Wednesday, 22 August 2007

Calm returns....for now

NEW YORK, Aug 20 (Reuters) - Calm returned slowly to financial markets on Monday, but there were lingering signs that credit problems persist despite policy-makers' insistence that the global economic growth would remain solid.

The Federal Reserve on Friday cut the rate at which it lends to banks to defuse the growing crisis in credit markets and encouraged more borrowing, particularly by big banks worried about their exposure to the beleaguered U.S. mortgage market. Deutsche Bank reportedly borrowed funds directly from the Federal Reserve on Friday, although it was unclear how much, the Financial Times reported on Monday.

However, the broader credit market seemed far from normal, particularly in the housing sector, where prices are falling and defaults are rising. "Investors' confidence in the mortgage financing space is not doing well," Larry Goldstone, chief operating officer of Thornburg Mortgage Inc, said in an interview with CNBC television on Monday.

In order to meet funding obligations, Thornburg said it has sold $20.5 billion of assets and reduced short-term borrowings by an equivalent amount. Adding to the uncertainty among investors, Fannie Mae, the largest source for U.S. home loans, said it will skip its monthly benchmark note issuance in August for the first time since May 2006.

Away from the trading rooms of Wall Street, policy-makers around the world struck a sanguine tone about the impact of market volatility on the global economy, even after the Fed said on Friday that the risks of the U.S. economy slowing have grown "appreciably."

Canadian Finance Minister Jim Flaherty told reporters on Monday that it would take "some time" for the turmoil in credit markets to be resolved, but that the fundamentals of Canada's economy remain strong.

Germany's Bundesbank said the outlook for the global economy remained positive despite recent market tension, which represented a "welcome normalization," albeit an abrupt one. "Nevertheless, the risks for the global economy have increased with the correction process in the U.S. property market," the German central bank said in its monthly report.

In the wake of the market turmoil, investors have sharply altered their forecasts for monetary policy. They expect the Fed, which added another $3.5 billion on Monday in short-term liquidity, to cut its key fed funds target rate and are no longer pricing in rate increases from the Bank of England. More than half of U.S. primary dealer banks polled by Reuters predict the Federal Open Market Committee will lower the fed funds rate at its Sept. 18 meeting, or even earlier.

The European Central Bank said it would again allot more funds than strictly necessary at its weekly tender, but aimed to reduce surplus liquidity in the short-term euro money market gradually as conditions normalize.

Australia's central bank also injected a sizable amount of liquidity into the banking system, seeking to temper upward pressure on some short-term money market rates.

But few investors are confident all the troubles stemming from the U.S. home loan market have yet seen the light of day, and they fear further market turmoil could cut growth.

Richard Shelby, a member of the U.S. Senate's Banking, Housing and Urban Affairs Committee, said banks would increase their mortgage rates in the coming weeks, exacerbating tight credit. "I think it will get worse before it gets better," Shelby said in Brussels. "There will be firms that will not survive. I don't think we should bail them out."

Tuesday, 21 August 2007

New Trade: NZD/JPY

Took a new position today, bought NZD/sold JPY at 79.50. Points are worth around 0.60 a month so we will see how it pans out.

NZD is rallying after recent selling. With $1 bil of new issuance in uridashi bonds today the NZD looks to have found a base.

I think the NZD/JPY will head back to over 90.00 at least so should be a good trade.
Time will tell!

Sunday, 19 August 2007

Circuit Breaker

The US Federal Reserve has provided just the circuit breaker that the markets needed.

By cutting the discount rate, not the Fed funds rate, and in between meetings as well, they have reminded the banking system that they are there when needed.

This will calm markets and the timing was excellent.

Traders will have the weekend to sober up, and sanity will be restored next week.

How does it make sense for BHP shares to fall 20%?

The ore they dig out of the ground is still there, they have fixed prices to sell it and with the AUD/USD so much lower, they will make more money.

Expect markets to stabilise this week, won't go up much, but will range trade.

US Federal Reserve Acts

To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility.

The Board approved a 50 basis point reduction in the primary credit rate to 5-3/4 percent, to narrow the spread between the primary credit rate and the Federal Open Market Committee's target federal funds rate to 50 basis points.

The Board is also announcing a change to the Reserve Banks' usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower.

