Capitalmind
Capitalmind
Actionable insights on equities, fixed-income, macros and personal finance Start 14-Days Free Trial
Actionable investing insights Get Free Trial
Commentary

Why Subprime Phase 3

Before I start my theory about Subprime Phase 3, I want to clarify one thing. Everything I mention here is a short term opinion on where things are going. That means a) I don’t think this situation will spell doom forever, just that we seem to be starting on a crisis and b) by using the word “opinion” I am weaselling out of being wrong by simply stating, “Maybe not also”.

So why this drama now? We already have had two bad shocks, is there a need for a third?

Yes, of course. The shocks need to hurt a lot more than they have. I believe the world has done a lot of financial fine-tuning which will hurt a lot when it unwinds.

Return of the home mortgage problem

Some of you will say it never went away. And you will be right. Foreclosures in the US are at record levels, home inventories are at record levels, commercial real estate is in the dumps, and worse, the highest loan resets are coming up in the next two months.

Citi is aggressively selling whatever it can in other countries – India and Germany I have heard of. Freddie Mac is hiding assets so they don’t have to disclose real prices – and indeed, there may be no real prices at all, as no one is currently willing to buy. JP Morgan and a number of banks are firing to keep costs at bay.

Asset backed indices are showing signs of crumbling again (but too early to say). As foreclosures and defaults increase, cities and counties are seeing lower tax revenues and one of them, Vallejo filed for bankruptcy recently. More to follow surely.

Note that this is not just subprime. Subprime reflects the quality of borrower’s credit, and referred to the lowest strata. Now the crisis is well spread out with even rich people and companies defaulting. This next edition of the crisis will be a “we are all subprime now” edition, to quote a famous blog.

Bank Failures
At least 150 banks will fail in the U.S. in the next two years, says Marketwatch. I suppose this is inevitable, as more and more banks get caught in a spiralling mortgage crisis, which has blown up to become a lending crisis in general.

Commercial real estate is down, home prices are down, lending is tightened due to much more stringent checks, savings rate was never much anyway etc. This is a sign for aggressive banks to tone down – but most small banks can’t, because their cost of funds is high and they have to leverage big in order to even make costs.

Indian banks too are going to be in trouble. With the moral hazard associated with a 72k cr. bailout of agri-borrowers, which agri-borrower will ever want to pay. They’ll say – “My neighbour didn’t pay his loan and got away. If I don’t pay a couple years, I’ll also get away”. The resentment in that is extreme and will hit way too many banks.

At the retail end, loans are in bad shape. ICICI recently bundled personal loan and vehicle loan portfolios and sold them – either as ABS or as portfolios to Arcil. Other banks are surely doing the same, and it’s very likely that the loans are at extremely low prices due to default rates rising. NPAs are increasing dramatically. Also credit standards have been tightened (try to apply for a home loan today), and fee income has dramatically reduced after the derivatives fiasco. CRR increases have reduced leverage capabilities (only a little, but still). With interest rates likely to increase if inflation stays this way, bond prices that banks hold will reduce, and hit their treasury and trading income. Lending is down, deposit rates are high but where do you put the funds, NPAs are increasing, treasury is hit – something will give, and some banks will show the white flag.

Politics

If what’s required is tightening the Congress isn’t going to be up for it. They already forced SBI to withdraw a circular that halted agri-equipment credit (the bank was facing 17% defaults, the moral hazard effect). They’ve balked at increasing fuel prices as it hurts their voter base. They don’t want to raise interest rates anymore as again, voters take loans. They won’t use the forex reserves to any good. They won’t even take a hit on taxes to ease prices. They will ban futures trading even if it does not help anything. They don’t want to do anything that might actually help the economy in order to be in a good position for the elections next year.

This is stupid, because in the process they will create a crisis of epic proportions which, if they get re-voted to power, they have to live with. But the lure of another 4 years of power is too much, I guess.

The U.S. is in a similar situation. They won’t draw on oil reserves despite this price. They will sign a bill that sues OPEC. (Come on now) They will not reduce subsidies for corn farmers in the ill-framed ethanol policy. (India has a crisis of this sort coming up this year)

The refusal of the powers-that-are to take steps to keep the economy stable will hurt us tremendously.

Oil prices that need to break

We are in the end-game of oil prices. Everyone’s predicting it will go up. Everyone’s waiting and watching a 10% rise practically every week now! Already, funds in the US have the highest ever allocation to commodities and literally everyone is talking about prices going straight up. $200 in a year, $150 next month and so on.

This is the final build up. Anyone who is short crude oil now is probably hurting like crazy. It’s only when the last big short is taken out of business, is when the slide will begin (no downside protection!). That may come when oil is $150, or $200, or wherever, but the question is now at what rate, but when.

