Thursday, July 08, 2004

Market Watch: Banks Hedge Risk, Emerging Market Meltdown?

Brad Delong stores here an article by The Economist that discusses why we shouldn't be worried about the exposure of banks to mortgage backed securities.

Many of these depreciating securities consist of mortgage loans and mortgage-backed securities (known collectively as mortgage-related assets, or MRAs). Indeed, regulators' biggest worry is the reliance of the banking industry on the mortgage market. According to the OCC, MRAs now make up 28% of American commercial banks' assets (see chart), thanks to a housing boom fed by cheap mortgages. A recent analysis by the OCC found that a rise in interest rates of two percentage points would cause equity capital at 101 banks to fall by at least a quarter. At 18 banks, it would fall by half or more....

All this may sound frightening, but the banks have had time to prepare for higher rates. America's big banks have been rejigging their portfolios for a while in anticipation of the Fed's move. Securitisations of interest-rate sensitive mortgages, for example, have boomed in the past couple of months. WaMu sold some $14 billion-worth of fixed-rate securities in the first quarter of this year. “This not a shock,” says Mr Wyss. “Greenspan has been running around the country kicking banks in the shins to get them to unwind their positions.”...

So of course these banks, having divested themselves of risk by securitizing - bundling and selling off packages of loans to spread risk - are going to invest in solid income producing assets and safehavens right? I would hope so. However not all investors are apparently so prudent. Well at least not according to Buttonwood in The Economist they aren't. Instead they're rushing into emerging markets ...
SOME things in life are not just surprising but truly astonishing. The enduring popularity of Cliff Richard is one. Greece winning the Euro 2004 football competition is another. But Buttonwood had another of those I-can’t-believe-what-I’m-seeing moments on Monday morning when idly perusing a piece of research by Credit Suisse First Boston (CSFB). Bonds issued by Bulgaria and Romania, according to a chart in the report, have rallied so fast in recent months that they now yield scarcely a percentage point over the rate at which the healthiest western banks lend to one another, also known as the swap rate...

And that problem, says Christian Stracke, a strategist at CreditSights, is made doubly, well, problematic because rich countries have current-account deficits to finance too. The biggest of them all, of course, is America, whose quarterly deficit has risen from $30 billion in 1994 to a staggering $140 billion. Of course, one country’s deficit is another country’s surplus, but for the first time since 1994 emerging economies will have to compete for savings with an America where interest rates, both short- and long-term, are rising.

Emerging economies that depend heavily on the whims of foreign investors to keep themselves afloat will find it very tough to compete, which is why emerging debt underperforms when rates rise—however expected that might be.

Who the heck would want to be in an emmerging market when the US Central Bank is about to raise interest rates? At least they should be in one that has a decent spread compared to the expected upper range that US interest rates should go. It would seem a no-brainer that these emerging markets will have a hard time maintaining bidding on their debt as US interest rates in competition. Or is the market seeing something that I'm not? It is true that the dollar appears poised for further downward movement. If it was then perhaps the choice to invest in emerging markets would not be so irrational afterall...

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