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Commentary

More Subprime – CDO Insurers Downgrade, Bad Doc Trails and The India Impact

I wrote a long while ago about the Subprime problem in the US, and then followed it up with a few posts on the topic.

Let’s see what’s happened since my first post.

After the last crisis, things were kinda ok and recovering, until in late Oct and early November, loss reports started to come in. Countrywide reported a $1.2 billion loss, Merrill Lynch took with a $8 billion write down, and Citi had to match it with a $8-11 billion dollar writedown.

After the losses came a revelation of complexity. (Revelation to me, as you understand I am a newbie at this stuff) Turns out these CDOs, which are essentially securities created out of a lot of loans, are rated as tranches – AAA (huge-ass prime), AA (prime), A (prime but just about losing it), BBB (sub-prime) etc. People buy either all tranches or only some etc.

Now if something is rated BBB, why the heck would anyone buy it? Higher rates of course. But some funds weren’t allowed to buy BBB. So what happened? These CDO creators got in what are called ‘monolines’. These are essentially companies that provide insurance on municipal bonds – idea being if the municipality defaults they pay you instead, and charge you a premium for the exercise. If the municipality does not default they keep their premium. You bought what is called a Credit Default Swap (CDS)on the CDO which is a hi-funda name for “insurance”. Now monolines like Ambac, MBIA etc. are hugely capitalised and have the ability to cover the bonds they insure, so they have always got an AAA rating.

So the CDO creators got the monolines to provide insurance for the CDOs, and the monolines greedily did it for all tranches of the CDO. The premium was exciting, but they didn’t charge too much – heck, who knew the sub prime problem was around the corner?

If you bought insurance from an AAA entity, you could say you have an AAA security, right? So now you can have a BBB tranche of a CDO, paying a fairly kick ass return (you hope) and that is insured by an AAA monoline. Life could not get any better (in terms of three alphabet ownership at least).

Recently someone at the rating agencies woke up and realised that if these Subprime CDOs fail – and as it seems, even the prime CDOs are going down the drain – these insurers will be exposed to an ENORMOUS amount of liability. That may mean that the monolines are not capitalised enough, which is a signal to re-rate them to say AA or something.

This is treacherous. If the monolines get re-rated downwards, some funds will HAVE to sell the CDOs they hold, since they are mandated to hold only AAA paper. Not just CDOs, but also bond-insurance holders who held sub-prime municipality bonds. (yes, municipalities do go bankrupt in the US, unlike India where they are always bankrupt anyway) The muni-bond market is greater a couple trillion, and the monolines are the major insurers, so a de-rate of the monolines is bound to cripple the bond market – the selling will likely be intense.

If the muni-bond market gets hit badly, holdings on the equity side and maybe the corp-bond side may be ruined and the entire financial sector is hit once more. This time it could be worse than the last bash-up in November.

But why aren’t they getting de-rated yet? The rating agencies – firms like Moodys, Fitch and S&P – have a very close relationship with the CDO issuers and insurers. So there will be some under-the-table bailing out (effectively only these guys pay the rating agencies). Now if they do this longer, no one will believe Moodys or Fitch ratings anymore no? Uhm, someone figured that out already – the rating company stocks are down nearly 40% since Jan this year.

Also, there may be capital rescue attempts, like when CIFG’s parent company offered it a $1.5 billion of extra capital to ward off a re-rating. My take on that is – $1.5 billion is nice, but it’s like dropping a grain of salt in water. You can see it drop and in a few seconds it’s gone, and the water doesn’t taste a whole lot different either. We need LOTS of the salt.

What’s also interesting is: some monolines like ACA have threatened to declare bankruptcy if they are de-rated. What does that mean? Bankruptcy = I don’t need to pay my liabilities (or not all of them), so the guys who bought my insurance essentially get less or even zero – meaning, they have no insurance. If that happens, a good part of the CDO portfolio that was assumed to be ‘covered’ by insurance suddenly takes the hit – and I can’t say for sure, but if the equity tranches of the CDOs of these banks have taken multi-billion dollar losses, who knows how much they own that they consider “insured and therefore safe”.

