What's really going on here?
OR...
Posted on 09/21/2007 8:04:08 PM PDT by shrinkermd
One of the world's leading experts on credit derivatives (financial instruments that transfer credit risk from one party to another), Das is the author of a 4,200-page reference work on the subject, among a half-dozen tomes...
Das is pretty droll for a math whiz, but his message is dead serious. He thinks we're on the verge of a bear market of epic proportions...
The cause: Massive levels of debt underlying the world economic system are about to unwind in a profound and persistent way.
He's not sure if it will play out like the 13-year decline of 90% in Japan from 1990 to 2003 that followed the bursting of a credit bubble there, or like the 15-year flat spot in the U.S. market from 1960 to 1975. But either way, he foresees hard times as an optimistic era of too much liquidity, too much leverage and too much financial engineering slowly and inevitably deflates.
...to warn anyone who will listen -- mostly banks and hedge funds that pay him consulting fees -- that the jig is up.
Rather than joining the crowd that blames the mess on American slobs who took on more mortgage debt than they could afford and have endangered the world by stiffing lenders, he points a finger at three parties: regulators who stood by as U.S. banks developed ingenious but dangerous ways of shifting trillions of dollars of credit risk off their balance sheets and into the hands of unsophisticated foreign investors, hedge and pension fund managers who gorged on high-yield debt instruments they didn't understand and financial engineers who built towers of "securitized" debt...
"Defaulting middle-class U.S. homeowners are blamed, but they are merely a pawn in the game," he says. "Those loans were invented so that hedge funds would have high-yield debt to buy."
(Excerpt) Read more at thestreet.com ...
At the very least, it needs careful reading and not the usual one-liners of "we are all going to die" or something like that.
Oh no, the forth posting of our upcoming epic beer market!!!! The sky is falling, some guy produced 4200 pages of stuff. He must know what he is talking about.
Hedge Funds. I wonder if Chelsea is listening.
I think we are already in an epic beer market.
What's really going on here?
Just change the name to ‘Fudge Funds’ and with all the packers our public schools are turning out, everything will be just fine in a few weeks. :)
Another good one is:
http://www.prudentbear.com/index.php?option=com_content&view=article&id=4748&Itemid=58
Excerpt (use link for the rest, which has some cute diagrams as well as further text):
By Satyajit Das
Credit Crunch – The New Diet Snack for Financial Markets
September 5, 2007
Satyajit Das works in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management and is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
Living in the Kaliyuga …
Inflexion points in financial markets are difficult to identify. As Yogi Berra observed: “making predictions is difficult, especially about the future”.
In Indian mythology, we are in the Age of Kali - the last age. The world ends when Kali dances the dance of death. There are no such clear markers in markets. Recently, we came close - Jim Cramer, a CNBC pundit, launched a “we’re in Armageddon” tirade on air. Embattled Bear Stearns’ CFO Samuel Molinaro pleaded: “I’ve been out here for 22 years, and this is as bad as I’ve seen it in the fixed-income markets.” Kali had begun to shake her booty. The credit bubble was finally deflating.
In 2007, householders in “cabbage-ville USA” (an English fund manager’s term) failed to make repayments triggering a global credit crisis. Markets ruminated about “a re-pricing of risk”. The faux “business as usual” calm masked the fact that the problems threaten to be the single largest credit crisis since the Savings and Loans collapse in the USA in the 1980s.
The early 2000s were a period of “too much” and “too little” – too much liquidity, too much leverage, too much complex financial engineering, too little return for risk, too little understanding of the risks. Steven Rattner (from hedge fund Quadrangle Group) summed it up in the pages of the Wall Street Journal: “No exaggeration is required to pronounce unequivocally that money is available today in quantities, at prices and on terms never before seen in the 100-plus years since U.S. financial markets reached full flower.” Traditional money fueled by loose monetary policy, excessive capital flows and now turbo-charged by “financial engineering” lies at the heart of the current credit crisis.
Structured Credit - Supersize My Debt!
