Esoteric Dissertations from a One-Track Mind

October 23, 2007

Understanding the Credit Crisis

Filed under: economy, politics — Tags: , — codesmithy @ 8:13 am

I went over some key points in a post titled “Economic Contraction Looming?” So, the two questions we have to ask ourselves are: “how does it work?” and “is this true?”

So, we’ll address “how it works” first. For those that don’t like the dry articles maybe some British humor will penetrate and be enlightening.

Based on this story, what data can we find to confirm it or to contradict it, essentially “is this true?” So, we start with the fundamentals. The base of how much money will be lost is directly proportional to the number of loan defaults we see. This can be measured by the foreclosure rates on homes. Compared to last year, the foreclosure rate is nearly double for September. To be fair it was down from August, but the article states:

It’s likely that the sequential decline in foreclosure activity between August and September was just a blip, not a bellwether of lessening foreclosure filings.

Fine, is there any data to back up that assertion. A significant portion of the crisis is in the so called sub-prime sector.

Well, one way is actually survey people that have these types of loans. 73% don’t know how much their payment will increase after the ARM resets. Only 1 in 5 knew what factors determine their rate adjustment. 1 in 3 answered incorrectly, and approximately half have no idea what factors affect their rate. In other words, these loans are not a responsible borrowing of money.

So, we expect the foreclosure rate to rise. Especially given the hit most home owners are going to take to heat their homes given current energy prices.

The structured investment vehicles based on mortgage-backed securities are hot potatoes. Right now, the hedge funds that own these securities are bluffing. They are trying to find a way to give these worthless securities to someone. Paul Krugman examines Henry Paulson’s plan to deal with the crisis.

Right now the bleeding edge of the crisis in confidence involves worries that there may be large losses hidden inside so-called “structured investment vehicles” — basically hedge funds that borrow from the public and invest the proceeds in mortgage-backed securities. The new plan would create a “super-fund,” the Master Liquidity Enhancement Conduit, which would seek to restore confidence by, um, borrowing from the public and investing the proceeds in mortgage-backed securities.

Although, I would state the thesis much stronger than Krugman. I would rewrite the sentence “Right now the bleeding edge of the crisis in confidence involves worries that there may be large losses hidden inside so-called “structured investment vehicles”” to be “Right now the bleeding edge of the crisis in confidence involves evidence showing there are large losses hidden inside so-called “structured investment vehicles””. The “may” makes it sound like it is 50/50, when it is in fact more like 90/10 when one examines the fundamentals.

However, Krugman is fundamentally correct in the solution. “… [T]his rescue scheme could be seen as an attempt to hide the bad debts everyone knows are out there, and as a result could delay any return of trust to the markets.” To return trust to the markets calls for an investigation and honest accounting of the “structured investment vehicles” and proper oversight of the hedge funds. Until that happens, there will be a continued belief that hedge funds are bluffing about their state of affairs.

Advertisements

1 Comment »

  1. […] — Tags: Credit Crisis — codesmithy @ 8:51 am As I have examined earlier in “Understanding the Credit Crisis” the main question we are facing is determining how much money has been lost in structured […]

    Pingback by More Insight Into the Credit Crisis « Esoteric Dissertations from a One-Track Mind — November 8, 2007 @ 8:51 am


RSS feed for comments on this post. TrackBack URI

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Blog at WordPress.com.

%d bloggers like this: