Subprime Collateral Damage

Good day… I spent a great evening at Chuck’s house watching the Home Run Derby with Chuck and his good friend Rick. Chuck is doing great, and is able to stand up and walk around his home. He is still in some pain but has weaned himself off the pain medication. Again, he looks absolutely amazing for someone who just went through two major surgeries. I no longer doubt him when he says he will be “back in the saddle” sometime next month; his positive attitude and the support of his family is helping to speed his recovery. Now on to the markets.

The dollar was little changed yesterday but then dropped early this morning as we wait for Federal Reserve Chairman Ben S. Bernanke to speak on inflation today. Bernanke is expected to reiterate inflation, which remains the Fed’s “predominant” concern. While Bernanke may say something hawkish, I wouldn’t expect him to move the markets. As I have said before, the current state of the economy has tied the FOMC’s hands with regard to interest rates. They have no choice but to hold on for the ride. In contrast, European growth is steady, and the ECB has made it very clear that interest rates will continue to rise. No matter what Bernanke says, the euro (EUR) will continue to rise versus the dollar as the interest rate differential will continue to narrow.

Again, the reason the FOMC will not be able to get more aggressive in their fight against inflation is because of the subprime mortgage mess and the collateral damage it is inflicting on the U.S. economy. During my visit last night, Chuck and I discussed this topic and the following email was waiting on me this morning:

“I continue to read more stories like this one regarding the securities that were created from the subprime mortgages. I don’t know where this fellow gets off saying that this is not a systemic risk. Problems like these will continue to mount and the risk will come from the Fed lowering rates in reaction to these problems… Just my view from the cheap seats.

“A report from Bloomberg says, ‘Losses from bonds secured by U.S. subprime home loans may reach $52 billion amid rising foreclosures on the mortgages, analysts at Credit Suisse Group said in a July 6 research note.

“‘Subprime defaults “are clearly a huge problem” for investors in collateralized debt obligations, Credit Suisse analysts led by Ivan Vatchkov in London wrote in a report. “But we do not think that they are a systemic one.”

“‘Banks are unlikely to lose more than $10 billion on the CDOs they hold because they typically keep the least risky portions of the securities, the analysts said in the July 6 report. CDOs package bonds and loans into varying pieces of risk, using their income to pay investors. Delinquencies and defaults on U.S. subprime mortgages will keep rising as borrowers who received loans with less rigorous checks miss payments, Robert Parker, vice chairman of Credit Suisse Asset Management, said on July 5.

“‘Investor losses from CDOs could range from $26 billion to $52 billion over time, the Credit Suisse analysts wrote. Deutsche Bank said June 29 that losses from bonds backed by subprime mortgages may reach $90 billion.

“‘Banks may face a bigger risk from the loans made to hedge funds that invested in subprime CDOs than from their own holdings of the securities, the Credit Suisse analysts said.

“‘European banks are likely to be less affected than U.S. lenders to CDO losses because they’re among the “most conservative” investors in the securities, the analysts wrote. Credit Suisse has an “outperform” rating on Frankfurt-based Deutsche Bank AG, Germany’s biggest lender, and UBS AG in Zurich.'”

Chuck has obviously had a lot of time on his hands to read up on the current state of things, so look for more and more of his nuggets of insight in future Pfennigs. We have not seen the end of the carnage in the debt markets; and we will continue to shed light on this very dark corner of the U.S. economy. Obviously, the media hasn’t been willing to report just how bad it could get, but you can count on us to keep you updated.

The euro and pound sterling (GBP) both held near their highs as positive reports on their economies were released this morning. Sales at U.K. retailers increased at the fastest pace since March last month and the country’s trade deficit unexpectedly narrowed in May. Revenue at U.K. stores that have been open at least a year rose 3% from the same month in 2006. The U.K. trade deficit unexpectedly shrank in May to the narrowest in more than one and a half years as buoyant economic growth in Europe and Asia boosted exports. The report indicates U.K. manufacturers are coping with the level of the pound. Look for more strength for the pound.

German industrial output rose the most in six months in May as factories increased production of goods. Output increased a seasonally adjusted 1.9% from April, when it fell 2.1%. From a year earlier, production rose 4.6%. Factory orders increased more than forecast in May and unemployment fell to the lowest level in 12 years in June.

Sweden’s krona (SEK) rose after a report showed inflation unexpectedly accelerated in June. The jump in inflation reinforced the central bank’s argument last month for quickening the pace of interest rate increases. Swedish industrial production rose 0.4% in May from April and 3.6% from a year earlier as export orders grew. We will continue to see interest rate increases out of the Riksbank, which will support a stronger krona.

In Asia, Singapore’s economy grew at the fastest pace in two years. Gross domestic product expanded at an annualized 12.8% in the three months ended in June, up from a revised 8.5% in the first quarter. The increase in GDP was mainly due to a construction boom and a recovery in the services sector.

China’s trade surplus soared to a record $26.9 billion in June, exceeding economists’ estimates and supplying more ammunition to U.S. lawmakers threatening sanctions. The trade gap, released by the customs bureau today, widened by 87% from a year earlier after exporters rushed to beat cuts in export tax rebates. More than half of this surplus was with the United States. In an attempt to soften the expected criticism, China let the renminbi (CNY) rise the most since the end of a dollar link in July 2005. The People’s Bank of China wants a stronger currency to curb exports, but the currency will need to rise at a much faster clip to have any impact on the trade gap. A 1% increase in the renminbi over the last month is a good start, but we will need to see another 10% to 20% to get it closer to where it should be trading. The People’s Bank needs to “bite the bullet” and take the reigns off the renminbi.

Currencies today: A$ .8600, kiwi .7780, C$ .9535, euro 1.3653, sterling 2.0163, Swiss .8245, ISK 60.72, rand 7.0033, krone 5.8361, SEK 6.7300, forint 180.21, zloty 2.7597, koruna 20.975, yen 123.19, sing 1.5183, HKD 7.8167, INR 40.38, China 7.5773, pesos 10.7773, dollar index 81.433, Silver $12.765, and Gold… $661.60

That’s it for today… Sorry this is a little later than usual this morning, got home a little late from Chuck’s last night. It was great seeing him, and he looks just great. Busy day on the desk today as we continue to try and deal with some computer glitches. As Chuck always says, we will adapt and overcome! Hope everyone has a great Tuesday!

Chuck Butler —  July 10, 2007

The Daily Reckoning