Wednesday, August 15, 2007

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.


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