Hedge Fund Subprime Credit Crunch to Impact Interest Rates
Interest-Rates / Credit Crunch Jul 31, 2007 - 12:50 AMBy: Nadeem_Walayat
The ongoing crisis triggered by the subprime mortgage defaults continues to spiral into new directions, making it difficult for even experienced market watchers to comprehend the complete picture and its implication for the financial markets. Therefore this article attempts to explain the crisis and what it implies for future interest rate trends.
What are Subprime Mortgages?
These are Mortgages made available to those of subprime credit risk (poor credit histories), hence called sub prime mortgages.
Why would financial institutions lend to people with poor credit histories ?
The lending occurred during the property boom, the longer it went on the more lax the rules for lending become, as has happened during past property booms. Property seemed like a one way bet and therefore lenders could charge poor credit risk customers more interest and fees in securing the mortgages. Whereas if the borrower failed to pay the loan then the lender could foreclose and sell the property at a profit and thus there was little perceived risk in the market place.
Where did the money come from ?
1. Low Interest rates - The world was and still is to some extent awash with cheap money due to historically low interest rates, this enabled lenders to borrow at low interest rates and loan out at much higher interest rates.
2. Fractional Reserve Banking and the Money Supply - Basically, the governments of the world borrowed from their central banks, especially in the US. This is in fact printing money. The commercial banks were able through the fractional reserve banking system lend out many times the amount they had on deposit with the central banks, and thus creating money from X10 to X20 the original amount borrowed by governments. This flowed into many assets including loaned out to those of a sub prime risk.
3. The Yen Carry Trade - This is an example of a Japanese government printing money to keep their currency artificially low so as to enable Japan to export goods to mainly the US through the use of very low interest rates. This enabled both financial institutions to borrow in Yen at low interest rates of say 1% and lend to those of a sub prime risk and charge them say 5%, and for Japanese investors to invest their capital abroad.
When did things start to go wrong ?
The US housing market was roaring ahead and as with any bubble, most participants tended to get carried away with themselves in terms of debt taken on and expectations of future growth. During the last 2 years of the boom 2005 and 2006, lenders were falling over themselves to lend money to even poorer risk borrowers so as to benefit from the extra return. However the sub-prime borrowers were saddling themselves with debt that even at low interest rates they would have some difficulty in servicing.
However, things started to fall apart when interest rates across the world started to rise.
Why did world interest rates rise ?
Money Supply Growth
Eventually the excessive growth in money supply over the last 3 years, which had chased most assets higher, was flowing into commodities that fed the chinease production machine started to take off and sky rocket to new highs as both production and speculative demand had soaked up the stockpiles and there had been relatively little investment in mining capacity during the preceding 20 year commodities bear market. Even gold came alive, threatening to march to a new high . This resulted with the coming to an end of the deflationary effect of cheap chinease goods due inflationary pressures within China. This is an ongoing process that will continue for years to come and have an upward push on world inflation compared to the previously deflationary effect.
Thus inflation took off and so did interest rates in the western economies, as an example Interest rates in the US rose from 1% in early 2004 to the current 5.25%. In the UK interest rates have risen from 3.5% in October 2003 to 5.75% today. In Europe Interest rates rose from 2% in November 2005 to the current 4%
Subprime Foreclosures
The credit crunch started to occur when people with poor credit were in, increasingly numbers unable to meet the higher debt repayments due to rising interest rates and were being foreclosed. As foreclosures escalated the housing bubble burst in the USA. This started in early 2006 and continued to worsen throughout 2006 and into 2007.
Feb 2007 - Yen Carry Trade Unraveling Warning's Impact on the Subprime sector
What happened was basically institutions that borrowed in Yen at less than 1% and invested elsewhere for much higher returns, such as in the subprime mortgage sector. This is further exacerbated as through the use of on leveredged derivatives products. The whole system is reliant on Japanese interest rates remaining low and the Yen weak. If the yen strengthens then the value of the debts increases and thus a rush for the exit as people look to liquidate positions further strengthening the yen and carry trade losses. This is what happened when China wobbled during Feb 07. There was a dash to liquidate Yen Carry trade positions i.e. reduction in global liquidity, out flows from stock markets and a squeeze on mortgage lending in the subprime mortgage sector. However the subprime mortgage market was already in meltdown as the losses were being realized through foreclosure.
This was expected to have an knock on effect on economic activity which increased the chances of a US interest rate cut, which ironically meant an even greater loss of liquidity due to greater risk of future failures. However this warning at the time proved temporary in most cases apart from the Sub Prime Mortgages which continued to deteriorate whilst the Stock markets recovered.
Why Hedge Funds are Failing ?
Hedge funds, deploy leverage to enhance their exposure to markets, When things are moving in the right direction this results in phenomenal profits. However as is eventually the case, the 'bets' get bigger and bigger and its only a matter of time before the 'gamblers' find themselves on the wrong side of the market. This is what happened with Two of Bear Stearns Hedge funds, which placed highly leveraged bets on packages of subprime mortgage derivative products. When the value and credit worthiness of these bond packages called collateralized debt obligation (CDO') was cut due to the subprime defaults.
The effect of this was to virtually wipe out the total value of the funds that had previously been rated as low risk. The problem here is that they should NOT have been rated as low risk. The CDO packaging enabled institutions to mix good risk and bad risk debt all in one pot and label it as good risk. Therefore the financial institutions earned a higher rate of return on what seemed like a relatively low risk CDO package. that was priced in the market price as low risk debt upon which hedge funds such as Bear Stearns leveredged to the hilt.
And here were talking about the Subprime Experts getting wiped out !
The Impact of Hedge Fund Losses ?
The Hedge fund failures has two key effects.
1. A Financial Shock to the System - Results in a re-rating of risk across the board, as financial institutions during the boom period have loaded themselves up with similar CDO packages, which are now expected to be worth much less than previously thought. As the market is pricing them at a much higher level of risk.
2. Derivatives Ripple Effect - Bear Stearns weren't the only people betting on the subprime mortgage market using highly leveredged derivatives. Many 'less experienced' hedge fund gamblers and other financial institutions also have exposure, and we can expect many more failures in the market place as people try to rush for the exit to cut exposure. It is unknown how much damage will be done. But the mark down of the financial sector in advance of bad debt provisions is a clue that were talking about in the hundreds of billions of dollars and there in lies the credit squeeze.
Effects of the Credit Squeeze.
As financial institutions are forced to 'cover their bets' by making provisions for bad debts, and losing their high interest rate / 'low' risk subprime cash cows. They are in effect withdrawing liquidity from the market place and making it more difficult for borrowers across the board of all shapes and sizes to borrow money for whatever economic activity. This means that this will impact on the economy and thus depress the US housing market further which results in more foreclosures and more squeezing of credit to cater for this.
Conclusion - What Will the Central Banks Do ?
The conclusion to be drawn is that as economic growth slows under the weight of the ongoing liquidity crunch brought about by the subprime mortgage losses rippling out to other sectors of the economy. Many of the worlds central banks will have to cut interest rates in an attempt to counter the liquidity squeeze. Therefore it is highly likely we are very near an interest rate peak of some significance. I expect the USA to be the first to cut interest rates, followed by the UK and then the European Central Bank. This is pretty much contrary to current market consensus and therefore an opportunity exists for those of a similar opinion to make decisions ahead of the curve as the market realise's the bullish implications of much lower interest rates.
By Nadeem Walayat
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