But the rise of oil in the interim will precipitate the crisis. As more people get on the platform to “hedge”, others will exit stocks and bonds that lose value in a rising inflation, rising interest rate scenario. The crisis will hurt asset prices a lot in the coming few months, which in turn will hurt the crisis. (or help the crisis, depending on how you look at it)

Carry trade unwinding

Earlier this year, the US Dollar briefly went below 100 Yen, a sign of carry trade weakness. (Borrow in yen really cheap, and invest in dollars, which doesn’t work if the yen appreciates) Now with an oil crisis and a subprime crisis, the US authorities will have to “appear” like they are doing something, like printing more currency or protecting banks or even trying to lower rates some more or some such.

This will weaken the dollar against the yen. May not be against the Euro because the Euro economies will try to do the same thing. Japan has a different set of problems and can’t react like this. Effectively I believe the U.S. dollar will go down against the yen, and destroy whatever is left of the carry trade – and there is far more than you and I are aware of.

Ok. Enough.

That’s it for now. These were reasons why I believe there will be a crisis coming up soon, in the next two months.

Now for why I only think one or two months. First, oil is heading down by the end of the year. Second, this crisis will kill a lot of the weak players, and some strong ones, meaning they won’t need further protection. Third, most of the political damage will be evident by then, and steps are likely to be taken to reverse them, like India driving the rupee up and so on. This will stem inflation. Then we’ll have a period of “nothingness” when nothing seems to happen, some scam may emerge, some financial stuff will make news and then die, and so on. This crisis will hurt much more than the last two, and after it, will keep things down but stable. Sorta like communism – everyone is equally poor.

And in the longer term the U.S. will see a problem of deflation and then rapid inflation – that will be Phase 4 of this crisis. It’s a little bit like the 70s, and they will find another Volcker. India is likely to emerge stronger after a few years, unless we have a stupid sort of political coalition again, like with the left parties.

So that’s me off the soapbox. I could be absolutely wrong and this may turn out to be the beginning of the biggest economy run ever. In which case, I’m happy to eat my words. (The advantage of writing on the internet is that I can swallow air and say I’ve eaten my words. Bwahaha.)

Disclosure: Do not trade this in the stock markets. Even if I was 100% right, there is absolutely no way to predict when, at what level, to what level, how etc. So please don’t take anything I say and try to take advantage before anything happens. DO NOT predict. React.

  • Anoop says:

    >Hi Deepak,

    Nice article. Whatever you said seems possible. Assuming the danger is looming large, the next big thing will be to save overselves and come out unscathed. As you say it may not happen, then in that case no problem, but what if it happens.

    Knowing the danger is half the job, now would apreciate if you could advice us to do something to remain unaffedted or less affected.

    Most of the investors are in the mid way. We have some money invested (MFs, Debt or equity or something else like Real estate etc). We are doing some investment and will keep doing it. Now the question is what the strategy should be to get the best mileage out of it.

    It would be great if you could let us know some more in detail, not mere a word – React.

    Regards,
    Anoop

  • Anonymous says:

    >I liked your post. But I am unable to understand why you are bearish on oil — there is also no reason in the post as to why oil will slide. I do track US inventory data and frankly its not encouraging. Of course its not too discouraging either, but then it never was even when oil was 67$ to a bbl. I would appreciate if you help clarify this point. Also, a corollary from your post is that people who hold auto stocks should continue to do so. Is that correct?

  • Deepak Shenoy says:

    >anoop: there are three different potential results.

    1) what I say is exactly the opposite of reality and the stock market goes to heaven, and inflation eases, and the US becomes a financial superpower again. That is a “V-shaped” recovery where we are at the bottom of the V.
    2) Nothing happens. Some bad news here and there, inflation smooths out over two-three years, everything goes back to normal.
    3) What I say comes true and we hit much lower lows in the market, inflation reaches its peaks and a slow recovery happens (U-shaped, where we are at the middle of the first pillar of the U)

    For 1) and 2) you need to do nothing if you’re a long term investor. In case of 1) you need to invest more – in case of 2) you can stay invested, or get out and then get back in after a couple years.

    In case of 3) you need to get out.

    But how do you know whats going to happen? You can set yourself a mark. Say Nifty at 4400 is a sign that we’re going on 2) or 3) (Sensex 14000).

    And then reinvest if the nifty crosses say 5000 after it hits 4400 – or Sensex 17K.

    Problem is you may get whipsawed and lose 10% on the downside from here and then 10% back on the upside before getting back in – this is a risk. the closer your stops are, the more likely a whipsaw.

    The other option is to get out and say forget this, I’ll participate only when the Nifty crosses 6000 again. You’ll miss only about 20% of a rally from now, and you can figure out what to do if 3) happens.

    Another way to react – set a warning bell that says “if due to inflation, interest rates go up 1% and oil goes to $140 and there are adverse political decisions and a large bank fails – I get the heck out”.

    But it is for an individual to decide, based on the risk taking ability and time frame, about what decision to take. If you’re a trader there are opportunities in all three scenarios above.

