|
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!
More commentary and stock picks follow for
subscribers…
Greg Silberman
CA(SA), CFA
greg@goldandoilstocks.com
I am an investor
and newsletter writer specializing in Junior Mining and Energy Stocks. Please
visit my website for more free articles and analysis
Click here: http://blog.goldandoilstocks.com
This article is
intended solely for information purposes. The opinions are those of the author only. Please conduct further research and
consult your financial advisor before making any investment/trading decision.
No responsibility can be accepted for losses that may result as a consequence
of trading on the basis of this analysis.
| 
