The+Subprime+Mayhem

India Fixed Income Research THE SUBPRIME MAYHEM September 29, 2008 Housing bubble burst; global credit engulfed As the days pass, the US economy continues to slip on tremors of a weak financial sector and financially-critical participants. The ‘Subprime Crisis’, arguably the most disastrous phenomenon to hit the global financial sector, has managed to wipe out top players, some of whom had even managed to withstand the Great Depression. The primary culprit of the subprime crisis was not the housing bubble, but the widespread assumption that the bubble will never burst. In the world of financial engineering and complex derivative products, the subprime mortgage loans were securitised and structured as collateralised debt obligations (CDO) and mortgage backed securities (MBS). As the Federal Reserve (Fed) raised the Fed rate to a high of 5.25% (increasing mortgage payments and disrupting refinancing ability), the housing market witnessed a turnaround, resulting in rising foreclosures and higher delinquency rates. As prices of the underlying (US house prices fell 17% in 2007) started falling, the derivative instruments - CDOs and MBS - which then were very attractive investment options, started losing value. Chart 1: Rising Delinquency and Foreclosure rates as house price crashes 24 18 12 (%) 6 0 -6 -12 -18 Jun-00 Jun-02 Jun-04 Jun-06 Feb-01 Feb-03 Feb-05 Feb-07 Jun-08 O ct-01 O ct-03 O ct-05 O ct- 07 Rahul Chokshi +91-22-6620 3019 rahul.chokshi@edelcap.com Varda Pandey +91-22-6620 3072 varda.pandey@edelcap.com De linque ncy ra te Fo re closure r a te Ho use price Source: Bloomberg These products were not actively traded; hence, pricing them for mark-to-market (MTM) adjustments was always a cause of worry as it relied on complex financial modeling. Tumbling housing prices and a rising delinquency rate drilled a hole in the portfolio value of CDOs and MBS, as investors (hedge funds, investment banks etc.) reported losses and faced redemption pressure. Sale of these assets further eroded their value as banks and financial institutions faced a double blow of write-offs on these assets and a rising default rate. Cost of protection and spreads widening With the rise in write-offs by top Wall Street players, credit, which was easily available prior to the crisis, became vital to survive the subprime crisis. As future developments were unknown, participants were reluctant to lend, making the credit market worse. Reluctance to lend against CDO and MBS, which were easily acceptable as collateral earlier, turned extremely adverse for those who had borrowed against them facing margin call pressures as values shrank. Edelweiss Securities Limited 1 The Subprime Mayhem With the financial market falling apart, bonds attracted money on account of ‘flight to quality’; this resulted in sell-offs in troubled assets and buying of treasuries, widening the spread between them. The Itraxx index, the movement of which is most susceptible to credit worries, has shot up significantly over the past year and a half (since the beginning of the crisis). Chart 2: Itraxx index heads north 700 560 420 280 140 0 Jun-07 Jun-08 Jul-07 Jan-07 May-07 Dec-07 Jan-08 May-08 Mar-07 Sep-07 Mar-08 Jul-08 Sep-08 Apr-07 Aug-07 Apr-08 Aug-08 Feb-07 Nov-07 Feb-08 Oct-07 (bps) Source: Bloomberg Ted Spread widening The Ted spread (where participants trade the credit spread of banks over sovereign bills) has seen a rise in volatility. The spread (T-bill over LIBOR; the former being a sovereign risk free instrument), which ideally measures the credit risk of lending to counter-parties (banks), surged after the recent turmoil in the financial market. Chart 3: Ted spread turns volatile on credit concern 3.5 2.8 2.1 (%) 1.4 0.7 0 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Source: Edelweiss Fixed Income research Fed’s diagnosis: Easing liquidity The financial framework, which seemed to have been fortified around lending secured by seemingly depreciation-proof housing assets, began to tumble like a pack of cards, Edelweiss Securities Limited 2 Research Note triggered by the closure of two hedge funds operated by Bear Stearns. The entity was eventually taken over by JP Morgan Chase at a cheap fraction in March 2008. The capital adequacy ratio (CAR) of banks, that measures capital maintained by them to cushion for risk, eventually fell short to cover risk-weighted assets as exposure shot up with the alarming credit defaults. This shortage