Thursday, March 08, 2007

Shocker from HSBC

The world's leading stock markets have tumbled over the past week. The markets are nervous. Why? You will hear analysts mention the Japanese "carry trade"- borrowing cheaply in yen and investing at a higher rate abroad. This could hit arbitrageurs if the yen moved against them. Then, there is the sharp fall in the Chinese stock market and its impact on international investors.

One other factor that is mentioned is the "sub-prime mortgage" market in the US. This is the segment of the home loan market comprising loans to those with poor credit histories. Nearly 25 sub-prime lenders, firms that specialise in lending to this market, have collapsed in a matter of months. But it is the impact on a leading bank, HSBC, that comes as a shock.

HSBC is exposed to the sub-prime mortgage market on account of its acquisition in 2003 of Household, a US consumer finance firm. Sub-prime mortgages are popular with those who cannot access loans from mainstream banks. A typical sub-prime borrower would be somebody with an unsteady source of income but with a house against which he could borrow. When housing prices were rising and interest rates were low, it was possible for such borrowers to raise loans and repay them- or use such loans to repay earlier loans. With the rise in interest rates over the past two years, repayments have become dicey. The slowdown in the housing market has undermined the value of the collateral.

In addition to the sub-prime mortages with Household, HSBC bought large amounts of risky loans from the market. It did so in the confidence that it had the analytics to price the associated risk accurately- more accurately than others. But, all analytics go out of the window in the face of two years of rate rises.

HSBC has taken a bad debt charge of $10.6 bn, up 35% over that for the previous year. If things don't worsen in the housing market, analysts reckon the charge will be adequate. Inspite of the charge, HSBC managed to grow profits by 5% in 2006. But its troubles in the US -and its first profit warning in years- have called into question the quality of its top management and its risk management system. Nearly half of HSBC's profits come from emerging markets and that's where the growth has been in recent years. Why would HSBC abandon its areas of strength and head for a risky business segment in the US? That's the question.

HSBC management had contended that the expertise built up through Household could be applied to emerging markets. That is a little hard to buy. Emerging markets are not known for excellent credit histories, so applying fancy models there would be difficult. HSBC would be bettter off simply expanding into normal housing loans in those markets: India's default rate of under 1% on housing loans is a dream for international banks. The question now is whether HSBC can cap its problems in the US and direct its energies to emerging markets.

To return to the point I started off with, why is the broader market apprehensive about sub-prime mortgages? These loans are said to be only 8% of the total and so will not bury banks by themselves. The problem, as John Authers points out in the Financial Times, is different:

Mortgages are packaged by banks in instruments known as collateralised debt obligations. These include a range of loans. Investors can buy different slices – or tranches – of the entire package that have been put together. Losses will first affect the most junior tranches, and must be severe before they affect the senior tranches.

Most people, even with bad credit histories, repay their loans. So the most “senior” tranches can qualify for triple-A credit ratings, encouraging risk-averse institutions to get involved. But the underlying collateral is still subprime debt.
The synthetic derivative market means that the same portfolio of risky loans might show up as collateral for many different instruments. Thus bad defaults in the subprime sector, even though it accounts for only about 8 per cent of US mortgage-lending, could force defaults on instruments that investors thought were almost as safe as Treasury bonds. And that way would lie the much-feared systemic collapse.

Get the idea? As in LTCM, the problem is that financial institutions are exposed in a bigger way than the direct exposure to sub-prime mortgages would suggest.

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