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Last Thursday, according to Financial
Times,
Mr Bernanke
told Congress he would support raising the limit on the size of the
individual loans eligible for securitisation by the government-sponsored
mortgage finance entities from $417,000 to $1m (€680,000,
£475,000) on a temporary basis.
He suggested that Fannie
and Freddie could pay insurance premiums on these loans to the federal
government, which would "act as guarantor" by taking on some of the
credit risk.
Charles Schumer, the
Democratic chairman of the Joint Economic Committee, enthusiastically
welcomed the idea and said he would try to insert it into legislation already
before Congress.
It came as Mr Bernanke told Congress that estimates that set the total
losses from subprime mortgages at about $150bn were
probably "in the ballpark".
http://www.ft.com/cms/s/0/6b9aebd2-8e65-11dc-8591-0000779fd2ac.html?nclick_check=1
Given that the Fed and European Central
Bank have already injected well over US $150 billion since August, Bernanke obviously lied about his ballpark figure. But
just how big is this subprime mess?
To measure subprime
losses, we have to first find out the size of the subprime
market. Fed data pegs the total US
residential value at US $20 trillion and the US residential mortgage market at
US $10 trillion. This number is substantial, as it eclipses the US treasury
market of US $9 trillion.
Of the US $10 trillion mortgage market, GSE
(Government Sponsored Enterprises) hold about $1.5 trillion, leaving $8.5
trillion in private hands. Within this US $8.5 trillion, we have various
grades and categories, with grades ranging from AAA, AA, Alt-A, BBB, and
categories such as the traditional 30 year fixed,
and non-traditional ARM, ARM with teaser rate, interest only, and
negative-amortization.
The exact definition of subprime is not clear, with various sources estimating
that the total subprime portfolio is between $1.5
trillion to $3 trillion. To precisely breakdown US $8.5 trillion by
categories proved to be difficult. Nonetheless below is our estimate. We have
valued the subprime market at $2 trillion. This is
in line with an estimate by MSNBC reporter and research firm First American
Loan Performance.
http://www.msnbc.msn.com/id/20216643/
So just how much of the $2 trillion subprime position is lost? Various sources including
First American Loan Performance estimated a default
rate of 15%, this would translate to $300 billion of
non-collectable principal and interest.
That in itself is not a big deal, as
every year the United States
spends well over $100 billion in Iraq and $400 billion in military
separately. The real concern is how such defaults
are affecting the value of the existing outstanding subprime
portfolio. In other words, would you eat beef knowing one in ten cows is a madcow?
We follow the ABX index published by
Markit.com, which is the basket of derivatives linked to subprime
securities. As financial tools go, this index is far from perfect, since it
is barely two years old, and tends to be thinly traded.
But right now it has the unfortunate
distinction of being the only tool easily available to measure sentiment in
the opaque subprime securities world. And in the
past couple of weeks, the message emerging from this measure has started to
look utterly dire, as it shows subprime mortgages
are changing hands at 25 cents on the dollar.
http://www.markit.com/information/products/abx/history_graphs.html
As we have shown in the pie, this 80%
haircut applies to potentially $2 trillion worth of mortgages if investors of
those mortgages were to exit today. The loss is not $150 billion, but more
like $1.6 trillion.
What’s more, the ABX shows that
since September 2007, the value of AAA mortgages has begun to crater, and now
trades at a stunning 70cents on the dollar. This means if all AAA and Alt-A
mortgage portfolios were to be marked to market, the loss will amount to
another $2 trillion.
Despite the fact that Ben Bernanke and the Fed moved to a neutral balance of risks
assessment last week, the market now sees a roughly 55 per cent chance that
the central bank will cut rates by another 50 basis points by the close of
its January policy meeting, and an additional 15 per cent chance that it will
cut by 25 points by then.
And now you understand why Mr. Bernanke was so frantic in lowering interest rates and
proposing the drastic policy measure of tripling the GSE limit to $1 million.
In essence Mr. Bernanke is trying to increase the
share of GSE in the pie above and hopes the problem will go away.
The curious mind asks, who holds those
$trillions worth of mortgages? Thanks to the genius of the American banking
and marketing machine, just about every sizable institution underneath the
sun with a fixed income portfolio. From Europeans to Asians, from Banks to
Brokerages, from Hedge Funds to Pension Funds, Institution to Retail, Trusts to Endowments.
And allow me again to quote the FT.com
article on Nov 1st.
…the experience of
living through the Enron scandals earlier this decade means that the audit industry is now terrified that it could face
lawsuits if it is perceived to be too lax towards its clients. So some now
appear to be demanding that their banking clients reprice
their mortgage assets according to the only visible market tool –
namely the ABX. It is thus little wonder that some banks have suddenly been
forced to increase their writedowns in recent
weeks. Indeed, I would wager that the pernicious combination of ABX and the
“Enron factor” is a key reason for the recent shocks emanating
from Merrill Lynch.
However, the rub is that
while auditors at some Wall Street
banks are becoming quasi-evangelical about the need to reprice
subprime assets, there are still other, vast
swathes of the financial system which have not been touched by the full blast
of transparency yet. Moreover, many financiers outside the world of Wall
Street banks remain very wary of rewriting their mortgage assets to current ABX
price levels, due to a lingering hope that the recent ABX slump will remain
temporary.
Most of those aforementioned outfits are
in a state of shock and have been reluctant to mark their $trillion+ subprime portfolio to market. Every other day there is new
revelation of substantial subprime loss. First it
was New Century in March, then American Mortgage and Countrywide in
September, then it got worse as Wells Fargo, Bank of America, Credit Suisse
First Boston, Citibank (albeit with a new CEO now) came out of woodworks. Last
Friday it was Wachovia (US 4th largest), and on Tuesday it was Etrade. Not one major bank dealing with mortgages was
immune. If there is such thing as systematic risk, we are sure looking at
one, and therefore expect a lot more skeletons to come out of the closet in
the months to come.
How about interest rates? Hiking
interest rates on US debts is like giving a discount on MadCow
infested beef, it’s not going to make a difference nor help its sale.
At this juncture, the Fed has no choice
but to redeem any and all mortgages at near face value directly, through GSE,
or offshore vehicles. The more the Fed redeems, the
more dollars they print. When you print $1 trillion (10%) a year, people can
reasonably swallow the extra money supply, but when you print a $1trillion in
a hurry and in a conspicuous way, you are directly challenging money
managers’ intelligence and you will see a squeeze in gold. It’s
that simple.
No sane foreign institution is going to
finance American home owners, and why should they when they can finance the
Brazilians, Canadians, Thais, Russians, Chinese, Indians, with an
appreciating currency? The dollar reserve status is now shattered. Mind you,
it’s not that we are against the dollar in particular,
we just don’t think any fiat currency deserves to be the world’s
reserve currency.
To those who say gold is due for a
pro-longed correction at $800, they are missing the big picture. To us
gold’s run has just gotten started, the Emperor is now naked for all to
see.
By :
John Lee, CFA
Goldmau.com
John Lee is a portfolio manager at
Mau Capital Management. He is a
CFA charter holder and has degrees in Economics and Engineering from Rice University.
He previously studied under Mr. James Turk, a renowned authority
on the gold market, and is specialized in investing in junior gold and
resource companies. Mr. Lee's articles are frequently cited at major resource
websites and a esteemed speaker at several major
resource conferences.
Please visit www.GoldMau for instant market alerts and stock
updates.
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