Stratfor on Sub-Prime

I wrote yesterday that the sub-prime mess doesn’t worry me because it doesn’t affect a large enough portion of the economy to bring on disaster.

Stratfor Founder and Chief Executive Officer George Friedman agrees. From his August 13 Geopolitical Intelligence Report:

Stratfor views the world through the prism of geopolitics. Not all events have geopolitical significance. To rise to a level of significance, an event — economic, political or military — must result in a decisive change in the international system, or at least a fundamental change in the behavior of a nation. The Japanese banking crisis of the early 1990s was a geopolitically significant event. Japan, the second-largest economy in the world, changed its behavior in important ways, leaving room for another power — China — to move into the niche Japan had previously owned as the world’s export dynamo. The dot-com meltdown was not geopolitically significant. The U.S. economy had been expanding for about nine years — a remarkably long time — and was due for a recession. Inefficiencies had become rampant in the system, nowhere more so than in the dot-com bubble. The sector was demolished and life went on. Lives might have been shattered, but geopolitics is unsentimental about such matters.

The measure of geopolitical significance is whether an event changes the global balance of power or the behavior of a major international power. Looking at the subprime crisis from a geopolitical perspective, this is the fundamental question. That a great many people are losing a great deal of money is obvious. Whether this matters in the long run — which is what geopolitics is all about — is another matter entirely.

When the subprime defaults started to hit, the banks that had loaned money against the mortgage portfolios re-evaluated the loans. They called some, they stopped rollovers of others and they raised interest rates. Basically, the banks started reducing the valuation of the underlying assets — subprime mortgages — and the internal financial positions of some hedge funds started to unravel. In some cases, the hedge funds could not repay the loans because they were unable to resell their subprime mortgages. This started causing a liquidity crisis in the global banking system, and the U.S. Federal Reserve and the European Central Bank began pumping money into the system.

Told this way, this is a story of how excess emerges in a business cycle. But it is not really a very interesting story because the business cycle always ends in excess.

There currently are three possibilities. One is that the subprime crisis is an overblown event that will not even represent the culmination of a business cycle. The second is that we are about to enter a normal cyclical recession. The third, and the one that interests us, is that this crisis could result in a fundamental shift in how the U.S. or the international system works.

We try to measure the magnitude of the problem from the size of the asset class at risk. But we work from the assumption that proved true in the S&L; crisis [of the 1980s]: Financial instruments collateralized against real estate, in the long run, limit losses dramatically, although the impact on individual investors and homeowners can be devastating.

The S&L; crisis involved assets of between 8% and 10% of GDP. The final losses incurred amounted to about 3% of GDP, incurred over time.

The size of the total subprime market is estimated by Reuters to be about $500 billion. This is the total asset pool, not nonperforming loans. The GDP of the United States today is about $14 trillion. That means this crisis represents about 3.5% of GDP, compared to between 9% and 10% of GDP in the S&L; crisis. If history repeats itself — which it won’t precisely — for the subprime crisis to equal the S&L; crisis, the entire asset base would have to be written off, and that is unlikely. That would require a collapse in the private home market substantially greater than the collapse in the commercial real estate market in the 1980s — and that was quite a terrific collapse.

Unlike commercial real estate, in which price declines force more properties on the market, home real estate has the opposite tendency when prices decline — inventory contracts. So, unless this crisis can pyramid to forced sales in excess of the subprime market, we do not see this rising to geopolitical significance.

From this, two conclusions emerge: First, this is far from being a geopolitically significant event. Second, it is not clear whether this is large enough to represent the culminating event in this business cycle. It could advance to that, but it is not there yet. We cannot preclude the possibility, though it seems more likely to be a stress point in an ongoing business cycle.

I reiterate a point I made yesterday on this free site and have made repeatedly to subscribers: smart investors are looking for chances to buy in this downturn.

That doesn’t necessarily mean piling into what fell the most yesterday. It means knowing in advance of the sale what you think could be unjustly marked down in the likely mood ahead. Watching the list of such targets in a market-wide scare, waiting for them to get to prices that seemed impossible just weeks before, and then buying at a significant discount to profit when — yet again — the crisis passes, is the way to wealth.

I’m pleased to note that the home builder we’re watching to buy fell another 16% yesterday. That stock, as just one example, is now selling at an 81% discount to its September 2005 price. Insiders bought recently, an encouraging sign. I wrote to subscribers over the weekend about this stock: “My initial buy target is $17, which is 16% below Friday’s close.” We already got there, but we haven’t bought yet. This sale isn’t over.

Watching and waiting is the key to this business and this is the time, folks! Crises that look frightening to the general public but are non-events to those who live in the market are manna from heaven.

When others look back in six months or a year and say, “Darn, I should have bought something,” smart investors will smile and say, “I’m glad I did.”

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