Subprime is still contained

Source: Danske Bank

How bad are the problems in subprime?

Earlier this year we visited the subprime issue in the report "Research USA: Subprime mortgage market - containment or contagion?" March 30 2007.

Back then we concluded that "There is no doubt that the problems in the subprime mortgage market are serious. Potentially they could be an early warning of more widespread troubles in the credit market, with a negative macro-economic spill-over. While signs of such developments should be watched closely, we expect the problems to remain contained within the subprime sector, which has the largest share of ARMs

If this is the case, the ramifications for the rest of the economy will only be minor. Moreover, the direct impact of ARM resets and rising foreclosures will be negative - but not disruptive."

We still hold the view that the problems in the sub-prime sector will not have major macro-economic ramifications. Both from a macro-economic and a financial market perspective, the subprime market is too small to have devastating effects, as long as the problems remain contained.

Will the subprime problems remain contained?

Recently, a couple of lenders such as Countrywide and American Home Mortgage Investment, which are engaged in the Alt-A (a quality in between prime and subprime), and the prime market have reported increasing losses. This could be a first sign that problems are spreading into higher quality mortgages.

The 10-year spread for mortgage bonds has been widening sharply in the recent week and compared to early this year the spread is more than 30bp higher. No doubt this indicates that some credit general tightening has taken place in the mortgage market and that lenders now require a higher compensation for mortgage risk.

It is however still too early to conclude if this spread widening has its roots in an actual deterioration credit quality among higher quality mortgages or if it is driven mainly by rising risk aversion and uncertainty. The newest foreclosure and delinquency data from Q1 show literally no problems for FRM, which accounts for by far the largest share of the market. If problems are going to spread into the prime market it will be through the ARM loans. However, as the major bulk of loans in the prime sector are FRMs, we doubt that negative impact from deteriorating debt service for ARMs will develop into a general problem for the prime market.

What to expect from here: More turmoil - but no credit crunch

Overall we believe that some of the recent risk repricing in credit markets, and the return of volatility in a numbers of markets is of a more permanent nature. The bad news from the US subprime market and related problems attached to LBOs, CDOs, and hedge funds are likely to continue. Thus, event risk is here to stay.

On a more general level, this should be seen as a first sign that we are witnessing a shift in the overall risk assessment in financial markets. With global monetary now being normalised, it is reasonable to expect more normal risk taking in markets in the coming year or two. But the process of normalisation of markets to price risk more correctly will probably not be smooth and steady. Markets may shift back and forth between a "goldilocks" scenario and experiencing turmoil.

However, we do not believe this is the first step in a credit crunch that will have serious and longer lasting effects on the macro economy. In this sense it is unlikely that central banks, including the Fed, will react to these events by easing policy. On the contrary, we are in a phase of policy tightening, and at the heart of the current crisis is not a too tight policy, but rather a too easy policy a few years ago.

There are at least four reasons why we believe this will not develop into a credit crunch:

Firstly, we are not worried about strong contagion effects from the US subprime problems, see also the chapter above. So far there is no convincing signal of tighter household credits. The Q1 senior loan officer survey sends mixed signals about consumer credits and we have not yet seen a meaningful widening of the spread among consumer loans (note newest available data are for May). However, the picture looks somewhat different for the corporate sector where corporate bond spreads have been widening lately - especially low quality bonds. That said the spreads are not near the highs of 2003 and 2004, see chart above. This indicates that the problems should remain contained.

Secondly, Economic fundamentals remain very sound, and we detect no weakness in the underlying drivers of the US or global economy. Global economic growth is close to the strongest in 40 years. In the US there have at most been scarce signs of any slowdown in business investments, consumer demand and the labour market. Corporations across regions are still awash with cash with huge amounts of free cash flow, extremely low debt positions, and overall financing conditions that are not tight. Thus, it is clear that the current risk repricing is not a response to bad economic conditions.

In fact, looking at corporate bond spreads, these seem to be driven to a large extent by corporate expenditures out of their net cash flows. In the current situation, corporate expenditures are much too low as a percentage of corporate cash flow to fuel any significant rise in corporate bond spreads, see chart below.

Thirdly, there are no signs of dramatic pressure in the banking system, and systemic risk remains contained. Spreads on banks' subordinated debt has increased but the increase has not been bigger than in the beginning of 2005 when GM and Ford were downgraded to junk and spread is still much lower than in the period 2001-2004, see chart below. Although the implied default risk for major commercial banks has increased, it is still close to historic lows, see second chart below. These developments are consistent with the economic fundamentals as showed in the charts above.

Fourthly, Global Monetary policy is not yet tight. This is important, because monetary policy is the main engine of liquidity in the economy. Until now we have merely seen a normalisation of policy, as shown in the chart below, which compares G3 monetary policy rates with G3 nominal GDP growth. Over the past twenty years policy rates have fluctuated around nominal GDP growth.

The biggest risk to our main scenario is in our opinion a prolonged period of financial market distress without any larger economic downturn. In 1997/98 the collapse of Long Term Capital Management created a lot of worries on markets, and it even had some temporary effect on the real economy. While only temporary, the economic effects paved the way for some easing of policy. The main difference between now and then is that economic fundamentals are better now and that we are coming from a period of even stronger buildup of credit.

Another risk is that this could develop into something like the savings and loans crisis in the beginning of the 90s. The big difference between now and then is that back then the housing crisis was more a result of a slowdown in the economy. The current situation is characterised by a slowdown in the housing market, while the rest of the US economy is still going strong.


Implication to equity market

The rising risk aversion was slow to hit FX markets, but once it did, there was no mercy, resulting in marked carry underperformance. Looking ahead, the strong global economy and relatively subdued inflation should continue to provide a highly positive back-drop to risk seeking in the FX markets, and we thus expect carry to return to the driving seat in G10 FX, once markets calm down again. While the continued withdrawal of liquidity through the tightening of monetary policy around the globe is bringing the end of positive returns on carry strategies closer, we still feel that we have not reached the turning point yet. The dollar has benefited from the recent bout of risk reduction but the fundamental picture has not improved and we still expect EUR/USD to head higher, once the present correction has run its course.

Having said that, the coming weeks could well bring more of the same, as nervous markets, excessive valuations and stretched positioning leaves carry strategies vulnerable for the time being.

Should the credit crisis evolve more seriously than we currently expect, the result should be a shift in investor focus from carry to valuation. The main beneficiaries from such a move would, not surprisingly, be low-yielders JPY, SEK and CHF, while high-yielders AUD and NZD look most vulnerable at the other end of the spectrum.