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Sub-prime: an idiot's guide - Eureka Report Article

August 15, 2007

Sub-prime: an idiot's guide
By Scott Francis



PORTFOLIO POINT: There seems little potential for sub-prime damage in Australia, except for those investors or funds with direct exposure to sub-prime mortgages or revalued debt.

Hold on a second, isn't it only a few weeks ago that market leaders such as Alan Moss, managing director of Macquarie Bank - not to mention the federal Treasurer Peter Costello - told us the 'sub-prime' lending crisis would have little effect on us here in Australia.

Since those pronouncements there have been a few developments:
  • The Australian sharemarket has fallen by more than 10%. It falling another 3% today.
  • RAMS Home Loans is now trading at a discount of more than 40% to its listing price of $2.50 from less than a month ago. The stock closed down 4% today at $1.35.
  • Bluestone, an unlisted non-bank lending company, has been in the media in the past 24 hours saying that it will have to increase its lending rates.
  • Macquarie Bank, recently a hot candidate in the race to be the second company after Poseidon to jump through the $100 barrier, is now back trading at less than $70.
  • One of Macquarie Bank's first investments, the Macquarie Fortress Notes, which was a geared fund that invested in debt securities, has slipped in value by a significant 40%.
  • Investors in Basis Capital and Absolute Capital hedge funds have had access to their investments closed, with expectations of an 80% drop fall in the value of the Basis Capital once the fund revalues its portfolio.
  • Superannuation funds with exposure to Basis Capital have been affected, as the article I wrote with James Kirby outlines. (Click here.)

Sub-prime defaults

What's happening? It started with a high level of defaults on mortgages held in the United States, specifically mortgages to 'sub-prime' or 'high-risk' borrowers. However, it was not just the fact that these mortgages were defaulted on that was the problem. It was also the fact that housing prices had fallen, which meant when these properties were being foreclosed the loan holder was not able to recover all of their money. This passed on losses to the holders of the loans.

The loan holders: pretty much anyone ... even super funds in Victoria and WA

In the 'old-fashioned' days of finance, when a lender gave someone a loan, they kept the loan until all the money was paid back to them. So the lender was very careful that they were lending to people who could pay the loan off.

More recently, loans had been bundled into parcels of debt, often called collateralised debt obligations. These debts had been onsold as widely as to superannuation funds in Victoria and Western Australia (and plenty of other places as well) through hedge funds such as Basis Capital, which invested in collateralised debt obligations.

Suddenly lenders were less worried about the risk of loans, because they were bundling them up and selling them as parcels of debt. They made an immediate profit up front, and did not hold the risk of the loan defaulting. That potentially made lenders a lot less careful about assessing the quality of borrowers; after all, if the borrowers defaulted the loans had already been onsold to someone else.

The value of debt fell

With some worries about the excesses of lending and a reminder of the risks of lending, suddenly the value of loans everywhere fell. For example, Macquarie Fortress Notes, which held a portfolio of pretty good quality loans, said that the value of those loans fell by about 4% as investors generally became cautious about investing in loans.

And then there was leverage

A fall of 4% in the value of assets for the Macquarie Fortress Notes does not sound like a big deal. However, the Macquarie Fortress Notes were heavily geared - about six times - so a 4% in the value of some debt saw a drop in asset value of more than 20%.

Similarly, borrowing to invest is a key part of many hedge funds operations and makes the funds very sensitive to a fall in the value of their assets. There have been many reports of crises, collapses and sudden drop in fund values in the hedge fund sector: Basis Capital, Macquarie Fortress Notes, BNP Paribas, Bear Sterns and Goldman Sachs. In each case we have yet to hear the full story.

What about those that lent the hedge funds money?

Which institutions lent the hedge funds the money? Will they be negatively impacted financially; that is, will their loans be repaid?

At this point there seems to be no hard evidence of lenders (banks and financial institutions) not being repaid, although it remains a source of some 'uncertainty'.

What about the cost of debt in the future?

Here a 'once bitten, twice shy' problem arises. Now that some investors are a little shy about investing in debt quite as freely as before, the cost of borrowing for businesses and private equity firms is likely to rise - at least for a while.

Why is this a problem? Almost all companies finance some of their operations with the use of borrowing (also known as gearing). It is a low-cost way of accessing money and, if their operations provide a profit above the interest cost of borrowing, it creates earnings for shareholders. However, if there is a reluctance to lend money as freely, this impacts on the companies in that they have to borrow money at a slightly higher rate - which eats into profits.

Private equity firms, which have been active and pushing the price of target assets up, also have their activities 'curtailed' by higher interest costs because they often rely heavily on debt to fund acquisitions.

That said, central banks have been 'pumping' extra money into the financial markets to try and offset this rising cost of debt by providing a strong supply of money.

And the impact on consumers?

Estimates of the number of defaults in the US are a major concern. Estimates range from two million upwards. US market pundit Jim Cramer has forecast 'seven million could lose their homes' in an extraordinary television interview. (To see the Cramer interview, click here).

Clearly a significant number of consumers will be under financial stress as they go through the process of having their property repossessed. This itself reduces the number of people willing to spend freely as consumers, impacting on the profits of industries as varied as retail to travel to car manufacturers to financial services.

Consumer sentiment (the confidence of other consumers) can also be negatively impacted as people become cautious about spending and focus on other goals such as paying off their mortgage faster or saving some cash to strengthen their own financial situation.

And the problem of consumer sentiment can quickly spread to somewhere like Australia, particularly when we hear some lenders are finding cheap money difficult to source and we have already just had a 0.25% rate rise that will eat into many family budgets.

From here volatility . and awaiting further news

One clear effect of this 'sub-prime' problem is that markets will be wary of any news of further debt problems. This will lead to the possibility of above-average volatility in markets for some time.

That said, there is now a lot of negative sentiment priced into the market. There are particular concerns about the US economy and a possible slowing of economic growth there.

In Australia, however, there would seem to be little potential effect at this stage except to those investors/funds that have direct exposure to sub-prime mortgages or to debt that has been revalued. Those people who have looked at our 'low-doc' lending - the equivalent of our 'sub-prime' market - have said that we do not face the same kind of fallout as in the US.

In the absence of any more bad news, and in the long run, the opportunity to invest in Australian companies with the ASX200 index around the 5800 mark, will look like a good one.