"C D Oliver"

Perceptions can turn on a six-pence, but the truth changes much more slowly. And boy, have we seen those perceptions shift in the past couple of weeks. In January if you had walked up to your average fund manager and asked them about "sub prime", they would have narrowed their eyes at you in that way that says, "You're a bond guy, right?" Now everybody seems to be an expert on sub prime. There are perhaps reasons why one should be suspicious of the new wisdom.

Thank goodness we have a credit team at Newton that actually understands this stuff and the technicalities that lie behind it. I put my version of events to them recently and they curtly replied, "No - that's completely wrong Stewart" with a kind of pitying look in their eyes. "Think of it like this," they went on. "Imagine a whole row of orphans holding out their bowls and the cook at the orphanage ladles out thin soup to them one by one - you know, like in Oliver Twist. Well, when the cook gets to the last child, she has no soup left in her pot and he gets nothing to eat. The next day the children return for their pitiful meal and this time the same thing happens but the last TWO children don't get anything to eat. Eventually, all of the children will die of starvation. It's the same in the CDO market but the soup is money and the orphans are investors. Do you get it now?" "I think so. But does that mean all CDO investors are orphans? I think I'm going to cry if they are." Their collective eyes swivelled in dismay.

As we pointed out in our recent pieces and also in "It's Hurting and It's Working" back in July of last year, there are undeniable early signs that the U.S. Federal Reserve has made a mistake on interest rates by pushing them up too high. Bankers have contributed to the problem with less than fulsome screening of potential clients but this was only really because they had one eye on shareholders who had gotten used to the kind of profits they had been producing in recent years. The desperate lending that set in last year can be seen as the last rush before the tills closed. The sub prime defaults were all but inevitable in the circumstances.

Of course, this could be one of those localised phenomenon that dissipates as quickly as it arrived. There isn't any conclusive evidence that, as yet, the delinquencies seen in the sub prime area have spread to the bulk of the consumer credit market and other interest rate sensitive areas of the economy.

Unemployment remains resolutely low for instance. Also, take a look at the Fed's own survey of credit card delinquencies for the whole of the banking system (see first illustration) 1 . This is like the next tier up from sub prime borrowing. There has been a rise in the delinquency rate recently but, as of yet, this hasn't consolidated into as rapid a deterioration of the picture as the CDO market might lead you to expect.

But this should not trivialise the situation because the amount of revolving credit (credit cards etc) outstanding has gone up a lot over the past 15 years, so a rise in default rates has a bigger numerical effect. So far things have stayed in balance and the system seems happy and able to cope with about US$33bn a year in credit card delinquencies (see second illustration). However, even allowing for a slowing of the growth rate of credit card debt from 6% to 3% per annum, a 1% rise in delinquencies would cause the annual bill to rise to close to US$50bn (see shaded area in the second illustration). Back in the early 1990s, at the time of the last housing-induced problem, this figure was only US$15bn.

This has all come at a time which makes the problems in the CDO market difficult to disaggregate from other effects. For instance, the collapse of some sub prime indices has come along when other risk assets (Chinese equities and the like) have gotten themselves mixed up with what looks like a seasonal repatriation of money back to Japan and an unexpected appreciation of the yen. As a result of this "derisking", and the perceived increased credit risks in the future, the cost of insurance (U.S. Treasuries) has risen. For instance, 10-year maturity bond yields have fallen by about 0.25% in the past month, which equates to a rise of a couple of percent in capital terms - a lot when you are only expecting 4.5% a year anyway. It all looks a bit overdone for the moment.

If all of this sounds like an appeal for calm in a hysterical world, then I suppose it is. As one who has been no stranger to hyperbole in the past, it's quite a departure from the norm for me. To be sure, all of our indicators and our models point towards the idea that, if you simply have to own bonds then own quality, own government bonds. But at the same time, because of the reactionary rise in the markets, if your bond ownership is optional, you may get a better time to buy before the real rot sets in later this year.