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The sub-prime effect

By Darren Stubing



The US sub-prime crisis and associated repercussion in structured investment vehicles and other collateralised instruments have seen substantial asset write-downs at a number of leading global financial institutions.

It has also caused institutional collapses at banks in Germany, the UK and the US. These collapses are due to specific factors including the sharp squeeze in wholesale funding and liquidity.

Although largely shielded from any direct exposure to the US sub-prime market, Gulf banks will see some reverberations through a higher cost of funding credit in the interbank market, lower appetite for Gulf bank risk from international institutions, and, if the slowdown in the US is significant and prolonged, lower domestic economic growth.

The length and severity of the credit crisis is still uncertain but could easily last another six months. It could certainly act as an accelerant to a slowdown.

Losses caused by the US sub-prime mortgage crisis could hit $300 billion (Dh1.1 trillion). Banks and hedge funds are in the frontline for bearing a lot of the losses. Such write-offs will erode capital and constrain banks’ ability to expand their balance sheets, which in turn feeds back on to the economy. It is estimated there is about $3,000bn (Dh11trn) in cash in collateralised debt obligations through packages of US sub-prime mortgage debt, of which, hedge funds have $1,400bn (Dh5.13trn) of exposure, banks $750bn (Dh2.27trn), asset managers $565bn (Dh2.07trn), and insurers $300bn (Dh1.1trn). The default rate of the mortgages upon which these securities are based will increase as house prices slump and mortgage interest rates are reset higher in 2008. It is estimated that about 14 per cent of sub-prime mortgages will default next year.

A number of GCC banks and corporates have postponed debt issues due to tightening market conditions. Bond issuances have declined on a year-to-year basis since August after the sub-prime crisis surfaced in July. The problems are acute in Europe and the United States, where the cost to borrow in the corporate bond markets has risen to a five-year high.

Issuance in these markets has also hit record lows. Gulf corporate bond yields are also likely to rise, with high costs for issuers as investors become more risk averse. The spread or risk premium for financial and corporate bonds over government paper will rise further.

Market turmoil and bond market volatility, together with a slowdown in investor demand forced Dana Gas and DAE Aviation Holdings to put on hold debt issues worth $1.94bn (Dh7.11bn). Saudi Basic Industries Corp was forced to lower the senior unsecured bond portion of its financing to buy GE Plastics to $1.5bn (Dh5.5bn) from about $2.76bn (Dh10.1bn) and raise the bank loan portion to about $6.6bn (Dh24.2bn) from $5.4bn (Dh19.8bn) due to the tightening credit markets.

In July Abu Dhabi-based First Gulf Bank postponed its $3.5bn (Dh12.8bn) Eurobond programme and Bahrain’s Ithmaar Bank delayed a $300m (Dh1.1bn) sale of five-year Islamic bonds. Most GCC banks have little or no exposure to US sub-prime instruments.

Although some banks do carry direct exposure the risk that may flow is manageable. The estimated mark-to-market impact of the exposure will be minimal on bottom-line profitablilty. The aggregate sub-prime exposure of banks in the GCC is estimated at around two per cent of total assets. The bulk of the exposure is concentrated on a few issuers. The quite limited direct exposure reflects the small need for Gulf banks to chase structured products in order to boost yields, often by less than 50 per basis points, in supposedly low-risk vehicles.

Although the current market disruptions will likely have few knock-on effects on the financial profile of Gulf banks, especially to cost of funds for wholesale funding, they should be limited. Even though liquidity in most markets has dried up, the Gulf region remains highly liquid due to high oil prices.

The UAE Central Bank has stated it is happy the impact on profitability of banks – from the marginal exposure of a few UAE banks on the sub-prime mortgage loans – will not affect the overall good results of banks in 2007. Direct exposure to high-risk home loans in the US was limited to a small number of banks, which are not significantly exposed to assets that have dropped in price during the crisis.

National Bank of Abu Dhabi has no direct or indirect exposure to CDOs, Structured Investment Vehicles or the US sub-prime mortgage market although it does have exposure to financial institutions that do. No new provisions were required this quarter as a result of the US sub-prime crisis. Most UAE banks have not reported any losses from the credit crunch although Abu Dhabi Commercial Bank (ADCB) has said losses on its investment portfolio because of the sub-prime crisis reduced third-quarter profit by $19m (Dh69.7m). The investment portfolio of ADCB has been negatively affected by the turmoil in the international markets and the bank took a charge to third-quarter profits of Dh70m.

It also took a charge to the bank capital of Dh213m to reflect current market prices for investments.

Companies like Emaar Properties are slightly more vulnerable because of its acquisition of real estate assets in the US. Emaar last year bought US property developer John Laing Homes, which is directly exposed to the crisis. Investors from the region, mainly banks, institutions and high-net worth individuals who have long positions in the global markets, will incur losses on their exposure to the collateralised debt obligations, hedge funds and leveraged-buyout activities.

Tightening of lending practices by the large global major banks will have an impact on the Gulf’s ambitious development plans, particularly in the energy and infrastructure sectors.

Gulf private equity firms are less dependent on leverage finance compare to those in the West. For the few large ones able to acquire 70 to 80 per cent leverage, new deals will be costlier to finance.