Oct 15/07

Gilbert Morris

We should never find ourselves in a position that we must draw on resources we never bothered to store up for a rainy day; and so find that in drawing on what is available, we merely increase, not only the problem, but the complexity of its negative effects. This is the situation facing the US Federal Reserve Bank (The Fed) at the moment, and despite the variety of predictions about what the subprime woes will mean, there have been few if any thorough-going explanations of the impacts, direct and indirect; and certainly too little said about what this means for the Caribbean.

Clarity on what is "subprime" is essential here: It means simply loans given to persons who do not meet general requirements, such as collateral base, or debt service ratio (ability to pay), credit history or even life insurance guarantees. (This is critical since many such loans are to single mothers over the age of 35, or poor families who cannot qualify for 30 year insurance policies). In Florida for instance, the "low doc, no doc" loans became infamous. These are loans given purely on the basis that the applicant had proof of a job, without additional due diligence on credit history.

Of course, it is not only the problem that people who could not meet the general bank criteria were given these loans. Perhaps it is not even the problem that the loan recipients would not have paid their loans. But that mortgage brokers convinced them to take variable rate mortgages. As such, when rates rose, they could not pay; whether they intended to or not.

This does not explain the peril we face. Consider also that mortgages were not only extended to those with little capacity or history of credit repayment, but also to neighborhoods of questionable investment value. And of course, now, those homes offer little of the financial returns promised to buyers or upstream lenders alike. Now imagine this: Those mortgage companies and banks, sold these 'subprime' loans to hedge Funds and private equity firms, who leveraged the package of loans; which are in turn funded by large established banks that invest in such funds, along with pension funds and other institutions (such as Insurance companies) with large pools of investable cash.

Now that loan recipients have defaulted on those mortgages, those houses are being sold at a discount to the original value versus the loans, but also, at a discount to the projected current market value. This means that all those institutions in the debt-chain, (or the upstream from the lender) are suffering and will suffer losses.

Here is the problem beneath the problem: We have no idea how large the subprime market was/is, and which financial institutions are carrying significant risk. As such, any institution maybe at risk for loss. (And as far away as Germany, they are). This may mean increased insurance premiums, pension risk and certainly higher interest rates for loans, and perhaps severely-restricted loans for small businesses. This will occur at the same time that the US economy is showing recessionary characteristics. In a single case, August jobs data shows not only a decline in job gains, but an actual loss of jobs in the US economy (100,000 job per month is required to support US job demand).

Following this trend, it means that even if the Federal Reserve lowers rates, the new cash will either be sucked up by price-affected assets such as foreclosed houses, creating an inflationary 'mini-bubble' or that money will be channeled to support existing deals that have run into trouble because of higher interest rates.

Also, The Fed is not omnipotent here. Even if the new cash injected into the market fosters a few new jobs, the consumer spending or the consumption that drove the US economy for the recent 15-20 years has been backed by home equity loans which will be harder to come by. US investment in foreign markets is also not 'unproblematic' - since the US dollar continues to fluctuate against other major currencies, and (as a critical point) gold rose against the dollar steadily over the past several weeks.

Casualties abound with more to come. Northern Rock bank in the UK saw a withdrawal of $1 billion dollars in four days. Whilst that is significant, it represents only 4% of its total funds under management. Worse is the specter of a "bank run", which undermines confidence in financial institutions.

The impact on the global economy is a story in itself. A key focal point is that the global economy does not depend on the US economy as it did before. US profits from overseas investment has grown 1% per year for the last 10 years. As such, except for those foreign banks or institutions with direct or indirect exposure to the subprime crisis, this is largely an American crisis, made in America; with intersticial effects overseas.

What does this mean for the Caribbean? In the last 5 years alone, there has been nearly $10 billion dollars invested in tourism-related projects. There are already instances of financial failure. (Which I shall not name for the moment). In the course of things, only those premium brand names will be able to the weather the credit crunch, which is bound to run deeper than it is now. Lower jobs numbers, tight credit, and increasing energy costs (which are likely to go higher the closer we get to the US elections), will mean borrowing money to build resorts in our region may prove difficult. Existing hotels, airlines and nearly every institution in the travel chain will likely encounter problems; not least of which beyond everything else may be paying customers. Governments in our jurisdiction will have to look at each deal very carefully to ensure that developers can meet their obligations vis-à-vis government concessions.

What will be the main fallout of all this now ? My advice is invest in bankruptcy firms.