was filled by raising more capital by offloading promoters’ stake to existing stakeholders (rights issue) or outsiders and selling non-performing assets at a discount or pledging them in return for capital. Citigroup is a case in point: after writing off losses worth ~USD 19 bn for Q4 FY08, it raised capital by offloading its stake to a ruling family of oil-rich Middle Eastern Emirate Abu Dhabi-based sheikdom, servicing its lowered tier-1 CAR to maintain the targeted 7.5%. Subsequently the higher capital requirement across financial institutions reinforced the liquidity crunch, raising the risk premia of lenders. In order to mitigate the slow-down panic, the erstwhile Great Depression remedy of central bank refinancing seemed like the urgent cure. Monetary authorities around the world have already offset ~50% of the USD 515 bn write-offs by banks around the world as at mid-July, 2008. The Fed has tread a long way to ensure refinancing support to financially-critical investment banks (that were allowed Fed lending for the first time in March 2008), securities firms, and government-sponsored Fannie Mae and Freddie Mac. The changes brought about were to ease their cash requirements and to retain the much-needed liquidity for a longer period (extending the overnight term auction facility to 28 and 84 days) and widening the ambit of assets posing as collateral to investment-grade securities. The opening up of refinancing windows to the troubled entities on the one hand reinforced the moral hazard problem (those in troubled waters hoped to be afloat on Fed’s helping hand), while on the other, averted large fluctuations for global markets that spiked at the very hint of credit write-offs. The discount window was opened with a view to detoxify the financial system by exchanging ‘toxic’ instruments with sovereign bonds that could be pledged for future borrowings. Central bank’s monetary policy bows to crisis As the financial crisis spread its tentacles around the world, the impact soon penetrated the real economy, with the lending machinery failing corporates of the non-farm sector, subsequently adding to the pool of the unemployed. Unemployment in the US soared to a five year high in August 2008, which led consumers to desperately turn to credit windows to finance their personal spending, even as the change in the real personal spending receded to a low of (0.4%) in five years as at July 31, 2008. Chart 4: Rising unemployment takes toll on spending 6.5 6.0 5.5 5.0 4.5 4.0 Jan-06 Jan-07 Mar-06 May-06 Mar-07 May-07 Jan-08 Mar-08 May-08 Sep-06 Sep-07 Jul-06 Jul-07 Nov-06 Nov-07 Jul-08 0.9 0.6 (%) 3 (%) 0.3 0.0 (0.3) (0.6) Unemployment C onsumer spending Source: Bloomberg Edelweiss Securities Limited The Subprime Mayhem Subsequently, the Fed took to monetary accommodation; Fed rate was slashed by 3.25% over the eight months of September 2007-April 2008 to a meek 2%, intended to cheapen the cost of credit for borrowers (as reflected in the overnight rates). Soaring commodities prices; crude price zooming 50% (Y-o-Y) to its peak on July 11, 2008, to USD 147/bbl; and metal prices going through the roof, adding to higher producer price indices around the world, exacerbated the growth slowdown (precursor to a recession), the global economy now facing a greater evil of inflation. What monetary authorities round the world looked to mitigate, through lowering of interest rates to stave off a recession, only fuelled price pressures. Inflation and unemployment looked to exhibit a positive relationship in the developed economies, the world seemingly heading towards stagflation i.e., a situation of slower growth bordering on economic stagnation coupled with higher inflation. The Fed and Bank of England (BoE) decisions (as on September 16 and September 4, respectively) to keep interest rates unchanged indicated this inflation-growth dilemma even as the liquidity crisis deepened with Lehman Brothers’ legacy buried for good and Merrill Lynch’s sale, before being lynched. Chart 5: A positive relationship inducing central bank dilemma 6.5 6.0 5.5 5.0 4.5 4.0 6.0 4.8 3.6 2.4 1.2 0.0 (%) Sep-07 May-07 Nov-07 May-08 Mar-07 Mar-08 Jan-07 Jan-08 Jul-07 Unemployment Inflation Source: Bloomberg The crisis behind the crisis In the course of seeking a medicinal boost for domestic demand with lower benchmark interest rates, the economy is seemingly trapped in the vicious circle of incessantly eroding home prices, lower purchasing power, lower