The dollar, still a currency that you run to?
There clearly has been a flight to liquidity recently. T-bill yields have collapsed (See the Econocator). Perhaps because of the Fed. Perhaps because folks are hoarding cash and nothing that pays interest is as close to cash as a T-bill.
And a rather significant unwinding of the carry trade. The Icelandic krona has fallen by more than 15% against the yen. The Kiwi has also sold off. Ms. Watanabe didn’t step up to dampen this bout of volatility …
The yen has rallied. Significantly. That makes sense. It was a big funding currency. And if credit is no longer going to be quite as readily available to finance deficits, the currencies of countries with current account surpluses are – one assumes – safer than the currencies of countries with large deficits.
Most big deficit country currencies are falling: the Australian dollar, the British pound, the Turkish lira as well as the Icelandic krona and the New Zealand dollar.
But the currency of one deficit country – the United States dollar — also rallied.
No matter that that the origins of this particular crisis are clearly in the US – and in the one area of the finance (turning subprime mortgages into triple AAA credit through financial engineering) where the US unambiguously had a comparative advantage. A couple of weeks ago the IMF even argued – in its summary of the staff papers that accompanied the Article IV — that the United States’ unique ability to create complicated financial structures would continue to pull funds into the US, and thus help finance the US current account deficit.
“Many industrial countries still have much to gain from further international diversification. Combined with innovative US fixed income markets providing many assets that simply are not available elsewhere this suggests … that a significant fraction of industrialized countries funds …will be directed toward US fixed income assets.”
Oops.
Can a bout of global risk aversion that has made much of the "innovative" US fixed income market illiquid really provide more support for the dollar than demand for US financial engineering ever did? Bloomberg reports that is could:
““This is where people take refuge,'' said Komal Sri-Kumar, who oversees $145 billion as chief global strategist at TCW Asset Management Co. in Los Angeles. “The dollar is still a safe-haven currency.''
Talk about a Teflon currency.
Can in it be that a credit crisis in the US is actually good for the dollar? In good times, the world clamors to buy US financial alchemy. And in bad times the world clamors to buy US treasuries. No matter what, the US deficit is financed.
The dollar, along with the yen and swiss franc, seems to have been a popular funding currency. That means folks borrowed dollars to finance their investment in high-yielding currencies like the Brazilian real and Turkish lira, betting that the dollar would fall against these currencies. John Authers:
Then there is speculation. Marc Chandler, strategist at Brown Brothers Harriman, says the dollar, like the yen and the Swiss franc, has become a “funding currency”: traders sell the dollar short, and use the profits generated as it falls to invest elsewhere. As they lose on those other investments, they remove their “short” positions – or, in English, buy dollars
And right now all funding currencies are rallying, and all destination currencies are falling – even the currency of a country like Brazil that doesn’t have a current account deficit. The real is down by something like 4% today ….
The US dollar though is a strange funding currency. The US after all, needs big capital inflows to finance its current account deficit. The US consequently differs from Japan and Switzerland, countries that save more than they invest and thus have funds to lend to the rest of the world. US investors could only borrow dollars to invest in say Turkey because foreign investors were putting more funds into the US than the US needed to finance its current account deficit, leaving some money left over to finance US investment abroad.
There are presumably two other reasons for the dollars recent rally.
US investors with profits on equity investment abroad are selling those investments to raise cash, and in the process buying dollars. Everyone wants a bit more liquidity. John Authers, again.
The retreat from risk is more important than fundamentals. US investors have invested heavily outside the US. Faced with subprime losses, they have taken profits. The net effect is to buy dollars.
It turns out that a lot of “European” demand for long-term US corporate debt was financed in the US money markets. European – and some US – financial institutions set up “conduits” and structured investment vehicles to borrow short-term in dollars in the US money market and buy long-term US debt, often repackaged mortgages and the like. Now I would bet some institutions that cannot access the US commercial paper market are borrowing in euros and then selling their euros and Canadian dollars to buy US dollars.
The ECB injected awful lot of liquidity into the market after a couple of European institutions got into trouble … .
But over time, well, the US still will have a big deficit to finance. The US economy seems more likely to slow than to accelerate, but the slowdown won’t reduce the US deficit all that quickly (especially if interest payments rise). The ECB seems more likely to rise than to hold, while the Fed may cut. Interest rate differentials should shrink.
Private inflows were not large enough, in net, to finance that deficit even when there was a lot of appetite for financial engineering. The world’s central banks will no doubt continue to help the US out. But they too would rather not have all their eggs in one basket –
And then, as Barclays notes, European and others have been big buyers of US equities – and if the US slows and there is a general flight away from risk, then US money coming home should be matched for European money coming home.
“Foreign investors are also likely to trim their holdings of US equities in this situation and the fact is they have bought as much US equities as US investors have bought foreign equities since the global equity markets began to recover in 2004. Is there any reason to think American investors will bring money home faster than foreign investors will reduce their holdings US equities? At least in recent history, there has been no such example.”
Count me among the skeptics that bad news in the US is good news for the dollar – at least over a longer-time horizon. Like Goldman, Merrill and Barclays, I would expect that problems in the US credit market will reduce foreign demand for US corporate debt, and thus for US dollars. That – particularly in conjunction with slow US growth — likely means ongoing dollar weakness and ever greater reliance on central bank financing …
“Talk about a Teflon currency.”
Brad, do you sometimes feel like you are trapped inside a story by Kafka?
It seems to me that the effective dollar region is so large that the currency is a sort of rogue animal outside Fed control. Like a lot of things in a globalizing world, there is no single “jurisdiction” with a handle on it. A patchwork of regulators means there is effectively no regulation.
I keep thinking of the line from Mel Brooks. It’s good to be the king.
Perhaps some people have thought that the dollar is a good funding currency because certain commentators keep saying that depreciation is inevitable!
Brad, what have you done!
Every body is fleeing to treasury market for safety.The treasury volumes have declined from
1.1 tn in july 2005 to 900 bn now.The problem here is that there is debt ceiling on the amount
of debt that treasury can hold.As more people start to buy & hold treasury and no more new
debt can be issued, there will a liquidty freeze in the treasury market on the buyer side
as more people hoard treasury.
The soln to this is increasing the debt ceiling,but it is a political problem.Democrats dont
like Paulson policy and obviously republican policy. Democrats want bush to vacate iraq for
further funding,But i dont think bush will allow that.
1995 crisis on d3ebt ceiling can be revisted to get some insight.
Investors will be caught naked as they have all flood gates opened as treasury market freezes.
am i the only one, or is some sort of bizarre code in the comments section making the pages wierd? - this one was normal until the first comment was added and it seems to be formatted differently….
