"Three horsemen and a stable door - History IS being repeated part III"

Back in March we wrote a piece highlighting the similarities with the 'Savings and Loans' (S&L) crisis, which was then updated in August. The basic message was that a fall in US house prices would cause a protracted reduction in US economic growth momentum. In August, the Federal Reserve estimated that the net losses from sub-prime would be between US$50bn and US$100bn but in their latest report they suggest it will be nearer to US$150bn. The S&L crisis was closer to US$500bn, or more than 6% of GDP. Estimates of the current problem are higher if you include the stock of unsold homes.

We are currently at the height of uncertainty (once again) about banks earnings and potential losses from exposure to the US housing market. See the chart above, which shows the fiveyear US Swap Spread over Treasuries. The three areas of concern (the three horseman of the apocalypse) for banks have been the LBO (leveraged buy-out) financing overhang, the Money Market Fund support, and exposure to sub-prime CDO's (collateralised debt obligations). The LBO bridging loan pipeline has been reduced from US$350bn to around US$170bn through restructuring deals, and actually selling the loans on to the market. The other two areas remain a concern. The creation of a super SIV (structured investment vehicle) fund may help horseman number two, but what about number three?

In the short-term, the headlines about write-downs will continue as we move through the financials key reporting calendar. By the time the fourth quarter numbers are out, the reality of the situation may not be quite as bad as previously feared. The longer it takes to resolve these issues the greater the chance it will impact the broader economy. The S&L crisis took several years to resolve and cost the US taxpayer US$87bn to clean up the overhang of property. The authorities created the Resolution Trust Company to facilitate the sale of unwanted property to bargain hunters. With many adjustable rate mortgages (ARMs) being increased, the pain in the housing markets is getting worse. Foreclosures are expected to rise and the unravelling of the complicated structures has only just begun. Fannie Mae and Freddie Mac could be used to work through the mortgage issues and reduce the back-log of unsold homes, as long as they are allowed to expand their balance sheets accordingly. Their spread over government bonds has already widened to reflect this risk and at 100 basis points over government bonds, they do look tempting. Although there is no explicit Government guarantee, if they are used to sort this mortgage mess out, will the Government be able to let them fail?

Meanwhile, the three horsemen of the apocalypse are removing potential loan growth by severely reducing banks ability to lend.

The latest US Senior Loan Officer Survey shows significant tightening in lending standards - closing the door after the three horsemen have already bolted and rampaged through the village, perhaps.

Trying to get to the bottom of the extent of the sub-prime problem is extremely difficult. However, there are some sweeping statements we can make. The ABX indices can be used as a good reference point for valuing CDO positions. The BBB tranches are only worth their coupon value as the capital is probably worthless; however the AAA tranches are probably worth closer to 90 cents on the dollar. Using this crude form of valuation many bank analysts are attempting to come up with total losses for the banking sector which range between US$80bn and US$135bn.

The more recent concern is that other areas of debt are now under threat. Price data for the commercial property market is worrying, so too are signs of increasing credit card delinquencies. Meanwhile, Central Banks have inflation rates Source Bloomberg to worry about, and could be slow in cutting rates.

With default rates set to rise next year and company profits coming under pressure from rising commodity costs and weaker demand for products, the high yield (HY) market will be littered with casualties next year. The higher cost of borrowing has yet to affect many high yield issuers who refinanced at low rates earlier this year. Careful selection of those credits that don't require finance and those that still have decent margins - will be the way forward in the HY market over the next six months.

Economic prospects outside of the US remain strong allowing commodity prices to stay high, and supporting EM (emerging market) sovereign bonds. This hasn't stopped the EMBI (Emerging Market Bonds Index) spread widening back above the levels seen in the summer. Local EM markets have also struggled as domestic inflationary concerns mount.

Global economic de-coupling is clearly evident but the more the sub-prime problem mutates and influences the US consumer, the greater the chance that exporting nations will be affected. We have maintained our underweight EM bond position but at the same time maintained exposure to EM currencies that are allowed to appreciate. (See ''EM currencies - how to benefit from rising food inflation'')

The S&L crisis rumbled on for many years costing taxpayers money and lining the pockets of lawyers. This latest housing crisis looks like it could do the same. House prices have only fallen 4.4% so far this year (Case-Shiller YoY Index Sept 07). This is manageable given how much they have gone up over the previous three years. If you assume a 90% loan to value level then the sub-prime issuance over the last three years at US$1,420bn is secured against houses with a value of US$1,588bn when adjusted for the average price rise in 2006 and subsequent fall in 2007 you are still left with a 10% equity value from here. BUT further house price declines are likely as the supply of houses increases, as delinquencies rise.

Given the level of hysteria surrounding the banks, there could be a relief rally in credit once the fourth quarter numbers are out. There are some bargains to be had in investment grade (government linked) bonds that are priced from the wide swap spread, but investors should not be sucked into high yield as next year's economic outlook is the main casualty from these current financial issues.

Credit response - recent turmoil may be overdone but watch the economic situation closely.

FOR PROFESSIONAL INVESTORS ONLY