Just when a majority of strategists thought it was safe to go back in the water the proposed bailout of the SIVs once again threw the spotlight on the fragility of the credit markets. SIVs are the investment vehicles, known as "conduits" and 'structured investment vehicles" that are designed to operate separately from the banks and off their balance sheets, It’s one thing to learn that that someone is taking action on a dangerous problem that was known for some time. But to suddenly hear that a problem hardly anyone was aware of as recently as two months ago was about to blow up is more likely to raise the question as to what else is out there that we still don’t know about.
A while ago we quoted a trader who said "We don’t know what we don’t know and we don’t know anyone who knows what we don’t know." We were reminded of this remark by this morning’s front page Wall Street Journal article on the evolution of the SIV problem. Referring to a meeting of bankers initiated by the Treasury Department, the article states that "In the room was Nazareth Festekjian, a 15-year Citigroup veteran who runs a group that deals with unusual situations, such as the restructuring of Iraq’s debt in 2005. Mr. Festekjian, 46 years old, hadn’t known what an SIV was until he received a call several weeks earlier from a government contact asking him to work on a solution." It all leaves us wondering what will blow up next.
Although the SIV proposal is still somewhat sketchy, we have our doubts as to whether it will work. Although we may be missing something, on the surface the plan just seems to shift around the assets to a new entity without solving the underlying problem. There are billions of dollars of subprime and Alt-A mortgage defaults ahead, and no matter how you slice it, holders of these assets won’t get paid. Of course, in the short run the SIV assets will be kept off the books of the affiliated banks and won’t be marked down to real market values. That may well be the point of the proposal.
In any event the housing situation keeps getting worse. This threatens to put even more pressure on the fragile credit markets and on the rest of the economy as well. September housing starts were down 10% from August and 30% from a year earlier to the lowest level since 1993. The NAHB housing market index dropped to a record-low 18 and every subcategory has set a record low every month since early spring. The sub-index for traffic of prospective buyers declined to 15, far down from its cyclical peak of 55 in mid-2005.
The economy is facing a vicious cycle of increased delinquencies, tight credit and lower house prices. The typical subprime borrower pays almost half of his or her gross income on mortgage payments even at the teaser rate before resets. This makes a further sharp increase in defaults virtually inevitable. Even now the subprime rate of default is 16% on mortgages originated in 2005, 12% on 2006 and already 8% on mortgages originated in the first half of 2007. Defaults on the most recent mortgages are increasing at the highest rates and all are rising sharply. The vast majority of these mortgages have not yet been reset to higher rates. Even the usually optimistic NAHB recognizes that house prices have much further to fall. Chief Economist David Seiders recently stated that sellers may have unrealistic expectations as to how much they can expect to receive for their existing homes.
We believe the housing turmoil is highly likely to spread to the rest of the economy. The last seven instances in which year-over-year housing starts were down 25% or more were followed or accompanied by six recessions, and none were affected by the significant credit and default problems we are facing today. There is little the Fed can do about it and the global economy probably won’t be enough of an offset. The economies of Western Europe and Japan are also slowing down, and together with the U.S. account for 70% of world GDP. Growth in the developing economies, which account for the other 30%, are heavily dependent on exports to the G-7 countries. It seems to us that even the former deniers now concede the dire situation of the housing industry, but believe that this will be offset by a combination of Fed policy and global growth. In our view this is wishful thinking.
