Subprime: Nightmare Scenario

By Mark Whistler | August 28, 2007 AAA

The word meltdown no longer applies to just nuclear reactors, unruly toddlers or Popsicles. Now, we can add subprime to the list of associations. (For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.)

As you're probably aware, over the past few years, low interest rates created a lending environment where many less-than-stellar-credit consumers were able to borrow hordes of money for real estate. As interest rates increased over the last two years , default rates followed. (To learn more, see Subprime Lending: Helping Hand Or Underhanded?)

We're not just talking housing foreclosures anymore, we're talking about the repayment of debt-securities by those who purchased many of the aforementioned loans. The problem is seeping into businesses who invested money in funds that held subprime loans. Thus, not only is real estate and the consumer in dangerous territory, but financial institutions, funds and corporations as well.

For example, Cameco (NYSE:CCJ), the world's largest uranium producer, recently issued a press release providing guidance to its investment portfolio. Cameco's portfolio totaled $332 million, in which it had $120 million in asset-backed commercial paper. What's important to understand is "asset backed commercial paper" can often be real estate backed loans. The company had $13 million invested in two Canadian commercial paper funds, "rated R-1 by DBRS, which is the highest possible rating for commercial paper."

The maturity date was August 17, which has since come and gone. Both funds defaulted. So, even a uranium mining company has exposure to the subprime nightmare. Cameco is in the best possible situation though, having only lost a small portion of its portfolio. Other companies will not be so lucky. Companies that had full exposure to high-yield asset backed commercial paper could potentially see their bank accounts almost completely wiped out.

Waiting For Damage Reports
And here's where it gets even more dismal. You, the investor, won't know how much corporate America will lose until third and fourth quarter earnings reports begin to surface months from now. Given that many, many corporations invest their funds in asset backed commercial paper, the losses could be staggering. What we're talking about is the complete evaporation of cash. It literally disappears into thin air.

Making matters worse, even though consumer credit remains stable, it could also "meltdown" in the following months. Should over-leveraged subprime consumers continue to be weighed down by housing payments, other areas of credit could suffer as well. Credit cards and auto loans could become the next wave of subprime woes.

Economy.com reports, "Securities worth more than $350 billion were issued in 2005, collateralized by credit cards, auto, student and other consumer loans. In the same year, just over $500 billion in securities issued were backed by home equity loans."

To put these numbers into perspective, the aforementioned loans in 2005 are the almost the same as Mexico's total GDP for 2006. The 2005 loans are even more than the 2006 GDP for Saudi Arabia and Austria added together. Should loan defaults spiral, we're talking about a GDP crippling situation. In fact, subprime could shave 1% off U.S. GDP this year alone. In 2006, over $600 billion worth of subprime loans were handed out - that's more than GDP for Thailand, Argentina and Portugal all put together.

History Repeats Itself?
Some may remember the Savings and Loan scandal of the late 1980s. What happened then was a "credit crunch" due to excessively high loan defaults. In plain English, a credit crunch is where financial lenders are extremely wary of loaning companies cash, because those doling out the money are afraid of not being repaid. Consequently, only those with rock solid credit can borrow.

What ensues is a significant slowdown in the larger economy, as new business is at a virtual standstill because new and existing companies (and individuals) can't borrow money. There's virtually no room for economic growth in this scenario. As with the late 1980s, it could take a half decade for the U.S. economy to recover, possibly even more.

Moreover, in the 1980s, during the S&L scandal, all it took was 100 savings and loan institutions to default on $150 billion to create economic havoc. Now, the subprime debacle could be crafting a similar situation with the Bank of Japan (BoJ). In late June, Forbes reported Merrill Lynch as stating the BoJ could have "about $1 trillion worth of yen [that] is being borrowed and then turned into higher-yielding investments."

High-yielding investments sounds pretty darn close to subprime commercial paper to me. Should the subprime debacle trickle down to the yen carry trade, the BoJ could immediately yank up rates, thus causing a global slowdown in liquidity. What we're talking about is a world-wide stock market meltdown.

The Bottom Line
The present subprime problem is a global issue affecting all levels of business and consumers. It's yet to be seen what the final fallout will be, but you can rest assured, it's not just going to just go away. In a worst-case scenario, significant default in commercial paper affecting funds of corporate America could take a massive bite out of the U.S. stock market. Expect more guidance in third and fourth quarter earnings reports; hopefully the damage to corporate bank accounts will be kept at a minimum. (For related reading, check out The Greatest Market Crashes.)

Top the whole thing off with a global reduction in liquidity, due to the yen carry trade's exposure to subprime, and what we have is a very, very bleak picture. I certainly hope the scenario abates without capitulation, but we do have to be aware of the "what if".

Now that you've had a look at the worst-case scenario, check out Subprime: Reality Check.

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