Treasury is already technically default as of now. Investors are really foolish to invest
in treasury that is sooner going to be insolvent soon unless democrats and republican come
to terms. IF Dems passes vote without any agreement ,reps can siphon funds to finance iraq
war.Dems will be suspicious about that
i wrote the prevoius post.
something strange did happen with the comments — i reposted STS’s comment with the intent of taking down his initial comment to try to clear things up, but well, i cannot take things down right now. there were some changes on the tech side that must be doing something here.
If people have no place to invest.they believe gold as the safe haven. That cannot be.
If US economy goes into a mild recession, South Asia,Turkey,Egypt will go into a depression.
That will free 1600 tons of gold per year into the market plus 20000 tons accumulated by jewellery
demand in these countries. Total production of gold is 2600 tons, investment demand is 600 tons
or even less. gold will collapse in these circumstances.
Sooner all money created from thin air will disappear in thin air. All the purchasing power
of people will come back especially for labour putting these financial institutions into
bankruptcy and revieve the common man from these vicious trap
Some error in the website. MY comment is repeated twice
Is there reason to believe that many of the securities manufactured out of subprime loans are worse? http://www.bbc.co.uk/blogs/thereporters/robertpeston/2007/08/us_exports_poison_1.html I’m afraid so. Here are just three reasons:
1) As the FT pointed out this morning, many of the underlying subprime loans were taken out by fraudsters and will therefore never be repaid in full.
2) When repackaged as mortgage-backed bonds, they were given ratings by the credit rating agencies based on delinquency experience during the benign conditions of the past few years - which almost certainly means that the ratings flattered their innate (poor) quality. Or to put it another way, investors have bought the financial equivalent of poisoned mutton dressed as prime lamb.
3) Hundreds of billions of dollars of these mortgage backed bonds have been re-engineered as collateralised debt obligations. These CDOs are customised bonds of varying quality and varying yields. There is nothing intrinsically noxious about them. However there are CDOs made out of other CDOs, called CDOs squared, which are marketed as high quality investments - and they’ve been bought by the “one-born-every-minute” brigade. What’s more, there’s accumulating evidence that even the simpler CDOs have been bought by naïve investors, who had no idea what they were buying.
It is wonderfully ironic that a disproportionate share of losses from America’s dodgy mortgages should be borne by financial institutions in France and Germany - and that the European Central Bank is pumping cash into the banking system to avert a possible crisis.
The incongruity is that the Anglo-American model of financial markets is despised in many European capitals; it is droll that their banks were seduced by Wall Street. But although I allow myself a chuckle, it is a hollow one. I fear there’ll be plenty more damage to come from America’s exports of subprime poison.
PPT is in full swing
our tech guys should have the comments looking a bit more normal in a bit (mozilla works fine now, but explorer is a bit off). back to the regularly scheduled discussion of why exporting subprime didn’t make the $ into a subprime currency …
For once, I flat out disagree! (Maybe I’m not an RGE toady after all
Since Macro Man is on vacation, I decided to look at the AUD/JPY and NZD/USD charts myself.
It’s very simple, really. US structural weaknesses are not going away by some sort of (dark) magic. Rather, speculators are forced to liquidate their positions abroad due to hedge fund withdrawals and margin calls back in the States. In other words, to meet funding requirements at home, they have to liquidate positions abroad–good or bad–to cover losses.
Sorry, but I simply cannot stomach the idea that the dollar is a “safe haven.” Do have a look at the charts on my humble site that explain recent carry trade movements. As I’ve said, if the dollar is a “safe haven,” then downtown Baghdad is a “zone of tranquility.”
“It seems to me that the effective dollar region is so large that the currency is a sort of rogue animal outside Fed control. Like a lot of things in a globalizing world, there is no single “jurisdiction” with a handle on it.” - STS
i go with that. the dollar is ?60 per cent of global currency. the united states only conducts ?25 per cent of world trade. so in some sense the dollar is a lot bigger than the american trade deficit/surplus ?
there are hints in the previous thread that people are learning to think outside ‘america’, ‘china’, and nation states as the actors in global financial affairs. the political framework has fallen behind the economic globalisation. it will probably stay that way unless we have a bout of protectionism / xenophobia / blame gaming / war.
And right now all funding currencies are rallying, and all destination currencies are falling - even the currency of a country like Brazil that doesn’t have a current account deficit. The real is down 5% today.
If brazil central bank had said that it is going to sell their dollar reserves, things could have been much more differnt. Brazil
has 260bn reserves to protect their currency from extreme volatility. Dollar rise is a short term phenomena. Sooner fundamentals will kick in
Of course a credit crisis is good for the dollar!
The immovable object that the dollar is resting comfortably on is approximately $1 Gazillion (Gz) dollars in debt. Debt is demand for dollars, pure and simple. Since there are only 1 Trazillion (Tz) dollars in the world, and 1Gz = 1000 Tz, any hiccup in the CB-controlled credit markets, and debtors will scramble for dollars the way famine-starved children scramble for a Baby Ruth.
The ugly truth of the matter is that there is no way for a financial market to distinguish between insolvency and illiquidity. The price of debt is the price of debt. It is set by supply and demand. If the yield curve goes ape and the market price of the debt you hold falls below your liabilities, you can become insolvent even with no change in counterparty risk. Of course, if this is happening to many financial players, there will be a change in counterparty risk, but so it goes.
But this is the fast feedback loop. As Brad points out, in the long term this is bad for the dollar.
The slow feedback loop will take several months to kick in, because it has to cause a recession, which in turn triggers rate cuts. Revealing that CB Nation cannot - politically - sustain interest rates of 5%, even while broad money aggregates are growing at 15%.
And triggering anew the search for any good whose demand can remain reasonably proportional to the money available to buy it. Imagine you actually have a savings horizon of 30 years. Over 30 years, 15% is a lot higher than 5%.
This is the irresistible force that goes with the immovable object. Together they create the lovely phenomenon we know as the business cycle.
Economic reasoning tells you the dollar should go to infinity. Political reasoning tells you it should go to zero. As a long-term investor, you are probably better off relying on the latter. As a short-term investor, if you know how to play the cycle you can make bank in both directions.
Someone asked the other day why gold lease rates had spiked. We now know. A classic attack on the spot market using leased metal. This would not work if investment demand for gold was anything but negligible. But perhaps it will not always be negligible.
Quotes of the Day from Henry Paulson and Hillary Clinton:
U.S. Treasury Secretary Henry Paulson said today that he is a big believer in a “strong dollar”, but reiterated that China’s currency needs to appreciate more against the greenback. The Chinese negotiators may be left asking themselves, If the big chief from Goldman Sachs thinks you can appreciate and depreciate a currency at the same time, what do Americans want?