    I can’t really say how right now – am studying news flow and charts of the 70s in the US before anything else.

  • Deepak Shenoy says:

    >Anon: My oil theory is more a factor of irrational exuberance in the commodity than fundamentals. Remember, that the reason for a fall in open markets is available only AFTER the fall.

    The problem with oil is supply has a weird way of turning up all of a sudden. Read this article

    ” Today we started checking on how many tankers Iran had, and soon discovered that there is a serious tanker shortage. Lease prices have soared in the past few weeks. It is clear there are a lot of speculators betting that oil is going to rise to $150 or so and are willing to pay very high prices for keeping the oil on the seas waiting for higher prices. It is a speculative boom.” (That’s what a friend of John Mauldin’s discovered)

    Auto in India has little to do with oil and more with interest rates. And auto in the us will lag oil because they have a ton of bonds out there and need to issue more in a very disturbed market. So I wouldn’t recommend auto anywhere as a sector. Individual stock picking may be interesting, though.

  • Rajiv says:

    >Good post. All likely scenarios. I guess a V-shaped recovery seems unlikely and U shaped is more likely. so can we expect major loan defaults in india too? and wats ur take on the rupee/dollar equation..is it going to stay at 43levels?

  • Ninad Kunder says:

    >Hi Deepak

    Let me say that markets retesting the previous lows of sub 15000 is a likely scenario as opposed to a worse case scenario.

    The scenario’s that you have listed down could lead markets to go far lower than that.

    You could be right that we might be on a intermittent top in oil but my worry is that even post correction if oil rests at about $100 a barrel, we have a huge problem on our hands.

    My call is that we might not see the worst case scenario but we are going to see a more prolonged time based correction. Also I see some serious contraction in some of the momentum high PE stocks like RNRL, Ispat etc where some serious money is going to be lost. It wont be dramtic but a gradual grind down.

    I had put out a note on RNRL as a case in point http://investingvalues.blogspot.com/2008/05/reliance-naturally-resourceful-limited.html

    Also in this country we live under the illusion that you can never lose money in real estate. We could see some serious time bound destruction of wealth there. It wont make headlines but will happen.

    Cheers

    Ninad

  • Anonymous says:

    >Hello Deepak,
    Based on your post it then is a likely scenario that if oil crosses 140 USD/bbl, we should get out. I am okay with it except for 1 basic point that you don’t seem to mention: what about the domestic institutions? The MFs and insurance companies are sitting on cash, mountains of it really. If we dip below 14k can we sustain there? I am tempting to go in for your option b) ’cause there’s only as much we can slide. On the contrary this market is ripe for long term guy to invest and asking traders to be out. What do you have to say to that?

    –Anon

  • Deepak Shenoy says:

    >rajiv: Loan NPAs in India are already high and default rates will follow. I think we’ll see a lot more evidence in the months to follow.

    I expect a massive decline in the dollar’s value, but only after a stunning rise. While I think a falling dollar is good for us, there are too many vested interests that don’t want it to happen, but it’ll happen when there is no choice left.

  • Deepak Shenoy says:

    >Ninad: Agree with most of what you say, especially the fact that real estate falls are not factored in. Will have to wait to see what pans out.

    Anon: MFs and Insurance co’s were sitting on cash in Jan, and then Feb and then March. They didn’t do much then, and even now it will be a sorry effort – trust MFs and ulips to get in only when the opportunity is half gone.

    Long termers can choose what they like as their risk appetite allows. My opinions largely address a one year or lesser horizon investor, honestly – I am not convinced what long term really means, and what level of predictability that time frame allows.

    To answer your other question – no, I don’t think this is the bottom or anywhere close to it; where’s the “value” when the index is at a P/E of 20 when the EPS only grew 10%?

  • sreeram says:

    >thanks deepak as usual wonderful. your opinion on what constitutes a ‘doomsday’ portfolio in India. Something like if you were in a disastrous movie like ‘Legend’ or ‘After 24 hours’ when the world ‘could’ end which investment would be best when you are lucky enough to climb out of the debris. RIL? Tata Steel? ITC? What do you think? Thanks

  • Mannina_Manga says:

    >Deepak,

    I agree with the general direction of your analyses on the implications of sub-prime phase 3 on India.

    Another factor that results in a bleak prognosis for the indian market is relative attractiveness of assets. Before the housing crisis hit the US (and Europe – pple seem to have ignored how much of trouble is there in UK and Spain), emerging markets were the only place where an equity investor could get high teens returns on an equity investment. Now, you can buy a portfolio of high-quality mortgage assets – levered 3-4x and get those returns with arguably lesser risk. So, the bogey for foreign investors investing in India is much higher and valuations have to be more attractive for the outflows to reverse.

  • Anonymous says:

    >I too like to know which scrips to buy which i can sell out in another 2-3 yrs, since the market is down. I am into long term and like to raise some money to purchase proporty later on.

    Rhytha