Credit Crisis
By Stephen Smith
August 16th, 2007
I will try to explain what is happening in our financial markets, but it is very difficult to quantify because we still don’t have all the accurate information.
The root of the crisis is years of easy money. The Federal Reserve and Central Banks around the world have kept interest rates low through the 1990s and into 2004. Investors seeking big returns forgot about risk and pushed money at everything from emerging markets to real estate. In the United States, many mortgages were offered to people with poor credit and no-money-down mortgages. These mortgages were then packaged into Collateralized Debt Obligations (CDO) and Mortgage Backed Securities (MBS). A CDO is similar to a regular mutual fund that buys bonds. However, unlike a mutual fund, most of the securities sold from a CDO are themselves bonds, rather than shares. In simplest terms, a CDO is an arrangement that raises money primarily by issuing its own bonds and then investing the proceeds in a portfolio of bonds, loans, or similar assets. CDOs gain exposure to the credit of a portfolio of fixed income assets and divide the credit risk among different tranches. These derivative products are highly complex investments that often traded based on the relationship among many underlying markets. The popularity of the Collateralized Debt Obligation market has increased substantially and is now a $2.6 trillion market.
The current credit crisis started when Bear Sterns Investment Bank announced its intention to bail out two of its hedge funds. These two hedge funds invested in CDOs which had a lot of exposure to sub prime loans in the United States. The hedge funds then borrowed what is now reported to be $9 billion from the largest commercial and investment banks. Then they leveraged the $9 billion in borrowings into $29 billion of investments in CDOs. The meltdown of the sub prime mortgage market and the rise of interest rates caused these investments to go wrong; they could not receive 50 cents on the dollar.
The problem, now that this market has collapsed, is figuring out who owns what and what is their exposure. BNP Paribas had to shut down three of its own investment funds. The Bank of China is speculated to have a big exposure to these derivatives; it’s a global issue, which has caused a global credit issue. The seizing up of the credit market has unleashed a wave of concern regarding the likelihood of asset write-downs, as debt securities get re-priced in an increasingly risk averse market. Furthermore, the spillover effect from the credit situation has been evident in M&A, IPO and debt underwriting activity, which has slowed dramatically. The biggest issue for the market is that it doesn’t know how extensive the credit problem is. The prevailing fear is that it is a big number due to the extreme use of leverage during the days of cheap credit. Right now, though, it’s a guessing game, and the market doesn’t like uncertainty. The sell-off in the stock market is based on concerns that problems on Wall Street will eventually lead to problems for the broader economy, even though there is little evidence that this is happening now. These concerns create fear because of the lack of hard data to support the concern. The Federal Reserve and Central Banks globally are trying to address these concerns. The Federal Reserve and the central banks have pumped in a massive amount of liquidity to prevent a credit issue from becoming a credit crunch.
At Trust Company of the Ozarks, we have always focused on credit quality and a fundamental value based approach to investing. We have found that over the long run this discipline matches the goals of our clients, namely to maximize returns while preserving principal.
