Unfortunately, this is just the tip of the iceberg (subprime-crisis)

 

This guy works as investment banker in Singapore, and knows what he is talking about. The context of the discussion is the suspension private equity firm, the Carlyle Group.

The calculation and logic seem OK. But I find it hard to imagine something as mundane as mortgage loans becoming tradable commodities which lead to fantastic returns or losses. Wouldn’t the lenders gain back part of the assets, even if the loans turned bad and thus mitigate losses. I need to see some solid examples, as the Liao does not touch on this area.

Author: mr. liao 
Date:   03-09-08 10:30

This is just the tip of the iceberg. Some have pondered how a relatively ‘trivial’ US$170 billion subprime losses could affect something as gargantuan as the US economy, with its mind-blowing GDP of US$13 trillion. The numbers do not ‘jive’ (in their simplistic minds). After all, is not US$170 billion just 2% of the total capitalisation of the US stock market? These jokers have omitted to traverse a step farther in their reasoning. The short answer to their question can be encapsulated in one word: leverage. Hedge funds are institutions that are leveraged over 10 times (in the case of Carlyle 32.0 times). Even a small loss on their portfolio would destroy economic value to the tune of several times greater than their level of equity, and that multiple would be precisely the gearing ratio.

Let us say you invest in a portfolio of risky assets (worth US$500 million) with an expected annual rate of return of US$200 million for 5 years, and you based the expected return on information provided by rating agencies concerning the probability of default on each of these risky assets. How could you pass up on a 40% rate of return? Whoa! You think to yourself. Sensing an opportunity, fund managers with equity capital of say $50 million will leverage up to 9.0x, borrowing the remaining US$450 million from banks (so they can buy this US$500 million asset). The banks are also fooled by rating agency calculations you have presented them, so they willingly extend credit. The corporate bankers already ran their models based on those figures and readily believed, like you, that you would be able to recoup on your investment and repay the debt.

If everything in this simplistic example had been hunky dory, you would have made a total return of US$1.00 billion over those 5 years. In each of those years, your ROE would have been 400% (return of US$200 million per annum on US$50 million on equity), thanks to your clever leveraging. After repaying the debt portion of your financing (bullet principal repayment of US$450 million and say accrued interest of US$50 million), you would have made US$500 million (net of debt repayments) on only US$50 million of equity over the last 5 years. That was the idea. That was the premise of the investment on the first place – that given the expected default frequency on the subprime loans (as dictated by the rating agencies based on historical data), your portfolio would be safe.

What happens instead is this. The expected rate of return does not materialize (mortgage borrowers were not able to obtain the expected cheaper refinancing due to the housing market downturn). They are unable to make their mortgage payments. Your portfolio turns into a basket case and registers losses of US$10 million each year (instead of the profit of US$200 million you had expected using the default probability data furnished by rating agencies).

At the end of those 5 years, you chalk up losses on US$50 million – an apparently small sum. But recall that you had borrowed US$450 million from the banks and in addition to the interest of US$50 million, owe them a total of US$500 million. Because you are unable to repay, the banks would have to write-off the entire US$500 million of assets (their loan to you) off their books. That was the total value in the economy that was destroyed by this particular investment.

So do not mistakenly think that you can measure the loss to the economy by the US$50 million ofv destroyed fund-manager equity alone. The spill-over to the financial sector would be considerable, since many of these hedge-funds are leveraged anywhere from 10-20 times. Although the losses from subprime are US$170 billion as of 2008, I suspect the total value destroyed in the economy would be far greater – possibly close to US$2.0 trillion. People, be prepared for a rocky 2008.

In an ideal situation, with the risks properly calibrated, this would never have happened. Banks should never have allowed hedge-funds to leverage up to 10.0 times and create a market for risky assets. Easy credit fuels risk-taking.

If rating agencies had properly calculated the risk, then no bank would have been willing to lend to a subprime investor. Subprime investors would be constrained in the size of their own investments by the level of their own equity. The size of the subprime market (and also the total economic value destroyed) would then have been capped by a factor equal to the reciprocal of their leverage. The scale of the problem could have been 10 times smaller (assuming hedge funds, accounting for size differences, are leveraged at 10 times on average).

Advertisements

About kchew

an occasional culturalist
This entry was posted in Economy and business. Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s