Oil sheds nearly $3 on credit squeeze

Thu 16 Aug, 2007 16:04


By Janet McBride

LONDON (Reuters) - Oil dropped almost $3 on Thursday as credit and economic fears pounded global financial markets and a storm threat to U.S. Gulf refineries and rigs receded.

Tropical Depression Erin crossed Texas without inflicting damage on the oil industry there, companies said. The U.S. National Hurricane Centre forecast Hurricane Dean would plough into Mexico's Yucatan peninsula in about five days.

U.S. crude fell $2.88 or 4 percent to $70.47 a barrel by 4:40 p.m. British time, 11 percent below its August 1 record high of $78.77. London Brent crude was down $2.55 at $69.09.

European shares fell to a five-month low and London's FTSE 100 hit a 10-month low below the 6,000 level as U.S. housing-loan problems and wider damage to global markets continued to worry investors.

Harry Tchilinguirian, senior oil market analyst at BNP Paribas Commodity Derivatives, said the credit squeeze that started in the U.S. subprime loan market threatened to have a knock-on effect on the wider economy and ultimately on oil demand.

"A slower U.S. economy has ripple effects. If the advanced economies of the United States, the eurozone and Japan slow down that could have a moderating impact on the countries furnishing these goods, on China and India."

"The U.S. consumer and his outlook is an important cyclical factor. Subprime issues are leading to a reappraisal of risk, credit tightness is increasing and that is a depressing effect on consumers."

Tony Dolphin, director of economics and strategy at Henderson Global Investors, agreed that the ripples from subprime loans were no longer just a Wall Street problem.

"Today is certainly a serious growth scare. For the first time really, we've seen big falls in the Asian market that suggest that what's going on in global credit could actually impact global growth going forward."

"The longer this thing drags on the more worried we get that this will have an economic impact."

HURRICANE

Chip Hodge, energy portfolio manager with John Hancock Financial Services, said the Atlantic hurricane season was a wild card that could prop prices up, although he cautioned "if there is no damage the effects would go away quickly."

Dean became the first named Atlantic hurricane of 2007 on Thursday.

The U.S. National Hurricane Centre showed a track that would take Dean across the Lower Antilles and into Yucatan, missing U.S. Gulf rigs and refineries that were battered by Katrina and Rita in 2005. Some weather models forecast Dean would enter the Gulf of Mexico.

"The grim situation in the bond and stock markets against a backdrop of possible slowing growth will act as the more dominant influence on the energy markets, and should more than offset any hurricane-induced bounces," said Edward Meir, an analyst at MF Global Energy Group.

In Nigerian oil city Port Harcourt troops and gangsters fought gun battles. Violence in Nigeria's oil heartland has shut down a fifth of output from Africa's biggest producer.

(additional reporting by Randy Fabi, Jonathan Leff in Singapore)

http://www.iii.co.uk/news/?type=reutersnews&articleid=MTFH00515_2007-08-16_16-04-26_SP311831&feed=Bus&action=article

The making of a market crisis

http://www.iii.co.uk/articles/articledisplay.jsp?section=Planning&article_id=7245300&catEnforce=YourStories

by Peter Temple
23.07.2007

The American consumer's addiction to using their home as an ATM machine had to come to grief somewhere. Most investors might have assumed that, when it happened, it would be nothing to do with them. In reality, the interconnectedness of financial markets means that home loan defaults in America can threaten large hedge funds, in turn provoking rumbles on Wall Street, weakness in the dollar, and a backwash into the FTSE.

Add to this the fact that some large UK banks have exposure to mortgage lending in the US and the conclusion is that we really do need to understand exactly what is going on here.

The problem starts with so-called sub-prime lending. For the uninitiated this might normally mean lending to the self-employed, those with adverse credit histories and other higher risk individuals. In the US, this has been taken to a new level with aggressive marketing bringing in individuals who might not normally participate in the home buying market, and their being given loans many times their income on the flimsiest of pretexts. When rates rise, and times get tougher, defaults become inevitable.



Collateralised debt obligations

For the next stage of the problem we need to reflect on the ingenuity of Wall Street in creating new financial instruments. Home loans in general, and sub-prime mortgages in particular, were repackaged into bundles known as collateralised debt obligations (CDOs) and sold to investors in search of high yield. The theory was that while some loans might go bad occasionally, this had always occurred with a predictable frequency that could be offset when incorporated into the terms of the bond that was backed by the bundle of loans.

Not content with this relatively simple idea, the next stage is for the packaged mortgages in CDOs to be sliced into different tranches, each with different degrees of seniority. Those lower down the pecking order stood first in line to take the brunt of defaults, when they occurred, and offered higher returns in the meantime to compensate. Higher-grade slices offered lower yields, but less exposure to default.

Now add to this the fact that lots of hedge funds bought stuff like this using massive amounts of leverage and it's possible to see the genesis of a financial crisis. The problems are compounded by the fact that the different classes of security created in the collateralised debt obligations are virtually impossible to value accurately. And what's more, there is no liquid market in them.


The issue of valuation

It's not a small problem. In the US, approaching $1,000 billion of a collateralised debt obligations based around residential mortgages was issued in 2006 alone. Not all carries a risk of default, but a fair proportion does.

Let's look at the issue of valuation in particular. Typically buyers of 'toxic debt' like this would go back to the investment bank responsible for the original issue and ask them for a price when seeking to value their holdings. Issuing banks, of course, would be reluctant to admit that their creations had dropped sharply in value, so the whole edifice begins to take on a slightly unreal quality. Everyone with any sense knows there is a problem, but no-one is prepared to admit (or even really knows) quite how large it is.

