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249 comments on DrumBeat: May 2, 2007

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Gail the Actuary on May 2, 2007 - 9:14am Permalink | Subthread | Comments top

The WSJ has an article today called "A Hard Lesson in Derivatives". Some quotes:

Investors, such as macro hedge funds, hit the bull's-eye with their bet that the cost of protecting mortgage bonds against default would rise as borrowers with patchy credit struggled to meet their monthly payments. They bought such protection enthusiastically by entering into a privately negotiated derivative contract.

But they underestimated the sticky nature of these derivatives, known as single-name asset-backed default swaps, that can trade infrequently due to the complexities of valuing them.

"It looks like a great trade but it isn't a profit if you can't get out," said Scott Simon, who oversees $250 billion in mortgage- and asset-backed securities at Pimco, a Newport Beach, Calif., fund manager. Pimco is a unit of Munich-based insurer Allianz SE. "Investors had a naïve belief in liquidity thinking just because you buy it, you can sell it," Mr. Simon said.

The result is a growing divergence between the price at which investors are willing to unload their derivative contracts and the price they are actually being offered. These asset-backed default swaps protect the contract buyer against a possible default on the underlying pool of home loans.

Once folks figure out you really can't sell the things, will this be the start of "the great unwinding"?

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Bruce Scott on May 2, 2007 - 1:12pm Permalink | Subthread | Parent | Comments top

Gail, in your monetary collapse models, do you have a scenario in which the US Dollar undergoes such a collapse due to fundamentals (exposed as it ceases to be a reserve currency), but the Euro and the Yen survive?

ciao,
Bruce

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Gail the Actuary on May 2, 2007 - 10:55pm Permalink | Subthread | Parent | Comments top

Bruce,

That's a good question. It seems like the collapse of one major currency would tend to bring the others along, because of the interconnectedness of the economies. At best, there might be hyperinflation in the US, and a lesser (but still significant) impact on the Euro and Yen.

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Dezakin on May 3, 2007 - 4:00pm Permalink | Subthread | Parent | Comments top

Thats not how hyperinflaction happens though. That happens when you use the central bank to print money instead of using taxes.

You can have a sudden currency correction where it loses say 50% of its value (certainly extremely painful) if say a country dumps all of its foreign currency holdings, but absent flooding of the money supply hyperinflation doesnt occur.

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Leanan on May 2, 2007 - 2:08pm Permalink | Subthread | Parent | Comments top

Fed: Hedge funds may pose huge market risk

Could be largest risk since Long-Term Capital Management crisis in 1998 says New York Federal Reserve

NEW YORK (Reuters) -- Hedge funds may now pose the biggest risk of a crisis since 1998, when the implosion of Long-Term Capital Management threatened the global financial system, the New York Federal Reserve said on Wednesday.

The statement represented the bank's sternest warning to date over the possible fate of the $1.4 trillion industry.

"Recent high correlations among hedge fund returns could suggest concentrations of risk comparable to those preceding the hedge fund crisis of 1998," according to a paper written by Tobias Adrian, capital markets economist at the central bank.

Back in 1998, the New York Fed helped bring together Wall Street tycoons who eventually cobbled together enough funds for an unprecedented $3.6 billion bailout.

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249 comments on DrumBeat: May 2, 2007

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