Wednesday March 1, 2006 - 11:30:32 GMT
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Black Swan Capital - www.blackswantrading.com
A bit more esoteric than usual this morningâ€¦but we are increasingly concerned by the market complacency we witness on a daily basis among the players.
â€śI believe the asymmetry arises out of a reflexive connection between loan and collateral. In this context I give collateral a very broad definition: it will denote whatever it is actually pledged or not. It may mean a piece of property or an expected future stream of income; in either case, it is something on which the lender is willing to place a value. Valuation is supposed to be a passive relationship in which the value reflects the underlying asset; but in this case it involves a positive act: a loan is made. The act of lending may affect the collateral value: that is the connection that gives rise to the reflexive process,â€ť writes George Soros.
It is probably understood by most participants now that an erosion of collateral values can depress the economy. (Is the inverted yield curve telling us anything?)
Loans and credit is extended during the â€ścognitive functionâ€ť, as Soros puts it i.e. this is when lenders and borrows pull out the crystal ball of expectations to view why this extension of credit will easily be repaid based on the future value of the underlying collateral and/or its ability to generate cash flow to cover the interest (and principal). But unfortunately, itâ€™s the â€śparticipating functionâ€ť as a result of those future events not playing out as our crystal balls suggested that leads to a â€śperverseâ€ť connection that can quickly erode those once seeming solid collateral values.
â€śCausa remota of the crisis is speculation and extended credit; causa proxima is some incident which snaps the confidence of the system, makes people think of the dangers of failure, and leads them to move from commodities, stocks, real estate, bills of exchange, promissory notes, foreign exchangeâ€”whatever it may beâ€”back into cash. In itself, causa proxima may be trivial: a bankruptcy, a suicide, a flight, a revelation, a refusal of credit to some borrower, some change of view which leads a significant actor to unload. Prices fall. Expectations are reversed. The momentum picks up speed,â€ť writes Charles Kindleberger.
A couple of tidbits from the most recent issue of Grantâ€™s Interest Rate Observer dated 24 Feb 06:
â€˘ â€śThe defining fact of the corporate bond market in 2006 is that, by value, there are many more credit derivative swaps (CDS) than bonds, i.e. more derivatives than things from which the derivatives are supposedly derived. In the four years ended in mid-2005, the CDS market grew by 19-fold, the bond market by only 38%. At last count, the CDS market totaled $12.4 trillion at face, or notional, amount, the corporate bond market a mere $5 trillion.â€ť
â€˘ â€śWithin the next 12 months, an estimated $200 billion of adjustable-rate mortgages will reset, jolting their obligors with increases in monthly payments as much as 70% greater than the teaser rates originally incurred.â€ť
Credit derivative swaps and/or real estateâ€”do we hear any votes for potential causa proxima?
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