Wednesday, October 22, 2008

bond market dislocation

If this does not scare you it should.
Here is how it works, you borrow money and issue bonds to loaner. The more you borrow the more risky your bonds become, increasing the rates people charge you to give you money. The more you pay in interest the less you have in real income. Now of course you are not the only person borrowing money, the government, other companies , other countries, etc. Now some governments can cause problems by issuing massive debt and driving up the rates for others. Also you can defaults by other people which spoke the market. Now imaging the scale increase and you the follow.
Massive home mortgage failures, governments start to default (Small places like Iceland) and Banks become insolvent.
It also means that now that the foreigners can get a higher rate of interest on the gov't debt they buy, the market for existing lower-rate non-gov't and gov't debt will drop, tanking bond prices across the board.

New bond issuers will have to raise the rates they pay their lenders to attract interest in their bonds, raising debt service costs for them too.

This will spread to mortgages as well. Mortgage rates will rise, causing an increase in the rates ARM and Option ARM holders will have to pay, forcing even more of them into foreclosure and making those assets that we issued that debt to buy even more worthless.


Now accelerate and what do you get? 1931....

What caused the flight out of bonds during GD 1.0? Governments around the globe started to default on their debt. Every time a domino fell, bond traders asses tightened up even further. They started to say, hey Fed your going to have to pay me a higher return for this kind of risk.

A once in a lifetime credit crisis has three components.

1st Numerous homeowner defaults
2nd Large number of banks become insolvent
3rd Large number of governments default on their debt

How will you know when there's a bond market dislocation. When the stock market starts to decline, and there's a simultaneous and sustained flight out of bonds as well (under normal conditions a flight to safety out of stocks entails moving to bonds, however under this scenario there is a flight out of stocks and bonds into short term treasuries) It got so bad during the great depression that for a time, investors were willing to have a negative return to keep their money parked in treasuries.


http://64.233.169.104/search?q=cache:wWqWQdaf458J:www.tickerforum.org/cgi-ticker/akcs-www%3Fpost%3D62732+bond+market+dislocation+1931&hl=en&ct=clnk&cd=1&gl=us
Both qoutes are from this forum and are summary information.

Also check out this link from better graphs
http://activerain.com/blogsview/735192/Credit-Market-Update-For-The-Week-Bond-Market-Dislocates

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