From the London Telegraph: Hillary Clinton has called for restrictive legislation to prevent America being ‘held hostage to economic decisions being made in Beijing, Shanghai, or Tokyo. Hilary Clinton’s proposal would ban the Chinese from buying American bond securities. That would be a change for the better for the Chinese. LOL
re: “their banks were seduced by Wall Street” - during the ‘tech meltdown’ one of Dilbert’s better cartoon strips boiled the guilty pleas down to two choices: 1) corruption, which generally requires someone: a) with great intelligence to take advantage of others’ incompetence, or b) mutually corrupt participants or; 2) incompetence of one or more players who are dealing with others who, presumably, are mutually or relatively more incompetent. So which option should Europe, the US, Asia et al. choose? Looking at this year’s bonus expectations, perhaps the 3rd option may be that, having already exceeded last year’s profits, key players decided to cut any risks and exit for the remainder of the year.
moldbug - interested in and appreciate everything you have to say, but how do key gold market participants (i.e. Munk), along with Indian jewelers and new waves of resource nationalization to mention a few, factor into what appears to be your ongoing faith in gold?
Might the USD’s moves now be driven more by its’ apparent role both as the foundation and grease for this market? http://www.morganstanley.com/views/perspectives/index.html
I like Hillary.
Alhamdulillah!!
“Abu Dhabi National Energy Co., better known as Taqa, expects to spend as much as $3-billion (U.S.) over the next 12 months buying Canadian oil and gas producers, the company’s chief executive officer said Thursday…” http://www.globeinvestor.com/servlet/story/RTGAM.20070816.wtaqa0816/GIStory/
The US hasn’t exceeded the debt limit, because the public debt includes small amounts that aren’t included in the ceiling. Also even if the US were to stop issuing debt there is a liquid secondary market in treasuries.
As far as MBS’s…..
Most mortgage backed securities have a provision that if the mortgagee defaults that the issuer pays the defaulted value. Since the issuer is typically an investment bank, this is why they have high credit ratings. The credit risk on MBS’s is very low, but there is a catch…….
The big risk in mortgage backed securities is prepayment risk. If the seller refinances or if they move, and the MBS is prepaid, the value of the MBS drops dramatically. A default by the homeowner is a prepayment since when the homeowner defaults, the issuer of the security repays the principal. Repaying the principal now causes the value of the MBS to drop dramatically.
Munk (of Barrick) has a bad reputation in various segments of the gold world, mainly due to his involvement in the mega-hedging of the ’90s. Why anyone would buy stock in a hedged gold miner is beyond me. If you want a straddle, buy unhedged miners and do the shorting yourself.
Resource nationalization is nothing but a boon to the bullion market. “Gold in the ground” is a competitor of bullion. Unmined gold in politically unstable countries has limited upside. Its counterpart in politically stable countries is environmentalism, which is even better for bullion.
The basic argument for gold is that it’s the only exit from this mad game of inflate-deflate-inflate. Furthermore, the more people take this exit, the brighter the sign will glow.
Gold has always been the enemy of bankers, central and otherwise, and the memetic genome of economics over the last century has been quite extensively crossbred with the financial industry. The result is that inflationism, along lines that were well-known in 1907 and even 1807, at which time it was the exclusive property of cranks and crackpots, became the conventional wisdom. Keynes and Fisher merely put a mathematical spin on the panaceas of Gesell and Major Douglas. It is a tough race to see who is more anti-gold, Ben Bernanke or Ezra Pound.
As the Internet ascends over conventional channels of information flow, it routes around this corruption, and understanding of preinflationist economic and monetary theory tends to improve. This predicts an increase in investment demand. Investment demand in gold tends to be self-fulfilling, because gold is a currency - its price is primarily a function of demand from savers. There is always at least one commodity in the world whose price is distorted by savings. At present the monetary effect on gold is very weak, but it is still enough to make the price of an ounce $650 instead of $65, much smaller than the dollar-to-toilet-paper ratio but still nontrivial. Much of the savings demand at present comes, as you allude, from the Far East, where “jewelry” tends to be crudely worked and sold by weight, in many countries largely to women.
I guarantee you that none of these women has read Ludwig von Mises, or is about to. So as the East modernizes one could imagine a dropoff in gold demand as these “paleo-goldbugs” shift to more “sophisticated” investments. However, (a) we are not seeing this, and (b) it is liable to be dwarfed by “neo-goldbugs” who buy new instruments such as ETFs. If Mrs. Nakamoto abandons AUD for AU, all kinds of crazy hell will break loose, because AUD is at least controlled by a monetary authority who has to answer politically to exporters if Japanese housewives drive it through the roof.
At present the CBs are able to use their vast gold hoard to prevent catastrophic drops in the price of their currencies relative to gold. They can also disrupt the credit cycle, as they are doing now, to make cash arbitrarily desirable. So the battle may be very long. I would certainly not recommend gold as an investment to anyone with a horizon under three years.
Also, as jewelry, gold is tacky and flashy. (Western consumption of gold jewelry has been declining consistently.) White metals are far more chic, whether you are male or female. I believe this trend is fundamental and I expect it to continue in the long term
don’t you mean mold? i don’t understand why anyone would put any store in gold.
emmanuel — i must have been too cryptic, since i think this is more a delevaging/ carry/ long em stock unwind than any fundamental statement about the dollar. I put a question at the end of the post’s title for a reason.
RE — deeply appreciate your comment … it in some sense is right. some for a deficit country to be a funding currency someone else has to lend it the money …
http://www.financialsense.com/editorials/blumen/2007/0813.html
Does the decline of US manufacturing and the growing trade deficit portend a collapse of the dollar? The many seemingly problematic features of the global economy can be understood as consequences of the growth of a new breed of US companies.
These “platform” companies come into being through the restructuring of existing companies. What starts out as an integrated manufacturing firm eventually divides into two specialized firms. The company first relocates its manufacturing operation offshore, typically to China and then spins off the offshore manufacturing arm entirely. What’s left, ex-manufacturing, is a “platform company”, a firm whose business is to buy finished goods and then to provide marketing, distribution, branding, and retailing.
The growth of these companies explains the more or less permanent advantage that the developed world has over emerging economies. Their argument can be summarized as follows:
1. The global economy is divided into two sectors: manufacturing (located in China); and platforms company economies (the developed United States).
2. The process of reorganizing a firm into a platform company is a model that can be adopted by firms in the developed world.
3. As more firms make this transition, the developed nations are becoming Platform Company Economies.
4. Platform companies earn a high return on investment, while manufacturing firms earn a low return on investment. This permanent returns differential accounts for a sustainable higher standard of living for those in the platform nations.
It is not clear that the trade deficit as such is a problem for the high investment return United States economy.
Redemptions
platform companies? Now? How about discussing the carry unwind instead?
