Observations from the Road: The Subprime Economy March 5, 2007
Observations from the Road: The Subprime Economy
This week, The IRA is on the
road, visiting the left coast of the US for our semi-annual partner meeting. During our trip, we caught up on our reading and identified a
few issues that fit under the global theme of "the subprime economy," a
label which seems to apply to economic conditions in both to the US and also
in some of the major Asian nations. A few observations:
China
Our colleague David Kotok at
Cumberland Advisors featured a comment last week: "The Chinese have extreme
incentives to keep their economy growing at a rapid pace. If they continue to
post 10% GDP gains every year, the earnings for these companies will soon
follow."
True, but are
the Chinese corp/macro stats reliable? Our years in the
technology channel suggests the answer is no. In fact, we hear from
colleagues in the field that the speculative bubble in Chinese real estate
and financial assets makes the US asset bubble seem tame by comparison.
Indeed, there is so much air in the Chinese economy that it may burst
before the markets expect. Contrary to the conventional wisdom,
we think that the Chinese economy is going to crater before
the 2008 Olympics. And in any event, the smart money will start moving out months before the music stops.
The Dealers -- Too Big To
Fail?
In the past week,
the credit default swap or CDS market determined
that broker dealers are among the worst credits in the
marketplace, junk to be specific, a conclusion that seems long overdue. After all,
with hedge funds as their most profitable clients and OTC derivatives as the
product of choice, is there any amount of capital that could insulate a broker
dealer from the combined credit, market, liquidity, operational and reputational risks involved?
Chief among the names in the
crosshairs are firms like Bear, Stearns & Co (NYSE:BSC), a large prime
broker which took a hit last week when a federal bankruptcy judge in
NY clawed back $160 million for investors in a
fraudulent hedge fund. Other major prime brokerage dealers such
as Goldman Sachs (NYSE:GS), Lehman Brothers (NYSE:LEH) and UBS (NYSE:UBS) have
the same problem, namely that their most profitable customers are also the
source of potentially fatal risks.
Because of the magnitude of the leverage employed by hedge funds and
the mounting problems related to asset quality
and liquidity in the OTC derivative market, a single mishap involving a large
hedge fund has the potentially to cripple these financial giants. As default
rates in subprime and conventional loan collateral accelerate, and this reality
impacts prices for OTC derivatives and structured assets, look
for a growing number of hedge funds to
default and for their dealers to get hit with a backlash from
hedge fund investors.
Question of the week: Can you name the former Fed
chairman who lost money in the Amaranth debacle?
The
large bank prime brokers have the same problem as the broker-dealers, but benefit from the perception
that they are "too big to fail." This reality was illustrated in the decision by
Moody's last week to raise the credit ratings of the large banks with explicit
reliance upon the federal safety net. Truth to tell, the large
broker-dealers would probably qualify for federal assistance under the rubric of TBTF,
but at the moment the CDS market is saying otherwise.
The money
center with the biggest exposure to hedge funds is JPMorgan Chase (NYSE:JPM), the giant bank which is also among the
biggest retail banks in the US. In IRA's proprietary Basel II
simulation, using Q4 2006 portfolio level data from the FDIC and calculations by
the IRA Bank Monitor, JPM would require economic capital equal to more
than 5x its current risk based tier one capital to offset the risks emanating
from its trading book, this in a fully stressed scenario. This
compares with 3x for Citigroup (NYSE:C) and 1.5x for Bank of America
(NYSE:BAC). Because of the
open-ended risk from JPM's hedge fund business, we assign a high
probability that this fully stressed scenario will be tested in the
near-term.
The Airlines
In Chicago yesterday, our plane was delayed when the pilot
of our American Airlines (NYSE:AMR) Boeing 757 noticed that the aircraft needed
a couple of new tires and a brake job. As we watched the maintenance being
performed at the gate, we asked our co-pilot, a 15-year veteran, why it was that
the aging aircraft even made it to the gate to accept passengers in this
condition. Not surprisingly,
he took the fifth.
But during the ensuing
conversation, the former pilot for the US Navy made a stunning disclosure: Due
to the pay cuts and other changes in the business model
of AMR, he took home $300 less per month during 2006 than he did in his last year flying
P-3 Orion anti-submarine aircraft for the US Navy.
During the last years of the Cold War, the Chief of Naval Operations publicly fretted
that skilled Navy pilots were being lured away by the high salaries offered at
commercial airlines. But today, when AMR and other commercial
airlines cannot compete with military salaries to retain skilled professionals
like the pilots who eventually transported us safely to LAX, look at this
picture and tell us that the US economy is alive and well.
As American
companies take away income from skilled
professionals like airline pilots, software programmers and auto workers,
this in the name of "productivity" gains, do we not diminish the aggregate credit
quality of the US economy?
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