HOW LONG IS THE SUBPRIME TUNNEL?

We were at the brink of something that would have made anything that's happened in financial history look pale. We were very, very close to a system that was totally dysfunctional and would have not only gummed up the financial markets but gummed up the economy in a way that would take us years and years to repair. - Warren Buffett There could be a lot more bank closures in the coming months which could create significant investment opportunities. As many as thousand banks could go belly up. - Wilbur Ross It is quite likely that the current synchronized global economic boom and the universal, all encompassing asset bubble will lead to a colossal bust. - Dr. Marc Faber

Introduction Adding Perspective

This report attempts to provide the reader with data and perspective on the current financial crisis, often missing in the barrage of the media and commentary of experts. Crises are endemic to market cycles. Whenever a super cycle turns, the crisis is that much larger. The 1929 crash was the last big crisis in which the Dow Jones fell by 90% and it took the US six years to reach the same level of GDP. In more recent times, housing/credit bubbles have burst regularly across the world. The chart below shows the damage these have caused to markets. Statistics Related To Past Real Estate/Credit Busts
Finland (1991-94) Real Estate Price Decline (inflation adjusted) Housing Commercial Equity Decline (peak to trough) Broad Market Financials Total Bank Losses or Fiscal/Recapitalization Costs (% of GDP) Estimated Loss (USD) 70% 92% 66% 71% 45% 83% 46% 80% 18% 40% 33% 51% 49% 65% 81% 42% 26% 59% 44% 24% 13% Japan (1991-02) Norway (1987-93) Sweden (1991) U.S. S&L U.S. Current (1986-91) episode so Far

11%

24% 725bn

8%

4%

3% 160bn

4%*

Source - BCA Research, *Based on $500 to $550 billion estimated subprime related losses. Estimates might increase if house prices decline

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Origin of the problem

Of the total equity in housing stock, just a tenth (subprime) has created a problem of such magnitude this could spread further! Essentially, the trigger (sub-prime mortgages) expanded into the derivatives universe, which in turn affected the leveraged hedge fund industry, which in turn again expanded to the banking & insurance industry, ultimately contracting money flow across the globe. Effectively, insolvency of a tiny pocket has snowballed into systemic illiquidity, making the world risk-averse & contracting the velocity of global money. This contraction of money-multiplier is the root cause of any economic trough and only various ways of pump-priming can work to restore confidence to consume/lend versus store and thus break the liquidity-trap.

How deep can the trouble get?

The asset write downs in the United States have reached $515bn so far and could potentially increase to $1,100-1,700bn. Besides mortgages, there is an additional $20.4 trillion in private sector consumer and corporate debt and $2.7 trillion in municipal securities outstanding (Federal Reserve data); a part of these is also at risk. The table on the right shows the assets already written down so far and the overall potential losses. The highest risk bearers after US Banks are global insurers and hedge funds4. The $2.5 trillion hedge fund industry suffered average losses of 10% in 2007. The current financial turmoil which has led to restrictions on short selling of stocks appears to have exacerbated the situation, with the average hedge fund falling by 5% in September and the fall in the first week of October being even greater. Given the leverage of such funds, capital losses are much higher. Credit default swap (CDS), a double derivative product, is the other fear that haunts the market. It is also one of the root causes of the crisis. A CDS is a contract through which a bond holder, who is worried that the issuer wont be able to pay, covers his loss with a third party. Because they are contracts, rather than securities or insurance, CDS are easy to create. The other reason why the CDS market took off is that you dont have to own a bond to buy a CDS. In fact, a majority of CDS consist of bets on other peoples debt2.
Losses, Writedowns And Capital Raised ($ Billions)
ASSET WRITE DOWNS -Subprime-Related POTENTIAL LOSSES -Subprime-Related -Other Assets CAPITAL RAISED* 515 200 1,100-1,700 400-550 600-1,150 350

Source BCA Research, * Banks only

Source Goldman Sachs & Bernstein

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In seven years, CDS have ballooned from less than $1 trillion into a $54.6tn market. However, as many players in the market hold offsetting positions, in theory if every entity that owns CDS had to settle its contracts tomorrow and all positions thus netted off, $1.2tn could be at risk. This is much larger than the subprime crisis2.

The chart on the right shows the amount of credit default swaps outstanding which is greater than the worlds annual economic output!

Leverage Ratios of US and European Banks

Source ISDA, World GDP data as of year-end 2007: other data as of second quarter 2008

American banks are not the only ones in trouble. Aggregate write downs for European banks since the start of the crisis had totaled $228bn until August, which were offset by $153bn of additional capital raised. In fact, the average leverage of European banks is much higher than that of American banks. For example, the leverage ratio of Deutsche Bank with liabilities of over two trillion euros (more than Fannie Mae) is greater than fifty. Source US Securities and Exchange Commission and company reports According to a Goldman Sachs 1 Defined as total assets/total shareholders equity report, European banks may need 2 Annual data except for UK banks where half yearly data are available an incremental amount of 60 to 90bn euros to recapitalize themselves and meet new capital adequacy norms3. As many as 14 European banks have loan/asset ratios greater than their respective countries GDPs.

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How are the US housing prices (the primary cause of the crisis) poised?
The S&P/Case-Shiller Home Price Index has fallen 18% yoy through July 2008. Analysts at Goldman Sachs expect another 9-11% decline from July levels8. The housing bubble has not been limited to the US and countries such as Ireland, Spain and the United Kingdom have seen even bigger bubbles.

