Subprime Debacle: The Fallout is Global

Compared to the growing contagion from the US subprime debacle, the LDP's drubbing in the recent elections and loss of it's majority in the Upper House is just a sideshow. Japan now has a lame duck Prime Minister that refuses to resign, but the implications from the losses eminating from the US are potentially more serious as they strike at the heart of the global financial system. When the subprime mess first began to unravel, we stated that containing contagion was the key, and signs that contagion is not being contained is what is most troubling for investors.

Ben Bernanke of the Fed in testimony before Congress guessed that "financial losses" from the subprime mess could reach $100 billion. Yet William Poole, governor of the St. Louis Fed has effectively said that "investors" (speculators) in derivatives of low quality mortgage loans got what they deserved, i.e., don't expect to come running to the Fed for help.

The rating agencies say that nearly 50% of subprime loan origination capacity has disappeared. Financial smart guys claim that the shake-out is "good" as it is removing "froth" from overheated markets. Well, it is doing more than that--i.e., the contagion continues to spread, not only in the US, but into international financial markets as well. Jeremy Grantham of asset manager GMO believes that at least one global bank and one~two of the largest private equity firms may also fall before the debacle ends.

Mortgage Lenders

Mortgage lenders like New Century Financial, American Home Mortgage and Countrywide Financial got whacked early. New Century failed, American Home is close to failure, and Countrywide says the contagion is spreading in to the prime mortgage market. The mortgage lender damage is not only in the US. Germany has moved to bail out a German subprime lender with exposure to the US market. Canada's Imperial Bank of Commerce is hurting from its exposure to US subprime loans.

Mortgage Insurance Companies

Large mortgage insurance companies like MGIC Investment and Radian Group have also been hit.

Hedge Funds

So far, Bear Stearns has seen two of its hedge funds blow up and another one that was not leveraged is also under pressure. Hedge fund Sowood Capital of the US has also collapsed, and now Tudor says it is seeing significant losses on two of its hedge funds, while Australian hedge funds Basis Capital and Absolute Capital have now been followed by MacQuarie's Fortress Investment.

Global Investment Banks

Global investment banks like HSBC are making record provisions for subprime loan losses and also tightening lending terms to hedge funds. The global investment banks with exposure reads like a list of the "who's who" of global finance, Bear Stearns, HSBC, Credit Suisse, Deutsche Bank, Goldman Sachs, Royal Bank of Scotland, Barclays, AIG, just to name a few.

In Japan, both the five megabanks and the Nomura Group have exposure. The losses by Japan's megabanks on subprime exposure (some reports of a total exposure of JPY1 trillion) come on top of losses on domestic consumer finance subsidiaries that are having to pay borrowers back for excess interest charged.

CDO Weapons of Mass (Balance Sheet) Distruction

According to a February article in the IHT ( http://www.iht.com/articles/2007/02/06/bloomberg/bxatm.php), CDOs were supposed to be "a free lunch" that made investors "immune to default", according to fund managers like Etienne Gorgeon of Fortis Investment Management in Paris. Investors investing in credit derivatives known as CDOs were getting 12% yields, or 3X more than yields on the underlying notes that were bundled in the CDO. Right. Is that why Bear Stearns had two credit derivatives funds blow up and other facing big losses? Is that why balance sheets of hedge funds are blowing up. Is that why the market for LBOs has suddently dried up because of lack of funding?

CDOs were the fastest-growing business on Wall Street, as contracts that ostensibly protected investors from defaults were being sold in record numbers and then bundled in CDOs. The market for CDOs is estimated to have grown to $2.6 trillion (which is about the same size as the assets in the world's sovereign wealth funds like Abu Dhabi Investment Authority). Low risk aversion and excess liquidity lead to diminishing returns on regular bonds, and institutions were switching our of bond investments into CDOs.

The "market" (if there is one left) for CDOs has grown as large as the entire amount of commercial/multifamily mortgage debt outstanding in the US, and issuers of commercial mortgage-backed securities (CMBS) and collateralized debt obligations (CDO) and other asset backed securities were responsbile for almost 60% of recent increases in commercial/multifamily mortgage debt outstanding. Commercial banks continue to hold the largest share of commercial/multifamily mortgages, with more than $1.3 trillion, or 43% of the total. CMBS, CDO and other ABS issuers are the second largest holders of commercial/multifamily mortgages, holding $661 billion, or 22% of the total.

Weapons of Mass Balance Sheet Destruction

CDO investments with high leverage recently buckled two hedge funds at Bear Stearns and are currently threatening another.

Liquidity conditions are suddently much tighter. Long-term interest rates are on the rise and banks are cutting back lending -- that's more commonly known as a "credit crunch." There is a real danger of the US sub-prime mortgage collapse turning into a wider financial crisis. What began as a problem for borrowers has now turned into a problem for lenders.

The ongoing crisis triggered by the subprime mortgage defaults continues to spiral into new directions, making it difficult for even experienced market watchers to comprehend the complete picture and its implication for the financial markets.

1) Financial Shock to the System--Risk is being rerated accross the board. Markets are trying to price for much higher risk levels, but there is no market for many credit derivatives now. The problem is no one knows the true magnitude of the problem.

2) More hedge fund blow-ups-- from exploding credit derivative positions.

2) Unwinding to the yen carry trade--The yen has quickly appreciated to the JPY117 level, but we believe that the bulk of the move has already passed, unless there is much wider contaigon and much more pain among the hedge funds and leveraged traders.

3) Banking system losses from a credit derivative crisis--$100bn, according to Ben Bernanke at the Fed. But St. Louis Fed chief Poole basically said "don't come running to us for help".

4) Falling 10-year Treasury yields--on a "flight to quality".

5) A drying up of fund flows into emerging markets, both equity and debt.

6) A synchronized sell-off in all equity markets.

7) After an initial liquidity crunch induced sell-off, gold could surge as a haven investment.

LDP Gets A Drubbing in Upper House Elections

The LDP (Liberal Democratic Party) losses in Sunday's Upper House elections are the worst in the party's 60-year history, with the exception of a similar loss in 1989, when the party first lost its single majority. Several voter themes were very clear in the election, a) Japanese voters have no tolerance for dirty politicians, b) they have even less tolerance for incompetant bureaucrats (pension funding mess), c) have absolutely no trust in the Abe Administration, and c) want to see younger politicians.

We believe the losses mark a significant shift to two-party politics in Japan, in that the DPJ (Democratic Party of Japan) now appears actually compenent enough to run the government. Rather than being a big vote of confidence for the DPJ, however, the vote results more represent a strong protest against the ineptitude and graft in the LDP.

Since the stock market had already begun to discount the possibility of the LDP losing these elections, we believe most of the bad political news is already discounted, even if PM Abe refuses to resign but nevertheless has to substantially reshuffle his Cabinet.

There was talk before the results within the LDP of pushing forward proposals for a Japanese Sovereign Wealth Fund despite MOF (Ministry of Finance) resistance of stock markets reacted very negatively to a big LDP loss. Even if preparations for such a fund move at record speed, however, it is unlikely such a fund could see the light of day within the next year. However, if Heizo Takenaka (the Koizumi Admistration's finance guru) is chosen as the next BOJ governor next year, the momentum could clearly turn in favor of establishing a Sovereign Wealth Fund.