As CS Lewis said, "I am not an economist and I simply don’t know whether the investment system is responsible for the state we are in or not. This is where we want the Christian economist. But I should not have been honest if I had not told you that three great civilisations had agreed (or so it seems at first sight) in condemning the very thing on which we have based our whole life."
This article from the Times identifies the right questions (in my italics), even if those in the last paragraph shouldn't have question marks:
[...] The financial markets have prospered in the past few years, because institutions have borrowed unprecedented sums of money to fund their investments. This boom in “leverage” has been possible because the financial world has been engaged in two global games at the same time: pass-the-parcel and spot-the-difference – otherwise known as Collateralised Debt Obligations and the yen carry trade.
The CDO, until recently an arcane acronym, is just one example of the burgeoning business of securitising debts. Banks have developed financial instruments – the CDO is just one of them – so that they can repackage loans and sell them on to other investors. Because they are, in effect, passing off parcels of debt, they have less on their own balance sheets and are willing to shoulder greater levels of lending.
The yen carry trade has, for years, seemed like a no-brainer, which has involved borrowing cheap in Japan to fund higher returns elsewhere. Interest rates in Tokyo have been near zero, so financial investors around the world have borrowed money in yen to buy equities, bonds and currencies that offer even marginally better rewards.
But both of these games have recently shuddered to a halt. The collapse of the US sub-prime mortgage market has had a devastating impact on the broader credit markets. It has revealed that debts bundled together in such a way that they were sold to investors as top quality triple-A paper were, in fact, very risky loans. This has spooked investors everywhere. If they cannot differentiate between a safe bet and a dangerous one, they would rather not bet at all. In countless ways, the sudden closing of the private debt securities markets, valued at $27.6 trillion, has had a knock-on effect on the equity markets, valued at $23 trillion.
In turn, this has had a damaging effect on hedge funds. As they have incurred losses, their investors, fearful of losing more, are asking to redeem their funds, ie, demanding the rest of their money back. This, it seems, is forcing some of the hedge funds to revisit their yen borrowings. And this may not sound like much, but it could signal the end of investment life as we know it.
The signs yesterday were that large parts of the yen carry trade are unwinding. Prolonged spells of low interest rates generally mean that risk will be mispriced somewhere in the system. Japan’s extraordinary decade of near-zero rates may have unwittingly allowed a supremely dangerous anomaly to develop: a spectacular, long-term global accumulation of mispriced risk.
The great trouble is that the ball of string currently unwinding is invisible: nobody anywhere – especially not the Bank of Japan – has any true sense of how far it all goes. We know that yen carry has financed US, European and Asian hedge-fund investment in risk assets, but how far has its use permeated every market? Much the same is true of the syndicated debt market: who has been left holding the baby?
Comparisons are easily made between this anxious August 2007, and the flight to safety in 1998, when Long Term Capital Management collapsed and Russia defaulted. But the difference this time is that it is harder to know who is to blame: the ratings agencies for failing to price debt accurately because they were in the pocket of the banks? The central banks for steadily pushing up interest rates, because they were worried about excesses in the credit markets? Commercial banks, which stopped pricing risk, because they could not afford to miss out on the mushrooming debt business? Read more
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