These changes will remain in place until the Federal Reserve determines that market liquidity has improved materially. These changes are designed to provide depositories with greater assurance about the cost and availability of funding.

The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets. Existing collateral margins will be maintained.

In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York and San Francisco.

Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward.

In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably.

The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets. Voting in favor of the policy announcement were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Richard W. Fisher; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Michael H. Moskow; Eric Rosengren; and Kevin M. Warsh.

Saturday, 18 August 2007

NZD close to bottom, watch for the move back up again

I have been trading the NZD for over 30 years. I have never seen the NZD/USD move as far, as fast...ever!

Thank God it's Friday, but still getting offshore calls wondering when it is safe to buy again.

I posted here in July that I thought the NZD had topped out, and I repeat:

The NZ dollar has topped out at 0.8109, nearly 17% from the lows seen at 0.6715 in March 2007. Now looks to retrace and could pull back into the 0.7400 area before stabilising.

The reason?

Not our economy, Not the RBNZ actions, Not any Government moves.

Purely offshore pressures.

See story below: Volatility sweeps global markets.

That's the reason: the rise of global risk aversion; something the RBNZ has been praying would happen.Investors are pulling money home, worried about potential losses.

It could run some way yet, as the US property market disasters come home to roost.

That means, currencies that were weak, like the Yen and Swiss franc, will be stronger, as funds are repatriated.

Currencies that were strong, like the NZD, AUD and GBP, will be weaker, as funds are withdrawn.

That means the NZD will weaken.Might not go too far yet, but that is the trend, with the first target 0.7500.

What would stop this going too far are calm markets.8.25% return is hard to beat, and that means the NZD cannot stay down for long.

Equally the Japanese will not want a strong Yen, and may talk of intervention again.

But for now, and the next few weeks, the NZD is finally on the back foot.

Well it has certainly gone further than I thought it would.

But the short NZD position taken at 0.7950 will certainly pay a few bills, having just exited at 0.6750.

Best to stay out of the markets now, until things stabilise.

I think the NZD/USD is close to the base around 0.6600-0.6700 area.

The next trade will be buying NZD selling JPY, ie a carry trade (yes they still work really well!).

But looking for the entry point at present. With any luck the Bank of Japan will start to protest at the stronger Yen, and a base in the NZD/JPY will appear.

Sunday, 12 August 2007

New NZD Kauri Bond issue

Who says offshore investment is drying up?

WASHINGTON, Aug 10 (Reuters) - IFC, the private-sector arm of the World Bank, said on Friday it had launched its first-ever New Zealand dollar Kauri bond, issuing a five-year NZ$300 million note to raise funds to support poverty reduction work.

The notes mature on Aug 23, 2012 and carry a coupon of 7.75 percent, paid semi-annually, and were priced to yield 82 basis points over the benchmark New Zealand government bond, IFC said in a statement. A Kauri bond is a New Zealand dollar-denominated bond issued by a foreign issuer. It can be sold to both domestic and international investors.

The issue was joint lead-managed by ANZ Institutional and Bank of New Zealand, and the notes were placed with both local and international banks and find managers, IFC said. The proceeds of the issue were swapped into floating rate dollars and will be used to finance IFC's operations to support and encourage private enterprise in developing countries.

Thursday, 9 August 2007

US housing crisis deepens further

Staff at American Home Mortgage Investment Corp have been laid off

American Home Mortgage has filed for bankruptcy in the latest sign the US housing crisis is spreading from sub-prime mortgages to the higher grades of credit risk.

The collapse of America's 10th biggest home lender came amid fresh gyrations on global bond and stock markets yesterday, and growing questions over the exposure of European banks and insurers to the US property slump. Credit Suisse warned that 1.5m people were likely to default on home loans worth up to $220bn (£108bn) as a huge tranche of mortgages are adjusted upwards over the next 18 months. AHM, which issued $60bn of loans last year, asked for Chapter 11 protection from creditors and began laying off almost all of its 7,400 employees after banks abruptly cut off access to credit.

It cited a "sudden adverse impact on liquidity from the extraordinary disruptions now occurring in the secondary mortgage and real estate markets". Unlike the other 50-odd sub-prime lenders that have gone bankrupt or closed since late 2006, AHM specialised in "Alt-A" loans for mid-tier borrowers thought to be a good credit risk. The company said yesterday that the market for Alt-A debt packaged as collateralised debt obligations (CDOs) had completely dried up, making it impossible to continue normal business.

