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What's Worse Than Subprime?

The wave of foreclosures hitting prime US mortgage borrowers is just picking up...

number one problem for the US economy? asks Eric Fry in the Rude Awakening.

De-leveraging, says Igor Lotsvin, co-founder of Soma Asset Management, LLC. De-leveraging might sound like a very innocuous term that describes a very a mundane process. After all, the term merely refers to reducing debt relative to the assets on a balance sheet.

But unfortunately, in the current American economic setting, balance sheet assets are declining in value faster than we can reduce debt. So as a nation, we must sprint just to stand still.

The economy is caught in a vicious cycle, wherein declining home values, coupled with soaring mortgage defaults, impair the assets on bank balance sheets – causing assets to shrink relative to their liabilities. This process forces banks to de-lever any way they can. So far, the preferred de-leveraging tactics include: withdrawing credit from existing and potential borrowers, selling equity stakes and/or selling assets. Unfortunately, as the assets on bank balance sheets continue to lose their value, banks must continue to de-lever. Withdrawing credit from existing and prospective borrowers is the easiest least over the short term.

But at the macroeconomic level, withdrawing credit exacerbates the financial distress that necessitated the de-leveraging in the first place. In other words, de-leveraging CONTRIBUTES to the continuing decline of home values, the continuing rise of delinquencies and defaults, and thus the need to continue de-leveraging – rendering a vicious credit cycle ever more vicious, as even credit worthy borrowers and businesses lose access to credit. This is the kind of stuff that converts recessions into depressions or that, at a minimum, converts the "green shoots of recovery" into the brown lawns of false hope.

"The de-leveraging that's taking place in the world is continuing on a very massive scale," warns Lotsvin. "The world is really on a margin call right now and it will not cure itself in the next couple of quarters. There is plenty more pain to come."

In order to see the beginning of a recovery, says Lotsvin, we would have to see the beginning of banks' willingness to lend. But that's not happening.

"Certainly the new administration gets an 'A' for activism," Lotsvin admits. "But I would go back and say, 'Is it working?...Are the banks lending now?' The banks have been pumped with hundreds of billions of Dollars of liquidity and trillions of Dollars worth of guarantees. We don't see any lending. Lending is not happening...Our premise is the economy will not work until you restore the credit pulse."

Ominously, credit trends are moving in the wrong direction. Credit is becoming scarcer, not more plentiful. Banks are repairing their balance sheets by withdrawing lines of credit from consumers and businesses alike. During the last six months of 2008, the nation's banks have cancelled more than $1 trillion worth of existing credit lines. One can only guess at the quantities of credit these banks denied to new, potential borrowers.

Are the banks to blame for failing to extend credit in this time of need? Maybe yes, maybe no; but the question is irrelevant. The banks are advancing their self-interest; and that means living to fight another day. In this environment, mere survival is a monumental challenge.

Subprime defaults caused the first wave of distress in the financial sector, but conventional mortgages, coupled with commercial real estate loans might cause the second wave of distress. And this second wave is MUCH bigger than the first.

"The wave of foreclosures [for prime borrowers] is just picking up," Lotsvin warns. "And to put it in context, the subprime crisis that we have all experienced...was caused by an asset class that is only $1.2 trillion in size. That's all. But the biggest bubble of mortgage resets is happening this summer and next year in the option ARMs and Alt-A market. And those markets are two and one half times the size of subprime. Even more worrisome, the leading indicators of foreclosure are rising in every asset class.

"The next shoe to drop of course is commercial real state," Lotsvin predicts. "There's no doubt about it. It's happening rapidly and furiously. What we see there is much more alarming than subprime.

"The size of the commercial real estate market in the United States is $3.5 trillion, versus $1.5 trillion of subprime. The banks hold on their balance sheets $1.7 trillion of the commercial real state debt. And I want to draw your attention to one particular subsegment of the commercial real estate market, that's construction loans...

"The banks in the United States have $700 billion of exposure to construction loans, and that's roughly 70% of their entire capital," Lotsvin relates.

"So to be clear, 70% of the bank's capital is tied up in the most combustible part of the commercial loan market..."

"In our view," hedge fund manager Stock concurs, "the number one problem for banks is that the banking sector is undercapitalized. Just to walk you through a very basic bank balance sheet [of the average bank today], you've got $100 of assets. The composition of that $100 is generally $85 of loans and $15 of securities. Those securities might be something as conservative as US Treasuries...This $100 of assets right now is being supported by roughly four Dollars of common tangible equity...So as you can quickly do the math, it doesn't take a lot of damage in a bank's loan portfolio or its securities portfolio to wipe out that common tangible equity.

"If you go back historically and look where the tangible-equity-to- assets ratios have been in the banking sector," Stock explains, "you'll quickly see that they have fallen off a cliff. If you go back into the 1990s and early 2000, banks consistently ran in the 6% to 7% tangible equity to asset range...

"Also," Stock concludes, "the real estate markets through late 90s and early 2000s were very stable-to-rising. Now we fast forward to where we are today...with these fairly thin capital ratios and you've got an environment where real estate prices are dropping and you've had very poor underwriting - the competitive landscape for banks has been so intense that banks were willing to do anything to get loan growth. So you've got a much riskier profile on banks balance sheets. If you rewind 10 or 15 years, banks didn't have the high- risk securities [on their balance sheets] that they've got today. So, we just think these ratios are not sufficient to handle the losses that we see on the horizon."

What do all these worrisome macro-economic data points mean for investors? Stock's partner, David Chu, provides a ready answer:

"We're not worried about missing this rally. When we build our long positions, we're looking for a period of multiple years and multiple baggers. So the fact that we've missed this brief upswing when there is still very, very meaningful risk on the downside in the near term doesn't bother us. When we see true signs of recovery – that banks are getting healthy, they're sustainable housing market return and when people start feeling better about their jobs – then we'll start looking at traditional investment metrics again."

Eric J.Fry has been a specialist in international equities since the early 1980s. A professional portfolio manager for more than 10 years, he wrote the first comprehensive guide to American Depositary Receipts, International Investing with ADRs. Today he reports on Wall Street from California for the renowned Daily Reckoning email service.

See full archive of Eric Fry articles

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