What Super-Size Leverage Means for Global Currencies
In my commentary yesterday, I explained why the world's major broker-dealers (like Goldman Sachs and Merrill Lynch) are overdosing on leverage these days.
They're riding this unprecedented liquidity boom with far too many derivatives contracts for their own good. And to make matters worse, they're using a very thin collateral base to make their super-sized leveraged bets. They're allowed to do this because they only invest in the highest rated securities.
According to Jim Grant's Interest Rate Observer "...a broker-dealer must set aside just 56 cents in capital to hold US$100 of triple-A-rated securitizations - but US$4.80 to hold US$100 of triple-B-rated securitizations."
Meanwhile, rating agencies like Standard & Poor's and Moody's have already begun to question the higher rated mortgage junk that's been leveraged to the hilt by banks, brokers and hedge funds the world over. Many of these ratings and market values are based on nothing more than theoretical market models that have never been "stress-tested" in the real world. I call this "fantasyland pricing," a leap of faith and imagination that would make old Walt Disney proud.
As I said yesterday, I wouldn't be surprised if the rating agencies started scrambling to save face, and begin the wholesale downgrading of sub-prime bonds in the process. And that will leave most broker-dealers in need of cash...fast. They'll have to scramble to finance their leveraged bets gone bad and balance their books. And that means panic-selling, which is bad news for everyone.
So just how does this process impact global currency markets? Well, I'm glad you asked.
The reason we're seeing another round of dollar selling has everything to do with fantasyland pricing. Most currency players believe the U.S. economy will get sucked down the drain right along with the ongoing problems in U.S. housing and the sub-prime mortgage mess.
This will also help unwind the yen carry-trade, which will send yen shooting higher against the buck. Besides the strength in the yen, many players believe euro, British pound, and Swiss francs are the places to hide from this liquidity boom and leverage overdoses. Thus, new highs in the euro and pound were achieved Tuesday and the Swiss moved sharply higher too.
Whether or not the commodity currencies will participate any further, having already lurched into new high territory, is an open question if global liquidity declines. Stay tuned!