While outstanding level sub-prime debt in the market is roughly $800bn, the Alt-A segment is a close second at $700bn, mostly issued in 2005 and 2006. The rating agency Moody's said Alt-A loans are in reality little better than sub-prime debt, which already faces a default rate of 12.4pc.

Merrill Lynch said the property slump was now so serious the Federal Reserve would have to start cutting interest rates as soon as October, predicting a fall from 5.25pc to 3.75pc by the middle of next year. The steady drip-drip of bad news from the US continued to irk Europe's bond markets yesterday. The iTraxx Crossover index measuring spreads on low-grade corporate bonds surged from 400 to 430, before falling back as Wall Street rebounded from last week's violent sell-off.

Suki Mann, a credit analyst at Societe Generale, said virtually all refinancings and leveraged buyouts had been frozen as investors stood on the sidelines. "Everything is on hold. We're not going to see any deals done until there is some clarity." The Dow Jones rose 73 points to 13,225 in early trading as markets began to settle after the resignation of Bear Stearns co-president Warren Spector, who stepped down on Sunday after the collapse of two in-house hedge funds that set off the global bond bust two months ago.

The group's chief financial officer, Sam Molinari, alarmed Wall Street late on Friday by comparing the credit debacle to the dotcom denouement in 2001 and even the 1987 crash. "I have been a mortgage banker for 20 years and have never seen such a severe reaction to credit risks in the marketplace, and things may even get worse before they get better," he said.

Similar fears have begun to emerge in Germany where Jochen Sanio, head of the financial watchdog Bafin, said the credit squeeze threatened Europe with the most serious banking crisis since 1931.

IKB Deutsche Industriebank stunned the markets last week with an admission that it had taken a massive $24bn bet on the US property market without fully informing the board, and suddenly faced imminent collapse. Just 10 days earlier it had claimed to be in rude good health.IKB is being rescued by a consortium of banks offering a \u20AC3.5bn (£2.4bn) credit line, while the state-owned KfW bank has provided an \u20AC8bn guarantee for bad debts. The bail-out, orchestrated by the German government, is facing a Brussels probe for alleged violation of EU state aid rules.

Dresdner Bank yesterday admitted to $1.4bn in US sub-prime exposure, but said it was well cushioned by business at home. Germany's Union Investment has had to freeze redemptions from an $1.1bn fund invested in sub-prime loans, and even the Pharmacist and Doctors' Bank admitted $115bn in exposure.In France, Oddo & Cie is to close three funds making huge losses in sub-prime CDOs, saying it had been "caught out by the sub-prime dilemma". Insurance group AXA has closed two funds hit by the credit turmoil after a rash of redemptions in July.

In the USA - from bad to worse

The sub prime lending fiasco is a slow burning fuse. How long it is and how far it will reach, no one can be sure. Here's the latest casualty:

In a move that sent shockwaves through the financial markets and left investors millions of dollars poorer, Melville-based American Home Mortgage Investment Corp. announced yesterday that it lacked the money to pay its lenders or the credit lines to pay its borrowers. It was the largest mortgage bank to face bankruptcy in a year of bad news for the mortgage industry.

The effects of American Home's insolvency are far-reaching. The company's 7,627 employees -- including about 1,460 in Melville -- face an uncertain future. Its borrowers will lose access to $800 million in approved loans. That number is mounting by hundreds of millions of dollars each day. Major investors have announced millions in losses on the company. Banks that lent the company billions of dollars could see their stakes dissolve.

And Michael Strauss, the hard-driving entrepreneur who built American Home from a home-office operation into a top-10 mortgage bank, remaining its principal stakeholder throughout, lost $42.8 million in 20 minutes when the stock was marked sharply lower. The announcement contained shreds of the specific information that anxious investors and analysts had been clamouring for since the company kicked off a spate of ominous announcements on 6 April with a downward adjustment of first-quarter profit projections and dividend policy.

The company's executive vice president and chief investment officer Thomas McDonagh, who was paid more than $1.8 million in total compensation in 2006, had resigned only one day earlier. The company has acknowledged what many had feared: It had lost access to its credit facilities, lenders had been demanding repayment of some of American Home's debts for three weeks, and there were "substantial" additional calls for repayment outstanding.

