Saturday, February 10, 2007

Sub-Prime Canaries

Sub-prime loans account for 14% of all US home mortgages, or some $1.4 trillion. Around 11% of those are already in trouble and some analysts expect that percentage to double, resulting in $280 billion in losses for lenders. This is not such a huge number within the context of a ~$14 trillion US economy, though it will mean substantial earnings cuts for those associated with the mortgage business. The news is out and the haircuts have begun with a vengeance (just look at the ABX indexes).

That's the rosy picture. Now the gray one.

Sub-prime lending is likely just the canary in the coal mine: the weakest go first. Tighter lending conditions will also affect other borrowers (once burned..) and the continuing drop in house prices will make it very difficult to refinance, even if interest rates decline, because remaining equity will be lower or even negative. The Fed would have to take interest rates down to almost zero to spark significant activity - a very unlikely prospect right now.

In addition, housing is a prime economic driver. Though it only accounts for 6% of GDP directly, studies have shown that the overall effect is around 25% (furniture, appliances, services, finance..). In a US economy emasculated of domestic manufacturing, a weakness in the housing market will have knock on effects for quite a while.

From the financial perspective, the creation of trillions in credit derivatives has firmly connected equities to credit risk and a self-reinforcing feedback loop is in operation. Weakness in credit conditions and perceptions will quickly find its way in the stock market, which will feed back negative signals to the credit markets. What was until now a virtuous cycle of continuously shrinking risk and volatility premiums can quickly turn into a negative one. This type of financial system sickness may be as unresponsive to lower interest rates as it was apathetic to higher ones. The reason is simple: it is the return of principal that is at stake here, not the cost of lending it.

Now, add to this unpleasant punch the "mickey": leverage. The hedge fund industry alone has $1.3 trillion in capital and it is not shy when it comes to borrowing against it to put on all manner of speculative positions. The private equity business has also expanded rapidly in recent years, also funding LBO's and takeovers with borrowed money.

It is plain to see that the canary has expired. The coal miners that run for the surface first will survive, but those that think the canary is just another silly bird that died of a tummy ache from eating too much seed...

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