The
Titanic Economy
By Mike Whitney
15 November, 2007
Dissident
Voice
On
Monday, Asian stock markets took another beating, on fears that the
credit squeeze which began in the United States will continue to worsen
in the months ahead. Every index from Tokyo to Sidney fell sharply continuing
the “self-reinforcing” cycle of losses started last week
on Wall Street. The Nikkei 225 average fell 3.3 per cent, India’s
Sensex 2.9 per cent, Taiwan’s 3.5 per cent, and Hong Kong’s
Hang Seng slumped 4.5 per cent. The subprime tsunami is presently headed
towards downtown Manhattan, where nervous traders are already hunkered-down
in the trenches—ashen and wide-eyed.
Amid the deluge of bad news
over the weekend; one story towers above all the others. The yen gained
1.5 per cent against the dollar. (9 per cent year-over-year) That means
that Wall Street’s biggest swindle, the carry trade, is finally
unwinding. The over-levered hedge funds will now be forced to sell their
positions quickly before the interest-rate window shuts and they’re
stuck with humongous bets they cannot cover. The faltering yen is the
grease that lubricates the guillotine. $1 trillion in low interest loans–which
keeps the trading whirring along in US markets–is about to get
a haircut. Cheap Japanese credit is the hidden flywheel in Hedgistan’s
main-cylinder. Once it is removed, the industry will seize up and clank
to a halt. Fund managers can forget about the vacation rental in the
Hamptons. It’ll be sloppy Joes and Schlitz Malt-liquor on Coney
Island from here on out.
Over the weekend Deutsche
Bank announced that losses from “securitized” subprime mortgages
were likely to reach $400 billion. The news sparked a sell-off in the
Asian markets where investors have become increasingly eager to pare
down their holdings of US equities and dollar-backed assets. Overnight,
the greenback has become the leper at the birthday party; everyone is
steering clear for fear of contagion. Foreign central banks are looking
for any opportunity to dump their stockpiles of dollars in a manner
that doesn’t disrupt their economies or the global financial system.
Their intentions may be prudent-even honorable-but it won’t forestall
the inevitable blow-off of US dollars that is likely to commence as
soon as the financial giants reveal the real size of their losses. New
regulations have been put in place that will require the banks to provide
“market prices” for their assets. This will expose the degree
to which they are under-capitalized. When word gets out that the banking
system is underwater; there’ll be a run on the dollar.
On Sunday, the AFP reported
that the Group of Seven richest nations (G7) is considering direct “intervention”
in the dollar’s decline to prevent a “disorderly correction”.
“It is not too early
contemplating the risk of coordinated interventions by the G7,”
said Stephen Jen and Charles St-Arnaud of investment bank Morgan Stanley.
“History shows that multilateral, coordinated interventions have
been key in establishing turning points in multi-year trends in major
currencies in the past three decades.” On Thursday, Treasury Secretary
Hank Paulson, full fathom five under the waves on the poop deck of the
Titanic communicated through speaker tube the news that “A strong
dollar is in our nation’s interest and should be based on economic
fundamentals.”
According to Bloomberg News:
“More than $350 billion of collateralized debt obligations comprising
asset-backed securities may become ‘distressed’ because
of credit rating downgrades.”
What’s clear is that
the situation is getting worse, not better. Honesty must at least be
considered as one of many options, although the Treasury Dept avoids
that choice like the plague. Eventually, the public will have to be
told about what is going on. Last week, the Financial Times reported:
“In recent days, investors have been presented with a stream of
high-profile signs that sentiment in the financial world is deteriorating.
However, deep in one esoteric corner of finance, another, little-known
set of numbers is provoking growing concern. So-called correlation -
a concept that shows how slices of complex pools of credit derivatives
trade relative to each other - has been moving in unusual ways ‘What
we are seeing in the synthetic [derivative] markets is that there is
a serious fear of systemic risk,’ says Michael Hampden-Turner,
credit strategist at Citigroup. ‘This is not just about price
correlation within the collateralized debt obligation market, but about
a potential rise in default correlation and asset correlation.’
Until recently, traders often tended to assume that there was relatively
little correlation between different chunks of debt, because they thought
that the biggest risk to the world was idiosyncratic in nature - meaning
that while one company, say, might suddenly default, it was unlikely
that numerous companies would default at the same time. However, some
regulators have been warning for some time that in times of stress correlation
does not always behave as traders might expect.”
The multi-trillion dollar
derivatives industry-which has never been tested in down-market conditions—is
now moving sideways. No one really knows what this means except that
the most opaque and volatile debt-instruments are now threatening to
unravel, triggering a cascade of unanticipated defaults and a colossal
loss of market capitalization. Credit default swaps (CDS) are rarely
thrashed out in market commentary. They are counterparty options which
provide hedging against the prospect of default. They are, in fact,
a financial equivalent of the San Andreas faultline which is quivering
menacingly as foreclosures mount and mortgage-backed bonds continue
to implode. As the Financial Times suggests, the shock waves should
be sweeping through the Wall Street trading pits in the very near future.
There are also new developments
on the sale of “marked to model” CDOs-the red-haired stepchild
of the new structured finance paradigm. “The trustee of a $1.5
billion collateralized debt obligation managed by State Street Global
Advisors has started selling assets, apparently starting a process of
liquidation,” Standard and Poor’s said. The sale is a red
flag for the other holders of $1.5 trillion of CDOs who’ve been
waiting for market conditions to change before they try to sell their
mortgage-backed bonds. The liquidation will assign a “market price”
to these complex structured investment vehicles. If the price at auction
is mere pennies on the dollar, then the banks, pension funds, and insurance
companies will have write down their losses or add to their reserves
to cover their weakening assets. Simply put, the State Street sale could
turn out to be doomsday for a number of under-capitalized investment
banks. Their revenues are already down; this would be the last stake
to the heart.
Finally, Greg Noland, at
Prudent Bear.com reports on the “looming disaster” at Fannie
Mae where, the best-known Government Sponsored Entity (GSE) has entered
into the current housing slump with a “Book of Business of mortgages,
MBS and other credit guarantees of $2.7 trillion” which is backed
by a measly “$39.9 billion of Shareholder’s Equity”.
That’s all?
As Noland concludes, “A
devastating housing bust will bankrupt the mortgage insurers, while
the solvency of their derivatives counterparties going forward will
be in doubt in any number of scenarios. The GSEs are now integrally
linked to what I expect to be Credit insurance’s and “structured
finance’s” astonishing downfall.”
Amen.
The only thing looking up
are oil futures. And they’ll be denominated in euros soon enough.
Leave
A Comment
&
Share Your Insights
Comment
Policy
Digg
it! And spread the word!
Here is a unique chance to help this article to be read by thousands
of people more. You just Digg it, and it will appear in the home page
of Digg.com and thousands more will read it. Digg is nothing but an
vote, the article with most votes will go to the top of the page. So,
as you read just give a digg and help thousands more to read this article.