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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:


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?

Questions? Comments? [email protected]

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