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The US subprime crisis – increasing chance of a US recession/burst of the US housing bubble

with 6 comments

Cross posted in http://www.acc101.com 

First of all, there’s been a lot of talk about this US subprime crisis and it causing a worldwide economic slump.

Lets look at it methodically and analyze it with an analytical perspective before jumping to conclusions about how the entire world economy can sink into a recession.

What is the subprime lending (B-paper, second chance or near prime lending) market – http://en.wikipedia.org/wiki/Subprime ? 

The US housing sector was in a state of a bubble for the past many years. Home mortgage companies used to lend money to people with bad credit risk at higher interest rates because the risk was higher (the very concept of subprime). When the subprime backed securities were collaterialized, it led to increased defaulters in this subprime borrower sector and the recovery of bad debt (people defaulting on mortgages) increased. This in turn increased the number of foreclosures by home mortgage companies in the US and regular sellers also got affected due to declining prices towards the later stages of 2006.

Collateralization can be explained further in terms of the CDO (Collateralized debt obligation) – for more details, please read: http://en.wikipedia.org/wiki/Collateralized_debt_obligation#Types_of_CDOs as it explains the concept well and its impact on the subprime lending sector and how it impacts the Investment banks, the Insurance companies and home mortgage companies.

What this did to the $1.5 trillion US housing industry? Large players such as American home mortgage (NYSE: AHM) declared bankruptcy on 6th Aug 2007. Wayerhaeuser (NYSE: WY) is a supplier to the home building industry and reported dropped earnings of 89%. DR Horton (NYSE: DHI) reported its first quarterly loss in its 15-years of business – they are a large builder. New century Financial (NYSE: NEW) is the 2nd largest subprime mortgage company in the United States. They lost almost 78% of their value recently and the NYSE was forced to halt trading on this stock – they face increased risk of bankruptcy. Others to face the heat to reduce prices (albeit at a much lesser scale) were large players such as Countrywide Financial (NYSE: CFC) – the biggest US mortgage lender) and Washington Mutual (NYSE: WM). Countrywide managed to keep profitability because of a diversification on the writing of the loans.

Alan Greenspan (the former Fed chief) predicted the odds of recession to 1:3. Similar views were echoed by the Indian economics writer Swaminathan Anklesaria Aiyer where he explained the possiblilty of a US recession is 33%. Not much of differing views there.

Why is Wall Street affected by this?

Wall Street companies are exposed to this sector because they carry a big part of this subprime lending bag on their shoulders. They are the ones who have lent money (hedge funds) to the companies such as New Century etc. Almost all of them – Citigroup (NYSE: C), Morgan Stanley (NYSE: MS), Lehman Brothers holdings (NYSE: LEH), Merill Lynch (NYSE: MER) and Goldman Sachs (NYSE: GS), Bear Stearns (NYSE: BSC) are affected by all this. Not just this – this is now spreading to geographies around the world – IKB Bank in Germany, Macquarie Bank in Australia, BNP-Paribas in France and NIBC Bank in Holland.

This is mentioned as the largest housing decline (burst of the housing bubble that began post 2001 and carried on through till 2006) in the United States in over 16 years.

People initially thought this was restricted to the US alone. It does not appear to be so. European banks and investment houses have also been affected by this as mentioned above. The Fed injected almost $68 billion dollars on 10th Aug 2007 into the banking system and the ECB (European Central bank) injected another $61 billion after $95 billion on 9th Aug 2007 to calm the markets after jittery investors got unnerved. This had a spillover effect on the worldwide financial markets such as the FTSE 100 (London, UK), CAC 40 (Paris, France), DAX (Frankfurt, Germany) and Asian markets such as the Nikkei and the Hangseng as also the Indian BSE Sensex.

Its going from bad to worse.

Swaminathan Ankalesaria Aiyer has written a good article on this on today’s Economic times  – http://timesofindia.indiatimes.com/S_Aiyar_Housing_bubble_burst/articleshow/2274708.cms

I had said I would explain this concept a few months ago in an earlier post – https://ecofin.wordpress.com/2007/04/17/cause-of-the-slowdown-in-the-us-economy/ –  I have done so here. You will hear more from me on this very topic in the days/months to come as its not going to abate without taking a few countries into recession – pessimistic standpoint notwithstanding!

What I am worried about is not the subprime lending crisis alone. As Swaminathan Aiyer rightly says, its not that the stock markets drive economic markets as the Central Banks maintain sufficient liquidity in the financial system to prevent a systemic collapse but the larger issue of concern is the bursting of the “housing bubble in the US”. As stated above, given the far reaching impact this crisis has had on the associated industries and the housing industry itself (that contribute to over 25% of the US economy), this can turn ugly very quickly. Home loan borrowers (who used to spend easily earlier due to easy liquidity availability) have already reduced spending as there is a credit tightening by lending companies for fear of defaults, Americans are the world’s largest importers, this will only get murkier by the day – mark my words.

Remember what happened in 2001 when the dotcom bubble burst and the world economy slipped into a recession?

That is enough to send chilling reminders to people who lost jobs in that period or were impacted adversely though the two problems are not related directly.

Update#1 – important update

Its not limited to the Mortgage lenders alone. This has hazarduous consequences as people had also taken option adjustable rate mortgages (ARM) or the Interest-only product of the same ARM where the outstanding amount remains static while they keep paying only the interest.

While most of the mortgage market concerns have so far have focused on the subprime losses, the ARM interest-only and the option adjustable ARM are other disasters in the making.

The economic damage of these would be that this can easily extend to other countries since much of the debt has been pushed into securities sold to pension funds, banks and investors around the world who were looking at high yield instruments to park their money. That could trigger a fallout which could further reduce housing prices leaving American consumers with less disposable money to spend (their propensity to spend would take a huge hit as a result) – thus trigerring a spending freeze that can spell doom for the rest of the exporting countries.

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6 Responses

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  1. […] about buying land in this peak of the boom cycle. Just as the US housing market bubble collapsed (https://ecofin.wordpress.com/2007/08/12/the-us-subprime-crisis-increasing-chance-of-a-us-recessionbur…), the Indian housing bubble will also see a burst […]

  2. The US subprime crisis has hit the IT service industry as well and the impact is huge. Some SME’s in India have been laying off employees in India and this along with the depreciating value of dollar against rupee has completely crippled the Indian IT industry.

    Ashutosh Didwania

    March 9, 2008 at 8:28 pm

  3. […] AIG struggling to stay afloat – no pun intended! Posted in Business schools, Corporate Finance, International Finance, International business, Investment banking, Mergers and acquisitions (M&A), Stock market, Stock market investing, Strategy by Naveen Athresh on September 16th, 2008 https://ecofin.wordpress.com/2007/08/12/the-us-subprime-crisis-increasing-chance-of-a-us-recessionbur… […]

  4. what about the credit card crisis in the making? Though the prabability of recession is 33%, with the prabable threat of such crisis, it can become ugly shopuld i say ever more) in no time for US and subsequently for everyone. Its said that the banks and FIs have been providing reserves against these potential crisis, but the basic question is, can any one estimate the impact of it in monetary terms with authority? Its just a curious question!

    Gurudas

    October 21, 2008 at 2:44 am

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