The company said it had retained outside consultants -- companies that have assisted bankrupt mortgage firms in the past -- to help it resolve the situation in the manner "least disruptive to its business and to the many thousands of home buyers to whom it has committed mortgages." One option, the company said, was "the orderly liquidation of its assets."

Philadelphia-based RAIT Financial Trust, a publicly-traded investment pool, issued a release acknowledging that a 2005 financing line to AHM exposed its shareholders to $95 million in losses.

8:00 PM EDT, July 31, 2007

UK property looking grim - subprime is spreading!

Angela Balakrishnan

Saturday August 4, 2007The Guardian

The prospect of a mortgage debt crisis loomed yesterday after the number of home repossessions in the UK soared by 30% to an eight-year high as households struggled to keep up with mortgage payments in the face of higher interest rates. With the Bank of England expected to increase borrowing costs again before the end of the year, analysts warned that repossessions could surge even further. The first half of this year saw 14,000 properties repossessed, a 30% rise on a year ago, the Council of Mortgage Lenders said. This is the highest level since 1999 and equivalent to about 77 homes a day.

The unexpected jump was blamed on an increase in lending to borrowers with a poor credit history in the so-called "sub-prime" mortgage sector. Interest rates, which have risen five times in under a year to 5.75%, were also a big driving force in rising debt and missed mortgage payments. Economists cautioned that the impact of the recent rate increases was yet to be felt and homeowners would not be able to rely on rapid rises in the value of their homes as the housing market cools. "With the housing market slowing into 2008 and interest rates expected to hit 6%, homeowners slipping behind with their repayments may be left stranded, unable to sell their way out of trouble," said David Stubbs at the Royal Institution of Chartered Surveyors.

Nearly 2 million homeowners will be coming out of fixed-rate mortgage deals in the next 18 months and find themselves having to renegotiate terms with interest rates 1.25 percentage points higher. The CML said that 125,100 homeowners had mortgage arrears of three months or more, 4% higher than the six months to the end of December, but 3% lower than for the first half of 2006. The housing charity Shelter criticised irresponsible lending to people who could not afford the repayments. The Liberal Democrat Treasury spokesman Vince Cable said borrowers needed to be fully aware of the risks.

Pat Boyden at PricewaterhouseCoopers said while it appeared people were switching from unsecured loans to mortgage debt, households may return to credit card debt in the future to make up for shortfalls in their income against a backdrop of higher inflation in recent months and modest growth in wages.

Tuesday, 7 August 2007

RBNZ intervention numbers out

Figures released today show the RBNZ sold a net NZD702 mln in June. The first intervention (officially confirmed) was on 11 June when the NZD/USD was at 0.7620, with other unconfirmed interventions happening in June and July at various higher levels.

Given that the NZD/USD is currently at nearly two month lows of 0.7570, I would say, at this point anyway, the RBNZ is ahead of the game!

Saturday, 4 August 2007

Excuse me, but Hodgson - we've got a problem

I don't often agree with Jim Hopkins stuff, but this is so worth it.

By Jim Hopkins

An open letter to ... Mr Pete Hodgson, Minister of Health, Wellington and ... Mr Steve Maharey, Minister of Social Development, Wellington.


The truly amazing thing is not the silliness of the idea - that's probably par for the bureaucratic course - but rather the breathless enthusiasm with which you have announced it.

Now, to be fair, you chaps undoubtedly know much we humble folk don't, but we are nevertheless gobsmacked - assuming Sue Bradford will permit it - by your apparent conviction that the best answer to an awful problem is ... the compulsory introduction of a perfunctory hospital questionnaire.

Our heads are being scratched, sirs. Especially since none of the three questions you've decreed that nurses must ask includes the word "children". This makes many of us very confused.

If you'll permit the discourtesy, Hodgson, we've got a problem. And this is it. Some people treat their children in a revolting and disgusting way. That is the problem. Some people inflict pain on their children. Pain that makes us weak - and weep - when we imagine it.

Some people beat their children; with fists, wood, tools, jug cords, or all of the above. Some people torture their children. Some people see fit to punish their children by putting them in a clothesdryer.

When we hear that, sirs, our reaction is simple. And so is our solution. We would put anyone who does that into a clothesdryer themselves. And we would leave them there for a month. Please understand this, Mr Hodgson - and you too, Mr Maharey. We want such cruelty to be punished. Yes, gentlemen. Punished. Look, we know that "punish" is not a word that comes easily to the ministerial tongue but that is what we want. And we want you to want it too.

