Friday, August 10, 2007

America sneezes...

So, panic on Wall St, collapsing stock markets east and west and an ill-conceived credit injection on the European markets. What's going on? Fraser Nelson seems baffled, commenting that I have yet to hear a convincing explanation about how the credit crunch is supposed to be such a disaster for the companies quoted in London and New York - yes, its bad news for American homeowners and a few of the more speculative private equity deals.
But there is a reason that we have good reason to be concerned about the credit squeeze and the collapse of the sub-prime market in the US - credit default swaps. All the debt in the US market that is now defaulting - the high-risk, sub-prime market, has been repackaged, often more than once, and bought up by banks everywhere under credit default swap derivative contracts. They were designed to spread the risk around - allowing much greater credit liquidity and therefore greater access to credit. However, the increasing complexity of the trades (wholly synthetic collateralised debt obligations for example) has meant that no-one is entirely sure who's on the hook.
The enormous growth in the CDS market has intermingled global debt to such an extent that it is impossible to talk of 'US debt' or 'European debt' - a huge amount of it is now mixed together in bundled debt obligations. Someone's dropped a plate - and no-one's quite sure who it belonged to. It doesn't take much to spook investors - and markets tend to follow the herd. Nelson may not see where this one's going, but it's a long road down.

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