Tuesday, August 28, 2007

Main Problem With Subprime Debt Is That It’s Hidden

Courtesy of John Browne, Financial Intelligence

There is growing evidence of subprime contagion, from within our domestic banking system and from banks as far away as Europe, Japan and Australia.

Meanwhile, legions of “cheerleaders” keep repeating that the subprime problem is small.

One recent CNBC item showed the subprime problem likened to just a small cupboard in a large house. Well, in size that may be correct.

The problem is that history is littered with examples of size being no indication of results. Two notable ones that come to mind are Lenin and his Bolsheviks who were very few in number, and Castro and his 17 henchmen in Cuba.

The problem with the subprime is that its tentacles are largely hidden, for three reasons.

Editor’s Note: Special Report: 5 Highest Yielding, Safest Investments
for 2007.

Firstly, derivatives such as Collateralized Debt Obligations (CDO’s) are sliced and diced so that the “toxic” subprime credits were mixed up, or bundled, together with triple-A credits.

This “bundling” confused not just the rating agencies but also many of the investors, who are still uncertain as to how much toxic waste they have and even who ultimately holds it.

This causes the assets of many highly leveraged financial institutions to become suspect and cause for great concern by potential lenders.

It is like the discovery of toxic waste in a giant batch of food. No one wants to eat any of the batch, no matter how impassioned the appeals and assurances of the producer that, “all is under control!”

Secondly, much of the investment in subprime mortgages and CDO’s was done by hedge funds and in the accounts of institutions, where valuations were done at cost or “informed estimate”, rather than at market, as no public market existed for such “privately” placed instruments.

The adjustment to a true “market price” of many of the assets of certain major financial institutions is a second cause of deep concern, out of proportion to the probable degree of subprime infection.

No one likes to come into physical contact with anyone close to someone who has succumbed to an infectious disease. The fear may eventually prove to be false, but for a time at least, it is all too real. Social contact, like financial markets, tends to seize up.

Finally, despite adopting genuinely independent investment strategies, many investors, including hedge funds, end up investing with a “common approach”. Today’s New York Times (NYT) contains a most interesting article on this very subject entitled, “Just How Contagious Is That Hedge Fund.”

The NYT article goes on to quote Lawrence G, Tint, an investment consultant and retired vice chairman of Barclays Global Investors as saying that he suspects that, “some hedge fund investors will be surprised that their funds lost money and because of problems in the subprime mortgage arena. That’s because those investors have been falsely assuming that just because their funds focused on completely different strategies—commodities, for example—they have no exposure to the subprime mortgage market.

So there you have it. The subprime market may be relatively small, but it is intertwined with the vastly greater credit and derivative markets.

Just as in CNBC’s “house” analogy, the room may be relatively very small, but if it is linked to the rest of a vast, tinder dry wooden house, a small fire in that room could soon affect the whole house.

We therefore urge our readers to ignore the siren voices of the cheerleaders, especially those representing interests that are either “long” the market or credit institutions.

We repeat our forecast made throughout the last year and more, that the housing bust will prove not just contagious but disconcertingly so.

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