links for 2008-04-15
Menzie Chinn Is Musing About the Course of the Dollar

Positive-Feedback Trading

There has to be an opportunity for somnebody patient with resources to make enormous fortunes in this situation. Doesn't there?

Neil Unmack and Sarah Mulholland report:

Bloomberg.com: Exclusive: April 15 (Bloomberg) -- The credit-default swap market has become a lesson in being careful what you wish for now that Wall Street has taken $245 billion of losses partly tied to such exotica. Rather than dispersing risk and lowering borrowing costs as former Federal Reserve Chairman Alan Greenspan predicted, the contracts have exacerbated the debt crisis. What was intended as a way for lenders to protect against defaults spawned a market covering $45 trillion of bonds and loans where no one knows how much is traded and speculators who bet on deteriorating credit quality end up forcing that reality.

Some credit-default indexes have morphed into what Wachovia Corp. analysts led by Glenn Schultz call Frankenstein's monster'' because they now often drive prices in the so-called cash bond market, rather than the other way around....The indices are just trading on their own account with no relationship whatsoever to an underlying cash market that's ceased to exist,'' Jacques Aigrain, chief executive officer of Zurich-based Swiss Reinsurance Co., said at a March 18 insurance conference in Dubai.... The last thing the securitization market needs is another no-cash-upfront instrument that people can use to knock the markets about with,'' said Andrew Dennis, the London-based head of the asset-backed debt syndication group for UBS AG of Zurich.... Accounting rules require companies to estimate a value for some assets that are seldom traded and to record any change as an unrealized gain or loss. Where quoted prices aren't available, companies are required to use other measures, such as indexes of credit-default swaps.The dealers got caught in a vicious cycle,'' said Schultz, head of asset-backed bond research at Wachovia. ``They did a great job of selling the indexes. At the end of the day, they had to mark their own books to the prices on the indexes. They fell victim to their own sales job.''...

The latest version for AAA rated subprime mortgage bonds slumped by 43 percent since it began trading in August, according to Markit, as rising U.S. home loan delinquencies triggered a surge in the cost of credit-default swaps. That implies a 53 percent loss on the underlying mortgages, according to Schultz, almost four times the 13.75 percent rate predicted by Wachovia.... ``ABX, CMBX, any kind of X you like, are totally uncorrelated to any kind of underlying market,'' Swiss Re's Aigrain said at the Dubai conference....

``In a volatile market, this mark-to-market process becomes a self-fulfilling prophecy, driving prices down based on index trading activity rather than asset fundamentals,'' wrote Dottie Cunningham, chief executive officer of the New York-based CMSA.

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