There is more pain to come from the subprime crisis
By Alan Kohler
John Adams, the First vice-president and second President of the United States, once wrote in a letter to Thomas Jefferson: "All the perplexities, confusion and distresses in America arise not from defects in the constitution or confederation, nor from want of honour or virtue, as much from downright ignorance of the nature of coin, credit, and circulation."
He knew a thing or two, John Adams, and ignorance of the nature of coin, credit and circulation is still a problem 200 years later.
It is highly amusing to see those who didn't predict this recession and bear market now predict that it's over. Have they no shame? Haven't they learnt that they don't know anything, and don't yet understand the nature of coin, credit and circulation?
I didn't predict it either, by the way, but I've at least acquired some modesty along the way. Now I know I don't know anything.
Last month we saw Wall Street rally on the back of dreadful firstquarter earnings reports from Citigroup, Merrill Lynch and JP Morgan. Citigroup lost $US5 billion and plans to sack 9000; Merrill lost $US2 billion, sacks 4000; JP Morgan Chase actually made a profit and isn't sacking anyone.
By one point the markets had got up such a head of steam there was a widening consensus that the worst was over. That was it. It's time to buy again.
Several weeks ago I said I was starting to reinvest in shares (up to 25% of my cash) and was starting with stocks involved in food and water because I think these represent good long-term growth opportunities whatever happens to the market in the short term.
This looked a pretty good call: the market has rallied more or less ever since then, and the food crisis is now the hot topic of the world economy and the sharemarket.
But I am NOT convinced that the worst of the credit crisis is behind us, and in any case at Eureka Report we are not in the business of calling market tops and bottoms. We want to come up with some sensible ideas for producing good investment returns over the long term, which includes being cautious at times as well being brave, and our baseline view about market timing is that it's impossible. The thing to do is invest
little bits at a time.
It's true that Fed fund futures are now, for the first time, predicting higher official interest rates in the US next year, which suggests a short, shallow recession in the US this year, which in turn suggests that the sharemarket may have bottomed.
But I am still not sure it is a time to be brave; rather it's a time to be selective and careful.
The bank losses and credit carnage we are seeing now relate to the sudden spike in US housing defaults and foreclosures last year, producing a big decline in the value of credit assets and a freezing up of interbank lending and commercial paper markets.
The spike in defaults and foreclosures was caused by the fact that the low honeymoon interest rates on about $US2 trillion worth of sub-prime mortgages that had been securitised were coming up for "reset" - that is, the borrowers had to start paying above the normal mortgage rate. Many borrowers simply handed in their keys and walked away, producing a massive overhang of housing stock.
Last year during the peak of the crisis, charts of forthcoming adjustable rate mortgage (ARM) resets were published routinely. Here's one from Bank of America published in September, covering all US mortgages (see chart below):
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The charts were all much the same, and they all showed adjustable rate mortgage resets peaking right about now.
Here's how it works: once a reset happens, it takes 30 days for the first payment to be missed, and then after 90 days the home owner is served with a "Notice of Default". It then takes another 90 days for the defaulting home owner to be served with a "Notice of Trustee Sale" and shortly after that the property is sold in a foreclosure.
In other words, there is a lag of six months between reset and foreclosure, which means foreclosures will peak in six months' time. They have certainly not peaked yet.
So far only about a quarter of the cumulative resets have occurred. From now on resets, defaults and foreclosures will surge, and there is likely to be another wave of credit security write-offs in the months ahead.
It's true that talking about sub-prime these days is almost passé. That was last year's horror show; now we're focusing on CDO (collateralised debt obligations) write-downs, monoline insurance problems, securities loan agreements and, biggest worry of all, credit default swaps.
But sub-prime mortgages started it all and remain the foundation of the bear market and, if anything, the rate of foreclosure on later resets could be higher than earlier ones because the mortgages were taken out when house prices were closer to the peak and lending standards were at their worst.
I simply don't know whether the market has bottomed and it's time to buy again. But I do know that we are still in the early stages of the problem that started it all: sub-prime ARM resets.
What's more, because these mortgages were bundled, securitised, sliced and diced, the institutions that now own them have no idea how to forecast defaults rates on them, and can only value their portfolios according to market value indices that relate to past defaults.
Therefore, the write-downs and bank losses we have seen in the fourth-quarter 2007 and first-quarter 2008 results take no account of future loan defaults.
Back to John Adams and coin, credit and circulation: one thing you'll probably hear a lot about is the "weight of money" or "cash on the sidelines", ready to slosh back into sharemarket and lift valuations again.
This is quite fallacious, as explained by John Hussman of Hussman Funds in the US in a letter to clients a month ago: "Balances in money market funds are not "cash on the sidelines." Securities are simply evidence that money has been intermediated from a saver to a borrower. Once the security is issued, it exists until it matures or is otherwise retired. If I have $1000 "on the sidelines" in Treasury bills, it represents money that has already been spent by the Federal Government. If I sell this Treasury bill to buy stocks, somebody else has to buy it, and there will be exactly the same amount of money "on the sidelines" after I buy my stocks than before I bought them."
Also when bank deposits are withdrawn, the bank must replace them with capital or wholesale debt funding. There is simply no free lunch with "cash on the sidelines".
Right now credit spreads are widening again and central banks are working hard to maintain liquidity in the system, replacing the cash that banks would normally lend each other, but which fear of counterparty risk has dried up.
In April, for example, the Reserve Bank bought $320 million worth of residential mortgage-backed securities from one or more banks to help them with funding problems. The same thing is going on in the US every day, on a larger scale.
In other words, the credit system is still on the edge of collapse, being held together by glue and string. It might be OK, but small problems will be magnified - probably for the rest of this year.
This article was written By Alan Kohler for D&B Insight.
For further details contact:
Danielle Woods
D&B PR Manager Australia & New Zealand
(02) 8270 2926
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