Living In Risky Times

Source : The New Paper, 7 Aug 2007

The worldwide economy isn’t doing badly, but things can get worse fast

Do we need to prepare for a perfect storm that whips up a worldwide depression?
In a depression, stock and property prices can fall 80 per cent. One out of two people lose their jobs. It isn’t pretty.

Is it unlikely? Yes.

Is it impossible? No. It happened once before, 75 years ago.

Three mini-storms have hit us in recent weeks. Together, they have the potential to produce an economic typhoon.

Storm #1: Raw material prices shoot higher

Could it happen? Yes. Last Wednesday, crude oil prices hit another all-time high. Commodities like zinc, iron, copper, tin and palm oil are at or near all-time highs.
Those prices filter through the economy and boost the price of all goods. It produces inflation.

We are accustomed to harmless 2 to 3 per cent annual price increases.

To see how bad things can get, we need to take a trip to South Africa’s northern neighbour, Zimbabwe. Its inflation rate has reached 9,000percent per year.

One expatriate from Zimbabwe complained: ‘The price I paid for my home 10 years ago buys only one bunch of bananas today.’

Storm #2: ‘Oops, wrong policy’

The US Central bank regards the inflation fight as their primary mission, and it always uses the same tool to fight it - higher interest rates.

I recently had the privilege to speak to one of the region’s central bank governors. She told me: ‘Raising interest rates in response to higher oil prices will not create one more barrel of oil. It will only slow economic growth.’

It is a great insight. Commodity prices are high because of (i) limited supplies and (ii) new demand from emerging markets.

Higher US interest rates won’t affect either one. It will not reduce inflation.

Higher interest rates, however, will slow growth and produce stagflation. It is the worst possible combination - a weak economy with high inflation.

Storm #3: Tight credit

Blame it on the hedge funds. Their investments stand at $2 trillion (one trillion is 1,000billion) and they are the biggest buyers of risky US home loans.

Not only that, they invest with borrowed money. It adds a kicker to returns. While risks are high, the returns can also be spectacular, like 20 to 30 per cent per year.

Now, many of those bets are turning bad.

Take the case of two hedge funds managed by investment banking firm, Bear Sterns. They had purchased $30b of assets with only $2.5b of investors’ money. The rest was borrowed.

Last month, Bear Sterns revealed that its investments in risky US home loans were not doing so well.

The firm apologised and said investors in one fund had lost all their money and those in the other had lost most of it. Too bad.

The banks and other lenders will get back their money. But even that required a $2.4b infusion by Bear Sterns.

Since then, conditions have worsened.

Nearly every day, another hedge fund closes down or halts redemptions. Losses are in the tens of billions and climbing.

Greed vs Fear

In the battle between greed and fear, greed had the upper hand. Now, fear is coming on strong.

The change is due to risky US home loans.

Our home loans work like this:

- We borrow money from a bank. Then we repay the loan with interest. Simple.

- It’s different in the US. First, banks and finance companies make home loans.
- Then they sell them to underwriters who put a few hundred into a package and re-sell it as a collateralised debt obligation (CDO).

CDOs are unique because investors buy debt plus a queue number. If you go for high risks and returns, you take a low number, like 1.

That puts you in the ‘equity tranche’ also known as ‘toxic waste’. You are the first in line in the event of default.

- The first 5 per cent of defaults get paid by this tranche.

- The next 5 per cent of defaults go to the BBB group.

Example: If 10 per cent of a CDO’s home loans defaulted, all losses would be assigned to these two tranches. Those investors would lose their entire investment.
The higher-rated A, AA and AAA tranches would suffer no losses.

It isn’t widely understood that the queue system of CDOs means their ratings are not comparable to corporate debt.

Moody’s data shows that from 1983 to 2005, the average default rate on Baa corporate bonds was 2.2 per cent. For Baa CDOs, it was 24 per cent.

TWO GROUPS BENEFIT

The system has worked well for two groups.

- First, banks and finance companies got access to a seemingly endless stream of money which they plowed back into more home loans.

- Second, practically anyone who could sign their name got a loan.

Sub-prime borrowers with low incomes or bad credit records found they were suddenly popular with lenders who offered super-easy terms like (i) no money down, (ii) 40-year loans, (iii) low ‘teaser’ rates in early years and (iv) interest-only loans with partial repayments.

The latter works like a credit card. It allows payment of part of the interest with the rest rolled over. It helps cash flow but the debt keeps growing like a balloon.

By Larry Haverkamp (Doc Money)