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We sometimes wonder if we’re the only ones who are bearish on the US economy.
The housing market is in its worst recession since 1991, and to our eyes it’s really only just started. The number of existing homes for sale is at its highest in relation to sales in 15 years, according to the National Association of Realtors, while actual sales in May were the lowest in nearly four years. Existing (or second-hand) home sales make up 85% of the US housing market.
And yet several Federal Reserve members, and plenty of other apparently intelligent analysts keep arguing that housing might be a drag on the economy, but it’ll pass.
So it’s reassuring to open The Telegraph’s business section this morning and see a really very worrying report from Lombard Street Research, suggesting that America is headed for a ‘severe credit crunch.’
So what’s got Lombard Street worried?
The crisis at Bear Stearns’s troubled hedge funds (for more on this, see yesterday’s Money Morning – US subprime woes start to spread) has ‘exposed the underlying rot in the US sub-prime mortgage market’, reports Ambrose Evans-Pritchard in this morning’s Telegraph.
A new report from Lombard Street Research says this will be the trigger for a US credit crunch. ‘Excess liquidity in the global system will be slashed… Banks’ capital is about to be decimated, which will require calling in a swathe of loans. This is going to aggravate the US hard landing.’
Phew! Talk about not pulling your punches – that’s about as straight-talking as you can get from the City.
The big worry, as we mentioned yesterday, is this whole issue of ‘collateralised debt obligations‘ or CDOs. Now most aspects of finance are actually not that complicated once you boil them down to the basics. CDOs are a little more tricky, but bear with me.
CDOs basically bundle together lots of bits of ‘junk-rated corporate bonds, mortgage bonds, high-interest loans, derivatives or even other CDOs’ says Bloomberg. A lot of the stuff they hold is pretty high risk, and therefore higher yield, which up until now is what has attracted investors.
But here’s the clever part – which, as is all too common, is also the part that’s now biting investors in the backside. What happens is you gather all this debt and heap it into one big cake. You then slice the cake up into different sections.
The bottom section, or equity tranche, is the riskiest. As soon as any of the underlying securities defaults, the people holding the equity tranche take a hit. Once the value of the equity tranche has been wiped out, the people holding the next slice up (usually known as the mezzanine tranche) start taking the hit from any defaults, and so on.
Now when credit rating agencies are rating these different tranches, they do take into account the quality of the underlying asset. But they also take into account that you’re investing in a portfolio of them – and here’s where the magic comes in.
Let’s say you invest in one dodgy Aim stock – it could be a ten-bagger, or more likely, you could lose all your money. So what you do instead, is you put your money in a fund that invests in 100 Aim stocks. You’re much less likely to lose all your money – they can’t all go bust (hopefully). So the fund is a less risky investment.
Now let’s say that, on top of this, your original investment is capital-protected, as long as fewer than 20 of the companies go to the wall in the next five years. That starts to sound like a pretty safe investment, doesn’t it? So a credit rating agency might well decide that, although each individual stock in the fund is high-risk, the fund itself is low or medium risk.
That’s pretty much what happens with CDOs. Each individual holding might be pretty dodgy, but the chances of them all turning to sewage at once are thought to be so low that you can give the top tranche of a CDO a AAA-credit rating, the highest one available.
(Now we can’t claim to be experts in this field, and this is a simplified, though hopefully not simplistic, view of CDOs. For a larger piece on the dangers of derivatives, take a look at a cover story from we ran in September last year: The dangers of derivatives. Or if any of our readers work in the field and would like to comment on this piece, please let me know at johns@moneyweek.com)
Anyway, the trouble with the high credit ratings given to CDOs is that these assumptions haven’t been stress-tested in the realms of the real world. And these assumptions also didn’t take into account just how careless the subprime mortgage lenders would be in who they lent to. This in turn meant that a lot of the mortgage-backed securities which accounted for a large part of what was in many CDOs, were even more toxic than anyone first realised.
As Nouriel Roubini, economics professor of New York University, puts it: “These highly illiquid securities have been priced so far on unrealistic and distorted credit ratings as the ratings industry has been complicit. They have not been rerated in a way that is consistent with rising subprime default rates.”
So unsurprisingly, now no one wants to buy these things. When Merrill Lynch tried to auction off $850m of assets seized from one of the Bear Stearns funds, it only managed to get rid of $200m before the auction was called off. Lombard Street says: “We hear buyers were lobbing bids at just 30% [of face value].”
They reckon Bear Stearns is just “the tip of the iceberg,” says Evans-Pritchard. With house prices still falling, and a lot of investment banks left holding CDOs that no one wants to touch with a ten-foot barge pole, we agree. There’s plenty of scope for a lot more damage. As Roubini puts it: “That is why Wall Street is in a panic. Losses will be massive once these assets are correctly priced to market.”
Just before we go, a lot of readers have asked us about currency trading, especially since our recent cover story on the forex markets (subscribers can read it here: How to play the currency markets). If this is a market you’re interested in – and certainly, with lots of the world’s currencies currently sitting at all-time lows or all-time highs, it seems ripe with opportunities – then one of our advertisers is offering a forex service which seems to have had excellent results over the past 13 months
Keep an eye out for the ‘4M’ advert which should be arriving in your inbox later today, and see if it appeals to you.
Turning to the wider markets…
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In London, the FTSE 100 ended the day 21 points higher, at 6,588, as the strong start on Wall Street prompted a recovery from earlier losses. Sainsbury’s was among the day’s highest risers on bid rumours. However, miners including Antofagasta and Lonmin were lower as negative broker comment took its toll on the sector. For a full market report, see: London market close
On the Continent, the Paris CAC-40 was 20 points lower, at 6,002 and the Frankfurt DAX-30 was 19 points lower, at 7,930.
Across the Atlantic, stocks gave up a strong start to end the day in the red as concerns over the subprime mortgage market and higher interest rates weighed. The Dow Jones ended the day 8 points lower, at 13,352, having hit a high of 13,488 earlier in the session. The tech-heavy Nasdaq was 11 points lower – at 2,577 – and the S&P 500 was 4 points higher, at 1,497.
In Asia, the Nikkei fell 21 points to close at 18,066 whilst the Hang Seng was 29 points higher, at 21,852.
Crude oil had fallen to $68.83 a barrel this morning, whilst Brent spot was slightly higher at $72.34.
Spot gold dropped over $3 yesterday as investors held off buying ahead of today’s US economic data and was lower still, at $649.90 this morning. Silver, meanwhile, had fallen to $12.81.
In the currency markets, the pound was at 1.9979 against the dollar and 1.4851 against the euro, whilst the dollar was trading at 0.7431 against the euro and 123.17 against the Japanese yen.
And in London this morning, shares in weapons maker BAE Systems tumbled by as much as 7.7% as the company admitted that the US Department of Justice had begun a formal investigation into its operations in Saudi Arabia.
And our two recommended articles for today…
The trouble with interest-only mortgages
– Even the property experts are now admitting that the only thing sustaining rising house prices is the expansion of the means to match them. But those saddled with interest-only mortgages are heading for trouble. For more on how the yawning gulf between the knowledge required to understand interest-only mortgages and the knowledge of actual home buyers looks set to cause problems for the property market, read:
The trouble with interest-only mortgages
Two ways to place your bets on the Chinese Las Vegas
– The more the Chinese earn, the more they gamble and the more they shop, says Merryn Somerset Webb. Hence the rapid growth of Macao, the Chinese Las Vegas. For two ways to gain entry to this compelling investment story, click here: Two ways to place your bets on the Chinese Las Vegas