My Two Cents - "Firecrackers and Picnics"

7/4/2007

When the Fourth of July rolls around, thoughts generally turn to picnics, pools, and fireworks. Ok, you know I didn't check in this week to write about picnics and pools. However, I am going to talk a bit about fireworks, but probably not the same ones you'll see in the skies above many American cities tonight. I am talking about a cache of fireworks that Wall Street et al are trying desperately to keep under wraps.

I have just read with a growing soberness an article from the Telegraph, an English newspaper about the nearly $2 TRILLION dollars worth of subprime and alt-a mortgage debt that is going sour faster than a truckload of Spanish melons sitting at Port Authority on a 90-degree day.

The problem lies in the fact that most of this debt was bought with borrowed money, and to be honest, the collateral just ain't worth what it used to be. This causes a huge problem for the folks that hold this toxic waste. It works like this:

Lets say for instance that you want to buy a car that costs $1000, but you only have $100. So you go to a bank and borrow the remaining $900 at some rate of interest. You take possession of the car. The car, however, is leveraged, meaning that you had to borrow to buy it. The loan is secured, in this case by the car. As long as you make the payments, no one ever gives two hoots about how much the car is worth. Let's say now that you make 3 payments of $50 on the car and then stop. You default on the loan. The bank in this case will want to repossess the car in order to sell it and make good on the loan. However, when they go to sell it, lets say the car is now only worth $200. So the bank, for its trouble collected $150 from you plus the $200 for the car. For all intent and purposes they eat $550. Don't feel too sorry for the bank; these risks are priced into the interest rate and on the whole they usually do very well.

The Collateralized Debt Obligation (CDO) in simple terms really isn't that much different from our prior example. In this case, you have a bunch of mortgages that are packaged and sold off. The payments that the homeowners make become the return on the CDO, paid to the holder. The CDO's were valued using fancy computer models that assumed a certain default rate. So what happens if the default rate is higher? Certainly we can't say that the CDO is still worth what the model thought it was. As it is turning out, the default rate is MUCH higher than anticipated and in some cases the CDO's are only pulling 50 cents on the dollar when a sale is forced. This is horrible given the fact that the owners of the CDO borrowed in many cases 90% of the money to buy it in the first place. Does everyone see the problem here? Start revaluing these things and we'll have the carcasses of hedge funds, banks and financial intermediaries littering the landscape on all 7 continents. Think this isn't a recipe for a credit crunch?

The banks involved, realizing what was happening quickly halted the sales of such instruments and calls for an 'orderly unwinding' became common. The term 'orderly unwinding' translated means that "We got caught with our hands in the cookie jar and we need help to get our hand out nice and slow before the lid slams shut."

This can no longer be dismissed as another annoying conspiracy theory. Mainstream financial figures (mostly notably ones outside the US) are calling attention to this growing problem:

Who now holds these risks, and can they manage them adequately? The honest answer is that we do not know." - Bank of International Settlements

"It was a cover-up," Charles Dumas, global strategist at Lombard Street Research

"This is the big one: All investment portfolios will be shredded to ribbons." Albert Edwards from Dresdner Kleinwort

In a nutshell - too much funny money. Too much greed. Someone wanted too much, too soon and pushed the envelope too far, relying only on the fact that they had gotten away with it last time. Ex ante it looked like another slam dunk. Ex post it may well turn out to be their worst nightmare.

The one thing I will say about this Fourth of July is that there are going to be some big time fireworks. And it isn't going to be much of a picnic for anyone that relies on the dollar bill for their way of life.

Andy Sutton holds a MBA with Honors in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics. This article and other information is located at http://www.my2centsonline.com Please feel free to distribute, copy or otherwise disseminate this information.