consumer spending, inducing lower investments, and higher layoffs. Increasing unemployment has, in turn, led to higher foreclosures. As per the report of the Joint Economic Committee of the Congress (September 2008), a single foreclosure devalues nearby homes by ~USD 1,508 nationwide, while institutions that inherit the collateral property incur a capital loss of USD 50,000. Edelweiss Securities Limited 4 Jul-08 (%) Research Note Fig. 1: Flow chart Virtuous pre-crisis cycle Higher demand for Assets/Real estate Asset Price Inflation/ Asset bubble formation Higher prices of Real Estate Higher purchasing power of asset -holders Higher creditworthiness and therefore larger mortgage applications Vicious post-crisis cycle Asset bubble burst/ falling house prices Higher housing inventories Declining values of CDOs and MBS Mortgage borrower’s vicious trap Lower equity/ purchasing power Rising Foreclosures Higher write-offs by investors as NPAs rise No refinancing Higher Delinquencies Lower business investments and higher layoffs/unemployment Rise in default risk reduces bank lending, even as losses eat into cash Higher lending costs indicating fears of growth slow-down Global liquidity Crunch – severe cash constraints to maintain CAR Source: Edelweiss Fixed Income research Edelweiss Securities Limited 5 The Subprime Mayhem A significantly lower interest rate made cost of borrowings lower for banking institutions, but the effect was not seen to trickle down to consumers. Mortgage rates did not report much softening, the intended impact of lower lending rates and larger credit offtake unfulfilled. This implied the chief problem of reduced creditworthiness of borrowers, bordering on absolute inability to repay, as opposed to a higher cost of credit. Chart 6: Benefit of low rate not passing to mortgage borrower 7.0 5.6 450 375 (%) 4.2 2.8 1.4 0.0 225 150 75 0 Jan-07 Mar-07 May-07 Jan-08 Dec-07 Mar-08 Jun-07 May-08 Apr-07 Feb-07 Sep-07 Apr-08 Feb-08 Jun-08 Fed Rate 15 year Mortgage rate Spread Source: Edelweiss Fixed Income research Even as heightened monetary accommodation was not able to significantly mitigate the sufferings of the crisis, the Fed’s refinancing measures - the latest being an augmented auction limit of USD 247 bn for the world’s central banks to undertake bailouts - only averted any immediate defaults by the institutions being saved, while those who default on their loans (primary borrowers for residential investment and speculative motives) were still not reached. A case in point is Fannie Mae and Freddie Mac, which operated as private entities with implicit government backing for all crisis-led losses, reported the instance of Fed’s cash infusion on July 13, 2008, to, in turn, refinance over 50% of the applications in the mortgage market. The cash support was only a temporary relief, since the Government sponsored enterprises reported larger than expected losses (USD 3.43 bn - Q3 CY08) and, subsequently, reverted to public agency status as the Fed takes over. The blow to the US capital markets, with outflows from both the debt and equity segments, is likely to also mean the ‘greenback’ being in the red. A weaker dollar will further add to the woes of foreign lenders as the loans extended in the past will be downgraded for their real value, nominally inflating the value of non-performing assets on their balance sheets. The currency swap deals (swap lines) with European Central bank (USD 110 bn), BoE (USD 40 bn), and Swiss National Bank (USD 27 bn) are instances, indicating that fresh dollar infusion in these markets may weaken the greenback, eroding the real value of lender’s assets. Markets feel the heat; Treasuries safe haven The comparison between the yield curve for the US government bonds at the hint of the housing crisis and the one just prior to the Federal open market committee (FOMC) interest rate review depicts the aggressive buying activity (specifically at the short-end) in the fixed income segment, which offered a ‘safe haven’ for capital amidst the crisis. The massive capital losses, which amounted to entire asset values being wiped out, shot up demand for US treasuries on account of a ‘flight to quality’ bid. The two-year note shed a massive 74bps in the two months till September 16, 2008 (in the wake of ~100% Edelweiss Securities Limited 6 Sep-08 Aug-07 Aug-08 Nov-07 Jul-07 Oct-07 Jul-08 (bps) 300 Research Note market probability of a 25bps rate cut to 1.75%); the 2s10s spread zooming from 