Page 2 of 2 Soothing words for
panicky
markets By Julian Delasantellis
financial institutions that their
losses could soon challenge many firms' viability.
Without soothed nerves, and if the selling gathers
enough momentum to turn into a true market panic,
the fears of liquidity contraction leading to
actual wealth destruction could become something
of a self-fulfilling prophecy
As I noted
in my July 3 article "Of termites and index
mania", during the good times in the housing
market from 2004-06, these
CDOs
glittered like gold to the heavy hitters of US
investment finance; they paid substantially higher
interest rates than stodgy old US Treasuries and,
as long as housing prices kept rising, were
considered just about as safe.
Hotdog-eating contests are now
commemorated as a sort of new US Independence Day
tradition of excess, as contestants compete to see
how many wieners and rolls they can shove down
past their fleshy faces into their bloated bellies
in a limited amount of time; for US finance,
putting subprime-based CDOs into the portfolio
became sort of like a contest of excess in and of
itself, as the contestants, the brokerages and
investment houses, stuffed as many subprime-based
CDOs as they could into their portfolios so they
could claim the prize of being at the top of the
investment-table returns.
Then they made
the problem worse, by using their portfolios'
subprime-based CDOs as either collateral they
could borrow against or as reserves they could use
to make new loans. This process is a core of the
so-called "sea of liquidity" that has been
sloshing across the planet driving up asset
prices; selloffs such as Tuesday's point to a
growing fear that this vast new skyscraper of
wealth may have, at its core, no real foundation
of any real quantities of anything with value.
Every recent time that subprimes have
spooked the markets, people like Paulson, Bernanke
and Cavuto have trotted themselves out to reassure
the markets: things aren't that bad, the subprime
crisis can be contained, subprimes have only a
limited presence in Wall Street's portfolios, the
US economy continues to be strong. Then, a few
weeks later, new facts about the crisis are
revealed: yes, things really are that bad. A few
weeks later, it's revealed that they're even
worse.
Indicative of how seriously the
world's investment community now sees the problems
in US finance arising out of the subprime crisis
is the recent anomalous trading in the Japanese
yen in the foreign-exchange markets. Since early
July 2005, the yen has been falling in value in
the forex markets, moderately against the US
dollar, sharply, to record lows, against other
currencies such as the euro and pound sterling.
This is because interest rates on Japanese bank
deposits are still very low, about 0.5%, while
dollar, pound and euro rates are all over 5%.
(Borrowing and selling a low-interest-rate
currency to invest in a high-interest-rate
currency is the core procedure of what the markets
call the "carry trade".)
Since early
Tuesday, the yen has reversed course, staging its
strongest rally against the dollar since the world
equity selloff in late February. (The dollar also
fell to record lows against the euro.) It is
feared that the credit issues arising out of the
subprime crisis are primarily centered in
US-dollar-denominated assets such as the
brokerages, and the subprime CDOs themselves
(although, in reality, greed knows no bounds;
subprime CDOs are in portfolios all around the
world), so forex players are "repatriating" assets
back to Japan so as not to get pulled down in US
finance's wake should it sink.
If you're
choosing an asset that pays 0.5% interest, such as
the yen, in favor of one that currently pays 5.25%
interest, the dollar, you're probably feeling
awfully negative about the short-term prospects
for the US economy and its credit markets, no
matter how many channels you can get on your
country's cable systems.
Bernanke and
Paulson are trying to head off a destructive
market panic; Cavuto, of course, is just another
smooth-faced midnight cowboy working the mean
streets of polarized US political debate to bring
the green home for the pimps at News Corp. Still,
those who belittle the seriousness of what's now
going on in the market for collateralized debt
obligations backed by subprimes are a lot like the
gentleman falling from the Empire State Building.
Things, on the surface, seem fine. The US
economy, like the world economy as a whole, is
benefiting from the tremendous headwinds blowing
out of rapidly industrializing Brazil, Russia,
India and China. Unemployment is low, and
employment growth is somewhat strong. There is no
fundamental reason, they argue, for the type of
generalized, widespread decline in housing prices
that might sink the CDO market, taking much of US
liquidity and finance with it.
Of course,
a few years ago, there was no fundamental reason
for the sharp run-ups in US housing prices,
especially in the hot markets such as southern
California and southern Florida, either. That
didn't prevent that phenomenon from occurring as
prices rose; the same dynamic is in play as they
now fall.
Just because you can't see
something happening does not mean it's not. The
process of real-estate depreciation leading to
successive waves of credit destruction is not
immediate; if you have the attention span of a
child, you might think it's not really happening
at all. But the process is going on, and Tuesday's
stock-market selloff means that the markets know
it is.
It starts with defaults by the
real-estate borrowers. The institutions that the
homeowners were sending their mortgage payments
to, whoever wound up with the mortgage note when
the game of musical money stopped, now can't make
payments to whomever they borrowed from. They
default, and so on it goes: borrowers default to
lenders, who then default on their borrowings to
their lenders, and so on, and so on.
The
process is not instantaneous; in the jargon of
economists, it is fraught with what is called
"friction". Papers have to be filed,
administrative assistants at law firms have to go
down to the post office so threatening demand
letters can be sent out to borrowers by registered
mail. But like the man falling through the
Manhattan sky, the inevitable denouement of this
process, an economy with a lot less liquidity, and
eventually a lot less wealth, comes ever closer.
If the worst happens, Wall Street will
dial 911 (the universal North American emergency
phone number). Unlike in the rest of North
America, where emergency calls are answered at the
firehouse or police station, 911 calls from Wall
Street ring on Bernanke's phone.
Julian
Delasantellis is a management consultant,
private investor and educator in international
business in the US state of Washington. He can be
reached at juliandelasantellis@yahoo.com.
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