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Business Times - 04 Oct 2007

The story of Goldilocks in the house of 'Bears'

Will cheap credit and hedges make her lead the world markets into the house of 'Bears'?

By SATYA SAURABH KHOSLA

GOLDILOCKS has strayed away from home once again. Deep in the forest of the global economy, Goldilocks has found a 'safe' resting place. Where porridge and lodging is free. Just like credit (well, almost - in yen carry trades). The three bears of 'twin deficits', liability of retiring 'baby boomers' and 'excess liquidity, cheap credit' turn out to be friends after all.

Like Papa Bear's porridge, some issues (like twin deficits) are too hot to handle and, therefore, irrelevant. Some others, like Mama Bear's porridge (fate of retiring 'baby boomers'), leave Goldilocks stone cold and, therefore, can be ignored. What Goldilocks loves is the porridge of Baby Bear, full of cheap credit and uncontrolled spending. This she can lap up until she falls asleep (sadly, after breaking the very chair on which she eats).

The three bears do not return Goldilocks favour of gobbling up the porridge by doing the same to her. Instead, they call out to a fleeing Goldilocks and invite her to keep supplying with them whenever she likes. Goldilocks has been doing so for some time now.

This 'true' story of global growth is referred to as a 'Goldilocks' situation by economists today.

Goldilocks prefers the borrowed house of bears to sleep and eat her porridge. Sleeping in a borrowed house is dangerous when the bears' mood changes.

From 2001-2005, outstanding mortgage debt in the United States had risen 68 per cent to US$8.88 trillion: an unparalleled debt expansion. Borrowing to own a house is easy when interest rates are low and 'easy' cash is chasing borrowers. Repaying the same loan when interest rates are high may imply a liability much larger than what the buyer can afford. This is more so if the loan was a little beyond the means of the buyer to begin with and/or his subsequent income stream does not increase to match the new liabilities.

When rates increase from 5 per cent to 7 per cent, that implies a 40 per cent increase in the amount of interest to be paid. US Fed fund rates have risen from one per cent to 5.25 per cent in last few years.

Why should a loan be given to a buyer who can barely afford it? There are reasons. Firstly, if the lending bank can push the risk of default (by selling these loans) to Fannie Mae (ultimately, US taxpayers) or to buyers of mortgage backed securities, then the risk of default is not on the banks' books, even though it remains in the system.

Secondly, the extreme competition among lenders to capture the same 'prime' target audience of homebuyers forces them to expand to 'sub-prime' borrowers who have dubious or no credit record.

Consequently, home prices in the United States today are not in any known relationship with either rents or salaries. Many homeowners complain that rents are less than half of mortgage payments. Salaries, for many, cover only short-run repayment using adjustable interest rates. When in late 2007 the interest rates are adjusted upwards, severe pain is likely to be felt (an estimated US$1 trillion on ARMs, or adjustable rate mortgage, will be reset).

According to a typical 'exploding' ARM sub-prime loan, buyers are considered qualified for loan if the original ('teaser') monthly payment is not higher than 61 per cent of their post-tax income. The scheme works out such that in two years, without interest rate increase, the repayment become 96 per cent of purchasers' income.

The Goldilocks economy has witnessed an explosive growth in derivatives. The housing loans, in a low credit risk environment, like many other transactions were converted into derivatives. The size of these derivative transactions, used to 'hedge' risks of Goldilocks growth, is many times larger than the jungle of global growth itself. Financial innovation has replaced technological innovation as the support system to global growth today.

The outstanding volume of derivative transactions is growing annually at 54 per cent, while global nominal gross domestic product (GDP) is growing at less an 8 per cent in dollar terms. If this rate of growth continues until end 2008, the total outstanding derivates would cross US$1 trillion. Some estimate that the total volume of derivatives is over 60 times global M1, more than 12 times M2 and about eight times global GDP.

In Goldilocks' world, every dollar of GDP is being hedged eight times; or every demand deposit, 60 times. Most of these hedges are done at historically low volatilities. Crisis occurs at high volatilities. We have seen what volatility in mid-August did to equity prices the world over. Surprisingly 90 per cent of these derivate transactions are on the books of a dozen global banks.

Nobody knows the collective impact of these derivative transactions in a financial crisis. Just as nobody knows what will happen to Goldilocks when the bears mood changes. The last time this impact was tested in 1998, outstanding derivatives were less than quarter of the current volume. The New York Fed had to undertake a dramatic rescue, supported by the same major banks that hold almost all the derivative paper today.

Of course, the objective behind most of the hedging transactions would have been to mitigate unnecessary risk or seek return. However, where the growth of derivatives is so much larger than the growth of global GDP, there is a high probability of some derivative transactions that are not funded by adequate capital.

These pose a risk to the global financial system in a period where consistent and continuous volatility upsurge happens. While liquidity has generated asset bubbles, the risk of these bubbles has been 'hedged' with derivatives and financial innovation. When will a pinprick burst a bubble? This is always difficult to forecast.

Financial innovation sometimes presents weakness as strength. Initially, excessive global liquidity allows the less credit-worthy to borrow more than they earlier could and now should. The big banks add fuel to the fire of credit expansion when they don't hold this debt but sell it to others through securitisation. Sadly, each bank believes that risk 'removal' is taking place by distributing debts 'far and wide so that no single holder has significant exposure'.

In reality, risk has spread while derivatives do insure 'holders against losses', but the sale of this risk to many small buyers spreads it in a manner that almost everybody will now be impacted.

It is true that Goldilocks is a story meant only for children. Also, using parables was relevant only during the time of Jesus. While the risk of Goldilocks growth being unable to extricate itself from the 'hedges' threatens to become real, one question inevitably arises: 'Will the porridge of 'cheap credit' and the shade of 'hedges' make Goldilocks lead the world markets into the house of 'Bears'?

The author is a Dubai-based private investor trading global financial markets. He is also currently setting up an IT special economic zone in India

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