What is now known is that two hedge funds run by investment bank Bear Stearns have all but collapsed as a result of the crisis. Some more may follow as reality takes hold. Other hedge funds have actually profited from the misfortune of their competitors. But that doesn't mean the whole affair is simply a gigantic zero-sum game.

The concern among central bankers and other policymakers is that the large scale mispricing of assets like this - which looks like it is what has happened here - will not be corrected in an orderly manner. Writing down of large tranches of CDOs to their correct price might necessitate the forced sale of more liquid bonds to shore up cash reserves. A subsequent sell-off in bonds would have a knock on effect on equities. Result: we all end up with higher bond yields, and lower share prices.


Peter says

The moral of this particular story is that financial markets never learn that complexity, leverage and illiquidity are rarely a good combination. CDOs have worked well for a while, but most observers with any knowledge of the history of financial markets could have seen the current crisis coming a mile off once US interest rates began to rise.

The bundling of mortgages, held to be a strength because of the diversification of risk of default, turns out to be a weakness. With a low-grade corporate bond (a so-called 'junk' bond), for example, buyers at least know what they are buying. They can analyze the company's accounts, and form a view on the true risk of default under a range of scenarios. If default happens, they can fight for representation at meetings of creditors, determine how a restructuring might be engineered, and maybe come out not too far out of the money.

Buy a slice of a CDO based around residential mortgages from an investment bank and none of this is possible. The amount you recover is a function of how prudent the original mortgage lending has been, the earning power of the mortgagees, and the value of the underlying property. History suggests, in fact, that the underlying property is little more than a house of cards.

Yen Rallies Across Board as Investors Exit Carry Trades

The yen rallied Thursday to its highest level against the dollar in more than a year, as investors unwound risky trades financed with borrowed yen on fears of a global funding crisis.

The yen rose against all major currencies and hit its strongest level since March against the euro, as the unwinding of carry trades accelerated on evidence companies across the globe were having increasing difficulty accessing credit.

In carry trades, investors finance purchases of more risky higher-yielding assets by borrowing in currencies with lower interest rates such as the yen.

In the United States, benchmark stock indexes sold off more than 1 percent as a report showing housing starts in July dropped more than expected. The data added to nervousness about the outlook for the U.S. economy as losses related to the U.S. subprime mortgage sector mounted.

"The strength of the yen has been driven by unwinding of positions that had been established over a very long period of time," said Meg Browne, senior currency strategist at Brown Brothers Harriman in New York.

"The market is also very concerned there will be a slowdown of the U.S. economy," Browne added. "There is concern that it will spread to the rest of the world."

The dollar Japanese Yen Spot%24%24USDJPY
[$$USDJPY 112.67 -3.90 (-3.35%) ] was 1.8 percent lower against the yen at 114.31 yen , its lowest since July 2006. The euro Euro / Japanese Yen Cross%24%24EURJPY [$$EURJPY 150.99 -5.77 (-3.68%) ] slipped two percent to 153.24 yen , its lowest since March.

The selling in other cross-yen pairs exploded as options barriers were smashed and automatic sell orders triggered, with the Australian Australian Dollar / Japanese Yen Cro%24%24AUDJPY
[$$AUDJPY 88.44 -7.15 (-7.48%) ] and New Zealand JPY/NZD REUTER CROSS%24%24NZDJPY [$$NZDJPY 75.89 -7.13 (-8.59%) ] dollars on track for their steepest daily declines against the yen in about two decades.

"Attention is on the turbulence in international markets," said David Powell, senior currency strategist, at IDEAglobal in New York. "We're seeing the yen crosses rise as a result."

The Australian dollar fell as much as 5.6 percent against the yen in intraday trading, which would be its its biggest drop in 21 years, according to Reuters data. It last traded at 89.88 to the yen. And the New Zealand dollar slid 5.7 percent, its biggest decline in 20 years, to trade at 77.61 yen.

The Australian dollar has now lost more than 12 percent in the last six sessions, while the New Zealand dollar is down about 14 percent against the yen.

U.S. Housing Troubles

The sharp increase in risk aversion came after shares in Countrywide Financial, the largest U.S. mortgage lender, plunged on Wednesday amid rumors it was having trouble raising funding. Countrywide Financial CorpCFC [CFC 17.74 -3.55 (-16.67%) ] shares tumbled another 15 percent on Thursday after it said it had to draw all of an $11.5 billion credit line to fund operations after it was effectively shut out of other credit markets.

The euro was down against the dollar at $1.3407.

Earlier the dollar erased all its gains versus the euro after the U.S. Commerce Department said housing starts fell much more than expected in July.

"Some very weak numbers, which certainly show that the U.S. housing market remains weak," said David Watt, senior currency strategist with RBC Capital Markets in Toronto. "There has been such intense focus on the U.S. housing sector that any signs of weakness and its global implications, one of the factors spilling over into other markets, adds to the nervousness."

Reflecting the fears of the markets remaining rocky, the implied volatility on one-month dollar/yen options -- how much a currency pair is seen moving over a given period -- soared above 17 percent earlier to its highest in over seven years.

Japanese Prime Minister Shinzo Abe said on Thursday the nation's economy remains in good shape and he expects the Bank of Japan to make an appropriate decision on monetary policy while examining economic conditions.

The yen's surge is fueling trader speculation that Japanese intervention in the currency markets is a possibility. The last time Japan intervened was March 2004 as it wound up a period of yen-selling intervention totaling some $350 billion.

http://www.cnbc.com/id/20287109/site/14081545