Insanity on the loose....

Discussion in 'Wall St. News' started by S2007S, Jun 25, 2007.

  1. S2007S


    Interesting Article...

    Analysts at Bank of America have called the woes at Bear Stearns’ two troubled hedge funds the ‘tip of the iceberg

    On Thursday, there was an air of nervous expectancy in the US markets. Bear Stearns, a leading Wall Street broker, was trying to rescue two hedge funds that it has floated. One was called the High Grade Credit Strategies Fund and the other was called the High Grade Credit Strategies Enhanced Leverage Fund. Although both funds called themselves “High Grade”, they invested in securities backed by subprime mortgages, i.e., mortgages extended to high-risk borrowers and then securitized. The second fund was launched with $600 million (Rs2,460 crore) and it borrowed to invest $11.5 billion in securities, with an additional $4.5 billion of short positions in various securities.
    One of the lenders, Merrill Lynch, threatened to auction the securities owned by the fund to collect its dues. That would have enabled “price discovery” for a pool of securities that were valued according to opaque methods. Depending on how much buyers were willing to pay for these securities, other funds that hold similar securities would have had to value them at the prices that buyers were willing to pay for the Bear Stearns fund holdings. That might have set off a chain reaction with unpredictable consequences for the funds, their investors and lenders to the funds. It appears that the immediate danger has been averted for at least one of the two funds, as Bear Stearns has agreed to lend money to it to pay off external creditors. Wall Street rallied on Thursday. However, on Friday, worries returned. The other fund could still be in trouble and Standard and Poor’s and Fitch have downgraded credit ratings (as usual, after the horse has bolted). Wall Street stocks plunged.
    Analysts at the Bank of America called the woes at Bear Stearns’ funds the “tip of the iceberg”. They wrote in a report on Friday that homeowners with about $515 billion on adjustable-rate home loans would pay more this year and an additional $680 billion worth of mortgages would reset next year. As homeowners are required to pay more for their mortgages, the risk of foreclosures and defaults rises. Securities whose values depend on soured loans would have to be marked down or extinguished at distress prices, as happened to the two Bear Stearns funds. Is this the end?
    A few other indicators, too, suggest that the answer is yes. The price of Brent crude oil is already more than $70 per barrel. It took the Israel-Hamas war and hurricane Katrina to propel oil to more than $70 per barrel in the last two years. Now, tight supply and rising demand are taking the price of oil above that limit.
    Other indications that the risk-appetite trade is running into resistance come in the form of intervention by the Reserve Bank of New Zealand (RBNZ) to weaken its currency. It has not succeeded. Speculators and Japanese residents have called the bank’s bluff and have pushed the Kiwi dollar higher against the yen and even against the US dollar. What would RBNZ do next?
    Much as these indicators push one to suggest that the end of the last few years of rising asset prices is nigh, the answer is that the game is not over yet. That would require a dramatic shift in policy in Japan towards higher interest rates and a turnaround in the macroeconomic growth strategy of China. Neither is imminent.
    China is the key variable in this game. As I had written on numerous occasions, their growth strategy relying on exchange rate competitiveness keeps the dollar from depreciating, keeps interest rates low and encourages Wall Street to build complex products based on debt since the cost of debt is low. That looks unlikely to change.
    Real interest rates are negative and the stock market bubble is growing bigger as negative real deposit rates lead to a flight of deposits from the banking system into stocks. The government makes periodic noises against speculation, but does little to stem it effectively. Many state actors are benefiting from the bubble. Perhaps that explains the reluctance to walk the talk.
    Surely, this is an unsustainable model. But predicting the timing of its collapse is hard. It will stop when it cannot run any more. Until that day arrives, one should expect more of the same from China. That means continued reliance on competitive currency, reserves accumulation and purchase of all kinds of international assets. So, besides manufactured goods, China would also continue to export its asset price bubbles abroad.
    That is why the answer to the question of whether this is the beginning of the end is a NO. Any wobbles in financial markets induced by the fear of a meltdown in the US mortgage finance would find investors who have hitherto stayed in the sidelines rushing to buy. Bubbles would get bigger much as I wish they would not. It is not easy trying to explain an insane world.
  2. Should've seen it coming.