US Subprime Woes Spreading; Feedback Loop Dictated by Market Ticker

``No matter how hard we try, our perceptions about people will be misguided a significant percentage of the time. Of course, it’s one thing to be off target occasionally but quite another to be consistently wrong. That’s because the foundational principle of all other success principles is having an accurate perception of reality. Which means that great achievements are virtually impossible if one’s perception of reality is perpetually faulty.”-Robert Ringer on Changing Perceptions

We also noted last week that fundamental variables such as the appearance of a contagion of the subprime implosion, new Taxes, and the state of the Japanese Yen could lend to heightened state volatility in the markets today.

BCA Research recently published two back-to-back issues which dealt with the Subprime sector. While the highly reputed independent research outfit acknowledges that yield spreads have widened, they think that the present anxieties over the permeation of the subprime woes are less likely to pose as systemic risks, as shown in Figure 3.

Figure 3: BCA Research: Subprime Weakness and Systemic Risks

Let me quote BCA Research (highlight mine), ``Falling home prices combined with rising delinquency and foreclosure rates have pushed the ABX index spreads (a basket of sub-prime home equity ABS) to new highs. A key difference from the selloff that occurred earlier this year, however, is the divergence between the higher and lower quality indexes. In the first three months of 2007, all of the ABX indexes sold off, up to and including the AAA-rated securities. In the more recent flare-up in spreads, the damage has been more concentrated in the low quality indexes. The market appears to be acknowledging that the latest disruption is more a reflection of credit concerns, unlike the February move, which was also accompanied by (unrealized) concerns of broader financial systemic risk. Bottom Line: the shakeout in sub-prime debt is not over, but may now be contained to lower quality securities, with less risk of a contagion into credit spreads and the banking sector.”

While we’d like to assume BCA’s optimistic position on the overall state of the US credit markets, so far the performances of the financial sector, including that of the banking indices has manifested strains from the recent subprime ruckus, in contrast to their outlook. Besides, understanding how BLACK SWANs or low frequency high impact events unfold, underestimating risks could lead to portfolio disasters.

In fact, the du jour apprehension in the global marketplace has been mainly focused on the valuations aspects of these so-called complex “structured finance” products that have proliferated in the world of finance.

In the US, where $375 billion Collateralized Debt Obligations (CDO) had been sold in 2006, subprime debts comprised 45% of its collateral backings, according to a Bloomberg report. CDOs are bundled pools of assorted debt instruments, from corporate bonds, mortgages, loans and others.

The problem is that such complex and highly illiquid instruments obtain their values not from market based pricing but from ratings issued by credit rating agencies or through “model” based-what the bankers or accountants say it is worth. When the going was good, nobody questioned the way these assets were valued…until now.

As the subprime saga deepens, losses which were once limited to the domain of mortgage lenders, have now appeared in the portfolios of hedge funds, as in the recent case of Bear Sterns and other funds, such as two London based funds-Queen's Walk Investment Ltd. and Caliber Global Investment Ltd., including a hedge fund shut by Zurich-based UBS AG which accounted for 150 million Swiss francs ($122 million) of first- quarter losses (Bloomberg).

In addition, as investors have become increasingly wary over mounting incidences of losses, deals, flotation and offerings have equally suffered such as Dollar General (could scrap its offering), CanWest MediaWorks (reduced its offering) and mortgage fund IPO by the Carlyle Group (reduced its offering). Such are signs of how investors have turned to risk aversion. And risk aversion implies for a prospective liquidity crunch.

Notwithstanding, the emerging risks wherein the escalating losses in the portfolios of hedge funds and other institutions could pave way for a re-rating from credit rating agencies as S&P, Fitch and Moody’s.

Let me quote at length Bloomberg’s Mark Pittman report (highlight mine),

``Standard & Poor's, Moody's Investors Service and Fitch Ratings are masking burgeoning losses in the market for subprime mortgage bonds by failing to cut the credit ratings on about $200 billion of securities backed by home loans.

``The highest default rates on home loans in a decade have reduced prices of some bonds backed by mortgages to people with poor or limited credit by more than 50 cents on the dollar and forced New York-based Bear Stearns Cos. to offer $3.2 billion to bail out a money-losing hedge fund. Almost 65 percent of the bonds in indexes that track subprime mortgage debt don't meet the ratings criteria in place when they were sold, according to data compiled by Bloomberg.

