Option ARMS

Yet more good stuff from the economist. Option ARMs - adjustable rate mortgages that allow (give the option) of paying less than the interest rate. The difference is then added to the loan balance. In a down market, you end up owing more than you originally borrowed on a house that is worth less than you paid. Oh yes, and these are mainly in CA.

The name option arm is ironic really because these loans are very much like options, where the buyer of the house is betting on house price volatility and hoping that the value of the house ends up in the money. Consider this fact also - in most cases, if the homeowner has been paying below the market interest rate for the loan for 5 years, he/she will have also been paying far below the rental cost of the property. So even in the case of default, where they loose the house, the occupant has still lived in a house at a lower cost than if they rented.

The trouble isn't going to be centered in CA either, my local bank Wachovia is in on the action...

An option-ARM product called Pick-a-Pay (a name that gave fair warning it could lead to trouble) accounts for 45% of consumer lending at Wachovia, a large bank.

CDS - Credit Default Swaps

The Economist has an interesting piece on the role of CDS - credit default swaps. Not surprisingly the cost of insuring debt has gone up...

The five-year CDS spread had more than doubled to 740 basis points (bps), meaning it cost $740,000 to insure $10m of its debt.

Also of interest is the increasing use of the CDS market to speculate on firms. In essence this might provide a means of betting on a firm's declining credit.

finance crossword from FinanceProfessor..

Huge hat tip to financeprofessor for creating a finance crossword. Combining the excitement of finance with the endless fun of crosswords - brilliant. Give it a try.

crossword

Beer and research

Posted on the freakonomics blog - research that shows that the more beer academics drink, the less they get published. Uh oh.

Inside the mind of an investor

Source:digg.com

Why have gas prices fallen?

Gas prices have fallen and oil prices are well below their recent peek - which raises the question: Why? Some might say it was supply and demand with the higher price reducing demand, thus resulting in a lower equilibrium price. Others offer a different explanation...prayer.

Perhaps this will lead to a new area of theological economics.

Confessions of a risk manager

Great article on the Economist website giving the views of a risk manager at a major bank at what went wrong in the credit crunch.

We had not fully appreciated that 20% of a very large number (of AAA bonds) can inflict far greater losses than 80% of a small number (of sub investment grade bonds).

italics added by me

Although he doesn't blame the traders, he does say that the risk managers were frequently ignored or overruled, or were under pressure to approve deals. And not surprisingly, the most pressure was on the highest returning deals....