The Market is Gyrating

At the risk of losing my veneer of coolness and respectability, I am going to confess: the subprime mortgage tumult in global financial markets makes me really excited.

I know, this is barely on the radar for most people unless you are working on Wall Street, or have been trying to obtain a mortgage. But this is a market crisis on the order of the 97-98 Asian financial crisis, and I'm in a prime (ha!) position to analyze and perhaps even influence what is going on.

In essence, subprime mortgages are those given to borrowers with less than perfect credit. The practice began in 2005 or so, when mortgage brokers began offering adjustable rate mortgages, with low interest rates and payments for the first 2 years, and an adjusted (higher) rate afterwards. Now it is 2007, and in a lovely surprise, families are suddenly finding themselves unable to pay their mortgages.

Just 2 weeks ago, Fed Chairman Bernanke released a statement suggesting the credit woes would not impact the wider economy, and that the market was going through a necessary self-correction. The global markets continued to slide, as lenders and securities tied to subprime mortgages murmured about bankruptcy and default. Ten days later, the Fed reversed course, and in an unusual move, cut the discount rate at which banks loan money to each other. It's becoming clear that a few risky mortgages are coming to impact financial sectors in unforeseen ways.

Today, I was doing research on asset-backed commercial paper, which is normally the most mundane security instrument out there, relatively risk-free. Until credit tightens and liquidity dries up, that is. In recent weeks, the yields on CP have risen overnight to 6-year highs. Here's an introduction to what commercial paper is exactly:

A: Can I borrow $10 till tomorrow?
B: Sure.
A: I'm good for it, you know.
B: But you're not earning any money tomorrow, how will you pay me back?
A: Oh, there's lots of liquidity at the short end of the yield curve.
B: In English, please?
A: You're going to lend it to me.
B: Lend what to you?
A: The $10 I need to pay you back.
B: Ah.

In other words, this is the kind of scheme that will work until it doesn't. CP is safe because investments mature quickly (say, tomorrow), but issuers must be able to roll over debt by borrowing what they owe. Thus, CP yields have increased to premium levels in order to attract skittish buyers.

I did some work and gave my results to Rich, who will be talking to Chicago Fed president Moscow tomorrow morning, who will be giving Bernanke an earful at the next FOMC meeting. So there, I like to think I've done my part to contribute to history.