China: Won't get fooled again

In his August Investment Outlook, PIMCO bond fund manager Bill Gross continues to fret about what deterioration in the values of securities backed by subprime mortgage loans is doing to investor confidence in other high-yield securities that have funded leveraged buyouts and propped up the stock market (and the economy).

"Housing is faring badly but corporate profits are in their prime and at record levels as a percentage of GDP. Lenders to corporations should not be affected by defaults in subprime housing space, (optimists) claim," Gross says. "Unfortunately that does not appear to be the case."

The bloom came off the rose, Gross writes, when institutional investors – many of them foreign – began to see the ratings downgrades in mortgage-backed securities (MBS) backed by subprime loans.

"Could the same thing happen to levered structures with pure corporate credit backing? To be blunt, they seem to be thinking that if Moody’s and Standard & Poor’s have done such a lousy job of rating subprime structures, how can the market have confidence that they’re not repeating the same structural, formulaic, mistake with CLOs (collateralized loan obligations) and CDOs (collateralized debt obligations)? That growing lack of confidence – more so than the defaults of two Bear Stearns hedge funds and the threat of more to come – has frozen future lending and backed up the market for high yield new issues such that it resembles a constipated owl: absolutely nothing is moving."

If true, it's not just mortgage lenders who will have trouble accessing the pools of international capital that helped fuel the housing boom, but corporations and the private equity firms fueling the leveraged buyout craze. That could slow the stock market and the economy, with corresponding impact on housing markets. 

For another perspective on how international investors view the market for U.S. mortgage-backed securities (MBS), check out today's Asia Times Online. Following up on HUD Secretary Alphonso Jackson's recent trip to Beijing to hawk U.S. MBS, the Asia Times finds influential Chinese economists skeptical. Not only are they skittish about ratings agencies' recent downgrades of MBS backed by subprime loans, but China already holds too much of its foreign reserves in dollar assets like Treasuries and is looking to diversify, the story says.

According to HUD, in 2006 China held $107.5 billion of MBS backed by Fannie Mae, Freddie Mac, and Ginnie Mae -- a seven-fold increase from 2003.

A senior economist with a central government think-tank, Yi Xianrong, told Asia Times that the surge in Chinese MBS purchases was the result of an inexperience in conducting risk assessments and miscalculations of the U.S. property market.

"After seeing how the property prices in China kept soaring, these Chinese companies never thought of the US property market as having problems and they bought a lot of mortgage-backed securities, particularly in the past two years," Yi said.

HUD says foreign investors held 9.7 percent of agency MBS in 2006 -- nearly double the 2004 share -- and that Asian nations held 58.6 percent of those securities, compared to 37.3 percent in 2004. Sounds like a long shot that those trends will continue.

As for the wider economic implications of the subprime fallout, Gross says to keep a close eye on the price and terms banks set in loaning $10 billion to Cerberus Capital Management as part of its plan to acquire Chrysler Group from DaimlerChrysler and take Chrysler, Dodge and Jeep private.

Today, the banks involved in the deal had to postpone it because investors balked, AP reports -- an indication that Gross' pessimism is justified. If it's going to happen, the banks are going to have to finance the deal themselves. 

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