Friday, July 14, 2006

What will Trigger the Financial Collapse?

There are housing bubbles all over the world, stock speculation at absurd levels, hedge funds and derivatives way out of whack. The question arises; what will convince everyone that the game is over?

Here is where it gets tricky. The common denominator of all the different parts is "Interest Rates." The trigger could very well be a panic in the bond market.

What people don't realize is, markets create interest rates. Governments can tweak them for a month or two, but they will come back to some desired level totally irrelevant of government prodding.

The Second Trust Deed Market is very vulnerable, a lot of that stuff was written with 7.5% rates. So lets say a dealer has a $100,000 second that he needs to unload, because the real estate market looks bad. So if he discounts the note to a face value of $50,000 it will pay an equivalent 15% interest. At this point there doesn't seem to be much damage, right?? Wrong!

Suppose you had a 30 Bond for 100,000 paying 5%. After that transaction, with an interest rate payout of 15% you could only sell it for 1/3 of its face amount.

The fundamental not realized, is that bonds have not had this low an interest rate in 45 years. So for a $100,000 thirty year bond at 5% to double in price, the interest rate would have to drop to 2.5%. That's not very realistic. But if we pursue the idea the other way, the same bond would be worth only $25,000 if the interest rate jumped to 20%. It would loose 3/4th of its value. Now that's not to say that you couldn't wait around 30 years and collect the face amount of the bond 100,000. I'd be almost 90 years old, so its not realistic.

Plus lets work it from the disaster end. If the interest rate were to jump to 20% you would buy the 30 year bonds paying 20% interest. Or you could buy the old 100,000 bonds paying 5% marked to market at $25,000 (what a deal if you live to be 90)!!! So at that point, if the interest rate dropped from 20% to 10% your bond face value would double. Not bad for a bond, plus you get the interest accrued.

So what is transpiring, is a contraction of actual assets. A doubling of the interest rate in the bond market can literally contract the money supply by 50%. It could from there double again without so much as the of a blink of an eye.

At this point, the hedge fund and derivatives managers would be in a melt down mode. This might seem illogical, but I suggest that these managers, might be invested in something like Google up to the hilt, and at the same time with options and derivatives satisfying their customers asset allocation directives.

Translated into layman's terms, the bond market will have a bad day, and the stock market will have an even worse one. After that, the housing market will have to deal with reality. The party is over.

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