``That may just be the beginning. Downgrades by S&P, Moody's and Fitch would force hundreds of investors to sell holdings, roiling the $800 billion market for securities backed by subprime mortgages and $1 trillion of collateralized debt obligations, the fastest growing part of the financial markets.

``You'll see massive losses from banks, insurance companies and pension managers,'' said Joshua Rosner, a managing director at investment research firm Graham Fisher & Co. in New York and co-author of a study last month that said S&P, Moody's and Fitch understate the risks of subprime mortgage bonds. ``The longer they wait, the worse it's going to be.''

Could there be a contagion? Of course, such is possible. Losses in a portfolio, especially from the leveraged positions, would imply liquidations in other areas in order to cover or offset such a loss.

Let us take for example the pension industry. According to a Bloomberg’s David Evans, ``Public pension funds have bought more than $500 million in CDO equity tranches in the past five years, according to data from public records requests.”

Equity tranches are known as ‘toxic waste’, because they represent the riskiest composite tranches of a packaged CDO.

According to the same report from David Evans (highlight mine), ``The California Public Employees' Retirement System, the nation's largest public pension fund, has invested $140 million in such unrated CDO portions, according to data Calpers provided in response to a public records request. Citigroup Inc., the largest U.S. bank, sold the tranches to Calpers.”

And we are all aware how the Philippine government exerted so much effort to keep the US largest pension fund’s investments here intact, which was valued at $78.5 million in 2005 from $12.46 million in 2002 according to Manila Times.

What if, by virtue of this subprime implosion, they experience outsized losses? And importantly, if the accrued losses have been amplified by the use of leverage? Naturally, they could take the route of selling on their other holdings such as their investments in Philippine assets. And this may not be limited to Calpers, as there could be other fund entities with equivalent exposure to Philippine assets affected by the present US subprime epicenter woes.

In short, one could expect the turmoil from the worsening subprime sector to ripple to the Philippine shores if the implosion turns into a rout or into a disorderly manner.

This is where our selling stops should be in place.

This is NOT to say that this WILL happen, this is to say that such events COULD happen and should NOT be discounted. As Nassim Nicolas Taleb wrote of Black Swans, ``ONE single observation can invalidate a general statement derived from millennia of confirmatory sightings of millions of white swans. All you need is ONE single (and, I am told, quite ugly) black bird.” Obviously the subprime debacle is turning out to be not an isolated event. The $64 trillion question is; to what degree the ramifications?

No matter how bullish our convictions are for the Philippine stockmarket cycle, such does not imply that the present trends will not meet speed bumps or be derailed by obstructions enough to shakeout the present prevailing sentiment. This always happens. As we always say, no trend goes in a straight line. Further, in every secular trend there is a counter cyclical trend.

Said differently, those blinded by euphoria today will encounter such periods as their day of comeuppance. Where due to heavy stress over unacceptable losses, such investors will abandon the markets until signs of recovery emerge. Since they operate on hope, the likely response under such conditions would be denial, frustrations and then fear.

This happened before. Remember the Phisix in the last secular advance cycle in 1986-1997 had two major crashes in between (40%+ losses in about a year in 1987 and 1989), but it did not stop the cycle from reaching 3,400 or a gain of about 22 times from trough to peak. And this could happen again.

Such is the reason why we always advise people to treat the present outsized gains as bonus, and not to expect markets to persistently outperform as today. Managing one’s expectations is one healthy way to improve on one’s portfolio performance.

Going back to the fix in “structured products” (derivatives, structured finance); while such innovative tools had been in the past repeatedly argued (especially by regulators) to have aided the capital markets by spreading risks to a wider universe of investors, today there is a newfound perspective; such diversity could in fact be a disadvantage.

Let me quote currency analyst Jack Crooks, ``HSBC Chairman Stephen Green said he was “’worried by the degree of leverage in some big-ticket transactions nowadays’ and felt ‘something is going to end in tears.’” “He also warned that losses could be higher because the parceling out of risk to so many parties across the financial system could make it more difficult to arrange a rescue – a comment that highlighted widespread and growing unease among senior banking executives.”

There you have it; it’s all in the perspective dictated by the ticker. Previously, broader market base was said to benefit investors since they spread risks. That was when the markets were strong where no one seemed to challenge such assertions.

Now that the air has come out of some over inflated markets, the view has changed. Because of the diverse base, rescue packages would be more difficult to address since many parties are involved.

It’s all a feedback loop depending on the angle you chose to take. That fundamentally is how markets operate.