(note that the material from blumen pasted in above is taken out of context; blumen is critical of the GAvekal argument)
“…An IT society supersedes the old zero-sum paradigm and Fordist mass-manufacture. It rewrites the orthodox laws of market economics. The ability of immersive multi-modal VR to make one - depending on the software title one opts for - Lord Of Creation, Casanova The Insatiable etc puts an entire universe at one’s disposal. This can involve owning “trillions of dollars”, heaps of “status-goods”, and unlimited wealth and resources…” http://www.huxley.net/
Twofish -
Forgive me for being a bit slow, but I’m not sure I understand how prepayment of mortgages bundled into a mortgage backed security can result in a large decline in value in that security. The holder of the MBS loses future interest payments,but surely can reinvest the amounts prepaid. This must have something to do with discounted present value of interest payments sliced and diced into derivatives along with the principle. This suggests that the MBS holder took a fat interest rate spread when repackaging. Can you enlighten me?
Reason for the recent dollar rally against the euro?
The explanation often heard is something like this:
But the main reason why investors are renewing their relationship with the dollar has more to do with a lack of places to hide during the volatility that has given financial markets their worst shakeup in about five years.
Above from:
http://www.canada.com/nationalpost/financialpost/story.html?id=de62a96f-318f-4ad6-ba24-47977077667a&k=22458
or something like this:
“The dollar continues to gain ground over both the pound and euro as concern mounts as to just how strong the European economies are now looking,”
Above from:
http://www.forbes.com/feeds/ap/2007/08/16/ap4025647.html
An alternate explanation was left by someone using the name AFFG on 2007-08-14 03:28:22 on the comments to Nouriel Roubinis article “The Moral Hazard Effects of Recent Central Banks’ Liquidity Injections”:
Third a most important. The European Banking System is being drained. But to understand what is happening, you have to know that the US Banking Industry owns a large amount of assets in the Eurozone which most probably were purchased by hedge funds and other jerks with massive leverage. They are now liquidating all that in order to deleverage. That is why the european stock market gets hit so hard and banks are in deep need of cash. The cash then goes on the forex and causes a big demand for dollars. The dollar starts to strengthen against the Euro.
In conclusion, many factors are probably at play for the reason for the current surge in USD value. Some of the factors are not as ‘big’ as others, however.
re: “none of these women has read Ludwig von Mises”
but perhaps Juerg Kiener and Reuters:
“…The yen carry trade has been unwinding, not collapsing, he said, adding that the trend is not over yet. The low-70s could be good buying area for crude… cash is a very good area to be, dollar cash maybe short-term because if you unwind leverage and all the debt is US owned, you have got to buy US debt. So in the short-term, US dollar cash might be looking very interesting… If you think the central banks have been spending USD 500 billion, you put that into the banking system, it is going to be USD 5 trillion of credit creation over the next six months. That is 15% of the global economy, which means you just lost 15% purchasing power. Cash position will not pay you that kind of returns and as a result people will be flocking to gold. Look at the Indian purchasing of gold for last year, it has been an increase of 72% and it is growing rapidly. We see the same trend elsewhere in the world too…” http://www.moneycontrol.com/india/news/fii-view/accumulate-precious-metals-further-swiss-asia-cap/13/31/298128
“…Investors were reluctant to sell gold heavily on expectations that cash gold’s fall will be cushioned by physical buying from India and the Middle East… Pradeep Unni, an analyst at Vision Commodity Services in Dubai… pegs support at $658…” http://today.reuters.co.uk/news/articleinvesting.aspx?type=goldMktRpt&storyID=2007-08-14T071810Z_01_T175680_RTRIDST_0_MARKETS-PRECIOUS-UPDATE-2.XML&pageNumber=1&imageid=&cap=&sz=13&WTModLoc=InvArt-C1-ArticlePage1
Blog Statement: “But the currency of one deficit country - the United States dollar — also rallied.”
Comment: The bottom line (in my opinon) is that as long as the Central Banks, the people and institutions, worldwide, are ready willing and able to hold (and increase) their dollar cash and other dollar assets, the dollar will rally and the dollar will continue to be the world reserve currency. I continue to be a dollar bull, because USA is the worlds superpower. A transition of power may be taking place, but, if so; it will take decades. For example the transfer of power from UK to USA. Furthermore, most of the huge illegal trade in narcotics and human beings, worldwide, apparently is financed in dollars.
well, right now the yanks are willing to sell their foreign assets to buy $ — and central banks are willing to add to their $ holdings — so the deficit is financed ….
USD — yes, the eurozone seems to be slowing. but then again, the us also seems to be slowing.
if everybody hoard treasury, the treasury market will freeze on the
buyer side as there will be no sellers
FR: Forgive me for being a bit slow, but I’m not sure I understand how prepayment of mortgages bundled into a mortgage backed security can result in a large decline in value in that security.
If someone has a 30 year note for $100,000 that is pays 3.5 percent above inflation, that note is worth $160,000 in current dollars. If someone repays, that note is worth $100,000. Yes, he can reinvest that $100,000, but if the note didn’t have a prepayment option, he could have sold it to someone else for $160,000 cash and reinvested that. The amount of money that you lose when someone prepays their mortgage is huge and in practice, it’s going to be a lot more than default (which on prime mortgages are rarely above 1%).
Now here is the tricky part. You aren’t dealing with one note, you are dealing with a basket of thousands. In order to value a mortgage backed security, you need to have a prepayment model, which is one of the hardest and most difficult things to create in finance. It’s hard because in most other financial situations, the decision process is easy. On a American bond option, if the holder can make money exercising the option, you assume they do, if you can’t make money exercising the option, you assume they don’t,
Mortgages are different because people prepay there mortgage for non-financial reasons (i.e. you move to a bigger house, the first note gets paid off). So the function that says given a mortgage paid to someone with a FICO score of X, which has been held for Y years, and has be interest rate of Z, what are the odds that this mortgage will be prepaid is not one that you can mathematically derive since it contains a lot of human psychology…..
One thing that seems to have overturned the apple cart, is that if the borrower says he has FICO score X, but he actually has a real score much less than that, or if he is buying a mortgage that does have a historical record behind it, your prepayment models can be wildly off.
Satish: if everybody hoard treasury, the treasury market will freeze on the buyer side as there will be no sellers
At which point the price will go up until the sellers sell and the buyers buy.
One thing that does concern me a bit is I’m seeing a “second domino” fall. There are a lot of quantitative hedge funds (Goldman Asset Management and Renaissance) that are reporting 2Q large losses. What concerns me is *why* they are reporting large losses. It’s unlikely that they had much direct exposure to the sub-prime market, so where do the losses come from????
My guess is that they were using options to hedge against shifts in the stock market, and the mortgage fiasco has introduced volatility to the market that wasn’t taken into account by those models. At this point, the pricing models for the options don’t work anymore, and the hedges reverse and become leverage.
It’s always disconcerting when you see a second domino fall, because you start wondering about the third, fourth, and fifth.
