A couple of weeks back, I wrote about the losses incurred by two hedge fund in the US through exposure to mortgage backed securities and their derivatives, based on housing loans to weaker borrowers ("The third big loss", 2/7/07). Bear Stearns, the fund manager, has since acknowledged that the highly leveraged funds are practically worthless.

While credit weaknesses have affected only a relatively small segment of mortgage securities, and obviously an even smaller segment of the overall credit market in the US, the contagion effect is being felt across all bonds. One also wonders whether the event has undermined the appetite of foreign investors for the US dollar -- during the last few weeks, the dollar has weakened significantly against both the pound and the euro. It has marginally weakened against the yen.

It may be recalled that, in real effective terms, the yen is the cheapest currency in the world despite huge and mounting current account surpluses. This is attributed to the  so-called 'carry trade' facilitated by the continued low yen interest rates.

To recapitulate, the carry trade involves borrowing yen, or use of yen savings by Japanese residents, to invest in higher yielding currencies. Investment in the higher yielding currency pays so long as the latter does not depreciate against the yen, more than the interest rate differential.

One particular favourite in recent times has been the New Zealand dollar. In fact, for quite some time, the New Zealand dollar has not only not depreciated, but has been appreciating from a low of JPY 68 in May '06 to JPY 97 now -- an overall return of 54 per cent over the last 14 months for the carry traders! And, New Zealand dollar interest rates may go up further.

Such appreciation of high interest rate currencies against low interest ones, of course, contradicts all economic theory. In terms of the purchasing power parity theory, high inflation (that is, high interest rate) currencies should depreciate against the low inflation ones -- the forward rate factors such a fall through the interest parity principle, but in the case of most currencies, the forward rate has been a lousy indicator of the future spot rate.

The carry trade has led to egregious deviations of currencies from their fair values. (The yen and the Swiss franc, the other favourite shorting currency, both boast of huge current account surpluses: 4 per cent of GDP in the case of Japan and a staggering 17 per cent in the case of Switzerland.)

On the opposite side have been the New Zealand dollar (a huge deficit on the current account and an overvaluation of perhaps 20-25 per cent), and, somewhat strangely, the Turkish lira, which is overvalued an estimated 65 per cent.

One wonders whether the recent marginal strengthening of the yen is indicative that the carry trade party may be coming to an end. (To be sure, it is too early to draw such inference). But as more hedge funds suffer losses because of the mess in the sub-prime mortgage market, lenders have tightened margin norms on loans. Earlier, lucrative earnings from the prime brokerage business had led to intense competition amongst lenders, a few of whom were apparently willing even to waive collateral.

Clearly, the lessons from the collapse of Long Term Credit Management have not been learnt, or have been forgotten in the nine years that have passed. This is strange given the fact that mortgage-backed securities and their derivatives are ill-liquid, and hence higher yielding, investments. In fact, most such securities are needed to be marked-to-model rather than marked-to-market, since there is no market price.

Following the mess in the sub-prime market, the prices of such securities, as also junk bonds have fallen sharply, even as the prices of credit default swaps have gone up.

No wonder, of course. Almost a hundred lenders to the sub-prime borrowers have been hit -- and something like $700 billion worth of such loans now exceed the value of the mortgaged houses! Estimates of losses in the sub-prime Collateralised Debt Obligations range from $50 billion to $90 billion -- even some pension fund investors may suffer. Interestingly, two people of Indian origin have been at opposite sides amongst the losers and gainers in the sub-prime market.

The person driving Bear Stearns' strategy in this market was Gyan Sinha, until recently quite bullish on the segment. The Big Bear was Anshu Jain of Deustche Bank: the bank must have made a packet by shorting the mortgage securities and their derivatives. Indeed, DB has been bearish on the segment since end 2005.

Will the mess reverberate into something bigger? The Fed Chairman does not rule this out. But this apart, participants and regulators are raising more questions over multi-tranche, complex structured financial products -- and, increasingly, over the ability of the rating agencies to analyse and rate them properly. But more on this later.