Credit Meltdown

The last week of trading has been dominated by an unwinding of positions on a global basis. The culprit; financial institutions and hedge funds that owned exotic re-packaged mortgages (Collateralized Mortgage Obligations, or Collateralized Debt Obligations) ended up facing an illiquidity crisis. They needed to sell in the short term, and it turns out that the crisis of confidence in the financials created an environment in which the pricing of these different CMO's or CDO's became increasingly difficult, thus illiquid. During illiquidity events, the hedge funds, mutual funds, and institutions sell whatever they can to create liquidity. Now, there is an expectation that the Fed will ease rates. However, they already have lowered rates by injecting nearly $45 billion in liquidity over the last week, equal to at least a 1/4 % rate cut.

In the financial markets, firms and individuals that made bad credit decisions must be allowed to pay the price for those decisions. Borrowers that took on too much debt, or lenders who lent too much debt, must learn that there are consequences for their actions. After all, the borrower likely experienced an increase in value, and the lender likely experienced an increase in earnings by behaving this way. Home builders that overpaid for land need to face the music. Wall Street firms that provided credit like drunken sailors must now pay the price. Homebuilders, mortgage companies, and banks have enjoyed exorbitant profits in recent years, as have shareholders and executives of these companies. Why now must the Fed give them all a pass? Nobody wants any company, or industry, to fail, and the Fed will obviously act as it sees fit to contain any contagion. However, to not permit losses now, a la a Fed bailout, is a direct violation of the principles of a free market that are the cornerstone of our economy.

Emerging Markets Riding the Wave

Emerging market economies have gone gangbusters in the last 5 years. In a world awash in liquidity, the flow of funds into emerging market stock markets has been tremendous. Not only are these emerging economies growing much more rapidly, they are producing goods and services competitively and building infrastructure. What do they need?: steel, aluminum, cement, oil, electricity, water, etc. As investment dollars have flowed into these emerging economies, returns have continued to be quite healthy despite the eventual compression of returns caused by large asset flows over time.

Some posit that the "disappearance" of risk in emerging markets will lead to an implosion. Perhaps, though it could be that there is simply lower volatility because of a credit upgrade cycle in emerging markets. As these economies grow and mature, these countries' debt goes through an upgrade cycle, which has the effect of improving the balance sheets of these countries, which in turn benefits the companies doing business there. As the level of risk appears to drop, even more fund flows enter these countries seeking higher returns from these higher growth economies with improving risk-adjusted fundamentals.

Sub-Prime or Sub-Slime?

All this talk about a sub-prime bailout for the mortgage companies who engaged in a bonanza of hay-making over the last 5 years is nonsense. We now have politicians talking about how to "solve" this "problem" in the future by creating more rules and regulations. All of this talk about introducing more rules and regulations just adds another layer of credit-tightening at exactly the wrong time. For 2 years the media has been talking incessantly about a correction in real estate in general; now that it's here everyone seems surprised! I have an idea-- how about letting the market mechanism work?

Let's allow prices to fall enough to a point where buyers will supply liquidity. Let's allow mortgage companies to fail that did a preponderance of risky adjustable rate mortgage financing. Let's allow all of those people who financed their not-really-affordable homes to learn a lesson and negotiate with their financial institutions-- these institutions do not want to hold millions of trust deeds, and would rather offer some flexibility to the homeowner anyway. Let's allow the publicly traded mortgage companies to be punished by their stock price declines; again, at the right prices, buyers will supply liquidity for these stocks. This entire process of correction, if left to the financial markets, would unwind, correct, and stabilize in a matter of months.