190bps to 235bps over the same period. Chart 7: US yield curve witness a downwards shift on dovish stance in FY08 6.00 4.50 (%) 3.00 1.50 0.00 2-year 31-Mar-07 5-year 31-Mar-08 10-year 23-Jul-08 30-year 16-Sep-08 Source: Bloomberg Credit default swaps (CDS), a form of credit derivatives meant to extend protection (insurance) for debt instruments of a reference party, reported large fluctuations on the unfurling of the credit crisis, premier financial institutions turning casualties. Goldman Sachs’ five-year CDS, which wavered in the 75-100bps range in September 2007, has rocketed to a massive 550bps in September 2008 on account of growing defaults and riskiness of the structured debt instruments spun-off from subprime mortgage loans. Capital markets around the world were severely battered, taking the Dow Jones (US equities index) that led the turbulence after declining 25% from 14164.53 as at October 9, 2007 to 10609.66 as on September 17 2008. Owing to larger defaults in developed capital markets, foreign institutional investors (FII) have also pulled out their investments in emerging markets. India is a case in point; it witnessed FII outflows of INR 81 bn in September 08 on growth concerns stemming from the global liquidity crisis. The Central Bank of China, which invested its trade surplus dollar in the Fannie-Freddie mortgage-backed debt at the rate of ~USD 27 bn/month in 2007, runs a dual impact of capital losses, one stemming from direct defaults in them and the other from the Yuan’s appreciation vis-à-vis the dollar. The Yuan has appreciated 11% in the 15 months of the housing crisis against the greenback. The broad sentiment of investors is skewed towards risk-aversion, as emerging market bond spreads (JPMorgan EMBI+ index 11EMJ) widened to 328bps by mid-March 2008 (highest since mid-June 2005) and 435bps by mid-September 2008, indicating lower demand for Asia’s sovereign bonds on account of higher global cost of capital and higher credit spreads for corporates. The cost of raising capital via Corporate Bonds (CB) in the developed world has risen not just on account of lower supply of funds (the on-going liquidity crunch), but lower demand for CBs, as the risk-appetite of investors has taken a serious hit. Edelweiss Securities Limited 7 The Subprime Mayhem Chart 8: Spread widens - Corporate bonds (FINRA-Bloomberg) to 5 yr US treasury 8.0 6.8 5.6 4.4 3.2 2.0 Jul-05 Jul-06 Jul-07 Jan-05 Jan-06 Jan-07 Apr-05 Apr-06 Apr-07 Jan-08 Apr-08 Oct-05 Oct-06 Oct-07 Jul-08 600 490 (bps) 380 270 160 50 (%) Spread Investment Grade C orp. bonds US 5 year treasury Source: Edelweiss Fixed Income research The Reserve Bank of India’s (RBI) measure to infuse capital in the cash-starved domestic financial set-up amidst the capital exodus, owing to foreign institutional investors sell-off amidst the liquidity crunch, has led to relaxation of external commercial borrowing (ECB) norms. With higher capital limits for the core infrastructure sector raised to USD 500 mn, owing to the liquidity crunch in global markets and increase in the average investor’s/lender’s risk aversion, the RBI has also raised the interest rate cap for the ECB beyond the 7-year maturity by 100bps (even as the 6-month LIBOR used to price these borrowings rose to ~4%). As the crisis ages, is there respite yet? A yet unraveled category of alternative A-paper mortgages, which hold loans worth USD 1 tn, could extend the crisis in due course as the loan service obligations are revised higher over the next three-five year period. Although these loans are typically extended to those with a higher credit rating than subprime borrowers, the latter are lent at terms keeping in mind possible foreclosures and refinancing, while the former are extended only at the reduced initial risk exposure that grows manifold as interest rates are reset. The leading mortgage finances agencies - Fannie Mae and Feddie Mac - have respective exposures of USD 340 bn and USD 190 bn, with alternative-A delinquencies rising 10.03% for the 2007 vintage since the May 2008 distribution date to 13.34% in June 2008. Personal consumption and personal income relationship are the two variables that have been observed to historically diverge, since consumption has been broadly supported by higher consumer credit. With the notable decline in personal income and therefore reduced credit-worthiness, personal consumption is expected to be increasingly in line with personal income (a gradual