Moin from Germany,
I usually don´t link to my blog but i have posted a graph that shows the performance of the major currencies during times when risk aversion is on the rise ( since 1998 )
So i hope it is ok not to “spam” your excellent blog.
http://immobilienblasen.blogspot.com/2007/08/economist-summary.html
Moldbug: If you have a reference for your point about the estimated value of gold without investment demand, I would be very interested to know it.
Twofish: I too had the same difficulty as FR. I can see your point about MBS, but it seems to me that, since mortgage rates have not been falling much, the value of the prepayment option will be low, so even if gets exercised for administrative reasons, the loss to the MBS holder will be minor.
USD: I think AFFG is short for “A Friend From Germany” and he (she?) does seem to know what he is talking about regarding Europe. He is wasted on the other RGE channel!
Thanks much, Twofish, for a very clear explanation.
“According to actuaries Aon Consulting, the UK’s 200 biggest final salary pension schemes had a deficit of £26bn at the end of trading on Thursday. That compares with a surplus of £9bn in mid-July…” http://news.bbc.co.uk/2/hi/business/6950990.stm
Mortgage hedgers get slaughtered when treasury rates (which they must use to delta hedge) move more quickly than mortgage rates (option gamma).
“…The U.S. budget deficit is 3.6% of GDP, and its current-account deficit equals 6.4%. Hong Kong, by contrast, sports a budget surplus of 1% of GDP and a massive current-account surplus equal to 11.4% of GDP… And the Hong Kong dollar’s rigid peg to the U.S. currency has translated into a 10% depreciation against the Chinese yuan since 2005 and a 5% decline on a trade- weighted basis… “The increasing odds of Federal Reserve policy easing in the wake of the mini-meltdown in the U.S. credit markets will add fresh stimulus to Hong Kong’s already strong domestic demand, and will be a tremendous boost to its interest-rate sensitive economy and stock market,” says Yan Wang, Montreal-based head of China strategy at BCA Research…” http://www.bloomberg.com/apps/news?pid=20601039&sid=arkm3iytRxeQ&refer=home
Central banks’ dilemma over information deficit: “…The dilemma for central banks is, if an information problem really is at the core of the turmoil, there is not much they can do to address it directly… There is a danger rate cuts could aggravate the information problem, by suggesting that central banks have more negative information than the markets possess. But if markets remain dysfunctional for a long period the case for rate cuts will mount, because they would help offset its consequences for the real economy.” http://www.ft.com/cms/s/01ea9608-4c2d-11dc-b67f-0000779fd2ac.html
It is official sport fans: the FED cut 0.5%
“…if the Fed lowers interest rates, and the European Central Bank raises interest rates as it is hinting it might do, would there be a run on the dollar?..” http://www.nytimes.com/2007/08/17/business/17paulson.html?pagewanted=2&ref=business
Foreign banks in $22B Treasury selloff
August 16 2007: 6:05 PM EDT
http://money.cnn.com/2007/08/16/markets/treasuries.reut/index.htm?postversion=2007081618
NEW YORK (Reuters) — Foreign central banks sold an unusually large $22.15 billion in U.S. Treasury debt last week, according to Federal Reserve data released Thursday, despite a rally in bonds that has taken yields to new lows.
That decline brought the Fed’s total holdings of Treasuries for foreign central banks, which own over a quarter of the market, to $1.224 trillion.
Bond prices have surged over the past two months as fears over tightening credit conditions have reached fever-pitch. The heavy foreign selling suggests domestic purchases were even stronger than the sharp upward price moves would indicate.
Purchases of agency bonds from government-sponsored entities like Fannie Mae (Charts) and Freddie Mac (Charts, Fortune 500) partly offset that drop. Overseas central banks added $5.08 billion to their agency holdings.
Total U.S. debt holdings, including Treasuries and agencies, fell by $17.07 billion to $1.990 trillion, having surpassed the $2 trillion mark in recent weeks.
“…Lehman Brothers points out that even losses of $200bn would be “far less in nominal terms than the half-trillion US savings and loans debacle of the mid-to-late 1980s”. It adds: “As a per cent of the world bond market, this is about five-tenths of one per cent; a large absolute number but small on a relative basis.”… better to deleverage when in a strong economy than a weak one …A more tangible threat is that US households will now respond to the turmoil by raising their levels of saving in response to slower growth or even future falls in house prices. That could reduce US growth prospects and has been an economic risk, unrelated to the current credit market woes, for some time…” http://www.ft.com/cms/s/00d0c8e6-4c5a-11dc-b67f-0000779fd2ac.html
hmmm — maybe central banks are taking some profits on their treasury portfolio and selling to those in the markets now desperate for liquidity?
that said, i don’t quite see the numbers reported by money.cnn in the latest fed data:
http://www.federalreserve.gov/releases/h41/Current/
treasury holdings fell by $3.9b .. and total custodial holdings fell by a bit less, but they seem to be above $2 trillion. am i reading the data incorrectly?
Federal Reserve will sacrifice the US Dollar monetary value to bailout reckless Wall Street speculators with the absolutely unjustified discount rate cut. In the first place, the current economic problems were caused by overly cheap credit. True to his words, Helicopter Bernanke is on the job printing more fiat money. Capital has been misallocated, making money cheaper doesn’t solve the capital misallocation issue. Creating more MBS subprime bonds with cheap money will exacerbate the nation’s long-term economic problems and increase systemic risk to the banking system. It is better to cleanse the financial system of reckless speculation.
Fed cuts discount rate, hits dollar
http://www.reuters.com/article/marketsNews/idUKL1776548020070817?rpc=44
Wayne Angel (former fed governor) was making a big deal earlier this week about a surge of foreign private demand for Treasuries and foreign CBs stepping in to sell. He seemed to interpret it as a very strong signal of deflation risk, and that the Fed should cut rates as a result. I couldn’t quite understand either point.
To Rebel: What happens with mortgage backed securities is that if the borrower defaults, the guarantor pays, and the default is treated as a full prepayment. This means that when lots of people default at the same time, the guarantor of the security (usually an investment bank) has to come up with a lot of cash.
Sub-prime adjustable mortgages have interesting and nasty problem called “negative gamma.” Basically if interest rates fall, people refinance and you make less money than a straight bond. If interest rates rise, people with poor credit default, and you make less money than a straight bond. If you are trying to balance your interest rate gains and losses with a straight bond and interest rates change suddenly, you lose…….
DC: Federal Reserve will sacrifice the US Dollar monetary value to bailout reckless Wall Street speculators with the absolutely unjustified discount rate cut.
It works out the other way. If you are a hedge fund manager, you are not going to find yourself in a soup kitchen or on the streets. You have skills, you have money, you can ride out the storm.
If the nation goes into recession, then the people that get hurt are “ordinary people.”
The economic damage that is done by loose money is far smaller than the economic damage that is done by a tight money policy in the face of an economic crisis (see Great Depression or Japan-1990’s). People that intend to “clean the system of speculators” often do much more damage than the speculators.
