Has This Cheap-Money Bubble Finally Croaked?

Adrian Ash - Fri 29 Jun, 2007

Clang! Clang! Ask not, gentle reader, for whom the closing bell tolled. Wednesday, 28 June 2007 might just go down in history as the day this cheap-money bubble finally croaked. "Mortgage payments are going up, up, and up...and so are delinquencies and defaults," writes Gross, adding that 7% of subprime US mortgages are now in default. In fact, says the Wall Street Journal today, the number of subprime US mortgages now in or near default has reached 13% of the total. - Clang! Clang! This contagion of debt has already hit the London money markets...

- Clang! Clang! Ask not, gentle reader, for whom the
closing bell tolled. Wednesday, 28 June 2007 might just
go down in history as the day this cheap-money bubble
finally croaked.

- "American mortgage crisis forces buyout firms to pull
debt offering," reports the Times today. "The collapse
of the high-risk mortgage market continued to send
shockwaves across the American economy yesterday as
the buyout firms KKR and Clayton, Dubilier & Rice
were forced to pull a key debt offering to finance a
recent takeover."

- The trouble at Bear Stearns' hedge funds, in other
words, has leached out – and the supermen of the private
equity market couldn't raise debt on Wall Street on
Wednesday. KKR and CDR were planning to raise $1.55
billion in bonds to pay for their most recent buy-out.
But they found the liquidity drain blocked. That left the
deal's underwriters to stump up a quick bridging loan.

- You might think one-point-five billion just chump-
change in the corporate bond market. After all, leveraged
loans funded $880 billion in mergers and acquisitions
last year, according to Standard & Poors data. But KKR
and CDR would still have needed to raise a further $2
billion in bonds to get their deal done. And suddenly
everyone is eyeing the risk of default.

- Why has the collapse of Bear Stearns' mortgage-backed
hedge funds created a problem for private-equity firms?
"Derivatives are a two-edged sword," writes Bill Gross,
head of Pimco – the world's largest bond fund. "Yes, they
diversify risk and direct it away from the banking system
into the eventual hands of unknown buyers, but they
multiply leverage like the Andromeda strain. When
interest rates go up, the Petri dish turns from a benign
experiment in financial engineering to a destructive
virus because the cost of that leverage ultimately
reduces the price of assets. Houses anyone?"

- Gross points to the mile-upon-mile of new houses
"financed with cheap and in some cases gratuitous money
in 2004, 2005, and 2006." Littering the boom towns of the
US, these houses "are not going anywhere," he says –
unlike their mortgages.

- "Mortgage payments are going up, up, and up...and so
are delinquencies and defaults," writes Gross, adding
that 7% of subprime US mortgages are now in default. In
fact, says the Wall Street Journal today, the number of
subprime US mortgages now in or near default has reached
13% of the total.

- Clang! Clang! This contagion of debt has already hit
the London money markets. On Monday, Queens Walk – a
listed hedge fund – admitted that it's written off
HALF the value of the subprime US mortgage-backed bonds
that it's holding. The fund also said it would slash
the gearing its uses – the derivative leverage that
turns £1 into £10 via the credit market – from 25 times
to just seven.

- Where to from here? "A recent research piece by Bank of
America estimates that approximately $500 billion of
adjustable rate US mortgages are scheduled to reset
skyward in 2007 by an average of over 200 basis points,"
says Bill Gross. "2008 holds even more surprises with
nearly $700 billion ARMS subject to reset, nearly three-
quarters of which are subprimes."

- Clang! Clang! Here in the UK, one million home-owners
will meet the end of their fixed-rate deals in the next
12 months, says the Financial Times – your correspondent
amongst them. The trouble has barely begun, in short. "It
is only since last month that those whose fixed rates
were expiring found themselves facing a bigger bill for a
new fix," notes Gary Duncan in today's Times. "Now ever-
rising numbers of people with expiring fixed-rate loans
will face an unappetising choice between a more expensive
variable rate, or a new, more costly fixed offer."

- None of this would need to cause trouble beyond a mere
house-price crash and consumer slump – if only it weren't
for the credit derivatives issued against so much of the
world's outstanding housing debt. Running up debt – a
promise to pay in the future – can only last as long as
the promise comes good. Squaring that promise by issuing
a derivative against it only increases the chance – and
the cost – of it failing.

- Once the promise is broken, and defaults start to kick
in, even the laziest lender finds it hard to accept fresh
I.O.U.s. Squaring fresh promises with financial magic
becomes tougher still.

- Just how much mischief now lies ahead? The greatest
unknown in the credit markets today is the weight of
credit derivatives issued against somebody else's debt.
When Delphi Corp. – the US car-parts firm – went bust in
October last year, for instance, investors holding credit
derivatives as insurance were entitled to MORE than the
value of Delphi Corp.'s bonds.

- More than ten times as much, in fact... 

Regards

Adrian Ash
For The Daily Reckoning

Adrian Ash is head of research at BullionVault.com the world's fastest-growing and best-value gold ownership service.

http://www.bullionvault.com/from/dailyreckon