Cluster Family Office Blog

Why are we in a credit crisis? Why has it come to the point where subprime mortgages are being securitised? Basically, because of the thirst inversopata from both institutions and private individuals. This demand for paper, which far exceeds the borrowing capacity of traditional issuers, has led to the financos the creation of AAA alternative. The tightening of the interbank liquidity market has exacerbated the negative outlook. And the accumulation of reserves by Asian central banks – which have played a decisive role in the financial landscape for the past decade – was not the most favourable backdrop for entering such a turbulent phase.

But let’s try to break down the components of this crisis: Wall Street christened this creation alternative AAA-rated debt such as structures in which the underlying asset was nothing more than junk bonds to which they added some ingenious payment rights. Their approximate 8% interest rate and the maths did the rest. These interest rates are divided into three categories: Senior, mezzanine and equity, according to their probability of default. The tranche senior, although its underlying asset generates higher interest, is traded only slightly above the yield on traditional AAA-rated debt. This ensures it can be placed on the market and, surprisingly – with the benefit of hindsight – it is also rated AAA. The debt mezzanine is attracting greater interest and is rated as still being considered investment grade. And finally, the investment bank or financial institution itself, which creates and promotes this structure, retains the radioactive waste, that is to say, the section equity, which will keep the entire facility on tenterhooks for years. It is rather like what happens when a nuclear power station suffers a major incident. Of course, this organisation can sell the waste to third parties and offload that radioactivity in true Where's Wally?.

In 2006, this phenomenon of credit securitisation reached a figure of 500,000 million dollars. Some sources say that 150,000 people are facing the risks associated with what is known as a mortgage subprime American. In the first half of 2007, the value of instruments maturing between two weeks and three months was comparable to Spain’s GDP. Although half of that amount had already matured by 16 September without any major surprises other than those already known.

Mortgages on properties in the US granted to those whom the ‘ordinary banking sector’ (I do love calling it that!) did not consider sufficiently creditworthy have largely fuelled these processes and make up the majority of the portfolios of these structured products. If we add to this the first fall in US property prices in 40 years, the result is a default rate of close to 20%. However, contrary to what one might expect, it is not the bondholders who have been the first to be affected mezzanine and equity but the senior or AAA. The reason is very simple: these are the ones with the nearest maturity dates – as we have said before, ranging from two weeks to three months. And as things stand today, in early October 2007, the outstanding bonds are still the key to what will happen to the system.

But here’s the crux of the matter: investors tend – as do we – to reinvest short-term funds in similar securities, but given the scenario of the subprime At present, lenders’ instructions are quite different. Faced with a lack of alternatives for investing the money in substitute securities, the developers and investment banks that have marketed these structures are now faced with having to repay the equivalent of Spain’s GDP in just two months. The result of this situation: Credit crisis. Added to the liquidity crunch in the international banking system – which is directly affected – is the contagion of caution (or panic) throughout the entire system and the demand for reserves from Asian central banks mentioned at the outset. The result is that central banks are obliged to inject liquidity into the system to prevent spikes in interbank rates and further caution (or panic).

Most of you readers will be thinking: «If the crisis has so far only affected maturities…’ senior Or AAA, what will happen when the mezzanine y equity?»Well, in all likelihood, the percentage of defaulted mortgage loans will rise, to the detriment of the solvency of those upcoming maturities. But risk aversion is unlikely to increase, and with it the existing liquidity crisis. We could therefore say that the collapse of the least solvent parties will affect those holding them at that time, but the impact on the system as a whole will depend solely on the panic that we are collectively unable to quell.

Where does the risk lie? In other words, which entities hold securitisations with underlying assets? mezzanine y equity? Here we must return to the article’s title: Where’s Wally? The vast array of reliable structured debt – not based on risky mortgage or even consumer loans – is so substantial and widespread that it provides the perfect environment in which to hide Wally. Furthermore, no one knows which institutions are particularly exposed, as these transactions are off-balance-sheet. The greed of financiers and investors It has allowed a corrupt Wally to change his clothes, to the point where he is no longer even recognisable by his red and white horizontally striped jumper, glasses, jeans and matching woollen hat. The very same major banks around the world could have Wallys with different appearances among their assets. And they may or may not be aware of it. That is why the reluctance to lend money to one another cannot be substantially reduced in the short to medium term. Central banks will have to continue injecting stability and bailing out specific cases of obvious illiquidity, such as Northern Rock. But these are likely always limited to smaller organisations and do not jeopardise the foundations of the system.

It may well be the very assessment of future risks in mezzanine y equity will help to mitigate its effects. If Wall Street was able to create the Beast, will certainly be able to create the Bella which will, in turn, finance current and future contraction. Although some people seem not to care in the slightest if they lose sight of Wally, as long as they have enough credit on their mobile to send a text message asking help as he explains to us Echevarri in his latest post. Perhaps if Wally were recognisable in his usual get-up, they would prefer to look the other way, as some have done for years, selling their fish with radioactive waste without the slightest shame. But the buyers of that supposedly AAA-grade fish are partly to blame for spreading the radiation we’ll have to live with for a few years.

The million-dollar question: How would the global credit system react if the mortgage crisis were to spread to Europe as well? It is true that the granting of subprime mortgages – an alternative to conventional banking – is not widespread here, but the crisis in the sector in Spain is showing us its worst side, as we are told in GurusBlog, describing that possible scenario as perfect storm.

A turbulent landscape in which the ‘smart’ currencies (the US dollar and the Japanese yen) continue their strategic standoff with the ‘tricky’ yuan. At the same time, they open up interesting diversification opportunities for European investors, as we discover José María Díaz Vallejo in *Bulls, Bears and Donkeys*.

Bloody hell, as our contributor and friend, Global Counsellor, would say: I love this game!