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Wednesday July 11, 2007 - 12:30:10 GMT
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New Credit Religion Rising in the Land

Key News
• Japan's 10-year bonds headed for the biggest gain in almost 10 months after credit-rating downgrades of U.S. subprime mortgages sparked demand for government debt. (Bloomberg)
• The national median house price [in New Zealand] dropped by at least $2500 in June, according to latest figures from the Real Estate Institute. The drop follows an increase of $45,000 over the last year. The national median price dropped from $350,000 in May to $347,500 in June, the figures show. (NZ Herald)
• Key Reports:
7:00 a.m. MBA Refinancing Index. Previous: -2.6%

“This is a delusion about credit. And whereas from the nature of credit it is to be expected that a certain line will divide the view between creditor and debtor, the irrational fact in this case is that for more than ten years debtors and creditors together have pursued the same deceptions. In many ways, as will appear, the folly of the lender has exceeded the extravagance of the borrower.

“The general shape of this universal delusion may be indicated by three of its familiar features.

“First, the idea that the panacea for debt is credit.

“Second, a social and political doctrine, now widely accepted, beginning with the premise that people are entitled to certain betterments of life.

“Third, the argument that prosperity is a product of credit, whereas from the beginning of economic thought it had been supposed that prosperity was from the increase and exchange of wealth, and credit was its product.”

Garet Garret, A Bubble that Broke the World, (Published in 1932)

FX Trading – New Credit Religion Rising in the Land?

A liquidity systems check may be in the making thanks to Standards and Poor’s and Moody’s new religion on the credit front. No matter that our “esteemed” credit raters past threw Triple-A ratings on a whole host of subprime-related junk when things looked peachy i.e. home prices were heading up; they now see the light. Why wouldn’t they try to get out in front of this debacle before their reputations are completely shattered?

Heck, with a good public relations campaign in front of them, our ratings agency heroes might still fool the average man into believing rating debt securities is about little things such as due diligence and a modicum of understanding of the potential risks of what one is rating. But the sad reality seems rating debt is about what most things are about—money. More specifically in this case—fees! Bankers and credit agencies have cobbled together a very nice subprime fee manufacturing machine. Here’s a look:

The subprime fee manufacturing machine:

Function: Fee Generation i.e. Higher Credit Ratings = Higher Fee Generation

Moving Parts: High Credit Ratings on Subprime = More Credit Issuance = More Derivatives Manufactured = More Credit Ratings Fees & Banking Fees = Lower Balance Sheet Capital Requirements per $ of Credit Manufactured = More Leverage for Speculation into Risky Assets = More Hedge Fund Heroes = More Private Credit Money Availability = More Derivatives Issuance = More Fees

There is only one problem with this marvelous machine, all the moving parts are predicated on one key element—rising home prices. Because no matter how many iterations one moves away from it, sooner or later the market has a way of zeroing on it when the business cycle turns. You know what it is; we’ve talked about it many times before. It’s collateral. And it’s a very scary word in a world built derivative upon derivative upon derivative.

This excerpt from a recent issue of Jim Grant’s Interest Rate Observer may help you understand why such a thin layer of collateral can manifest in system that has both rules and regulations.

“Under CSE [Consolidated Supervised Entity, a new regulatory system for broker-dealers], the broker-dealers (in voluntary fashion) are implementing the risk-based capital rules known in the trade as Basel II. The liberating feature of Basel II is that the financial institutions to which it applies may hold more assets per dollar of equity capital than they previously could—provided that a ratings agency judges the assets to be top-flight. Specifically, under Basel II, a broker-dealer must set aside just 56 cents in capital to hold $100 of triple-A-rated securitizations—but $4.80 to hold $100 of triple-B-rated securitizations. [That’s an eight-fold difference in cap requirement!] Inasmuch as structured mortgage assets—event he combustible material in the Bear [Stearns] funds—are usually rated Aa or Aaa, Basel II has been a force for rapid balance-sheet growth.”

So, we could see a dash for cash by broker-dealers. Yes, the same broker-dealers who have doled out a lot of credit to hedge funds and private equity types everywhere. Liquidity would drain from the system if the dash gets underway. For now the currency guys are seeing this as a US problem leading to a slowdown in US GDP. We think that is only partially correct. The US may be ground zero, but the credit implications are global. And though we’ve been blowing this horn way too long, maybe this will finally be a trigger for some kind of reversal of all the so-called carry trading that has made credit look so darn good in this cycle. All things have to end sometime. After all, that’s what religion is all about.

Jack Crooks


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