Source Goldman Sachs & Bernstein

Source Robert Shiller, Milken Institute

The chart above brings out the irony and shows that underlying subprime houses are only a small percentage of the total housing market and it was the CDO & CDS bubbles that caused the real problem

The chart above shows the percentage annual change in nominal home prices in the last hundred years along with the average change (white dotted line) and standard deviation (yellow dotted lines)

What has led to the current liquidity crunch?

The money markets have completely broken down, with no trading taking place at all. There is no market any more. Central banks are the only providers of cash to the market, no one else is lending. - Christopher Reiger (Dresdner Kleinwort) Banks have become so risk-averse that they deposited a record 44 billion with the ECB on September 30th even though they could have earned more than two percentage points extra by lending to other banks. Moreover banks are anxious to conserve their own cash, in case depositors make large withdrawals or their money gets tied up in the collapse of another bank, as with Lehman. A good measure of the liquidity in the system is the London Interbank Offered Rates (LIBOR). Only a week back, LIBOR stood at 6.88 %, almost twice the yield on the 3-month US Treasury bills. This shows how much riskier financial institutions think it is to lend money to each other rather than the U.S. government.

Source Thompson Database

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Money market funds, structured to protect value, are unable to do so because of unprecedented mark-to-market losses. As a result they are unable to buy any commercial paper and hence financing working capital outside the banking system has become impossible. The US Fed has just announced a programme to invest directly in the commercial paper of well rated companies. There is no other lender! This is just the kind of paranoia that the recently approved $700bn package was trying to remove.

How have global markets reacted to the subprime crisis?

The world market capitalisation has fallen by 20% since March 2007 and by 31% since December 2007. Year to date, the Indian and Chinese markets have been the worst performers amongst the larger indices. World Free Float Market Capitalisations
Dec 07 to Sept 08 (% change) -21% -23% -33% -51% -33% -39% -16% -35% -20% -34% -33% Mar 07 to Sept 08 (% change) -21% -30% -29% 31% -30% -7% -3% -23% -22% -8% 23% Dec 07 to Sept 08 (% change) -51% -33% -36% -40% -29% -52% -26% -38% -15% -34% -31% Mar 07 to Sept 08 (% change) 10% -28% -36% -20% -23% -53% 5% -42% -7% -21% -20%

Country United States Japan United Kingdom China France Hong Kong Canada Germany Switzerland Australia Brazil Source - Bloomberg

Sep-08 13,931 3,479 2,713 2,170 1,844 1,616 1,475 1,441 969 935 934

Country India Spain Italy South Korea Taiwan Russia Argentina Sweden Mexico Singapore Total World

Sep-08 894 734 703 660 496 479 418 359 340 327 41,806

There are factors that indicate that there may be more trouble left in American equity markets. The US has a low private savings rate and a negative household savings rate. It has a large current account deficit and a currency that needs to depreciate further to reduce this gap. There is also a severe financial crisis affecting all sectors of the economy. It does not seem likely the trouble has ended just yet. The Dow has fallen 27% since March 2007 when the crisis first came to light, much less in Euro terms.

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Is there light at the end of the tunnel?

Warren Buffett may have started to see some light and has invested $5bn in the preference shares (attached with equity warrants) of Goldman Sachs and $3bn in the preference shares of General Electric. After an extended debate the U.S legislators have thought it fit, probably even profitable, to create a bailout fund of $700bn. This has been widely endorsed by most while some still feel the amount to be grossly inadequate. Central Banks around the world are putting up a concerted effort to provide liquidity to the globe by extending lines and cutting rates. This cannot but have a stemming effect. Commodity prices (and hence inflation) are falling sharply and this will bring relief to the world and make a stronger case for lower interest rates. This also mitigates the impact of higher interest rates warranted by rising fiscal deficits of the governments being created to bail out/takeover financial institutions. Wealth of the world is estimated at $150 trillion*. A lot of it got built in the last 3 years. Some of the current losses in stocks and wealth is of course very painful but in the long term may prove to be just a bad dream that led to some much needed reform and changes in global leadership. This nightmare looks like it shall last a while. Never before have housing, banks, hedge funds, insurance companies, commodities and currencies got so badly intertwined. Untangling them will take sometime. When done, this will create a new world order.

* United Nations Universitys World Institute for Development Economics Research estimate $125.3 trillion, as of the year 2000 so extrapolating considering recent growth

Analysts
Saral Bhanshali Sharad Dhariwal Nikhil Krish

References
1) 2) 3) 4) 5) 6) 7) 8) 9) 10) 11) 12) 13) Is This The Big One? - BCA Research, September 19 2008 The $55 Trillion Question - The Fortune Magazine Europe Banks Goldman Sachs, July 03 2008 Turmoil in Financial Markets: Causes, Consequences and Choices - Chris W. Marx, April 17 2008 Proposed $700 Billion Bailout Is Too Little, Too Late to End the Debt Crisis; Too Much, Too Soon for the U.S. Bond Market - Martin D. Weiss and Michael D. Larson, September 24 2008 The financial turmoil 2007-2008: Old and new insights into the nexus between the financial sector and the real economy - Mr Gudmundsson, May 20-22 2008 American Housing, A Map of Misery The Economist, May 08 2008 Commercial Property Prices The Economist, July 17 2008 The two days that shook the financial world - DNA Money, October 03 2008 How the $700bn bailout will work DNA Money, October 06 2008 Flow of Funds Accounts of the United States, Flows and Outstandings Second Quarter 2008, September 18 2008 World Federation of Exchanges Hedge Fund Assets Reach an Estimated $2.848 trillion in Q1 2008 Business Wire, May 21 2008

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