Thursday, August 09, 2007
The ECB (Euro Central Bank, got a currency, need a bank!!) plopped over 100 billion out there to try to prevent worse effects. Bloomberg article. By definition, central banks are the lenders of last resort.
LIBOR is a commonly used ARM index (in different terms), so rising LIBOR rates have a direct effect on US loans, and the effect is not a good one. I watched the BNB Paribas news drive the overseas markets down, which had been rising nicely until then. It also will have a hefty impact on US indexes.
These are not the first overseas funds to be taken out by Asset-Backed Security (ABS) problems, but it's the ongoing nature of the problem which is creating nerves. Everyone is trying to clear, and the effort will slowly drive down commodities and other assets. Basically you have a cash-fueled speculative craze that is slowly unwinding as everyone tries to get to a safe cash-rich position, and these types of moves always do have a net deflationary impact. The goldbugs are not likely to be all that happy for a while.
I have written over and over again in this blog that the problem with commercial paper (CMB and LBO) is worse than that with mortgages, and the unwinding in that will have a far more immediate impact on the economy.
Highly leveraged hedge fund trading (and currency carries) have created the same sort of far-flung chains of lending that prevailed in the late 20's. When a highly leveraged trader gets into trouble, such a trader is forced to sell even under disadvantaged terms. It amounts to a widespread margin call. Now the international situation is quite different than in the 20s right now (all though risk factors are emerging), and central banks will respond differently. I am not predicting a huge depression - but individuals should be aware that clearing debt and maximizing cash is important to prepare for such periods. The ability to borrow always tightens up, and if you can borrow, rates are likely to move higher for almost all borrowers.
Calculated Risk will undoubtedly have excellent discussion. Other blogs I watch for financial perspectives are Mover Mike and Oraculations. They are not financial blogs per se, but both gentlemen have experience in the industry and are independent thinkers. Both already have significant posts up.
I want to stress again that several years of exceedingly lax underwriting standards are what is really causing the ABS problem, and by extension, the overall borrowing prolobem. It was not speculation which caused the 1929 stock price break, but the breakdown of the reporting system on the exchange. This led to an inability to move to rational positions, because no one knew what trading was really occurring.
Just as it was then, no one now can safely model what will happen, because when you start writing a bunch of loans with weak appraisals and don't bother to verify income and/or assets, you have no way to assess risk factors. So once trouble hits, it is extremely difficult to reprice such pools accurately. An overleveraged trading operation facing a margin call can afford to take a one-time loss, but from there it must be able to consolidate and move to rebuild. Because of the lack of correct pricing, such operations are now being forced to sell off more and at worse prices than would be necessary if they could figure pricing correctly, but these very sales will become a self-fulfilling prophecy triggering a race to the bottom
Right now the effect on the US exchanges is being moderated by the weakening dollar, which is creating some oportunities to buy profit- generating operations at a net discount compared to other currencies. This will not persist forever, and the companies which have the best long-term prospects are those that actually do produce a profit. Treasury prices have dropped a bit (raising net yields), so there is an opportunity there for some buyers.
Bank of Korea raised rates overnight. Bank of England was rumored to be planning a rate increase. If the US doesn't match, it will hurt the US dollar even more. The Canadian loonie has been strengthening against the dollar, but I have (perhaps mistakenly) developed an uneasy feeling about it. So much of Canadian trade is conducted with the US that it is hard to conceive that the Canadian economy won't be hurt by the situation.
Plus, there was a lot of news yesterday, mostly lenders pulling products. And I think anyone who understands the industry is waiting with great anxiety for FNMA's next move which will likely be a hefty tightening. As the markets tighten the value of the current exotic loans drops, because the probability that they will face a reset or a recast and be unable to refi out of it.
In addition, the mortgage insurers are reporting some worrisome numbers. This also would make everyone believe that mortgage insurance will tighten, which will also lessen the probability of being able to refi out of trouble.
The Mortgage Lender Imploder site keeps track of a lot of news related to the downward spiral.
Bottom line is, whatever these bonds were worth two weeks ago, the reasonable expectation is that they are now worth less. It's a continuum - once you set one of these negative factors to work, you don't see the market effect in the numbers for two to three months, but you do know it is there. That, in turn, causes more tightening, and so it goes.
The high-return tranches were the most risky tranches, and one way or another, many funds were invested in those high-yield instruments. So a small downward move in the overall market - say 3-5%, disproportionately reduces the value of their holdings.
This stuff is often packaged up as CDOs and the like, but to get the yield you are always working with the more speculative tranches. Highly leveraged funds working with highly leveraged investments is not a recipe for stability.
In the absense of analysis of the power of central banks, especially when they coordinate their actions, it is impossible to predict(i.e.posit probablities) in any scientific way.
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