How Does it Affect Us, You Ask?

It has been a tough three weeks: what started out as a concern for the investors in derivatives, bled into concern about investors in equity, and has now made its way into concern about pricing in all asset classes and what effect all of these events will have on the US economy.

The banks, and I suppose soon the prime brokers, have shut down leverage funding for the hedge funds. Traditional investment companies have suspended their purchases of derivative products. So now that there is no more liquidity for mortgage derivatives and no institution wants to add mortgage paper to their books, funding has dried up for the mortgage originators. So that's the temporary end of easy money in the US housing market. It also seems to be the end of easy money in other housing markets as well - RAMS in Australia, Northern Rock in the UK.

How did this US mortgage problem impact other mortgage origination markets? They all get funding from the same cabal of derivative specialists and buyers. Rates are going up everywhere for borrowings, risk appetite for the products has disappeared and it looks like the business is going to at least temporarily revert to the old days where banks originated, funded and held the mortgages.

So far so good. We've been waiting for the credit markets to return to rational pricing and for the resulting unwind of leverage created by the easy credit. The problem is that everything under the sun, especially in the US, is affected by leverage. So as the deleveraging progresses, asset prices fall - homes, companies, commercial properties. As asset prices fall, risk appetites fall, and all perceived higher risk assets (derivatives of all kinds, emerging markets) get whacked while the only "riskless asset" (US T's) go up.

This multiple year asset inflation period also created real and perceived income streams: IBank bonuses at the top of the pyramid, consumer equity lines at the bottom. These incomes stop growing and drop, in many cases to zero. But even worse is the psychological impact of flat or declining asset prices and there resulting income streams: when your house stops increasing in price, stocks are falling and you're as levered up as you can be, well, you stop spending - on a dime.

Consumer spending in the US is one of the most important support structures to world economic growth. If growth this year is projected at 3.5% world wide, how much of that is due to the voracious appetite of the US consumer? Not sure, but its bigger than a thimbleful. It's certainly a huge (70%?) part of US growth. So a retrenching US consumer is like to lead to a slower US GDP growth, maybe recession; it is also likely to lead to a slowdown in world wide GDP growth. That relationship will be the most interesting one to watch.

Collateral Damage

After a three day world wide rally in all markets, Bank Paribas comes out with the classic French capitulation manoeuvre: we are too scared to price our assets in this market, so we will avoid creating liquidity for our investors and suspend redemptions. See no evil, hear no evil, speak no evil. Bouf. Who is willing to start the tsunami of repricing? Are we gonna just let Citadel come in and buy all of the crappy paper at sick discounts or are we going to try to create a liquid market and fair pricing?

It seems clear that over the coming weeks we will continue to have dribs and drabs of asset managers reporting losses, shutting down funds and retiring to the hamptons. The silly euro buyers who seem to be the major suckers at this poker table will report major losses and will suffer an even worse liquidity situation.

If this were the downside, then no worries. Some investors get hammered, the weak funds get eliminated, the remaining players have a better understanding of what derivatives mean and we all move on. Maybe this takes until October, waiting for the third quarter reports and tax year ends to clear the books. Or maybe it even takes until next spring, taking some extra time to push fund managers into a mark to market. When the ratings agencies have downgraded the investment's credit rating, the fund managers will be forced to reprice the paper.

But what about those leveraged funds and their funding partners, the banks. Funds borrow and lever up 5:1 or maybe 10:1 and buy a bunch of fixed income assets. Some of those assets are illiquid CDOs - they don't trade and therefore have no market pricing. The funds use their own internal model to decide on the price of these assets, creating an opportunity for very subjective pricing. And an opportunity for severe collateral damage for the banks' loans.

The banks are likely to decide that they need to look a bit deeper into the funds' holdings and the result is a growing uncertainty by the banks about their own risk as lender. If they can't price the assets, then they can't figure out if some of the collateral backing the bank loans is any good. The banks then ask the funds to liquidate the marketable assets and repay some or all of the loans.

Then there are the CDO ratings and the ongoing collapse of the housing market. As the default rates on mortgages, which are quite low at the major banks, start to go up, the mortgage paper gets downgraded. I suppose then the funds have to change their pricing models and then the mark downs come. The ARM resets peak in Jan/Feb of 2008, so the default rates peak maybe about June. The markets usually price in events six months ahead of time, making the bottom in this whole mess around Nov/Dec of this year.

Back in Feb, we started the process of preparing for this repricing in the credit markets. We are now getting a bit more visibility on the players involved - IBanks, commercial banks, insurance companies, ratings agencies, mortgage insurers and originators, fixed income funds, etc. I can't imagine owning any of these names until late in 2007. In general, August 15 is the cut off for capital redemptions for September 30, so it looks as of today like the hedge funds are selling off their most liquid equity positions to prepare for redemptions. So the solid names like BA and GE are getting hammered 5%.

The US housing market collapse will impact the US economy, and Q3/Q4 will be slow growth quarters, maybe even recession quarters. This will impact Asia and its exporting/dollar buying machine, but by how much? One thing that hasn't changed is the liquidity glut is still with us. Rates are going up worldwide and some of the carry trade is coming off, but there are still vast pools of capital ready to play. Oil is still over $70, the Asian trade surpluses are still strong and the private equity guys are still raising $20b funds. Any ideas?

Rumsfeldian Knot

If only this "credit risk repricing" event that we currently find ourselves in were a simple Gordian Knot. Holders of "The Untraded" paper could simply come out of the closet and elegantly and simply cut the knot in two. In one move, they could create transparency, liquidity and erase a chunk of the uncertainty. Unfortunately, we are in a Rumsfeldian Knot: it's a metaphorical knot to which no swift solution is available. It is full of known unknowns, unknown unknowns, and very few known knowns.

Every fund that owns "The Untraded" either fears a shutdown, massive embarassment or simply doesn't realize that they own such toxicity because it never gets marked to market. We know that credit insurance is getting very expensive, spreads are breaking wide and the CDO indexes are imploding. The equity markets are responding to this violence with complete fear, shedding 4% a day, worldwide. Some funds are coming clean, especially the ones that got deep in the subprime CDOs. A chunk of the mortgage companies have gone under, most recently including one thought to have been primarily focused on higher quality Alt-A loans (relative quality - mostly option ARMs for the speculators).

We still have no idea how this paper is distributed - who owns it and how much do they own, and we have no accurate picture of pricing. We hear that the paper is spread out among the many - hedge funds, insurance companies, sovereign funds, banks, etc. But who owns the truly crappy stuff, the low rated junk and the so called equity and how much do they own? Is it more than the firms capital base in the case of leveraged positions? So many known unknowns.

Then, of course, the unknown unknowns are, well, unknown. What nugget of information will smack the market on the head as the true source of this worldwide market uncertainty? Will it turn out that the real problem is a US economy already in recession? Are we creating a self fulfilling the problem in this sell off, shutting off liquidity to this new age world economy? I think the name of the game is still liquidity; we now have too much and we are cleaning up the excess. Lets hope the sponge is not too thirsty.