More to the point, we want an immediate end to all the inducements and all the incentives that are available to those who visit hideous harm on children. We want all the well-intentioned but shamefully administered unconditional taxpayer-funded assistance stopped! Immediately.We don't want our government - through the neglect of its agencies - implicated any longer in the violation and murder of innocents.

Gentlemen, you can do this. You needn't wait for the Mayor of Rotorua to suggest that some conditions might possibly apply to the payment of benefits before saying, "Gosh, that's a good idea!"

Find a mirror, Mr Hodgson - and Mr Maharey - then say to yourself as you gaze in the glass, "I can do that myself!"

Because you can!

We do not want any more stories about people popping into McDonald's before, finally, delivering their brain-damaged twins to hospital.

We do not want any more reports of famished children locked outside in the rain and driven to scavenge in neighbours' rubbish bins while their parents watch TV in a warm, bright house. (You may have forgotten that one but check your files, it'll be there.) Well, not any more! That's our message. Stop it. Now. Do everything you can to end this ugliness. And that includes accepting unintentional complicity.

See, we're not silly. We may not be clever - as you are - but we're not silly. We can read. We can listen. We can watch TV. And we're literally sick and tired of discovering, time and again, that our taxes (and your employees) are implicated in these shameful deeds.

So be brave, gentlemen. Tell your 25-year-old senior policy analysts that asking an 80-year-old lady who's spent two years waiting for a hip replacement if she feels "controlled or always criticised" won't fix the problem. Tell them that asking a nun admitted with a heart murmur if she's been "asked to do anything sexual that you didn't want to do" won't save the life of a single child. Tell them, if they want to spend $11 million preventing domestic violence, not to waste it on questionnaires, but post it as rewards for any information that might spare a child and convict its abuser.

Better still, tell them to write a speech explaining why the Government is no longer willing to ladle out cash and neglect in equal quantities. Tell them you want everyone to know why benefits - like wages - will henceforth come with conditions attached.

Tell them to find a nice way of expressing this old and inescapable truth: "We've all got to sing for our supper" and precisely how this will apply to those being paid by the state to care for a child.

Spell out the terms and conditions of the contract clearly and unambiguously and then spell out the consequences if they are ignored. That's what we want, gentlemen.

You see, sirs, when all's said and nothing's done, the national scandal described in this week's headlines is not that adults are beating children. That is a personal disgrace.

The national scandal is that your government, our government, is all too often a party to the outrage. But it's not doing an effective thing about it.

So here are your three questions, gentlemen: Do you care? Will you do anything worthwhile?


Now that didn't cost $11 million, did it?

Yours sincerely,
A Citizen. - I Got It From My Mama MUSIC VIDEO

A diversion from the markets!!

German banking heading for crisis?

The US subprime lending fiasco is spreading to German banks, this story from Reuters yesterday:

Banks funding the rescue of Germany's IKB expect it to lose up to a fifth of its roughly 17.5 billion euro ($24 billion) investment in U.S. subprime mortgages, a source familiar with the plan told Reuters on Thursday.

The revelation of the scale of the problem prompted the Bundesbank president to make a statement to calm nerves over the affair, which watchdog Bafin had said threatened to snowball into the biggest banking crisis in Germany in more than 75 years.

To stop IKB unravelling, German banks clubbed together to provide 3.5 billion euros to cover the lender's potential losses from the subprime crisis. The source said this represented about a fifth of IKB's total exposure. "The worst case possible is, naturally, that the market collapses and nothing is realisable," said the source. "Or you might lose nothing. You can't be sure. But 20 percent is a realistic assessment." IKB, which specialises in lending to small- and mid-sized companies, has become Europe's highest-profile casualty so far of the crisis in risky U.S. subprime mortgages. Its troubles have sparked fears that other German banks might also be hurt. News of the scale of IKB's exposure sent its stock tumbling more than 40 percent. The shares closed down nearly 30 percent at 12.31 euros. Since the start of the week, the crisis has wiped out more than half of the bank's market worth. Its chief executive has left and late on Thursday a source familiar with the matter said its chairman would also quit.