“…”From Russia’s perspective the point is we don’t know how bad it’s going to be… There is clearly a big risk it’s going to get worse. In these circumstances, we are advising to get out now,” said Roland Nash, chief strategist at Moscow investment bank Renaissance Capital. “Russian financial markets have been expanding extremely rapidly over the last couple of years and there are bound to be weaknesses which will be revealed when liquidity dries up which is what is happening now.”…” http://www.ft.com/cms/s/cdaad60e-4c00-11dc-b67f-0000779fd2ac.html
“…Lloyd Blankfein apologized to VTB Group CEO Andrei Kostin for an analyst’s “sell” recommendation, a VTB spokesman said… Russians, who lost billions of dollars in multiple bank collapses and stock-market schemes in the 1990s, rushed to buy VTB stock in the so-called “people’s IPO”…” http://www.bloomberg.com/apps/news?pid=20601109&sid=a0qZdO5WuEnI&refer=home
TwoFish,
The Charter of the Federal Reserve specifically states that it is to ensure the monetary value and stability of the US Dollar. It was the “cheap money” policies of the 1920’s that massively misallocated capital which caused the depression of the 1930’s. In fact, after the 1929 stock market crash, the Federal Reserve rapidly lowered interest rates but to no avail, the damage from capital misallocation was already baked into the cake. We simply don’t need more bad subprime and Alt-A loans on the books of the Banking system and GSE Fannie Mae. And for all the criticisms of the China PBoC, at least the Chinese are moving to restrict money supply growth by raising interest rates, increasing the bank reserve ratio, and raising loan requirement standards; everything that Bernanke resists tooth and nail. At least the Chinese take monetary policy seriously. If the Bernanke Federal Reserve is not prepared to implement a “hard money” policy as the organization’s charter specifies, Bernanke should immediately tender his resignation. Period.
China is expecting a trade war with the US
expect MAJOR changes in official policy towards domestic growth in Oct!
Twofish,
I repeat (some of) what I said last week when you raised Japan and the Great Depression:
I believe a crash would be healthy, because it would finally reward those who stand aside when they consider prices too high and replenish the natural restoring forces of the economy. Of course there would be costs, but I believe they would be outweighed by the benefits.
In my opinion, the conventional economic wisdom has Japan wrong. Its problem is that it did not crash sharply enough. Leaning against the correction has meant that asset prices have been a one-way bet for years…..ie down. The ability of the central bank and government to support the economy has been squandered on braking its descent. If you make a reasonable assumption about potential growth in Japan and cumulate the lost output, it probably now amounts to more than a depression would have been anyway.
I also think that the consensus has the great depression wrong too. I am no expert, but I doubt that it would have been so bad if the government had stepped in earlier with fiscal expansion, and avoided some of its repressive regulations on business in the 1930s.
Why do I think I am right and the majority is wrong? Because I suspect that economic consensus has been “captured” - sub-consciously perhaps - by those who say what the government and people want to hear. That is, that easy policy is OK. Bernanke is the classic example. I was sure that he would become Fed chairman after his 2002 speech about the Fed buying long bonds in a slump. He may believe that stuff for all I know, but I am sure that with a large fiscal deficit and extended asset prices, the president did not care.
It seems that, today, Bernanke is doing what is expected of him.
I think the Fed trying to calm the market is good, but this is just treating the symptom and like giving an addict a prescription of heroine because he/she is having withdrawal symptom. No body complains when stock market goes up by 300 points. So if it goes down by 300 points so be it. The point of the matter is, the whole mess is created by easy money and unregulated an non transparent institutions and of course conflicting incentive of rating agencies. The excesses has to be cleaned up, like the internet bubble. Recession is a natural part of economic cycle and trying to stop it is not going to do any good to any body. People should take prudent risk. The whole thing created by conflicting incentive and greed.If you believe in free market economy, you should believe it in both up market and down market. Let the market decide and Fed should stop intervening on behalf of politicians and big money
thx.
Barry.
Gamma has nothing to do with ARMs.
DC: The Charter of the Federal Reserve specifically states that it is to ensure the monetary value and stability of the US Dollar.
No. The Humprey-Hawkins Act of 1978 establishes the goal of the Federal Reserve to maintain long-run growth, minimizes inflation, and promotes price stability. The Fed is not under any legal mandate to do anything about the value of the dollar.
DC: It was the “cheap money” policies of the 1920’s that massively misallocated capital which caused the depression of the 1930’s.
There are schools of economics that argue that, but the conventional wisdom is that the cheap money policies may have caused the crash of 1929, but it was tight money that turned a crash into a decade long depression that was only fixed with massive expansionary policies with World War II.
DC: at least the Chinese are moving to restrict money supply growth by raising interest rates, increasing the bank reserve ratio, and raising loan requirement standards; everything that Bernanke resists tooth and nail.
A policy that works in 2007 would have been disastrous in 1993 and 1997. After the slowdowns of 1989-1990 and between 1994-1997, the PBC responded with massive monetary injections.
Rebel E: In my opinion, the conventional economic wisdom has Japan wrong. Its problem is that it did not crash sharply enough.
At which point, it looks to me like you are burning a village to save it. This is the type of economic thinking which IMHO, resulted in the disaster of Russia-1990’s.
Rebel E: If you make a reasonable assumption about potential growth in Japan and cumulate the lost output, it probably now amounts to more than a depression would have been anyway.
But maximizing industrial output at the cost of economic benefits isn’t one that most people are willing to make. One thing that needs to be emphasized is that the “cost” and “benefits” of economic policy are subjective. Most people would consider losing their job for three months to be an unacceptable “cost” for the “benefit” of 1-2% extra GDP growth. (Causing someone elses job to be lost, however…..)
Rebel E: Why do I think I am right and the majority is wrong?
I don’t want to sound too harsh, but an argument based on psychology doesn’t prove anything. Yes, people might have a self-interested reason for believing what they do, but that doesn’t make it wrong.
Also, there are some things that are just subjective. Maybe an economic crash would raise industrial output in the long run, but if you present these options to people and they say, yes I know that doing X will result in slower economic growth, but I want to keep my job, then that is a perfectly valid response. Yes I know that the real estate bubble is causing abstract economic inefficiencies, but I like selling real estate.
At that point you need to give some details to people about exactly what are the likely costs and benefits, and you run into a real problem that you just don’t know.
Guest: Gamma has nothing to do with ARMs.
Ugghhhh…. I’m thinking like a mathematician. Equity traders call it gamma. Bond traders call it convexity. It’s the same thing mathematically.
Bond traders call it gamma as well.
Either way, it has nothing to do with ARMs.
