Subprime and the biggest risk of all

Following the US subprime mortgage alarm, some investors have been reassured by rebounding indices and optimistic pundits. But the biggest risk of all lies in thinking that risk has been conquered. It has not - it merely slumbers, so long as massive quantities of cheap credit allow the roll-over financing of future rounds of debt. If this slows sharply, the subprime housing turmoil is the tip of the iceberg.

Mar 28, 2007

By Max Fraad Wolff

The subprime mortgage market is in a state of flux. Risk reduction and risk sharing financial products are being stress-tested and the results are unclear.

Recent announcements by HSBC, New Century and others have rattled volatility-complacent investors. Rapid downward repricing has occurred and global contagion has emerged. A few weeks out, some smiles are evident as indices have whipsawed and jawboning has reassured investors. Others see catastrophe on the horizon. We are in neither camp.

Estimates are that there is about US$1.5 trillion in subprime housing loans in the US market. Slowing house-price appreciation calls into question repayment on some of these loans. The greater risks and lessons are symbolic. The subprime boom and the risks from a rapid deterioration in the market are much bigger than subprime. Questionable loans and the misallocating credit models that generated them are everywhere. Trillions of dollars in managed speculative wealth seeks returns greater than traditional low-risk assets offer.

Global deregulation and consolidation of banks and financial intermediaries creates a world of opportunity. New risk and asset securitization innovations enable products to arise to meet the ravenous hunger that fuels a global credit boom. Risk redistribution and repricing derivatives proliferate to "offset" and safeguard the rising exposure required. We may be on the brink of testing our new portfolio and solvency safety equipment.

Lehman Brothers and Bear Stearns base cases call for subprime national defaults of $200 billion to $250 billion over the next two years. This would translate into 1 million to 2 million residential-unit defaults. The next 22 months will see nearly $1 trillion in adjustable-rate mortgages resetting, with $650 billion in subprime. Industry base cases assume average house prices will be flat to 2% down across the next two years. Given the scope and size of recent house-price appreciation, the projected housing-market correction is very modest. Confidence derives from many questionable assumptions. Default risk and hedging products must turn in stellar performances, fear must not grip markets, and contagion must be limited. This is possible and has happened before. This best case requires us to thread the needle.

Risks must be measured against private US housing stock valued at $20.6 trillion on January 1 and total mortgage debt of $9.7 trillion on the same date. The sheer size and recent growth of household net worth is constantly and impressively invoked to sooth. Household real-estate assets increased by 50%, or $6.857 trillion, from 2002-07. During the same period, the Federal Reserve Z1 Flow of Funds records an increase of $3.708 trillion, 62%, in mortgage liability. Disposable personal income increased by $1.851 trillion or 24% over the period. Net worth grew by $16.829 trillion, or 43%. It has been a crazy few years. All this growth of wealth and debt amid asset inflation is made possible by new markets, methods and innovation in risk hedging and sharing.

The rise of collateralized debt obligations, credit-linked notes, over-the-counter finance and custom derivative products are the enablers. The subprime situation, credit quality, hedging techniques and products must all be considered together. Across the past three years there has been a steady decline in the quality of mortgages written and creditworthiness generally in the system. Credit-default protection has been extended to lower credit-quality-rated debt.

Massive international capital flows and global financial deregulation have grown exponentially over the past decade. Cross-border capital movements have increased more than threefold to more than $7 trillion since 1996. This has made far more credit available at much lower cost. For riskier borrowers - subprime - this has meant a maiden voyage deep into debt. The securitization and sharing of default risk has allowed issuers to share loss risk and markets to grow.

The sheer mass of managed wealth has reduced the returns to traditional safe investment grade assets. Thus supply and demand are generated by the same forces. These forces include rising risk/return appetite, global upward distribution of wealth, financial deregulation and financial innovation. Risk-management products have been inexpensive and the hunt for yield intense. There is more capital chasing riskier assets to gain acceptable returns. Lower-quality loans are made, hedged, bundled and sold. The serious systemic risk associated with the recent subprime episode stems from the prospect that the new financial architecture is less robust and more highly correlated than assumed. The rising cost of hedging debt positions and greater fear of lending to riskier borrowers is far more worrisome to us than the US subprime market.

New risk product and the rapid growth of established hedging and sharing contracts and trading techniques have boomed. From a systemic perspective, this does not reduce total default or shock exposure. Redistribution and repricing of risk occur. This is valuable and acts as a shock absorber for intermediaries that would otherwise have to restrict activity or ride unsound direct loss exposure. As higher risk assets are sold or hedged, there has been a tendency to use the raised cash to purchase other risky assets in the hunt for yield.

A prime example comes from the CDO (collateralized debt obligation)/mortgage-securitization process. As banks issue mortgages they assume a first loss position (FLP) to be able to sell off the loans for securitization. If we assume a fully funded standard contract, the banks pass the loans to a special purpose entity/vehicle (SPV) that sells the loans and assumes the loss position. Losses from "unlikely" system shocks are partially passed to the buyers of the securitized loan bundle, but that first loss position means the banks still bear risk. In addition, the total reduction in risk achieved hangs heavily on what is done with bank proceeds generated by this process. You guessed it, the evidence is that banks make further loans and repeat the process. The good news is that banks have a more diversified, riskier portfolio. The bad news is that risk exposure does not fall, it rises. The total risk in the system rises and is diversified and more broadly shared. This is the good news and the bad, out of our brave new era.

We see subprime as risk and valuable lesson. This market is in for a rough run. There are sweet dreams of containment; they defy reality. There is no such thing as a subprime neighborhood. Subprime is concentrated more heavily in some areas than others; it is everywhere. Thus broader housing-weakness questions are when and how bad, not if. Hundreds of billions of dollars in loans were made to people who clearly could not repay, absent significant annual house-price appreciation and cash-out refinancing. This means that we made housing loans to create housing-price appreciation on which loan repayment was predicated. Sometimes we are tempted to think that this credit boom has gotten a bit out of control. There is no long-run safe substitute for earnings, savings and income growth when increasing credit. This is not to say there cannot be a lot of money made, valuable financial innovation and long periods of great returns.

The other vital lesson involves our brave world of fully managed risk and nearly perfectly hedged positions. Have other markets and asset classes become dependent on credit growth to drive up asset prices to allow further credit growth? A huge Maginot Line of default defense has been erected to keep loss exposure out. Many valuable and potent new risk-management techniques and products have been developed. Riskier borrowers remain risky to all the various parties that extend credit to them. This showed up fast and furious as the cost of credit-default protection shot up and interest-rate premiums snapped into correlated action with every increase in subprime stress.

The greatest risk may be in thinking that risk has been conquered. It cannot be. It has not been. Risk has simply been redistributed and repriced, downward. As perceived risk fell and sharing grew, new monies were freed up for riskier lending and new, riskier projects. Loans went through and new projects were launched. Default risk continued/continues to grow as credit grows and allocations hunt for return. There is no innovating around this basic reality of financial gravity.

We are looking for periods of contagious fear in credit-risk-reduction markets feeding back and forth with particularly risky asset markets. The real danger slumbers - we hope - so long as massive quantities of cheap credit allow the roll-over financing of future rounds of debt. If this slows sharply, or runs in reverse, US subprime housing turmoil is the tip of the iceberg. There has been a lot of subprime allocation of capital and risk across the past few years. Subprime will either become a heeded warning shot across the bow, or a prelude to violent repricings to come.

Max Fraad Wolff is a doctoral candidate in economics at the University of Massachusetts, Amherst, and editor of the website GlobalMacroScope.

(Copyright 2007 Max Fraad Wolff.)