We’ve seen in the previous part of this story how credit self-fueled itself and how risk spread, “infecting” low-risk portfolios and industrial companies. Now let’s go back talking of homeowners.
When foreclosures increased (since many homeowers couldn’t afford payments), what happened is that mathematical models that should had guarantee a low risk portfolio showed to be unreilable. Therefore, all securities based on those models became risky, and moreover banks and financial companies didn’t have anymore a method to evaluate them. Thus, banks and funds started to refuse mortgage based securities and CDO in general.
This start a leverage problem (as we have seen, $1 of “real capital” backed $20-30 of loand), since leverage can significantly increase profits, but does the same with losses.But this isn’t even the main problem: some analyst thinks the main problem is that banks need to convince CDO owners to keep them, because a massive trading (now that they are perceived as more risky) could lead to a collapse of their value. But CDO in the last years have indirectly been a propeller for the stock market. For example they financed leveraged buyout, but also shares buyback.
All this will lead to a liquidity crunch, that will have awful effects on the stock market: not a simple market correction but maybe even a recession, driven by the burst of the liquidity bubble. From this point of view FED’s interest rate cuts may, at best, soften the slope, but can’t invert trend. Problem we are facing may not be the result of the amount of money in the economic system (that is determined by interest rate), but come from the leverage, risk transfer and counterpart transparecncy models, that may be flawed. If this is true, we are facing the beginning of a epochal change, that will leave their mark on financial world.
Original post (in italian): Crisi del credito: è appena l’inizio? (parte 3)
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