A Very Tough Ride

We are in for a tough ride. Take a look at the latest Ivy Zellman Report. It shows when all the ARMS are going to be resetting. It is an ugly graphic. So here is my question: What will that do to all of us and our 401Ks? I am not even looking at what has happened to mine these past weeks.

I am not an expert on the inner machinations of the Federal Reserve. But I am going to try and explain this in very clear terms. US sub-prime loans were packaged into investment tools such as bonds and hedge funds. These were then sold to investors. The bet was that the original borrowers (i.e. new home owners) would pay back their loans and investors would get the interest or the profit from having sold their share of the investment. When an investor (be it an individual or an institution) cashes out of such an investment, the bank goes into its safe (currency reserves) and gets the cash and gives it to the investor. All banks are required to keep a certain level of cash reserves on hand for just such events. However, when too many people or institutions want cash at the same time, the bank’s reserves run low and the bank has to borrow cash from another bank. When a bank borrows, it has to pay interest to the lending bank, just like anyone else. The FED likes to keep this overnight lending rate at 5.25%.

So with that info allow me to move forward. Investors around the world invested in U.S. mortgage backed securities, those sub-prime loans I mentioned above. One investor was Paribas. Paribas then sold those securities to its clients. However, last week, many of its clients wanted to cash out. Paribas risked running out of cash. So it suspended trading in the three funds that were exposed to the U.S. sub-prime market. This means that they halted redemptions. No more cashing in on investments that were tied to mortgage backed investments. This caused a panic as it was a public acknowledgement that the bank 1) couldn’t re-sell these investments to raise the cash to pay off investors and 2) that the bank had so many investors who wanted out of these securities (referred to as “distress selling”) that it didn’t have enough reserve to pay them off. Paribas needed more dollars. 3) the crash of the Sub-prime lending market in the U.S. is going global. This is very, very bad. Can you say “WORLD RECESSION”. For a good article on what this is doing to the global economy, see From The Australian .

In the sort term, this Paribas crisis, like the Bear Sterns crisis before it, drove the over-night lending rate for dollars up above the FEDs 5.25%. This threatened the trust that people have in the investment system. The level of trading is being driven by fear more than by calculated thinking. So, to make sure that there wasn’t a run on Paribas and to keep the overnight lending rate close to the5.25% target, the European Central Bank injected $154 billion into the market and the FED injected as additional $74 billion. The Bank of Japan and Reserve Bank of Australia also participated. They basically bought these crappy sub-prime securities from the bank with dollars.

What the ECB and the FED did as arrange a "Repo" or repurchase agreement. In short, the FED purchased $74 bil. in these mortgage backed securities from the Europeans with the understanding that once the European market stabilized, the Europeans would buy them back.

So logic will tell you that the value of the dollar against the EURO must have been affected. And you would be correct. Take a look below.