 players. Mainly buyer( a young couple), seller (property/home builder) and bank (mortgage loan). Buyer paid for the initial amount, took out a loan and services the loan yearly until all are being paid. Bank earned on the interests charged while property company earned on what they sell. If there is a bubble, the involved parties are pretty restricted. The pain may be confined to these groups. Not anymore with the current trend with the most developed financial and property market in the world being hit hard by waves follow by waves and more and more parties getting involved. It is hard to know how many more waves are coming and how many more external parties are going to be drag in, where the likely causes of the complexity in the market.

The US property peaked in mid of 2006. Some said the property bubble bust while other being sanguine say the property market has many more legs to go or able to hold their value. As it turned out naysayer got it right this time. But the involved parties sort out as possible getting into trouble are the usual suspect. Speculators, home builders and related businesses and finance companies. Except a few, most of the efforts are being use on trying to predict when the property market will recover. Thoughtful thinkers which make up the minority link up the possible links and potential waves in the financial market. These kinds of views won’t get into the mainstream presses, even if it does, reader will ask, “Is it true?” I guess that separate knowledgeable thinkers from just another player.

“Subprime ” becomes one of the most common words in articles/news on US property market since Mar 07. Of course we now know that New Century Financial Corporation, the largest subprime mortgage lender filed for bankruptcy but there are many more which should be in the north of 40 lenders bankrupt due to subprime lending. Subprime rank the lowest credit profile in all mortgage loan so when borrower unable to repay their loan as interests rate went up and reset of the interests payment hit hard on the lenders and when loans that were  throw out of their loan book with securitisation being returned, there is no where they can run and many went down.

It seems to be not spreading and confined to this segment of the loans or that is what many hope but it is just not the case. Careful reader and thinker already see the changes, changes that putting more pressure on the property market, pushing it downward. When the next hit come, it is hardly any surprise, at least for me. In June, two big hedge funds at Bear Stearns face shutdown because of their investment in subprime-mortgage bonds and CDOs. Unable to liquid their assets in the funds, Bear Stearns pumped in US$1.6 billion(final count) to stable one of the fund and let the other “live” by itself.

At that juncture, it seem securitisation, hedge fund and derivative were at work. And it turn out it is not a US kind of stuff anymore, more hedge funds from UK and Aus face the same trouble. There is a bigger fear in the market, how many more funds are not facing the music yet. When Merrill Lynch & Co., one of the hedge funds’ lenders, trying to sell their seize collateral — much of it mortgage-backed debt, they are unable to find buyers. Already illiquid market becomes totally no liquidity.

That is just the beginning, 17 Jul 07, Bear Stearns dropped another bomb, warned investors of total loss for one fund and a lost of 90% on the other. It means investor get almost nothing after years of investing in these high flying funds prior this event. They earned high rate of returns before this and in a single event, the so call hedge fund just “pop” into the thin air. Bear Stearns said that the decline in investment rated AAA or AA are part of the cause.

Now, more parties are getting involved. After rejecting calls from a long time, rating agencies, Moody and Standard and Poor’s downgrade many lower non investment grade loans. They are in the process of reviewing whether to downgrade investment grade such as AAA or AA of the subprime mortgage loans. Had everyone forget about Enron where rating agencies only downgrade Enron debts into junk bonds(non investment grade) at the eve of Enron fall? Many will be surprise at what they said in the press this time. When rating bond, — as Moody’s puts it in its own code of conduct, “Moody’s has no obligation to perform, and does not perform, due diligence.” The other two agencies have similar provisions. A securities law professor said “The agencies are on fairly strong ground that their ratings are just opinions, but that doesn’t absolve them from liability risk,”  This may be a shock to many, who to depend on when the rating on bond are just opinions, no due diligence is required…

How many local bond fund investor feel safe about their funds because they invest only in investment debts? And with the clever securitisation, subprime mortgage become AAA or AA, anyone worry about whether these bond funds which invest in investment grade debt bought them as well? Lastly, how many of those pension and insurance companies that are required to invest in investment grade debts bought these loans and may subjected to selling them in firesale price in the event where the downgrade come? Now the parties involved are spreading wider and more global.

At this juncture, the spread on risky debts is widening, and it wider not just on subprime mortgage debts. The recent news said that non investment grade are transacting at less than 50 cents on a dollar. How many more hedge funds are going to drop the bad news? It is possible due to the increase default by borrower, the AAA debts can be worth not more than zero? Don’t forget the US property market is still going downward, many mortgage loans are waiting for reset at a higher rate.

The spiderweb link does not stop here. With all the news flow, investors are starting to avoiding riskier securities which include those issue in the process of LBO where provide equity are enjoying their parties. Higher yields are being demanded, underwriters are using their expensive equity to take in those debts as they are unable to find investors willing to invest in them. This is not a healthy sign as it increase risk and reduce return for bank. Perhaps, this may end the orgies of private equity, which take times as well. Will this reduce the valuation of many companies because they may not be taken private anymore since it is more expensive to do so? It is unknown yet but don’t be surprise if it happens. But the bottom line of many companies will dropped because of increasing repayment in interest rates as the cost of borrowing increase.

As the financial market grow and mature, seldom we will get an isolated event. Everything seems to be interlinked and interlink.

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