TwoFish,
Is not ensuring price stability the same as retaining the monetary value of the currency. A rapidly inflating asset bubble is equally distorting to the efficient allocation of capital as is a high inflation rate. With the cost of capital remaining well below the “real” inflation rate, the Federal Reserve risks both a higher consumer inflation rate and inflating various asset class bubbles, from bonds to real estate. In short, the Federal Reserve monetary objective should not be the inflation of one asset class bubble after another. The Greenspan-Bernanke inflation of an asset bubble in real estate ameliorated the fallout from the earlier Dot-Con stock market bubble, but the larger massive misallocation of capital has resulted in the even bigger mess in bad subprime and Alt-A mortgage loans, which has had systemic failure implications for the entire US banking system. Federal Reserve regulators have proven irresponsible in their lax oversight of the banking system, and providing excessive “cheap credit”.
Asia Seen as Better Able to Deflect U.S. Recession
http://www.nytimes.com/2007/08/17/business/worldbusiness/17global.html?_r=1&oref=slogin&ref=business&pagewanted=print
HONG KONG, Aug. 16 — In the past, when economic growth has stalled in the rest of the world, the United States has usually been there to pick up the slack. Now that dynamic is reversed.
“We’re no longer in a world where the United States sneezes and the rest of the world catches a cold,” said Nariman Behravesh, chief economist with Global Insight, an economics research firm in Waltham, Mass. Experts say those nations are less interested in extending a lifeline to the United States than in discovering whether they have reduced their ties to the American consumer.
Countries in Asia, particularly China, have started chafing at their dependence on the thirst of Americans for imported goods, on the sway of the American dollar around the world and on American financial institutions. Indeed, many in Asia have been taking pride in the extent to which the region seems to have been weaning itself from reliance on the United States economy.
Now, from the Asian perspective, the United States is seen as the place where regulation has been weak and where consumers and businesses alike borrowed with little restraint.
“The Asians do not trust the American economy any longer,” said Frank-Jürgen Richter, a specialist in Asian economies who is the president of Horasis, a research group in Geneva. “America is not the engine of globalization any more. They are looking for a new engine, and it might be China, it might be Europe — but it’s not the U.S.”
RE,
I have no reference at all. The number is quite immeasurable. I am just guessing. It could be $65, $265, or $26.50. It is probably greater than $6.50. But $650 it is definitely not.
When Nixon delinked the dollar from gold, most “reputable” economists thought that the gold price would dive in just this way and for just this reason, because gold’s role in the monetary system was over. They were right that B follows from A, but they were wrong about A.
Guest: Bond traders call it gamma as well. Either way, it has nothing to do with ARMs.
I disagree. It has everything to do with adjustable mortgages. Gamma is a measure how the value of a security changes in response to an external change in something like interest rates. If you have positive gamma (the curve looks like a smile), then a major jump in interest rates will make you money. If you have a negative gamma (the curve looks like a frown) then a major jump in interest rates will lose you money.
If you have negative gamma then you have to either buy and sell securities to move the frown around so that you are always on top of it. Or you can buy volatility options to also stay on top of the frown. Now if you are in a situation where the markets stop working and you can’t buy and sell to keep on top of the frown, then……..
Now in the case of subprime ARM’s. Gamma is negative. If interest rates rise, people default or refinance, this causes the price of the security to drop. It drops more than prime mortgages because there is a larger spread between the interest rate of the mortgage and the discount rate.
If people were indeed trading subprime ARM’s with the belief that gamma has nothing to do with ARM’s, this would go a long way to explain how we got into this mess.
“Platform companies earn a high return on investment, while manufacturing firms earn a low return on investment. This permanent returns differential accounts for a sustainable higher standard of living for those in the platform nations. ”
The higher standard of living in the West is a result of a couple of centuries of capital investment, most of it manufacturing.
The most robust qualitative economic expansion in recorded from poverty to wealth was of course the United States from about 1875 to 1930. This was on the back of technological-oriented manufacturing, a strong internal market, and some external trade barriers.
The next one is happening now in China.
It is well known that rent-seekers (I guess this is what a “platform company” can personally make more profit, but a competitive economy producing products probably makes overall more wealth for owners and workers, even if the profits of the individual firms are smaller. The ‘lord’ of a banana republic can get really rich from political connections but the
This is a composition fallacy, that maximally profitable individual firms lead to greatest net prosperity.
The point is that manufacturing extends its influence of wealth, multiplier effect, to a far larger extent than rent-seeking platform companies. Manufacturing faces more competition and requires more capital investment. The factory owner might not make as much easy money—but far more people, over the long run, will benefit.
China knows this. The US used to know it. There is a difference between laissez-faire {where rent-seeking can flourish} and capitalism. Remember that Adam Smith was a liberal and wanted to change the system.
Written by Twofish on 2007-08-17 15:34:28
Thanks for the explanation. But I don’t think so.
Negative gamma or negative convexity results from accelerating prepayment expectations on fixed rate mortgages as market interest rates decline. It’s essentially a put option on an underlying notional liability whose value increases as rates decline. Such an option is a function of fixed rates.
Generic ARMs are not fixed rate, so there is no fixed rate risk or related optionality risk in respect of prepayment or default on the underlying.
ARMs permit conversion to fixed rate mortgages when rates decline, but at the prevailing market rate. An option with a strike price equal to the prevailing market rate has no option value and no gamma.
Default risk is no different in its optionality consequences than prepayment risk with respect to interest rate risk on underlying assets that aren’t fixed rate.
Guest: Negative gamma or negative convexity results from accelerating prepayment expectations on fixed rate mortgages as market interest rates decline.
That’s one source of negative gamma. There is another. When interest rates rise, people with poor credit with adjustable mortgage rate mortgages can no longer pay them, and they default. This triggers a prepayment. When you have a prepayment, the value of the mortgage drops. If you graph the curve of the value of the mortgage versus interest rates, you get a frown, which is the dreaded negative convexity/gamma curve.
Guest: Generic ARMs are not fixed rate, so there is no fixed rate risk or related optionality risk in respect of prepayment or default on the underlying.
Yes there is. If a poor credit refuses to pay, then this triggers a default event. Subprime ARM’s have a “hidden” option which you need to include in your prepayment models.
It gets worse. If a person with poor credit defaults, you get cash which you can reinvest at current interest rates. The trouble is that the interest rate for the ARM was probably much higher than the market interest rate since you were charging more for poor credit. You lose that extra interest if the person defaults.
And it gets even worse…….
You can deal with gamma risk either by constantly buying and selling securities to make sure that you have a balanced hedge or by buying and selling volatility swaps which allow you balance the frown shaped payoff curve with another curve. Neither works well in the type of market environment we have now. You can no longer easily buy and sell securities which means you can’t rebalance your portfolio easily. In a market crisis, then the equations that govern option prices for exotics are likely to change radically so balancing a portfolio with those is likely to stop working.
But there is some good news:
1) One bit of good news is that *some* investment banks and hedge funds saw this coming and didn’t have big or any positions in subprimes.
