Credit Woops - Part 5

So, who bought all these asset backed securities? Lot's of people, but most notably, hedge funds. Hedge funds are just like mutual funds, except they usually require large amounts of money to join, have relatively few investors involved, and don't have to say up front what their investment strategy is (in other words, they can do pretty much whatever they think will make money). They play an important role in the financial system, but they often times swing for the fences since the hedge fund manager can be paid a percentage of the assets gained - double $300 million dollars for investors, and a 5% commission is looking pretty good.

Hedge funds, pension funds, and foreign banks all bought various flavors of these asset backed securities for their varying mixes of risk and reward. Those institutions that bought too much of the bad stuff are going to have to take a hit. And that's how the mortgage in Miami can give a bank in France some nervous moments.

There is one other side to the whole story, and that is that a similar liquidity boom was happening with respect to loans to companies, also called the "commercial paper" market. The same story pervades there. Quickly, typically when a bank makes a loan to a company, it requires "covenants", which are simply benchmarks it requires the borrower to maintain. These requirements help the lender know that their borrower is sound, and will be able to make interest payments. But, in all the hubbub, new "covenant-lite" loans were issued, and companies didn't have to show how they could pay it back. One telling quote I read recently was a lending manager saying that he didn't meet with a borrower over a $25 million loan because "it wasn't worth the meeting time". Not good.

As a result, lenders are now nervous about the loans they have already made, and don't really want to make many new ones. And here is the serious problem: without freely available credit our economy doesn't function, because many companies take loans to make large investments that keep their businesses running. If they can't make those investments, they can't hire people, they can't compete as well, and they can't meet demand.

Put the rising defaults on mortgages which are now connected to the world financial system with the lock-up in the commercial paper markets, and a lot of people are very worried.