Is the credit bubble about to explode?

Following the crisis at Bear Stearns, investors are shunning risky bonds for the first time in years. Is this the start of a global credit crunch?

Specialists are insisting that nothing's wrong. But "there is a sense of crisis in the credit markets", says Lex in the FT. Last week the turmoil in the subprime mortgage market crossed the Atlantic, with two UK-based hedge funds, Queen's Walk and Caliber Global Investment, reporting large losses owing to mortgage-linked derivatives; the latter is to be wound down. This followed the near-collapse of two leveraged Bear Stearns hedge funds, one of which required the biggest bail-out since the rescue of LTCM in 1998. And now investors have grown cold on other forms of debt, raising fears of a global credit crunch.

The major worry is the market for collateralised debt obligations (CDOs), whereby subprime mortgage loans are packaged together with other assets and sold on. They consist of different sections based on risk and interest paid. The top tranches can receive top credit ratings (so institutional investors who aren't allowed to buy low-rated debt can still snap up CDOs), even though many are ultimately backed by subprime loans. Lump together enough securities beneath the top tranche and the buffer is eventually deemed big enough to merit a top rating. Welcome to the "wacky world of modern financial engineering", says Lex.

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