OK, OK. It’s not going away so I’m going to have to muse over the sub-prime debacle, but how can I make it interesting?

I know, think of one of your mates, he’s probably the stalwart of the rugby team or the life and soul of your group, a really good mate, but you wouldn’t lend him a tenner. Well, you might coz he’s a good mate but you wouldn’t expect to see it again. He’s not a crook; he’s just hopeless with money. It might be that he’s a self-employed sofa-warmer or just that he treats his credit card like a gift from the benefits office, but he ain’t gonna get a mortgage.

Ah well, funny I should mention that, because up until a couple of weeks ago he probably could have. These banker types like to show that they have interesting and adventurous lives, and to prove it they started granting mortgages to lots of people like your mate; people who had little hope of ever repaying the loan. But these bankers (no, that’s not a typo) were clever people and they had two solutions to that:

1. If they can’t afford the repayments we’d better charge them more (doesn’t seem too bright to me)
2. Let’s put lots of these loans together and sell them to some one else (BRILLIANT!).

I’ll try and keep the mechanics of this light, but the bankers use a type of portfolio theory that if you combine enough bad risks you increase the credit quality through diversification (they won’t all fail to pay their debts). Then using very clever slice ‘n dice and pick ‘n mix structures they persuade the credit rating agencies (firms like Moodys and Standard & Poors) to give pretty good, sometimes top, ratings to these structures which are then sold on to hedge funds, fund management outfits and even insurance companies.

Sometimes there’s even more slice ‘n dice and pick ‘n mix, to the point where it’s really very hard to value these holdings. So what happens? The investor will ask the guy he bought it from for a value and it never seems to fall!

Not until the little boy said, “Look! The King isn’t wearing any clothes.”

Remember a couple of weeks ago when two Bear Stearns hedge funds went tits up? One bank tried to sell some of the loans to get its money back, but soon stopped when it realised that if it sold at the low prices being bid, it would have to value all its other funds on the same basis, and that would lead to a much bigger problem.

“OK, thanks for the history lesson, but FTSE’s fallen over 500 points in just over a week; what’s that all about then?”

Not just FTSE; equity markets around the world fell to greater or lesser extents, government bonds rose in price and the foreign currency markets did a very sudden about turn from selling the US Dollar to buying the pants off it.

The main culprits, rising interest rates and sub-prime mortgages were both known about when the American stock markets hit record highs two weeks ago. In fact, some would say that the US markets were in the final throes and that hitting the highs had sucked in all those who needed to buy the market.

A couple of earlier sub-prime stories had caused short-lived corrections in markets, but at the time these were viewed as buying opportunities in a bull market. This time, the Bear Stearns admission that two of their funds were virtually worthless concentrated investors’ minds enough that every subsequent reference to loans and debt caused increasing amounts of discomfort.

Late in the day the credit rating agencies, resembling Chief Wiggum in the Simpsons, decided that they ought to start reviewing some of these mortgage bonds. After over 60 mortgage companies in the US had fallen into trouble, Moodys lowered the credit ratings on $5bn of sub-prime mortgage bonds and said that it may cut ratings on $5bn of collateralised debt obligations.

So, markets are going crazy and we’re all blaming sub-prime loans but, as is often the case, we have very little idea of what to really worry about. We’ve been told that the major banks won’t suffer unduly; they’ve passed on a lot of the risk to clients! It’s hard to believe that many tears will be shed if a few hedge funds or private equity firms go tits up. The concern is what wider effects might result from the non-repayment of these loans. The main concerns seem to be:

1. Will ‘ACME Investment Management’ have to sell equities to cover the losses incurred on their loan portfolios? If so, how much, and how many other ‘ACME Investment Managements’ are out there?
2. Will the inability of private equity firms to borrow money take away the demand for equities?
3. Higher interest rates and fears of unpaid debts will cause a slowdown in the economy as higher mortgage and loan payments leave consumers with less to spend. This fear was emphasised over the past week with several high profile companies warning that they were already seeing such effects on their business.

Now, I’m neither an equity analyst nor an economist so don’t go quoting me down the pub tonight, but here’s a few thoughts:

On the first concern, I haven’t got a ‘Scooby Doo’. I’ve got no idea of who might have to sell what, how much or when. I’ve read about some pretty big figures, but I reckon I’m not alone in my ignorance.

I have absolutely no idea how far equities will fall. At the moment I prefer not to have a strong view as, hopefully, that will stop me getting too badly hurt.

For quite some time I’ve felt that equities were due a correction and lots of clever people are talking of 10-15 %. But, I’ve also been told for months that, apart from the stocks with ‘bid potential’ built into the share price, equities were reasonable value, not over-priced, so do they need that much of a correction?

I don’t subscribe to the fear of a lack of money chasing equities. Yes, there might be a lack of borrowed money chasing potential buyout candidates, and yes a lot of shares prices pushed up by ‘whispers in the wine bar’ could still fall. But there’s a fairly new word in the stock market lexicon, Sovereign Funds, referring to the billions being channelled into overseas markets from the Middle East, Russia and China through government-backed development banks. Further, the Chinese Authorities have just granted their insurance companies permission to raise the percentage of funds invested in overseas companies from 5% to 15%. Apparently this represents a further £24bn available for the market.

I have some sympathy with the third concern raised, but I also worried about that last year with rising interest rates, taxes and energy prices- and I was hopelessly wrong.

One area to watch, and we saw a bit of it last week, is the reversal of carry trades (which I blogged on earlier). Investors borrowed Yen at bugger-all % and invested in alternatives with a better return. The ‘cake’ was the difference in interest rates and the ‘whopping big cherry’ was making money on the currency trade as well. Last week’s ‘cake’ would have depended on the ingredients; if the borrowed money was put on deposit then that would have remained OK, but if it was invested in equities then it had probably gone very mouldy. And in either case the ‘cherry’ would have been the sort provided by wicked stepmothers in old fairy tales (a note for anyone under 25, fairy tales used to be bedtime stories for children, not what you’re thinking). Last week the ‘cherry, lost a packet as the Yen strengthened and high interest rate currencies, like the Aussie, Kiwi and Sterling, fell a lot. I mentioned in today’s blog that so far a lot of currency pairs had bounced off support levels; the key is whether they will hold. Even if the Japanese raise interest rates they will still only be bugger-all plus a little bit and other assets have cheapened. The carry trade is still there, but it won’t be if investors think they will lose, either on the market or the Yen.

The markets could get very ugly if banks stop providing the hedge funds with capital to run their positions, forcing them to liquidate at any cost. Then the markets wave goodbye to all logical support levels and look as pretty as Cherie Blair, with or without make-up.

The great news for spread betters is that we can sell as well as buy the market, so there are loads of opportunities, just remember, be careful out there.

Happy Trading