Prior to a shock profit warning on Monday, IKB had not outlined its involvement in U.S. subprime lending. Only 10 days beforehand it had said it would be almost entirely unaffected by the problems in the American property market.

Germany's central bank chief once again tried to reassure investors, dismissing the possibility of a banking crisis. "The problems at IKB are of an institution-specific nature. They have been absorbed effectively by the support of (German state bank) KfW," said Bundesbank President Axel Weber. There had been signs earlier in the day that IKB's creditors were growing more confident after the rescue package put together by KfW -- which owns 38 percent of the company -- and Germany's banking association. "Everyone's calming down about the story," one debt trader said earlier. But others continued to fear the worst. "No-one knows what to make of the situation," Olaf Kayser, an analyst with German bank LBBW, had said earlier. "There is absolutely no information coming from IKB."
Default rates on mortgages to high-risk, or subprime, borrowers in the United States have been creeping up, leading to problems for lending banks as well as those sharing the risk. Deutsche Bank , worried about IKB's subprime exposure, had cut a credit line to the bank, said the source, a move which sparked the IKB crisis and spurred watchdog Bafin into action.

Friday, 3 August 2007

Yen to gain as leverage dominoes fall

This is a great article on the structure of the Yen carry trades:

London, August 2 (Reuters) - The great repricing of risk now happening in global markets will undermine the lure of the yen carry trade, supporting the Japanese currency and hitting higher yielders like the New Zealand dollar.

It will take months at a minimum for the near panic now gripping credit markets from mortgages to leveraged loans to be resolved, and it's likely that more shocks will emerge. This means volatility in markets stays high, the appetite for risk is suppressed and everything that involves borrowing money is, on the margin, less attractive.

The carry trade, variously estimated at between $20 billion and $1 trillion, is perhaps the world's biggest bet. It is narrowly defined as borrowing cheaply in yen and buying investments in other currencies that pay a higher rate of interest. But many investors also fund in yen to make bets in any number of markets that they think will go up. The trade, popular with hedge funds which often borrow many times the capital they commit, is sweetness itself, so long as the yen doesn't appreciate.

Official rates in New Zealand, a popular play for carry traders, are at 8.25 percent, against a 0.50 percent overnight rate in Japan, while Iceland boasts a 13.3 percent nominal discounted rate. But, like so many other leveraged bets now coming unstuck, it can be very painful if markets move the wrong way. Thus far the yen has appreciated 3.8 percent on a trade weighted basis during recent tensions, according to Barclays Capital. That will have piled pressure on investors holding leveraged yen short positions.

The New Zealand dollar has been hit, plunging more than seven percent against the yen since July 24. During this period, yen strength has been highly correlated with stock market weakness. Volatility in yen has risen along with other measures, such as the Chicago Board Options Exchanges' Volatility Index <.VIX>, the so-called "fear gauge." "The (yen) needs to be watched closely at this juncture for if its steady appreciation starts to accelerate the walls could come tumbling down on the carry trade and that could make the recent market panic look like a picnic," Bear Stearns currency strategist Steve Barrow wrote in a Wednesday note to clients.

But while hedge funds, which may be exposed to other volatile markets, may be quick to rein in carry trade bets, it is an open question if increasingly influential Japanese retail investors will. Japanese salarymen and housewives, not satisfied with puny local interest rates, have been big buyers of high-yielding debt in other currencies, often trading from computers at home or using mobile phones. While the size of this market is hard to measure, some estimates show it accounting for a quarter of all spot foreign exchange trading during Tokyo hours.

These small fry are less aware of global trends and may only capitulate after a long and grinding rise in the yen, rather than because of the latest hedge fund collapse or prime mortgage default. At issue too, is the Bank of Japan, which is expected to raise interest rates to 0.75 percent in late August in a move which would eat into the interest rate differential carry trades exploit. While even a small decrease in the carry trade could have a big market impact, some very bearish analysts are expecting more.

Tim Lee, of piEconomics in Stamford, Connecticut, sees an imminent unwinding of the carry trade. "Over the last few years we have been experiencing an enormous credit bubble that has been based on a willingness to ignore risk, both credit risk and exchange rate risk," he said in an email interview. "Necessarily therefore credit has been drawn in the low interest rate currencies and funds have been placed in the high interest rate currencies. The whole bubble is now beginning to collapse, and the process of collapse cannot be reversed."
By James Saft, a Reuters columnist. The opinions expressed are his own. At the time of publication James Saft did not own direct investments in any securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

Wednesday, 1 August 2007

Future, hedge or just a gamble

This is a really excellent article from The Dominion Post. Well worth the read:

They have been called the glue of the modern economy – and the financial equivalent of weapons of mass destruction. John McCrone ponders the $US500 trillion world of derivatives.

