Tuesday, August 14, 2007

The Sub-Prime Summer II

It’s just another volatile summer trading day in the financial markets and Rob Kirby is reminded of phrase: “If you see a cock-roach, you’ve got cock-roaches.” First some details from Bloomberg.

Subprime-Infected Funds Drive Demand for Dollars: Last week's credit crunch has set off a worldwide rush for dollars as banks and fund managers scramble to pay back loans used to buy risky mortgage securities. … While the credit-market turmoil originated in the U.S. as delinquencies rose on subprime mortgages -- those made to borrowers with poor or spotty credit history -- it has spread around the world. European banks are particularly at risk after borrowing in dollars to finance their investments, analysts said. … The overnight lending rate for dollars in Europe, the London Interbank Offered Rate, jumped to its highest in six years as investors and lenders sought cash to unwind bets gone awry.

This is not an unfamiliar story: “borrowing dollars to finance their investments” turns into “bets gone awry”. Gambling with borrowed money is a bad habit, but apparently a widespread inclination as there has been a whole lot of speculation for profit. Rob Kirby points the finger at way various collateralized debt obligations (CDO's) have been used in privately negotiates swaps.

Derivatives Melt Down: In the past few weeks we’ve all been ‘peppered’ with reports about CDO’s and growing contagion associated with sub-prime mortgages. For clarity’s sake – everyone should first understand that these instruments are – for the most part – all broadly defined as OTC derivatives. ... The difficulties stemming from Bear Stearns has created reverberations throughout global financial markets with difficulties being reported in Australia, France and Germany. But what about other U.S. financial institutions? In the grand scheme of things, Bear Stearns is a “small payer” when it comes to OTC derivatives.

OTC Derivatives differ from futures trading in that they are privately negotiated contracts rather than exchange regulated contracts. (Derivative FAQ's) In the broadest terms OTC derivatives are agreements to trade cash flows between two parties. When the investment source of the cash flow starts to diminish, you need to find the cash elsewhere.

One of the points I was trying to clarify a couple posts ago is that the demand for high interest mortgage backed securities from the big financial institutions was the driving market force behind the weakening lending standards in the mortgage industry. Mortgage backed securities are not the problem. Gambling with leveraged assets is the culprit in this mess. Mortgage backed bonds are what create the continual circulation of cash enabling people to acquire home mortgages. Without a secondary market for mortgages our widespread home ownership society would not exist.

So some big banks are going to get hammered by losses and the effects will ripple through the economy for a while. Michelle Malkin links up some thoughts about tempting but inappropriate political desires for a housing bail out. Political interference has much more potential to make the situation worse. A contract is a contract and changing the rules on Wall Street or Main Street for political outcomes will damage society far worse than rich men loosing money and foolish dreamers moving back to an apartment.