US Mortgage Crisis Contagion: There is NEVER One Cockroach!

``This is the age of what I call Vehicular Finance. The key intermediaries are no longer just banks, securities dealers, insurance companies, mutual funds and pension funds. They include hedge funds of course, but also Collateralised Debt Obligations, specialist Monoline Financial Guarantors, Credit Derivative Product Companies, Structured Investment Vehicles, Commercial Paper conduits, Leverage Buyout Funds – and on and on. These vehicles can fit together like Russian dolls. By way of illustration – and, I fear, slipping for a moment into alphabet soup – SIVs may hold monoline-wrapped AAA-tranches of CDOs, which may hold tranches of other CDOs, which hold LBO debt of all types as well as asset-backed securities bundling together household loans. (The diagram may, or may not, help!)”-Paul Tucker, Executive Director and Member of the Monetary Policy Committee of the Bank of England

Domestic mainstream analysts have correctly pointed out to the US subprime sector as one key catalyst to the recent selloffs, but obviously missed out is the carry trade linkages which have been an equally important contributor (Japanese Yen up .68% and Swiss Franc up 1.34% week-on-week). They have been simply echoing much of what mainstream international news have been saying instead of thinking independently.

In the meantime, experts in the local banking industry have been swift to dismiss the exposures or implied associations of the local financial institutions to the US subprime mess as much as with the Asian region.

While there may be some grain of truth to such assertion, the vast dispersion of risk assets has resulted to unforeseen losses surfacing in unexpected parts of the world. Following several blowups, which we have previously pointed out in some Australian hedge funds, German bank IBF (presently being bailed out by the government), German mutual fund German mutual fund Union Investment Asset Management Holding (halted redemptions) and France’s AXA (closed two subprime funds) have been the latest high profile ex-US casualties, according to Bloomberg.

We are not inclined to believe that this is the end of the episodes of the US housing subprime contagion, to borrow the quote of the illustrious Dennis Gartman of the Gartmanletters, ``There is never one cockroach”. Our primary concern is that this may just be the beginning or the proverbial “tip of the iceberg” and market behavior could be at present reflecting this.

In the following months or so, there is a big possibility that we are to countenance more institutional casualties emerging from the impact of the “one-two-three punch” of the US real estate industry to the subprime (structured finance-derivatives combo) jitters to the subsequent re-ratings in the global credit markets as well as in the equity markets. Of course, I could be wrong and truthfully, wish I would be wrong.

As we explained at our June 25 to 29 edition (see US Subprime Woes Spreading; Feedback Loop Dictated by Market Ticker), the problem is not much with the exposure of local banks to the US subprime imbroglio or related credit instruments, although this should NOT be discounted.

The basic problem lies with margin calls or the “common holder problem”. The Financial Times describes this as ``This is where investors from hedge funds to insurers are forced to sell more liquid assets, such as loans, to cover losses in assets that are difficult or impossible to sell, such as stricken mortgage-backed securities, or collateralised debt obligations built out of these.” (highlights mine).

We in fact used CALPERS, both with significant exposures to unrated CDOs (about $140 million) and to Philippine equity assets ($78.5 million as of 2005) as an example to our hypothetical scenario.

Since foreign money constitutes about half of the Peso trading volume in the PSE year to date, thus, our major question is; to what extent does foreign investors in Philippine assets have similar exposures to these imploding credit instruments?