Global Outlook

Toxic Cash Flows and the Subprime Crisis Until recently the US real estate market was in full swing. The credit market was growing and loans such as Jumbo (loans with high values), ALT-A (low document loans, loans which do not require much verification) or Subprime (loans for individuals with low credit scores) dominated the market.

Almost 70% of real estate loans were originated by brokers working on a 1-3% commission. Although this growth was unsustainable in the long run, few were those who knew what was coming.

How did we reach the Subprime Crisis?
Brokers were interested in originating as many loans as possible, as they were paid a commission based on volume originated. A borrower's ability to repay his loan was not a broker's problem, as servicing a loan became a bank's issue once originated.

Hence, many ALT-A and subprime loans were originated, despite the reduced ability of clients to make their monthly payments. Moreover, banks tried to get rid of such 'toxic' loans from their balance sheets by securitizing them and re-selling them towards asset managers or pension funds from around the world.

Despite this market misallocation, until 2006 subprime loans caused little short term harm to the credit market, as the real estate market was still growing: an individual who could no longer make his monthly payments would sell his real estate and repay his debt. As the long as the market was growing, this did not pose a problem: the price of homes was growing and any individual who was unable to pay, had a home worth more than his total outstanding debt.

However, in 2006 the US real estate market took a sharp turn (headed by Florida and California) and started tanking. Home values decreased and selling a home no longer covered the value of one's loan, which in turn led to a liquidity crisis.

Once borrowers started to default, a vicious circle spiraled out of control: investors who bought securitized loans no longer got their returns; hence they stopped buying new loan packages. Securitization groups at major investment banks no longer had buyers for their subprime loans and were therefore stuck with 'toxic' loans on their balance sheet. This caused banks to constrain the money available for new subprime loans, thereby putting brokers out of business.

Furthermore, in many cases securitized loans were sold within the same bank from the securitization group towards the asset management group, as profitability and performance were measured separately for the two distinct entities. Those who securitized loans wished to sell them, regardless of their buyer, as they were rewarded for volume sold as well.

There are several problems that led to this crisis, some more obvious than others. Brokers wished to sell their loans, regardless of a clients' ability to repay in order to make their commission. Securitization groups did not always understand the level of risk of loan packages and mispriced them as they were reselling them towards investors. Investors are also to blame as they followed a mass mentality and all bought into the securitized loans they did not fully understand.

Current Situation
Aftet the Implode-O-Meter website, 242 major US lending institutions have imploded between December 2006 and April 2008. Imploded means bankruptcy filing, temporary but open-ended halting of major operations, or a "firesale" acquisition. Out of the ten subprime originators, all have closed their gates or went bankrupt.

Names such as HSBC Direct, Option One Mortgage or American Home went bankrupt or no longer exist in the subprime market. In 2006, the subprime origination market was 0 million. By 2008, this market almost disappeared.

Despite this downturn, some market players will survive the storm. Since all investors have become very averse towards buying financial institutions' stocks, market players who are outperforming the market are undervalued because of the general aversion and investor panic. This means that hedge funds or investors who can analyze company fundamentals and figure out which companies have little 'toxic' cash flows on their balance sheets can make large profits after the storm, as most financial institutions are undervalued.

The US real estate market continues to decrease in 2008, which will further compress credit markets and increase borrowers' leverage, decreasing their ability to repay. As before, this will continue to shake down international markets: it has already been speculated that the Japanese real estate boom will be affected by the subprime crisis.

JP Morgan and other investment banks announced a restriction of credits and increase in credit qualification standards. Wachovia announced that the real estate slump is far from over. Giant Bear Stearns was on the verge of bankruptcy and has just been acquired by JP Morgan. In Massachusetts, homeowners took the streets and demonstrated in front of JP Morgan and Bear Stearns against the taxpayer bailout of Wall Street. The near term outlook is not very rosy.

In Romania, the subprime crisis has not been felt as much as in the US. The downturn exists, despite the lack of media coverage. Growth of foreign investment started to decrease due to the lack of international market liquidity. Large investment funds no longer have access to cheap capital as they did until now and they have become significantly more selective with their investment types.

The real estate market is now starting to form different segments which are growing or decreasing at different rates. The phrase "location, location, location" now also has meaning in Romania, as land at the outskirts is no longer growing at unprecedented rates and land prices in downtown urban centers is still growing (similar to developed economies).

This is partly due to the maturity of the market but also due to the credit contraction: since there is less money available for real estate developments in Romania, investors will better pick their investment spots. As the market matures proper due diligence and fundamental analysis will become key to success for funds that will succeed to outperform the Romanian market.

articol scris de Alexandru MANAILA -