2) The other bit of good news is that this is a “slow motion train wreck.” The thing that you want to avoid is a cycle in which high interest rates -> defaults -> people don’t lend -> higher interest rates -> more defaults -> people don’t lend
If that starts to happen you could blow apart the economy. Fortunately, the thing is happening slow enough so that the central banks can react and pump in liquidity to keep the cycle for happening. The situation is unfolding on a day by day basis. It’s not minute-by-minute like the 1987 crash or hour-by-hour like the LTCM or Mexican peso devaluation situation.
The analogy that I had about not forcing a heart attack victim to run to the emergency room is an apt one. Maybe the heart attack victim was remiss at smoking, eating bad food, and not exercising enough. Maybe the second you patch them up, they’ll leave and start doing bad things which will get them in the hospital again.
However, to try to “teach the victim a lesson” when they are on the stretcher is a horrible thing to do. You’ll almost certainly kill the patient.
Written by Twofish on 2007-08-19 08:09:20
Thanks for taking the time to elaborate. I know it’s a laborious topic.
There are some things you’re saying that I think I understand, and some I don’t.
First, I understand that credit risk and default risk can trigger an effect equivalent to prepayment risk on fixed rate mortgages, and therefore credit and default risk are a source of gamma in attempting to hedge interest rate risk on such mortgages. But I don’t see how this applies to ARMs.
Second, I don’t know why sub-prime mortgages would have any unique credit risk effect as far as default is concerned. By that I mean unique in terms of the type of risk - obviously, the degree of credit risk is higher with sub-prime. But the type of risk and the type of effect on gamma wouldn’t be different than with prime ARM mortgages - just the degree of risk.
Third, I understand that volatile or illiquid markets pose risks of increasing net gamma exposure for delta hedgers.
I’m not too familiar with volatility swaps but I get the idea.
The extra interest charged on the ARM is a charge for the higher credit risk. I can see where credit risk exposure is a contingent function of interest rate risk, but you can’t hedge changing credit risk exposure with interest rate risk instruments unless its done to protect the interest rate sensitivity of the funding. Credit risk scenarios should have been taken into account in the original pricing of the spread and the associated return on capital. So I don’t see how that relates to option gamma in the event of default, unless its exposes the interest rate sensitivity of the portfolio on the funding side. The portfolio is being paid for the credit risk - any credit loss on default shouldn’t be compared to a market reference rate at a different credit risk level. It’s a pure credit loss.
Finally, I may not fully understand the basic interest sensitivity of sub-prime ARM mortgages. I assume it is not fixed rate and that the neutral interest rate sensitivity used in funding them would be short term - the same sort that banks would use to fund prime rate loans.
If interest rate sensitivity is short term, then prepayments have minimal effect on assumed duration and therefore minimal impact in terms of duration mismatch on the asset-liability portfolio (short term funding can also be paid off). This should be true whether prepayments are due to cash repayments or credit risk default.
But if sub-prime ARMS have embedded fixed rate risk, then clearly gamma enters the equation. Perhaps they do and I’ve missed this.
2fish –
i also appreciated your explanation.
your noted that some i-banks saw this coming, which implies “some” did not. who - setting bear aside — is a likely candidate to be among those who did not?
Written by Twofish on 2007-08-19 08:09:20
Thinking about it further, gamma risk or negative convexity for a prepayable fixed rate mortgage is exacerbated when rates decline. The value of the mortgage declines from what it otherwise would be, because expected prepayments increase, reducing the mortgage duration. As a result, there is a loss to total value of some capitalized future interest, which is the reason why the value drops.
Moreover, from this new level of assumed duration, unexpected prepayments over and above expected prepayments also decrease the value of the portfolio from what it otherwise would be, because the new assumed duration was still overestimated.
An unexpected default event has the same effect on duration and portfolio value as an unexpected prepayment. But in addition to the contribution through the duration effect (which arguably is a gamma effect) there is the more fundamental contribution of outright credit loss (which is not a gamma effect).
This all assumes we are talking about fixed rate mortgages, which is not the case with conventional ARMS, and I don’t believe it’s the case with sub prime ARMs. If not, gamma is not an issue for either prepayments or credit risk.
Written by Twofish on 2007-08-19 08:09:20
Finally, unexpected prepayments that are made from a fixed rate mortgage portfolio when interest rates are higher than booked rates actually add value to the return on interest rate risk, because fixed rate assets (ex credit risk) can be replaced at a higher yield (conversely existing lower cost funding can be used to fund new higher rate assets). A prepayment option that is exercised when rates are higher is exercised out of the money. It’s exercise costs nothing to the writer of the option and in fact transfers economic value back to the writer. This is true whether it is a live prepayment or a credit event prepayment - because credit risk is a separate risk from interest rate risk - again, we are talking about credit risk combined with with options on interest rate risk - not options on credit risk. There is no ‘credit risk gamma’ - only interest rate gamma induced by credit risk when assets are fixed rate. Even if there is such a thing as a fixed rate sub-prime ARM, which I don’t think there is, credit event prepayments at higher interest rates would generate profits for interest rate risk and losses for credit risk.
Guest: Second, I don’t know why sub-prime mortgages would have any unique credit risk effect as far as default is concerned.
There are three effects:
The first is the credit risk in prime mortgages is very small. Prime mortgages tend to have default rates of less than one percent. Ordinarily, mortgages have negligible credit risk to start with.
The second is that sub-primes have high interest rates. This is important because if you get a prepayment, then you can reinvest the money in treasuries, but you lose the high interest rate that the sub-prime mortgage had originally.
Third, I strongly suspect that lots of people were using large amounts of leverage, which made even small differences from expected behavior to be deadly.
Guest: Credit risk scenarios should have been taken into account in the original pricing of the spread and the associated return on capital.
Because prime MBS’s have low credit risk, it’s traditional for the securitizer to assume this risk and so credit risk becomes prepayment risk. It makes it easier for the buyer of the security since it folds credit risk into prepayment risk models. Ordinarily it is a very small correction, and it makes life easier for the buyer.
When there is significant credit risk, it messes things up since it makes it difficult/impossible to distangle things.
Guest: your noted that some i-banks saw this coming, which implies “some” did not. who - setting bear aside — is a likely candidate to be among those who did not?
Mentioning specific companies is a big no-no that will definitely get me in trouble with the my employer and with the SEC.
However, the information for this is pretty public, and you can get a good idea of bank exposure by looking at the SEC filings and seeing what the banks are investing in. The other thing to do is to look at the management team for the banks, google a bit, and see how the people have behaved in the past. If you have a CEO and upper level managers that did well as far as risk managment in previous crises, they are likely to do well again.
My general sense is that as far as investment banks go, lightning has already struck and there isn’t going to be any new bad news as far as the investment banks go.