The world economy is worth US$50 trillion (NZ$65.3 trillion). The global derivatives market – the intricate network of bets taken on the world economy – now totals US$500 trillion.

Feeling nervous? Sound anything like a house of cards to you?

A derivative is a financial contract that speculates on something happening to a real-life asset. It is a future, an option, a hedge, a swap, an arbitrage, a securitisation – a gamble, to be blunt. Some say derivatives are the glue that binds the world economy. They explain the relatively smooth ride of recent years. Others say they are toxic, a timebomb, the financial equivalent of weapons of mass destruction. Either way, they have swollen to become the bulk of the financial markets. As in Las Vegas, the casino seems to have taken over the town.

And this must have implications for the ordinary investor.

Many will feel that they can afford to view the derivative markets with bemused detachment. They may have read about the recent subprime mortgage woes in the United States and its connection with exotic financial instruments called CDOs – collateralised debt obligations. Investment bank Bear Stearns is having to stump up US$3.2 billion to cover two of its CDO funds, whose value somehow evaporated overnight. When you hear of some of the crazy US mortgage lending practices, it seems less of a surprise. They have these ninja loans. No income, no job and no assets? No problem. Can't afford the repayments on one house? Well, we will lend you enough to buy five – an instant rental property empire. Your first two years of interest will be dirt cheap and when the real rate kicks in, you simply sell a few places. With rising house prices, everything will be covered. Sweet!

Plainly, some loose lending has been going on. Some of the institutions like Barclays and Merrill Lynch which have lost out big on the Bear Stearns CDOs should really have known better. But the subprime story seems remote. The equation changes, however, if this kind of financial sloppiness is now systemic; if the US$500 trillion stack of trades proves to be pretty much a mass of speculative froth. One man who should know is Sydney derivatives expert Satyajit Das, who has been working in the business since 1977. A former trader for Citicorp, Merrill Lynch, Commonwealth Bank and the TNT Group, Mr Das has written a couple of standard textbooks and now lifts the lid on the industry in his expose Traders, Guns & Money. Mr Das is feeling twitchy. "We have built an edifice that is extremely complex, extremely interlinked and extremely leveraged. Which means that ultimately a small shock could have absolutely unforeseen consequences. "Then it comes down to the question of whether there is enough wealth in the system, and enough political and regulatory will, to bail people out. At some stage – and I don't know whether it's in three months, three years or 30 years – there is going to have to be a day of reckoning."

Because of the size and global reach of the derivatives market, if it is one festering bubble of risk, then a market "correction" could be bigger than any other financial crash in history, Mr Das says. He is not the only commentator worried. Fabled US investor Warren Buffett labelled derivatives as weapons of mass destruction when it cost him US$400 million just to unwind a tangled legacy of deals in a company he had bought. Other derivatives pioneers, like Richard Bookstaber of the US hedge fund FrontPoint, have been muttering of the dangers of a market melt- down. And what the doomsters say is that ordinary investors cannot escape the fallout. Every pension fund, every high street bank and large corporation, will now have some exposure to the derivatives business. Mr Das says that for the first third of his career, the use of derivatives was relatively sane. Futures and options were employed to hedge risk.

Hedging strategies developed to smooth commodity prices like grain and tin then gradually spread to other areas of finance like exchange rates. Exporters would pay a premium to reduce their exposure to currency fluctuations. In the 1970s, things began to get really creative with interest-rate swaps. Mr Das says that as a large institutional investor, you might have the problem that you held a fixed-rate bond, but really you wanted a floating rate deal. The problem was your own company charter prevented you from doing this. A derivatives trader could arrange to swap the income from your bond for the floating rate that someone else was earning on some matching asset.

And the beauty of this virtual ownership was that it could be off the balance sheet. Who would know? Mr Das says the first time he was involved in an interest-rate swap, it was like winning the lottery. As the go-between, his bank picked up US$18 million in fees on a US$200 million deal. Everyone loved the ingenuity of this new financial engineering. It made almost anything seem possible.

