	Generational Dynamics
	Forecasting America's Destiny ... and the World's

\| HOME \| WEB LOG \| COUNTRY WIKI \| COMMENT \| FORUM \| DOWNLOADS \| ABOUT \|

Generational Dynamics Web Log for 31-Oct-07
Wednesday's Fed announcement is the most watched in a long time

Web Log - October, 2007

Wednesday's Fed announcement is the most watched in a long time

As the continuing rapid collapse of the ABX indexes signals a time of great danger, the Fed has never been watched, and speculated about, more obsessively than today.

The Fed Open Market Committee (FOMC) is having its regularly scheduled meeting on Wednesday, and will announce whether it will cut interest rates again.

Investors are overwhelmingly expecting a Ľ% interest rate reduction, and many are hoping for a ˝% reduction, as happened last month. Last month's ˝% reduction caused a great deal of instant drunken euphoria among investors, and most would like to get drunk again.

Lowering interest rates will weaken the dollar as international currency, and it's already the weakest it's been in decades. Leaving interest rates unchanged with bitterly disappoint investors, though it will strengthen the dollar.

One major issue is the surging mortgage crisis, which appears to be getting worse by the day.

Many mortgage loan foreclosures are from ARMs (adjustable rate mortgages), where the homeowner signs up for the mortgage with a low monthly payment, based on a low "teaser" interest rate. That teaser rate expires after 1, 2 or 3 years, depending on the terms, and then the interest rate "resets" to a much higher value, and the homeowner's monthly payment can double or even quadruple.

Here's a chart showing ARM reset schedules that I've used before:

Monthly ARM reset schedules, 2007-2009 <font face=Arial size=-2>(Source: Calculated Risk)</font>

Monthly ARM reset schedules, 2007-2009 (Source: Calculated Risk)

As we've described many times before, these mortgages went through "financial reengineering," slicing and dicing the mortgage loans into tradable securities called Collateralized Debt Obligations (CDOs).

I recently had occasion to be reminded of some of the lyrics from Gilbert & Sullivan 1878 musical play, H.M.S. Pinafore, where the First Lord of the Navy explains how he came to rise to that position:

    As office boy I made such a mark
    That they gave me the post of a junior clerk
    I served the writs with a smile so bland
    And I copied all the letters in a big round hand
    I copied all the letters in a hand so free
    That now I am the Ruler of the Queen's Navy

Well, the financial engineers who created these CDOs created them with a hand so free that even the riskiest of subprime mortgages was somehow converted into the highest-rated AAA CDO securities.

A web site reader has asked me how it's even possible for a high-risk mortgage loan to be converted into a low-risk anything. I won't try to describe the entire process, but I'll give an example of how it works.

Suppose you owe me money, and there's a 25% chance that you won't repay me, which is a pretty high risk loan, which is why I charged you a high rate of interest. Now suppose that 1,000 people owe me money under the same conditions. Then I can expect 750 of the loans to be repaid, and 250 of the loans to default. So I take the 1,000 loans and put them into a pool, and I sell shares in the pool. Actually, I sell two types of shares, low-risk shares and high-risk shares. When people start paying off the loans, the income from the first 600 who pay the amounts owed goes to the investors in the low-risk shares; after that, the remaining income "cascades" to the investors in the high-risk shares. If you've gone through this example, you can see that the low-risk investors should receive the income from 600 people, and the high-risk investors should receive the income from 150 people (750-600=150). But suppose that the 75% figure is wrong? Suppose that only 50% of the loans are repaid? Then the low-risk investors get income from only 500 repayments, and the high-risk investors get nothing.

Prices of ABX-HE series 07-2 for various risk levels on 30-Oct-2007 <font face=Arial size=-2>(Source: Markit.com)</font>

Prices of ABX-HE series 07-2 for various risk levels on 30-Oct-2007 (Source: Markit.com)

That's what the ABX index is for. The mortgages are sliced and diced into credit default swaps and then into CDOs. There are low-risk, AAA-rated securities and there are high-risk BBB-rated securities. The income from the mortgage loan repayments goes first to the AAA securities, and anything left over "cascades" down to lower-rated securities.

As you can see from the adjoining graphs, the low-rated securities (at the bottom) have been falling in value so quickly that they're almost worthless. The high-rate securities at the top have been falling in value as well, because the number of defaults and foreclosures is so much higher than anyone predicted.

This is an incredible situation. It's out of public view because these CDSs and CDOs are so opaque to the general public.

But there are trillions of dollars (notional value) of these things in financial portfolios around the world, and nobody knows how much the damn things are worth -- except that nobody any longer believes that they're worth the trillions of dollars originally claimed.

It was just last week that Merrill Lynch shocked the financial community by writing down $8.4 billion in value of securities that turned out to be almost worthless. And on Tuesday, Switzerland's largest bank, UBS, reported its first quarterly loss in five years because of similar writedowns.

The ratings agencies, Moody's, Fitch and S&P, are re-evaluating the ratings of all the CDOs that were previously rated too high -- which is all of them. Tens of billions of dollars worth of CDOs are being reevaluated downward each week.

The continuing rapid collapse of the ABX index, which is a proxy for the values of these CDOs is a very alarming development, as the collapse may reach a tipping point that causes a domino effect throughout the global financial system.

From the point of view of Generational Dynamics, we're overdue for a generational panic and crash, as I've been saying since 2002, long before the CDO crisis burst forth. It's impossible to predict whether this is the time, but we can be certain that it's a time of great danger.

What does Ben Bernanke think about all this?

As I wrote in my August article, "Bernanke's historic experiment takes center stage," Ben Bernanke is putting into practice his core beliefs, acquired on his grandmother's knee as a child in the 1960s: That the 1930s Great Depression could have been avoided, and a future Great Depression can be avoided, by injecting money into the economy. That seems to imply that he'd rather err on the side of reducting interest too much, rather than on the side of not reducing enough. (31-Oct-07) Permanent Link
Receive daily World View columns by e-mail
Donate to Generational Dynamics via PayPal

Web Log Pages

Current Web Log

Generational Dynamics Web Log for 31-Oct-07 Wednesday's Fed announcement is the most watched in a long time

Web Log Pages

Generational Dynamics Web Log for 31-Oct-07
Wednesday's Fed announcement is the most watched in a long time