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Mon 18 Feb 2008 02:53 PM

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Armageddon time

Evidence is building that rate cuts are impotent in solving the credit crunch, and the looming derivative mountain threatens to derail us all.

There’s an unnatural calm around markets at present. It seems that interest rate cuts have lulled even the wary into a state of false optimism.

Yet the evidence is building that not only are rate cuts impotent in dealing with the credit crunch, the looming over-the-counter derivative mountain threatens to derail us all.

Although the events of recent weeks may ease the pain in a few areas of home equity credit, there is likely to be little immediate relief for borrowers with mortgages tied to LIBOR, as the cuts will only affect loans tied to US banks' prime rate.

It’s possible we may even be facing higher rates on fixed-rate mortgages if bond markets anticipate inflation, which they will do as the Fed put all of its chips on the prospect of a possible recession and very little on the possibility of inflation. If inflation does occur, then they would have no other option but to increase interest rates, which could be an unmitigated disaster.

In reducing borrowing costs, the Fed quite rightly attempted to prevent systemic collapse in the banking system. But in its attempts to alleviate the worst housing recession in the US since 1991, it misses the point -that it is not just a sub prime problem.

Many top economists point out the futility of this exercise saying that this cut will have little impact on the overall scenario. According to them, it is a case of too little and too late.

Too late at least for the estimated one million homeowners with payment option adjustable mortgages, known colloquially as neutron loans. These $500 billion of loans are beyond the help of interest-rate cuts.

While sub prime borrowers face an average increase of less than 8% when their mortgages reset, option ARM homeowners may see monthly payments double after their adjustments kick in.

Accounting for around 9% of the almost $3 trillion in U.S. home loans made in 2006, nearly one in five of these option ARMs packaged into bonds last year required less than 10% down payment. About $460 billion of adjustable-rate mortgages are scheduled to reset this year.

At Citigroup, economists compute an index of overall financial conditions in the economy that measures not only official interest rates but also variables, such as asset prices, credit spreads and other exotica.

The latest index shows a sharp deterioration in conditions since the Fed began to cut rates last autumn. In October, presumed to be the worst moment in the credit crunch, Citigroup's index suggested that conditions overall were about neutral — neither stimulative not accommodating.

Last week the index had dropped to its most negative level in more than five years. They must have taken particular note of the wholesale markets, where the price of credit has tumbled. Credit default swaps, by far the dominant instrument in the OTC derivative market, have been in free fall for six weeks.

The leveraged loan market is in complete disarray and loans issued at 100 are trading at 80, with the smart money bids around 60. No one knows for sure where the bottom is.

In its semi annual report, The Bank for International Settlements reported that the total notional amount outstanding of OTC derivatives stood at $516 trillion.

Optimists quote the emphasis on “notional value” i.e. the face value of the underlying instrument on which the derivatives are traded. However, as Jim Sinclair puts it “ when the losing side of the special performance contract called a derivative fails to perform, as is the case now, notional value becomes full value”.

Which means what exactly? It means there is no practical tool to cure the effects of an OTC derivative meltdown. If rates have to go to zero they will and it will still make no difference.

One could say that the credit crisis is only just beginning. It will almost certainly lead to recession, yet analysts remain far too upbeat in their earnings forecasts. If earnings were to fall as they normally do during a recession, then current forecasts for 2008 earnings growth could be out by as much as 40%.

High inflation and growing salary levels must be eating into the profits of many companies here in UAE and today’s report that two Gulf-based banks have prepared ``contingency'' plans to raise about $300 million to cover writedowns linked to U.S. sub prime home loans must raise some concern about the region’s ability to decouple from the world’s ills.

All in all there’s a remarkable amount of disappointment not currently built into stock prices.

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