What is also troubling is that in the rush to close loans since the 2005 times, people didn’t quite do the documentation right and now some foreclosures are getting thrown out the door for not having correct paperwork in place. The cost to do that will have to be borne by the banks, and that is another huge-ass loss. And they’ve already paid the bonuses, unfortunately. Those who haven’t, say they will continue to – because they are afraid to lose people. (No, I don’t get it either, but you have to understand that losing most of your staff is a short term nightmare, and no one in this business thinks long term when it comes to bonuses at least) Any Indian company that has outsourced or provided BPO services on such terms is most likely going to get screwed – as the banks are going to say that they messed it up and that the function will have to happen in-house. Why? Because maintaining and managing the doc trail requires a lot of work, training, local contacts and domain knowledge etc. and there are going to be a lot of such professionals in the US who need work (and do it faster as they understand it better)

Let’s get to India now, finally. Why do we care? Global liquidity is one of course, and the fact remains that because we don’t have loan securitisation (or “factoring”) anymore, we don’t have the intensity of the problem internally. But we have something, definitely – US home prices started to decline in 2005 – I have personally seen Bangalore real estate prices coming down in 2007. In two years, we are going to see some shake ups if the trend continues – and what will happen then?

Too much supply, too little demand. The market value of a house can become less than the loan outstanding. This can trigger margin calls (“pay up the difference”). High interest rates, and slowing global economy. In India, we can’t just walk off with a “foreclosure” and the process takes time, and banks can’t securitise and pass off the risks. So the banks will have to take the hit, and perhaps that will drastically reduce their ability to give out more loans, meaning further income losses as well. Where they do foreclose, they will auction and the resulting sales will bring market prices even lower, and there is no organised real estate fund or player to do the buying. (heck, you can’t even short right now)

That could lead to further problems with real estate sales, and in turn with higher discretionary spending (as people struggle to pay off mortgages, they cut down on buying high end cars etc.). The overall market decline will take years to undo as it has to run through the cycle.

Note: I am not predicting this will happen. I’m just saying that the problem could progress in this manner. Yes, we could reduce interest rates dramatically – something our RBI will surely do in a crisis. But it may be too little too late – as the RBI already seems to be complaining about too much bad lending. Sticky wickets.

I’m not buying a house right now, for sure. But then, I can’t afford to anyway, so call it sour grapes :).

  • Anonymous says:

    >Your extending the arguments to India are a little flawed.

    1. Loan to Value in India is low not as high as US.

    2. Margin calls if arises may be solved by extending the duration like they did in Japan 100 year. Politics will kick in.

    2. Banks may be saddled with loans but they will be bailed out by the Government.

    But I agree with you in 2 years time we may get good opportunities to buy property.

  • Deepak Shenoy says:

    >Loan to Value does not matter, plus a good percentage of loans have even been at 100% (if you recall 2006).

    Duration extensions are already stretched as that is the primary way to do things when interest rates go up on floating rate plans (ARMs)

    Betting on banks getting bailed out is crazy; a bail out is not good for shareholders or the economy. See what happened to Northern Rock in the UK, bailed out: yes, shareholders got screwed: yes.

    Lastly property is a much longer term cycle than a few years but I do hope it bottoms out in two.

  • Anonymous says:

    >Deepak,

    One significant difference from the US mortgage scenario is that we do not have ARMs. ARMs issued 3 years ago that are resetting now is a significant source of the problem.

    In India, you do not have 5% teaser rates that go up to 12%. Check http://www.signonsandiego.com/news/business/20071202-9999-lz1b2mortgage.html We have had a gradual increase from 7.5% to 12.5% in some cases.

    I believe the RBI has done a much better job than in the US in reigning in speculation in the real estate market. We could argue if it could have been done earlier, but I strongly believe India’s RE market is much better placed.

    – bhaskar

  • Deepak Shenoy says:

    >bhaskar: I think ARMs and floating rate loans are the same (no?)

    I agree that we don’t have teaser rates but in 2005, we had rates of 7.25% floating, which are now at 11.5% today. A 4% increase on a 20 year, 40 lakh loan is more than 10K higher per month (for the same tenure, and I believe tenures have been stretched).

    The problem is that tenures go up first (so you pay the same EMI). Suddenly the bank decides it doesn’t want to extend tenure so it pushes up the EMI. While this is gradual I know instances where banks insist on an EMI reset with a tenure reset as well.

    I agree that RBI has done a good job in keeping speculators at bay but the problem isn’t speculation, really. The problem is that asset prices are just on the top end of their cycle and as cycles go, they must retreat and the more we hold on, the bigger the eventual fall will be.

  • Anonymous says:

    >RBI has done a good job of reigning in speculator in Housing.

    Bull shit.

    I know in 2003 several HNIs took loan from Banks and bought property in Mumbai in Powai and leased it out to companies and now they have increased the rents 3 times and the propety has appreciated 4 times. These are speculators.
    Indian real estate markets have been controlled by Builders and Speculators for a long time. RBI has been a mute spectator. Builders lobby has solid politcal support.

