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100-fold increase of US sub prime impact on financial markets

Alliance Trust says that the complicated chain of structured finance underpinning the $600bn US sub prime mortgage market means that the impact on financial markets could be up to 100 times the value of the original loans.

Alliance Trust says this chain allowed the expected income from the original sub-prime mortgages to be “packaged up, pooled, sliced and diced, mixed with other assets and resold to other institutions”. It says the high level of leverage involved along the chain resulted in the increased value.

Alliance Trust Research Centre head Shona Dobbie says there has been a role reversal between the world’s financial markets and the economy.

She says: “Before this summer’s credit crisis, it seemed to be the economy that was driving markets forward, and now it is the markets, and how well they can weather this crisis, that appear to hold the key to the future direction of the economy.

“We have uncovered a lot of astonishing facts and figures in our research into the causes of the credit crisis, but what is most surprising is how little we can unravel about where these enormous liabilities have ended up. It is now up to institutions to untangle this web because trust among them can only be rebuilt when we get more clarity.”

The Alliance Trust report says: “As investors chased higher returns leveraging, or gearing, became increasingly popular. An investor starting with $1,000 of equity could easily leverage this into $3,000 of debt, to put into an investment fund. The fund could leverage this cash inflow a further three to four times, placing the resulting $10,000 with a hedge fund, which invested heavily in the higher risk junior tranches of a CDO which was already leveraged, by up to ten times.

“Through this process, the initial equity of $1,000 becomes part of a chain of leverage amounting to $100,000, resulting in an overall leverage ratio of 100 to 1. This ratio is so high that even a small decline in the price of the CDO could cause the whole chain of leverage to unravel quickly, with catastrophic results. Vulnerability was increased by the fact that the CDOs were frequently underpinned by MBSs, and these remained almost impossible to price correctly.”

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