Saturday, October 11, 2008

A Three Prong Attack

I'm sure by now you've heard that we have a problem in our financial system. I could go on in detail about every headline discussing how bad things are, but you can read those on your own. Instead I'd like to talk about why things are so bad, which you won't hear on the news, and where we go from here.

There are three powerful forces right now causing the market chaos. Let's discuss each one in some detail.

1. LIBOR

The LIBOR rate is the London Inter-bank Offered Rate, the rate at which large global banks are willing to lend to each other on a short term basis. In place since the 1980's, it's calculated every business day in 10 currencies and 15 maturities (time periods), ranging from overnight to one-year.

Usually central banks can control the LIBOR rate by adjusting their lending rates. (For example, when the Fed cuts interest rates it will usually have the effect of bringing the LIBOR rate down with it.) Unfortunately, over the past 5 weeks the central banks have lost control over the LIBOR rate. They are now rising on their own because banks will not lend to each other. (Why they will not lend is discussed below.)

Why is this a problem? 40% of adjustable rate mortgages are tied directly to LIBOR. This means if the LIBOR rate rises, American's monthly housing payments rise with it. With a tsunami of rates to adjust over the next 36 months, this will cause a new onslaught of foreclosures. This will trigger additional losses to all the bonds now floating around the world. This will trigger additional write downs, which will trigger additional bankruptcies, which will trigger an explosion in the Credit Default Swaps market.

2. The CDS monster has been revealed

Looking back now, I would bet the government would like to have a redo on Lehman brothers. This small company in the large scheme of banking has revealed the true horrific power of Credit Default Swaps.

All through the month of October, entities that insured the debt of Lehman brothers are now having to pay up on the losses from the bankruptcy. The problem with this, as we discussed before, is that they do not have the capital to do this because none of them factored in the risk of this type of market atmosphere.

Where are they getting the capital? They are selling everything they can. Stocks, bonds, commodities, everything. This is causing everything to go into free fall and everyone to sell at the same time. They have to do this because if they don't then they will then be out of business, and another company will have to cover the insurance on those losses.

Remember, this is only from Lehman brothers. If AIG was allowed to fail, well, I couldn't even imagine what would be happening right now. This selling pressure is creating additional selling pressure from over leveraged hedge funds who are now having to sell irrationally to keep their margin requirements. (Enough capital in relation to their assets) The fear of additional explosions from Credit Default Swaps has frozen the global credit because banks do not know what other banks have on their balance sheets. This is causing LIBOR to rise and has also awoken another sleeping giant that no one saw coming.

3. The yen carry trade

I could write three full pages on the implications of this, but I'm going to try and keep it simple as always. Japan has had very low borrowing rates for many years. This has allowed speculators to borrow Yen at a very low interest rate (let's say 1%) and then take that money and invest it in another country returning a higher yield. (let's say 5%) They can then pocket the difference, and it's like printing money. The only risk with this is that if the Yen starts to appreciate in value against the currency you're investing in, you're going to take losses.

The yen has exploded upward in value over the past few weeks creating a rush to the exits from investors utilizing this carry trade. In order to unwind their positions they are having to sell the foreign assets they are investing in; stocks, bonds, ect. This is creating massive additional selling pressure which again is causing additional selling.

So where do we go from here? Well, in my mind it can go two ways.

1. The government will do the correct thing and allow all the credit excess to purge itself from the system. This will cause a massive global sell off, and create a tremendous amount of pain in the short term. As the financial markets crumble, they will find a bottom as REAL capital will enter the markets to purchase the assets at a discount. (Warren Buffet, Wilbur Ross, ect.) This is the equivalent of sending a loved one to rehab to take care of their heroin addiction. The withdrawals will be horrible and painful but they will have been cleansed.

2. The Federal Reserve and central banks around the world will print money to try and keep the credit bubble expanded forever. This will cause a tremendous loss in the purchasing power for every paper currency around the world and bring the dollar to its ultimate death. This is the equivalent of pumping your loved one with more and more heroin every day so they do not feel any pain. You continuously up the dosage until they finally overdose and end up dead.

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