an excerpt from our friends at ContraryInvestor
contraryinvestor.com
But what is also different is that a ton of existing debt in the US system is variable rate. Moreover, the massive derivatives complex that does exist today was almost non-existent in the late 1980’s.
Why bring this up? First, we already know that Fannie is in a world of hurt having tried to hedge their mortgage portfolio. You’ll also remember that when we covered the 3Q banking system derivatives report, we told you that the single most important item in the report was the first ever very large loss in interest rates derivatives in the banking system occurred during 3Q of last year. Now we have Countrywide Credit hitting a rock with recent quarterly earnings due to assumptions used to position their derivatives book that turned out to be incorrect. Like many, they assumed long rates would move higher as the Fed Funds rate rose. Wrong, and it cost them $140 million. Point blank, the continued flattening of the yield curve is hurting real world businesses who apparently seem to be doing forward planning around assumed historical relationships in terms of yield movements. Just how many more Countrywide’s are “out there”? You’ll remember one of our main considerations/themes for 2005 – Distortion. It’s playing out right before our eyes, at least as far as CFC is concerned. Now what? Do they plan for a flatter yield curve ahead and reposition the derivatives book? And risk being wrong again?
As we have said many a time, Greenspan has been cushioning the Fed Funds rate increases with very heavy doses of liquidity injections (repo market and coupon pass activity, as well as Treasury activity as of late). We believe this is creating unintended consequences. His “measured approach” (of which the Fed really has no other choice given the extent of leverage in the system), coupled with the backdoor liquidity, is allowing his buddies playing the carry trade to continue partying. The distortion in foreign buying of US financial assets is simply fanning the flames. For now, the leveraged carry trade crowd isn’t even blinking. After all, telegraph operator Al is at the wheel. But it’s probably a good bet that a few folks are blinking – shareholders of Countrywide, Fannie, and the banks who lost a billion and a half in interest rate derivative transactions in 3Q of last year. What other unintended consequences of the new period of liquidity and yield curve “distortion” lie around the corner? Don’t blink. |
