Total carnage

July and August 2007 is proving to be one serious downer for investors, and this blogger, if he didn't exactly tip it, certainly knew that fall-out was imminent.

So far, in Australia, as we speak, markets are down about 12%, and it looks like it's going to continue for some time. The story is similar around the world.

So what's causing it this time?

When the markets had their last major quiver, back in March, this blogger tipped that it would pass and that things would soon be back to normal again, soon.

The reason for the volatility in March was a slide in the Shanghai Stock Exchange, and, as tipped by this blogger, there was absolutely no reason why this should have been seen to have had the major impact on markets that it did.

This time around, I'm tipping that markets around the world will have more lasting problems, and the impact from these will be a little more heavily felt.

Allow me to demonstrate.

The first thing that should be realised, is that this little bit of mayhem is being caused by problems in the US housing sector created by too much money being lent to people who shouldn't have been allowed to borrow in the first place. In delightful understatement, these are called, 'sub-prime' mortgages.

Lenders in the US were bundling up their loan books and then on-selling them on to the market in securitised packages. This had the double impact of raising further money for lenders to continue their risky activities, and re-locating the credit risk on the money lent to the new owners of the loans in question. The most common arrangement was called a collateralised debt obligation, or CDO.

This is not a new practice. Lenders have been doing this for some time. And not just lenders of 'sub-prime' mortgages.

A lender in Australia, RAMS, recently floated on the Australian Stock Exchange (ASX). RAMS floated at a share price of about AUD $2.50 back in July. RAMS' share price is now around AUD 89c and there is nothing that their management can do about it.

RAMS is not really exposed to 'sub-prime' activity (which is called 'non-conforming' in Australia). However, RAMS needs to be able to on-sell it's current mortgage book, otherwise, it will not be able to continue to lend money out to people.

And if no one is willing to buy RAMS' current crop of mortgages from them, then RAMS is going to have to discount the whole package until they can find a buyer. Hence the fall in RAMS' share price.

RAMS will have trouble selling the current lot of mortgages because the institutions that buy this kind of security from them are now reconsidering if this sort of security is worth the risk. And that is regardless of the quality of RAMS mortgage book - mortgages of any type, hell, fixed interest of any type is now being re-assessed across the board and investors are now expecting higher returns for the risk that they're taking on.

Anyway, RAMS investors really have to ask themselves could they have foreseen this? I don't believe that they could.

But this whole meltdown doesn't just end with the lenders, folks.

The debt securities sold by the lenders have been traditionally bought by fund managers for their mortgage and fixed interest portfolios. Normally, these are considered defensive assets - all other things remaining equal, mortgage and fixed interest funds are recommended as short to medium term investments within a portfolio, and form the defensive part of most Australians' superannuation funds.

But investment in CDOs is crystallising risks far riskier than what would normally be considered prudent.

So mortgage funds and fixed interest funds are going to take a hit. This is bearable. At least I would have thought.

But it turns out that quite a lot of buyers of these investments are a different type of fund manager again.

Hello, hedge funds. Fancy seeing you here?

Hedge funds, in their never-ending quest to satisfy investors seeking lower risks and greater returns for their investment whilst at the same time kicking a shitload of fees in the direction of fund managers have had their snouts in the trough for some time.

This was apparently a no-brainer for your average inscrutable hedge fund manager. Borrow at standard rates and invest in a fixed interest security paying well more than your standard mortgage or fixed interest rate of return. And then do it again. And again.

The end result of this was that some hedge funds, in their search for endless returns were geared several times over mainly as a result of idiotic risk assessments that had these sub-prime mortgages being seen as relatively low-risk, when the reality is substantially different.

So much money was whizzing round the economy and inflating asset prices that when the housing price crunch set in in the US last year, there was going to be problems. Bear Stearns was the first company to feel the heat and have advised that the investors in two of their hedge funds are unlikely to get anything back.

In Australia, we heard problems initially from Basis Capital, a fund manager whose products were actually rated AAA from Standard and Poors. Not long after this, Macquarie Bank have advised that some of their hedge funds are suspending new investment and redemptions, because they are having a hard time valuing their portfolios.

So what for the broader market?

Well a lot of the sell-off that we are seeing has to be driven by hedge fund activity. Hedge funds own other assets and it makes sense that they simply have to liquidate large sections of their portfolios just in order to ensure that their offerings are sufficiently liquid when the investors come a calling.

On top of that, because hedge funds are so opaque in their operation, investors in the broader market simply don't know the level of exposure of other businesses.

One municipal council in Sydney is facing losses of up to AUD 60c in the dollar due to some unwise investment in CDOs directly.

And all this is contributing to an environment where borrowing is going to be so much harder in the months ahead - which stymies investment by you, me and businesses. About the only people who should be rubbing their hands together with glee are going to be the banks - their main lending operations come from quality mortgages, and they don't relay on sourcing cheap funds by way of securitisation to do it.

This is going to be nasty, folks. For me, what makes matters worse is that all my money is currently invested and I don't have any more to plough into what appears to be a corrected market. And for most Australians, superannuation returns will be the worst this year that they have been in quite some time - probably about 7 years.

On the plus side, it does appear that that Australian stock market has fixed up the serious over-valuation that has been identified for some time by financial journalists. It means that some rationality has returned to the table.

But things may actually get worse before they get better. This is not like March, folks.

Disclosure: This blogger owns shares in Macquarie Bank Limited.

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.