Article originally submitted to subscribers on 24th June 2007...
A repricing of the risk inherent in Collateralized Debt Obligations (CDO) is underway with significant implications for the price of Gold.
Here's the Problem!
Years and years of monetary inflation have completely desensitized us to risk. From a national, corporate or even individual level, the availability of cheap debt has conditioned us to borrow without abandon.
And nowhere has the debt binge been more apparent than in the housing market. Low mortgage rates have been a boon for homebuyers and created an insatiable demand for structured products from yield hungry investors. Eager to oblige, Wall Street has been having a feast making loans to homebuyers then packaging them up and selling them to pension funds, hedge funds and large insurers. The fees have been MASSIVE.
When you package up individual loans into a product (called a CDO but with many name variations) you are able to pick and choose the exact payout you want to achieve. Add in some AAA rated mortgages, mix in BBB+ paper and stir in Toxic Junk bonds (bound to default) and voilà you have an instrument with very specific yields and cash flows.
Ofcourse there are bands as to what constitutes for example a BBB- Investment Grade Bond. And all the structurer has to do is use the loosest defined Bond to comply. Compliance is overseen by ratings agencies that help banks put the products together. It's a cozy lucrative arrangement and its complicated stuff. One of the highest paying jobs on Wall Street is for Correlation Traders. Quants who make sure the underlying paper behaves according to their promise.
And then there's the leverage. And boy is there leverage! Payouts can be magnified by up to 10x using synthetics or derivatives that link to even more mortgage pools.
The party was going great until interest rates started to rise and housing began to fall.
Chart 1 - Centex homebuilder and 10 year Bonds (bottom) breaking support - CDO reaction 1 week later
Last week the financial world was awoken by the harsh reality that hey, maybe these mortgages are not going to perform as originally planned. Maybe the risk of default is a lot higher than originally thought GULP! Bear Sterns announced a $3.2Bn 'loan' to bail out two of its troubled hedge funds doing exactly what I detailed above.
Based on the banking indexes sharp fall on Friday, this problem may be a little more widespread than that.
Chart 2 - Banking index (top) reacting to CDO news; price of gold trending lower (bottom)
Earlier this month we detailed how higher interest rates would benefit the price of gold. That is, in the long-term the fundamentals for Gold are incredibly bright, but there will be short term pain. The reason is that Gold has been bid up along with all other assets under the current wave of liquidity. A repricing of CDO risk would likely curtail the issuance of these instruments and cause a sharp contraction in liquidity with a commensurate drop in ALL asset classes - if last week is an indication, the speed of this deflation would be mind blowing and completely overwhelming. However, Gold's Credit rating has been and always will remain sterling. When investors realize the incredible DANGER in front of us, they will return to Gold in droves!
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