If, for instance, Britain had an inconvenient rule that foreigners must pay tax on share dividends, investors would use derivatives to create a virtual holding. For a fee, a British bank would buy the shares for them. The investor would then buy an option to buy the shares at some future date – an option priced to include the tax saving. Every year people found more tricks they could play with derivatives. Mr Das says the traders behaved like bandits and if a deal did blow up on a client – which was not infrequent – then all concerned would find ways quietly to bury the problem. It was rarely in anyone's interest to wash dirty linen in public.

He says the real shift came in the late 1980s when it was realised derivatives could be used to speculate as well as hedge. Instead of playing safe by balancing both sides of a deal, a derivative would just take a naked bet on some future event. And because the only cost to get into the game was the derivative's premium – you did not need to actually own an asset, just buy the option – the bets could be hugely geared. For every dollar put up, $10 or even $100 could be in play. It is leverage that allows the total of deals now to have reached US$500 trillion. Mr Das says if all the bets could be unwound, then only perhaps US$5 trillion of real money would be found. The rest would be an elaborate web of IOUs. The move to gambling with derivatives was quite deliberate, he says. The world had become hungry for returns.

Traditional stocks and bonds just did not have enough juice. Pension funds and other institutional investors were being expected to earn 10 to 12 per cent year in, year out, and so derivatives became a way to manufacture investments with a greater element of risk. Derivatives shifted up another gear in the early 2000s when credit derivatives – the packaging of loan and debt obligations – became the "newest, bestest, thing" in high finance circles. Again the first credit deals were hedges. Banks used credit default swaps (CDSs) to insure against the risk of clients defaulting on loans.

But once the risk element of loans had been separated from the loans themselves, Mr Das says, the fun with speculation and leverage could begin. Eventually the CDO was spawned. A CDO is a bundle of loans usually split into three tranches – equity, mezzanine and senior notes. Equity investors are promised the highest rate of return but also have to cover the first few loan defaults. For a smaller return, mezzanine investors suffer any further defaults once the equity investors have been wiped out. Senior note holders stand third in line, well back from the fray, so a CDO is a way to turn a pot of middling-grade loans into an apparently AAA structure with a skim of high- paying B and C-grade junk bonds. Banks loved CDOs because they were a way of getting their loan risk off balance sheet, enabling them to take on yet more lending. Mr Das says the ability to juggle risk also encouraged slack lending practices like subprime mortgages.

With a booming global economy, even the diciest bets have been paying off. But because of the highly leveraged nature of many of the CDOs – some of which are, in fact, CDO2s, or CDOs which combine the mezzanine and equity tranches of many other CDOs – any tightening of the markets can bring a sudden unravelling.

As has just happened in the past few months with Bear Stearns.

Mr Das says the problem is that derivatives are always based on models and future forecasts. And the more remote from real- world assets the derivatives market becomes, the more chance there is for excessive optimism to colour the predictions.

The question is: will we continue to see isolated collapses or some day a general tumbling of the dominoes?

The list of those hit by derivatives trading down the years is impressive: Procter and Gamble, Orange County, Gibson Greeting Cards, Barings Bank, Metallgesellschaft, Chase Manhattan, Allied Irish Bank, Sumitomo, Parmalat, National Australia Bank, Barclays Capital and LTCM. Of course, the ability of the financial system to shrug off shocks like the US$6.6 billion lost in a month last year by natural gas hedge fund Amaranth Advisors is cited as evidence that the global web of derivative deals is indeed acting as a glue.

Deutsche Bank market chief Anshu Jain recently told Economist magazine that during the past few years: "The market has been characterised by calm, continuous, and even benign conditions. Derivatives are a big part of explaining that phenomenon." However, Mr Das says the real story was that worried institutions rallied around to take over Amaranth's bad trades, allowing them to be liquidated slowly and quietly. If Amaranth's positions had simply been allowed to flop, then many other connected deals would have been knocked down as well, sparking a real market rout.

Mr Das says there is a limit to how many of these billion-dollar blow-ups the market can swallow. And the worry is that no one really knows what percentage of derivative deals are secretly junk.

Meanwhile every year, the monster grows 15 per cent or 20 per cent larger. Feeling nervous?
Traders, Guns & Money is published by FT Prentice Hall.