What the subprime collapse means for your investments
By
Tim Price Nov 08, 2007
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“Innovation has brought about a multitude of new products, such as sub-prime loans… Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in sub-prime mortgage lending… fostering constructive innovation that is both responsive to market demand and beneficial to consumers.”
So said Alan Greenspan, then chairman of the US Federal Reserve, on 8 April 2005.
How Alan Greenspan sowed the seeds of subprime market risk
History is unlikely to be kind to Alan Greenspan. It is the fate of most central bankers to be overrated during office, but posterity tends to be more objective. Now at a safe distance from Washington DC, Greenspan has dedicated recent weeks to sniping from the sidelines, warning of possible recession immediately after his successor, Ben Bernanke, forecast stronger US growth.
As the FT’s Lex column pointed out, intergenerational conflict at the Fed is nothing new: back in the 1980s, President Carter and former Fed chairman William Miller publicly attacked then Fed chairman Paul Volcker for his hardline stance against inflation. The irony this time round is that Greenspan is the arch-inflationist of the new millennium. During his reign, no financial crisis – the East Asian crisis of 1997, the near collapse of the hedge fund Long-Term Capital Management in 1998, the terrorist attacks of September 11th 2001 – was so severe that a swift rate cut (“the Greenspan put”) couldn’t deliver the goods.
Greenspan sowed the wind, but it is left to Bernanke to reap the whirlwind. As for Greenspan’s 2005 comments on risk assessment in the subprime market – as Barry Ritholtz observes, nothing you can add to these words is more damning than the original.
Who is involved in the subprime debacle?
More than 30 sub-prime lenders have shut down in recent months. Other players in the US subprime debacle are, happily, big and diversified enough to withstand further deterioration.
HSBC, for example, no doubt regrets its awkwardly timed acquisition of sub-prime specialist Household International, which triggered the first profits warning in its history. Two-thirds of HSBC’s $10.6bn of loan defaults in 2006 were incurred in North America, a market that has, once again, become a graveyard for European banking expansionists. The marked deterioration in prospects for US real estate and its associated financing have replaced vague fears about China as the dark cloud over markets.
The chief executive of homebuilder DR Horton, Donald Tomnitz, speaking at the Citibank Housing Conference, was refreshingly candid: “2007 is going to suck, all 12 months of the calendar year. Our future is not as bright as we would like it to be.”
Which other sectors will be affected?
The trillion-dollar questions are whether softer housing will hurt US consumer confidence, and whether defaults in the subprime mortgage sector will trigger contagion in other parts of the credit market.
The prudent investor’s defensive response would be to cut exposure to the US consumer – just in case – and raise exposure to assets with a realistic chance of delivering genuinely weak correlation to the US equity market.
Corporate debt remains unattractive, particularly at the lunatic fringe, though quality credit will likely retain a safe-haven character comfortably into the second quarter.
Within US equities, the $40bn in market value sliced off Merrill Lynch, Goldman Sachs, Morgan Stanley, Lehman Brothers and Bear Stearns in recent weeks is probably a fair reflection of the possible downturn facing investment banking if sub-prime contamination hits other asset classes. US banks in general now look cheap – but for a reason. And while sub-prime lenders are going to the wall, traditional financiers are unlikely to pick up the slack.
Schizophrenic equity investors might be inclined to see good news in a US slowdown, to the extent that the interest-rate cycle might turn back down again.
That would probably be the wrong conclusion: a firming in lending standards has begun and US banks may yet deliver a monetary tightening, which the Fed would ordinarily oppose.
The outlook is brighter outside the US, with Europe on the up. Recent mergers and acquisitions activity in Carrefour points to the health of the European consumer.
And the Asian engine continues to fire. Regardless of whether markets experience aftershocks from February’s volatility, investors pursuing diversity and quality should thrive.
Are stockmarkets being overly sanguine about prospects for a US-housing-triggered slowdown? The last word goes to Angelo Mozilo, chief execuutive of lender Countrywide Financial, an originator of $41bn in “non-prime” mortgages in 2006: “I’ve never seen a soft landing in 53 years.”
Tim Price is chief investment officer at Union Bancaire Privé
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