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Where are the subprime bodies buried?

By Martin Hutchinson
Director of Global Investing Research 

When the subprime mortgage crisis broke in February, I assumed (like most others) that its ill effects would be confined to obscure housing finance companies within the United States – a niche of the financial sector in which I had no interest in investing anyway.

But the recent collapse of the German industrial credit bank IKB Deutsche Industriebank AG abruptly signaled to investors and analysts alike that the problem was much more widespread than originally anticipated. IKB – a mid-sized bank – accumulated $17 billion in subprime mortgage exposure through the derivatives market. In the end, its exposure far exceeded the bank's liquidity and equity capital… thanks derivatives market!

On the heels of the IKB collapse, we’re now discovering subprime mortgage exposure the world over, and market jitters grow worse by the hour. Particularly frightening to investors are foreign banks, previously thought to be immune to such a “U.S.-only” crisis.

The drastic decline in value could put daily operations of some banks in peril and have nasty spillover economic effects.

Considering the severity of the credit crunch and the anxiety that’s gripped world financial markets, it’s time we all understand precisely who owns what, and how much.

Fortunately, Wachovia Bank’s Jay Bryson just published a special commentary that spells out exactly where the greatest subprime mortgage exposure exists.

Eurozone Exposure

According to Bryson, residents of the 13 nations in the eurozone (the geographical and economic area where European Union countries have adopted the euro) own about $280 billion in U.S. mortgage debt.

Fannie Mae (NYSE: FNM), Freddie Mac (NYSE: FRE) and other government-funded entities issued about $160 billion of the total; corporations issued the other $120 billion.

Of the $120 billion of corporate-issued debt, $20 billion is commercial paper, and $100 billion is residential. (It’s the corporate-issued debt, specifically residential debt, where exposure to the troublesome subprime mortgage debt exists.)

Some unknown fraction of the $100 billion (in residential debt) is subprime, which accounts for only 1% of securities owned by eurozone residents, and is likely concentrated among relatively few financial institutions.

We know that IKB owned $17 billion of subprime-backed securities and the French bank BNP Parabis (EPA: BNP) owned $3 billion… so it’s plausible that only modest exposures remain yet undiscovered in the eurozone.

British Exposure

Britain – the largest financial services sector in Europe – has $70 billion of outstanding mortgage-backed securities, roughly $44 billion of which are corporate-backed mortgages (with subprime exposure). The sheer size of the exposure suggests that some British institutions will incur substantial losses. But there’s more to Britain’s subprime story than merely gauging exposure to U.S. debt.

Britain is a wildcard because its own subprime crisis may actually be worse than that of the United States. According to the Council of Mortgage Lenders, lenders foreclosed on 14,000 properties in the first six months of the year, 30% more than in the year-earlier period. The council estimated that 125,100 British residents are behind in their mortgage payments – about 1% of the total.

Far East Exposure

Japan and China each have large exposures to the U.S. mortgage market. A fat chunk of China’s $260 billion-exposure is held in the central bank’s foreign reserves (which currently total $1.33 trillion).

Japan’s U.S. mortgage exposure rings in at $200 billion.

But Fannie Mae and Freddie Mac back the majority of the mortgage debt in China and Japan, leaving only marginal exposure to corporate-backed mortgages. Japan has roughly $10 billion in corporate-issued mortgage debt. China has about $20 billion, of which only a slice is subprime… a small amount relative to its economies.

And, it seems none of the major Japanese investment houses had a large, or troubling-enough position to cause concern.

Taiwan and Korea also have substantial holdings of U.S. mortgage debt – around $50 billion each – but like China and Japan, their exposure to subprime is also a very small percentage of overall holdings.

How To Play The Subprime Bust

All told, U.S. subprime mortgage debt is spread pretty widely around the world. Many banks and investment managers simply couldn’t resist the mortgage debt’s high-yield appeal. The problem is they didn’t know the U.S. markets well enough to avert trouble.

As the data indicates, some regions carry far less guilt than others, but are being unfavorably impacted by the panicked selling, nonetheless. As a result, investors in sound foreign banks and finance companies should feel confident in using any subprime-related market declines as opportunities to add more shares.

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