One Year of Subprime

By Dr. Duru written for One-Twenty

February 11, 2008

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CNBC's Fast Money held a neat little "birthday party" for the subprime crisis (click here, see 11:28 to 14:00 on the video). One year ago, on February 8, 2006, Hsbc Holdings Plc (HBC) was the first financial institution to announce a subprime-related write-down. We all know the tumult that has happened since - highlighted by 4 big sell-offs and three big bounces to-date. I thought I would take a look at what I was doing around that time. You know - see how smart and savvy I was about this event, see whether I added value to your life by providing ample warnings. While I had nothing to say about subprime for many weeks to come, the other stuff I wrote around that time seemed appropriate.

Three days before HBC's write-down, I had an epiphany of sorts. On February 5, 2007, I wrote "Driving the Economy with Negative Savings Rates" after reading that America's savings rate fell negative for the first time since the Great Depression. After digging through some statistics I discovered much to my dismay a direct correlation across the bull market that started in 1982, the multi-decade decline in interest rates, and the persistent multi-decade decline in America's savings rate. This all warned me that the bull market was both tired and was at risk for a major turn-around once interest rates and/or America's savings rate finally go as low as they possibly can. I had nothing else to say for over two weeks (you know, the "real job"), but then I exploded with a series of missives that reached a climax the day after the market was clobbered in the first of our three market market swoons for 2007. On Feb 28, 2007, I wrote "Private Equity Prays the Hardest that the Market Has Not Topped Out." With the S&P 500 now trading 5% below those levels, clearly, those prayers are yet to be answered. Worse yet for those leveraged buyouts, investors cannot seem to run away fast enough from the debt offerings used to fund those deals. In fact today the Wall Street Journal reports in "New Hitches In Markets May Widen Credit Woes" that:

"Especially hard hit: the market for loans to big U.S. companies with low credit ratings. Problems in this market have been percolating for months. These loans, known as leveraged loans, were a popular way to finance the multibillion-dollar private-equity buyouts of recent years that have wound down amid the credit crunch...Investors started to shun buyout loans last summer, causing a buildup of the debt on bank's balance sheets. During the past two weeks, prices on many of these loans have fallen to levels that in a normal environment would indicate that the market expected the corporate borrower to restructure or seek bankruptcy protection. But, though they are creeping up from record lows in 2007, the default rate on leveraged loans is still very low, at around 1% in January, out of the more than half-trillion dollars of these loans outstanding. Investors are also fleeing leveraged loans because the payments they make to investors are tied to short-term interest rates. With short-term rates falling, thanks to the Fed's rate cuts, those payments are shrinking."

Yikes. Sounds like the LBOs are getting hit from all sides now.

Anyway, so what has happened to HBC over the past year? Well, clearly, the market was very slow in absorbing the full implications of this bank's subprime writedown. I managed to get short HBC the day after its announcement but a month later I barely had a 3% gain on the position when I closed it out. I dabbled some more on the short-side in March but, again, the profits were small. In fact, the 9-day chart below shows you that HBC was never hurt all that much and even managed to rally to set a marginal new all-time high last Fall! That last run turned out to be a blow-off top. HBC is now down a whopping 26% since then and is scraping 4-year lows. That is one dramatic turnaround! I wish I had been "smart enough" to re-establish my short then, but I was too busy looking to a big bullish run to close out 2007. Silly me...


It seems HBC and the rest of the financials could go even lower from here. This morning, the Financial Times reported from the G7 meeting: "Subprime credit loss heading for $400bn, say G7 finance chiefs." This amount is considerably higher than estimates for last year's write-downs. These finance chiefs have a dour outlook on things. They apparently have conceded slow global growth this year. Even U.S. Treasury Secretary Hank Paulson implied that we should discredit the feel-good decoupling theory that separates the planet into a struggling U.S. and a booming rest-of-the-globe. Uh oh! Never fear though: "The finance ministers said they were braced for individual and collective action to ensure financial stability and avoid recession."

Be careful out there!

DR. DURU®, 2008