With the collapse of sub-prime real estate market as well as some prominent hedge funds, traders have increased volatility in the market and necessitating constant dismissal of (legitimate) economic fears. All of these dismissals -- from the White House, the Fed, Goldman Sachs analysts -- only enhance these underlying fears. As Floyd Norris of the NY Times wrote in recent column, declarations of stability only serve to highlight the instability hiding just below the surface.
On Thursday, the key US indexes were down nearly 3% with the Dow experiencing a near 400 point drop. Today, the (inexplicable) optimists were celebrating a mere 30 point drop after a day that saw the index down over 200 at one point. But the celebration is premature. The volatility (and drops) in the equity markets are just a symptom of a much larger problem. In opposition to what many investment analysts are saying, nearly all equities are bloated. When it comes down to it, everything is over-leveraged. And the money, well, it just is not there.
But then where did it go? As always, market processed begin with real money. A wannabe homeowner takes out a $500,000 mortgage with a $10,000 down payment. This money has transferred to the home seller, and the new owner is indebted to the bank for that amount. But, in recent years, the bank has relinquished the risk by immediately selling the debt to third party. In most cases this sold mortgage is bundled with thousands others to create a CDU fund. This fund is then sold to investors -- hedge funds, pensions, rich people -- who often earn a nice return. But the real scandal, which has been much discussed, is how bundles of high-risk mortgages -- those taken out by individuals of dubious creditworthiness -- were consolidated into AAA, or seemingly low risk, funds. Thus, a pension manager looking for a high return would be ecstatic to invest in a low risk fund that may yield 11% or more. With many of these sub-prime loans set to see massive interest-rate increases, the yield could potentially be higher. But, if that seems to good to be true, it's because it is.
Those loans should never have been lent in the first place. And, instead of a windfall of high interest payments, investors are left with defaults. The pension that I gave as an example could lost all its investment. So much for that AAA rating.
But it is not just mortgages that are bundled and mislabeled in such ways. This practice is endemic in the marketplace. And the unfortunate part is that as the bluff is finally called, the withdrawals will only cause more withdrawals. The end result may very well be a run on these funds. With this, liquidity will dry up, as we have been made obvious by the Fed infusions today. The effects, however, will not as many believe be contained in narrow equity markets. The lack of liquid capital will cause a decline in mortgages, but also in much of the financial services activity (mergers and acquisitions, leveraged buy-outs, stock buybacks, and leveraged investments) that have made so many companies so profitable. The result here could be a decline in profits among numerous companies, mass layoffs, and general malaise in capital markets.
But it only gets worse from there. The policy measures that the Fed has at its disposal can only escaberate one side of the problem. Of course, any rate increase now could cause instant recession and perhaps worse. But a rate decrease and continued liquidity could potentially cause the dollar to collapse. And, the chief trade partner of the US, China has consistently unvalued its currently. The effect here is two-sided. A crashed dollar may no longer be seen as an effective investment for the Chinese and may shift to
(to be continued)
