Analysis of a Market Correction - Part II

(Part I of this has been posted earlier. Check the earlier post)

so where were we? Liquidity, yeah. If you have been paying attention so far, you would have picked up that the cause for this chaos is not entirely due to the mortgage payment default but also because Bank B (and others like them) has stopped giving loans. The point I am trying to make here is that the market correction was not entirely the fault of sub-prime meltdown. Sure, the sub-prime mess triggered it but a simple look at the mergers and acquistions action that has taken over Wall Street (and Europe) over the past 5 years and you know there is a lot of cheap credit being offered.

Everywhere around investors have become accustomed to getting into riskier and riskier ventures over the past few years. Structured products of all kinds-SIV, SIV-lites, CDO, CLO, Swaps etc. Structured products are developed from computer models that try to extract minute differences in the markets. At the same time most of the time these models are capable of handling volatility in the markets. That is they are usually hedged. For example if a product combines 50% sub-prime loans with the rest 50% distributed between less risky investments (regular mortgages/treasury bonds etc). But these models go crazy when the trends go always in one direction. So, if the sub-prime related parts went down the model could handle it and still return ok money as long as the rest went in the other direction or stayed stable. Due to the panic selling, almost everything in the market was going down, so the models got completely destroyed.

The other aspect of risky investments is the private equity buyouts of large corporations. You have to realize that these private equity buyouts are financed by putting down 5-10% of own money with the rest being borrowed from banks. The banks will loan a reputed private equity money as long as they are convinced that these guys can get good a return for it. Well, that remains to be seen in the next couple of years. One thing is for sure, dont expect to see the flurry of buyouts in the next year or so.

The following factors also played a role in the market correction:
-Housing markets slowing down-->less people buying-->less loans
-Housing markets slowing down-->slow construction-->basic metals demand down
-Oil price going up-->low consumer confidence-->less spending


So what now? What can we expect? Here is what I think:

-Apparently an expected $700 billion worth of ARM will come off in March 2008.
-Look out if people start defaulting on their mortgages after that. That could get messy.
-It will definitely be tough to get cheap loans for another year or so.
-The performance of all the companies bought over by private equity firms will be watched carefully.
-People will continue to invest in structured/quant products. Everyone needs to understand that these things work for a majority of the time and fetch you good returns in the long-term.
-Today sub-prime packages tommorow something else. yup, there is no stopping financial innovation. Hopefully all parties involved are educated more on the risks involved.