The casualties of the subprime crisis are mounting fast. Around $200bn has been written off global stockmarkets in the past month, several hedge funds have blown up and banks are fretting at the prospect of being unable to offload the $300bn of loan commitments for buyouts already in their pipelines. Nobody is really sure exactly which companies are exposed to the subprime crisis, or to what extent. But working out which sectors the rot will take hold in next isn’t so difficult. Here we look at four to avoid as the fall-out continues.
US construction and lenders
Among the guiltiest parties in this crisis are American housebuilders. As the construction sector boomed in the 1990s, US housebuilders entered into a building frenzy to house a rising tide of young married couples, divorcees and immigrants. On top of this, “builders jumped into the mortgage business to a degree they never had” before, says Mara Der Hovansian in BusinessWeek, with loans underwritten by lenders on Wall Street. But as more and more homes were built, supply started to outstrip demand. As more houses sat empty, some builders tried to “prop up their financial performance” by lending to riskier customers. They offered loans that allowed young couples and immigrants to borrow up to 110% of their income, without having to jump through many hoops to secure one.
But as Der Hovansian points out, the borrowers probably didn’t read the small print about upwardly mobile interest rates. As repayments rocketed, foreclosures have surged too. “And now the bust is taking a brutal toll.” The number of housing starts has dropped by 44% this year, house prices are falling, and builders are being saddled with a host of bad debts as the rolling interest rates they offered their clients kick in. In January, industry analysts predicted that the ten biggest builders would produce average earnings per share of $3.69 for 2007. The latest forecast is for a loss of $1.18. As if that wasn’t enough, builders could also face trouble in the US courts over their lending practices. KB Home paid $3.2m back in July to settle allegations that its mortgage unit overstated borrowers’ incomes, although the firm denied wrongdoing. Meanwhile, Countrywide Financial, America’s biggest mortgage lender, could be facing a class action lawsuit alleging that it issued false statements about its financial results. The sector may already have faced a lot of pain, but there’s much more to come.
Insurers
US builders and mortgage providers may be the ones in the dock – but the bill for these legal actions could ultimately be picked up in the UK. That’s because the firms faced with these lawsuits are likely to claim on their errors and omissions insurance, much of which was sourced from British insurers, to cover the cost of their defence, says Christine Seib in The Times. Marsh, the world’s biggest insurance broker, has warned that it has already received several notifications of claims against clients who bought cover in the UK. Jonathan Davies of Reynolds Porter Chamberlain told The Times that “while much of the legal action that will result in insurance claims is likely to be launched in the US, it’s likely to be the London insurance market that has to pick up the lion’s share of the bill”.
Ratings agencies
Builders aren’t the only ones to have aroused the ire of the authorities – rating agencies may find themselves in trouble too. Officials in both Brussels and Washington are planning to take a closer look at the sector’s role in the whole subprime crisis. Problems with subprime mortgages have been bubbling under for two years, says Tobias Buck in the FT, but it wasn’t until this spring that S&P and Moody’s started downgrading the ratings of mortgage-backed securities on a significant scale. Officials have also drawn attention to the fact that because the agencies are paid by the very firms that they are rating, there is a blatant conflict of interest at work. Moody’s earned $884m last year (43% of total revenue) from rating structured notes, more than three times what it earned in 2001. “The securitised subprime mortgage market would not have grown to the extent that it did without the favourable ratings given by some agencies,” said an EU official, quoted in the FT. Even if the agencies escape heavier regulation, the collapse in demand for structured products will hurt profits now that the boom is over.
Luxury goods
There are also tough times ahead for all the businesses that have thrived on the morsels thrown off by City bankers in recent years. As Kevin Dowling and Miles Erwin point out in The Sunday Telegraph, a small army of private bankers advises the City on how to spend the estimated £43bn in savings accumulated by just 35,000 of its employees. But the first expense to be eliminated as the credit crunch bites will be banking bonuses, says Jonathan Said of the Centre of Economics and Business Research. And that means there will be far fewer £5,000 cases of fine wine sunk in the City this year and more sports cars left on the lot at luxury dealerships. A 30% drop in the prices of fine wine would not be a surprise, as investors who need cash offload their collections in a hurry, said Alun Griffiths, wine director of Berry Brothers and Rudd to The Sunday Telegraph.
Eventually these sectors will drop far enough to present decent buying opportunities. But as Yale economist Robert Shiller points out, a fallout in the housing market lasts for years and we are a long way from the bottom yet. So for now, we’d be wary.