Wednesday, August 5, 2009

Hot markets - History all over again.


Some of you may be confused what in the world is happening - aren't we supposed to be in one of the worst global recession ever faced?

As it turns out, the flow of liquidity (by printing money like toilet paper) is so powerful that it propels stock prices higher after each correction. Basically what is fuelling the run-up is the ability to borrow at next-to-zero interest costs in US dollar to punt regional markets.

Not to forget that as the greenback weakens against all major regional currencies, foreign exchange gains are quite substantial as well.

Many would draw the connection to Japan when it slashed interest rates to zero to fight deflationary pressures a decade ago. The end-result was a multi-billion dollar yen carry trade, as traders borrowed in the low interest yielding Japanese currency to make huge bets in emerging stock markets.

Now, with the Fed also slashing interest rates to almost zero, the greenback has replaced the yen as the new carry trade currency.

Well, print all the money you want, there will be consequences. People seemed to have forgotten all about the dangers of hyper-inflation, once again falling foley to the ludicrative paper tradings. The economy hasn't yet recovered from the implosion of risky investments that led to the worst recession in decades and already some of the world's biggest banks are peddling a new generation of dicey products to corporations, consumers, and investors.

In recent months such big banks as Bank of America, Citigroup and JPMorgan Chase have rolled out newfangled corporate credit lines tied to complicated and volatile derivatives. Others, including Wells Fargo and Fifth Third are offering payday-loan programs aimed at cash-strapped consumers. Still others are marketing new, potentially risky "structured notes" to small investors.

Banks once again making dangerous loans to borrowers who can't repay them and selling toxic investments to investors who don't understand the risks—it sounds awfully familiar, doesn’t it?

Lenders typically tie corporate credit lines to short-term interest rates. But now Citi, JPMorgan Chase, and BofA, among others, are linking credit lines both to short-term rates and credit default swaps (CDSs), the volatile and complicated derivatives that are supposed to act as "insurance" by paying off the owners if a company defaults on its debt. In these new arrangements, when the price of the CDS rises—generally a sign the market thinks the company's health is deteriorating—the cost of the loan increases, too. The result: The weaker the company, the higher the interest rates it must pay, which hurts the company further.

While the lenders stress that the new products give them extra protection against default, the opposite is true for companies. Managers now must deal with two layers of volatility—short-term interest rates and credit default swaps, whose prices are affected for reasons outside their control.

Corporate borrowers also have to deal with higher fees. With corporate credit remaining tight, banks increasingly are steering borrowers to the CDS-linked loans and many companies have little alternative. As such, banks are raising their rates for credit lines across the board.

Then you have big banks turning to payday loans, whose interest rates can run as high as 400%. Historically the market has been dominated by small nonbank lenders, which mainly operate in poor urban centers and offer customers an advance on their paychecks. Their argument is they offer a valuable service for those who need emergency cash.

More big banks are getting into the market just as a recent flurry of usury laws has crippled smaller players. In the past two years lawmakers in 15 states have capped interest rates on short-term loans or kicked out payday lenders altogether. The state of Ohio, for example, has imposed a 28% interest rate limit. But thanks to interstate commerce rules, nationally chartered banks don't have to follow local rules. After Ohio limited rates, Cleveland-based Fifth Third, which has 400 branches in the state but also operates in 11 others, introduced its Early Access Loan, with an annual interest rate of 120%.

On the investing front, big brokerage houses, including Morgan Stanley Smith Barney and UBS, are selling new forms of debt instruments called "structured notes". Structured notes are essentially derivatives for small investors—and they make sense for some. Basic structured notes let buyers benefit from the growth in stock, bond, or currency prices while offering some degree of loss protection. Yet many of the latest iterations are highly complex and may not compensate for all the risk. Buyers without the financial experience to evaluate risk should best stay away .

The new debt investments offer attractive rates, sometimes guaranteeing double-digit returns for the first couple of years. But when those teaser rates disappear, investors face huge potential losses over the life of the instrument, up to 15 years. The prospectus usually states a trend or historical support, but as the recent market turmoil has shown, historical patterns aren't always reliable. Need I remind you about Lehman Brothers and Long Term Capital?

Those with the deep pockets will once again be heading for real estate thus explaining at least why the Vancouver market which is overheated is still standing strong if not climbing.

Meanwhile, summer is entering its last stretch. Soon, it will be winter again.

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