Overreliance on the market’s ability to properly value assets has been the prime cause of the 2007-2008 collapse in financial markets. The error-prone nature of investors’ opinions on the security and value of various kinds of mortgage papers has been demonstrated repeatedly by various episodes of bankruptcies and bailouts. But all the shock and awe that the markets have had to experience after August 2007 seem to have failed to diminish the bullishness of some resilient investors of various risky mortgage bonds. MBS, or mortgage backed securities, have enjoyed a recent surge in value, in harmony with the ongoing general risk rally in the global markets which has been ongoing since February of this year.
The most senior tranches of 2006-2007 MBS backed by prime-jumbo mortgages are being valued as high as 80/100, according to New York based analysts. Even the notorious ARMs, defaults on which are among the main causes of the present crisis, are enjoying a rally, as pricing has reached 48/100, from as low as the “low 30s”.
The main cause of this bullishness is thought to be a blanket attitude to risk by investors of the MBS. It appears that all kinds of MBS have appreciated in similar amounts, regardless of the level of equity backing the loan. Given how important this one value is for correct analysis for mortgage securities, the conclusion must be that the recent rise in prices is mostly brought about by traders who wish to capitalize on the mini-bull market experienced in risky assets all over the world, and not by committed traders who really have the intention to hold the papers to maturity.
Meanwhile, ABX of subprime mortgage CDS on bonds issued in the first half of 2007 has climbed to as high as 29 from the June low of 18. The ABX is a kind of index which pools the various credit defaults swaps serving as insurance on asset-backed securities (NYSE:ABS), including the MBS, and it is helpful in gauging the health of the the mortgage market. (It was one of the earliest indicators of the August 2007 crisis.)
What is the implication of all this for forex, and the markets in general? We need to notice and recognize that the heavy-handed interventions of the authorities after the Lehman Event have proven to be successful so far in stemming the ensuing collapse of the financial system. The inter-bank market, the derivatives market, emerging markets, and the carry trade have all been revived powerfully in response to government injections of liquidity, and promises of intervention. But the period ahead is full of tests and trials. In the absence of economic shocks, and market collapses, political authorities are unwilling to extend or expand the recent bailouts provided to bankrupt firms and the economy in general. And with so much unemployment, sustaining the recent prices in risky assets will be a gigantic task. The illusions created by pumping money into the markets, artificially inflated prices, can last for only a limited time: the reality check cannot be too far away from today, and when it happens, its speed and severity may surprise bullish traders greatly.