reduction in their spread). The yesteryear creditinduced growth cannot be relied upon, even as larger credit defaults reduce banks’ willingness to lend. Edelweiss Securities Limited 8 Research Note Chart 9: Spreads shrinks between personal income and personal consumption 4.0 4.5 3.6 2.7 1.8 0.9 0.0 3.2 2.4 1.6 0.8 0.0 (%) Sep-05 Sep-06 Nov-05 Nov-06 Sep-07 May-05 May-06 May-07 Nov-07 Personal consumption Personal income Source: Bloomberg Massive refinancing to wade through the crisis, now heightened by the USD 700 bn bailout proposal by Treasury Secretary Hank Paulson, is expected to have serious implications for the US fiscal scenario. With the Fannie Mae and Freddie Mac rescue expected to jerk finances by USD 100 bn each, the absolute fiscal deficit is likely to shoot up way beyond the estimated USD 400 bn over 2008-10 (deficit was USD 160 bn in 2007). The immediate cost (tax burden) to American consumers (who will save much less today due to a higher time-value for money) in the medium term will, however, depend on the maturity of instruments used to raise funds for the bailout: the usage of T-Bills allows usage of the proceeds for a shorter period as opposed to the three-year and five-year corporate bonds, correspondingly scheduling redemptions much earlier for the former. The interest rate cycle that reported a peak at 5.25%, the highest in seven years also witnessed an extremely narrow spread (less than 50bps) for the 15-year mortgage rate. The present 2% level for the fed funds rate that may be near the trough of this cycle, on the contrary has reported a much higher spread of 330bps, the underlying for the mortgage loan adding to the default risk that has become hard to price. The flat interest rate is likely to continue till the willingness to lend by the banks comes in line with the Fed’s prerogative to boost lending—banks lowering interest rates to allow the benefits of lower borrowing costs to flow to consumers, reducing the spread thereby from present level. US Treasuries are expected to report greater volatility as capital withdrawn from equities is diverted to risk-free fixed income instruments. As the economy deepens into an economic slowdown, pass-through of the USD 700 bn bailout proposal is expected to be supplemented by an interest rate cut in the October 28 FOMC meeting; likely to reinforce the rally in Treasuries. Increased supply of government bonds and treasuries on the back of constant central bank refinancing, is likely to cap the gains. Incase of the stated developments, the 10-year note is likely to touch the 3.50% level. The dollar’s flow across countries as the international reserve currency may seriously be impacted as emerging market economies begin de-leveraging investments away from the greenback with a view to diversify their portfolios, even as the average purchasing power of the American importer loses value. With global confidence in the reserve currency dwindling on the back of soaring deficits and fears of growth slowdown, developing country investors will typically divert investments in safer and more stable avenues, the euro arguably being the next choice for the most transacted currency. Edelweiss Securities Limited 9 May-08 Mar-05 Mar-06 Mar-07 Mar-08 Jan-06 Jan-07 Jan-08 Jul-05 Jul-06 Jul-07 (%) The Subprime Mayhem Edelweiss Securities Limited, 14th Floor, Express Towers, Nariman Point, Mumbai – 400 021, Board: (91-22) 2286 4400, Email: research@edelcap.com Ketan S. Shah Ajay Manglunia Co-Head Co-Head Corporate Debt Desk Corporate Debt Desk ketans.shah@edelcap.com ajay.manglunia@edelcap.com +91 22 2286 4854 +91 22 4009 4548 - Source of above data is in house interbank desk and database and various sites - Bloomberg, RBI, NSE and CCIL This document has been prepared by Edelweiss Securities Limited (Edelweiss). Edelweiss, its holding company and associate companies are a full service, integrated investment banking, portfolio management and brokerage group. Our research analysts and sales persons provide important input into our investment banking activities. This document does not constitute an offer or solicitation for the purchase or sale of any financial instrument or as an official confirmation of any transaction. The information contained herein is from publicly available data or other sources believed to be reliable, but we do not represent that it is accurate or complete and it should not be relied on as such. 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