    There may be some salary earners who bought at the peak and they may get affected due to higher EMIs but even they may have other options like for eg. prepayment, help from family, cutting down on expenses to meet increased EMIs etc. Worse come to worse selling the property at a loss. Finally some of them may just not move and Indian courts are known for taking linient view of the tenents if they can show some geniuine reasons.

    I agree that Indian situation is quite different from US.

  • Bhaskar says:

    >ARM by definition is a floating rate loan. However, Hybrid ARMs are common products in the US and is the significant source of the problem.

    5/1 ARM – Fixed for the first 5 years and floating rate adjusted once every year after that.

    2/28 ARM – Fixed for the first 2 years and floating rate adjusted once every year after that.

    The US banks entice customers with a significantly low fixed interest rate that grows to a much higher floating rate when the fixed term resets. There are “caps” specified in the contract that limit the increases at the end of fixed term (for ex. 3%) and every year after that (for ex. 1%).

    The Hybrid ARM products were well received since the customer believed he could just refinance into another hybrid ARM at the end of the fixed term. It worked for the past 8 years or so, when the RE prices continued to increase. Now, with RE prices falling, it is another story.

    Additionally, the use of Home Equity Lince of Credit (HELOC) (essentially a credit card with the additional home equity as collateral) is rampant. The interest rates for HELOC are 7.5% compared to 14% for credit cards. (Source: bankrate.com). HELOC has been funding the customer spending in the past few years.

    In India, Hybrid ARMs are not common. Fixed rate loans are revised periodically, but they do not come with initial teaser rates. HELOCs are not used commonly, though similar products are available. This is the significant difference, which allows users to hold substantial equity in their house. Also, the savings rate of a household in the US is almost 0% compared to 40% or so in India.

    http://bp1.blogger.com/_pMscxxELHEg/R0yf01cEz5I/AAAAAAAABOs/5LycEbX4Icg/s1600-h/GoldmanNegativeEquity.jpg
    If someone did publish the graph for India, I bet it will be very different.

    – bhaskar

  • Deepak Shenoy says:

    >anon: curbing speculation doesn’t mean killing it. speculation is good, because it makes markets. Wild speculation is unsustainable that’s why it’s bad, and the RBI has taken steps like loan cutting, high rates etc. to clamp down on the wild speculator. HNIs will always speculate, and honestly when they have the money to lose, no one can stop them.

    bhaskar: Excellent comment – I have put my response as a separate post.

  • kram says:

    >Deepak:

    I’m a little late to this party (mainly because I discovered your blog rather late). Hoping to put in my 2c so it will make some difference.

    While the comments (and main article) have been of a high quality, the whole argument is being made with the basis of ceteris paribus – all other things being the same.

    The trigger to the RE crash will be sudden (and “unexpected” – will be the comments from the affected) loss of purchasing power with simultaneous increases in EMIs. And this critical ‘purchasing power loss’ (like the aircraft losing power on approach to landing) will happen due to loss in earning capacity (job-market turning around and people supply getting ahead if demand resulting in pay-cuts and double-income families forced to become single-income or worse).

    I suspect this will start in the IT sector as US customers start cutting back sharply and this is already showing as IT biggies have started getting nervous and defensive about future prognostications. Next step is denial as the downtrend gathers steam (2008 may hold some unpleaant surprises for us in this regard).

    BTW, discovered your blog while searching for good info on RE in Bangalore upon hearing rumors that in the Sarjapur Road area there are as many as 50,000 flats going vacant – unbelievable and any hard info on this? If this is true, our decline may have already started!!!

    I remain a happy renter hoping to pick up RE at 50% discount to peak prices a 2-3 years down the road!!!
    Nothing like a real bargain!

    cheers,

  • Anonymous says:

    >I agree with you subprime was a symptom and disease is yet to be discovered , the losses in financial sector are not yet fully disclosed and eventually when everything is over we can see a lot of erosion in financial health and some big corp going busts. In indian economy we have only speculators and no real buyers. Builders lobby pushed the prices up by almost 300% in last 2 years which are not sustainable if you dont have real buyers only speculators .Today in gurgaon there are more than 95 thousands apartments are at sale of which their are only 2% real buyers and lot of new launches are coming on still..I believe indian real estate will fall flat and a house which is for 3000 Rs a sqft will cost you 1400-1500 Rs a sqft in coming days….golden days are over speculators accept reality..