Candyfloss (cotton candy or fairy floss) - spun sugar - consists mostly of air. It is the quintessential experience of a visit to a fairground. New financial technology is “candy floss” money 1- money spun out and expanded into ever larger servings. Derivatives, securitisation and collateralised lending allow fundamental changes in credit markets and leverage.
Derivatives – highly leveraged commercial bets on movements in prices of interest rates, currencies, shares and commodities - can be used to manage or create risk. Investors increasingly use derivatives to increase risk to earn higher returns. As at the end of 2006, derivative outstandings were around $485 trillion. In comparison, total global Gross Domestic Product is around $ 60 trillion. Derivative trading created additional liquidity and leverage.
Derivatives on credit instruments are a relatively recent innovation. A credit default swap (“CDS”) is credit insurance on a specific company. The buyer of protection (usually a bank who has lent money to the company) pays the seller of protection (usually an investor) a fee. In return, the seller of protection covers the bank buying protection against losses should the company go bankrupt. CDOs are steroid-fueled mortgage loan securitisations. A portfolio of loans, bonds or mortgages is assembled. Interest and principal from the underlying portfolio is used to make payments on the CDO securities issued to investors.
In a CDS contract, unlike a loan or bond, the investor is not required to pay the full face value. CDS volumes are not limited to the outstanding amount of debt. General Motors has around US$130 billion of debt. CDS volumes on GM are around 6 to 10 times that. CDSs allowed the credit markets to “supersize” trading volumes.
In CDOs, the bank uses the dexterity of the Iron Chef to cut and dice the risk of the underlying loans. “Tranching” allows the creation of different CDO securities - equity, mezzanine and senior debt. Equity receives high returns and bears the most risk. If there are losses on the portfolio of loans then equity takes the first losses. The senior note holders take the least risk as they are first in line to get paid and last to lose. They get low returns but more than on comparable traditional securities. Mezzanine (code for subordinated debt) is somewhere in between. Tranching is used to alter credit ratings on portfolios of A/ BBB loans to manufacture AAA/ AA securities.
CDOs concentrate risk and increase the potential gain or loss for a given event. CDOs are based on “diversified” underlying portfolios; e.g. a $1,000 million portfolio made up of 100 loans of $10 million each. Assume that if any of the 100 firms goes bankrupt, you lose $6 million (60% of $10 million). If the equity tranche is $20 million (2%), then the investor takes the risk of the first 3 firms to go bankrupt out of the 100 firms in the portfolio ($20 million of losses divided by $ 6 million). The investor’s risk is not diversified; it is taking the risk on the 3 worst firms out of the 100 in the portfolio.
If the investor invested $20 million in the 100 loans ($200,000 per corporation calculated as $20 million divided by 100), then 3 defaults in the portfolio would result in a loss of only $0.36 million (loss of $120,000 per company (60% of $200,000) times 3). In a CDO, if there are the same 3 losses then the equity investor losses $20 million. The leverage to default is 56 times ($20 million versus $0.36 million). Frequently, the holder of the equity tranche borrows to fund its stake further increasing leverage. A regulated bank can leverage around 12 ½ times. CDOs concentrate credit risk – the term is “toxic waste”.
The structured credit market has supersized debt levels using techniques of staggering complexity, incomprehensible to all but a small group of practitioners. The market was so “like hot” that one professional confessed that even his headhunter had been recruited into a structured credit role at an investment bank.
Would you like debt with that?
Repurchase agreements or “repos” (secured lending against government securities) and margin loans (lending secured against stocks) are well established. Now, investors use repos to raise substantial amounts against any security or instrument, including distressed debt.
Investors routinely structure asset purchases as a total return swap (“TRS”). The investor receives the return on the asset (income and increases in price) in return for paying the cost of holding the asset (decreases in price and the funding cost of the dealer). The investor posts a modest initial margin or “haircut” and promises to post more cash if the value of the asset declines. The trader has bought the asset with money borrowed from the dealer with which it entered into the TRS. Favorable regulatory rules, optimistic views of liquidity (the collateral must be sold if the borrower fails to pay) and faith in the models used to set the margins drives aggressive use of collateral increasing available liquidity and leverage.
Banks have also institutionalized the collateral game in a plethora of off-balance sheet structures – arbitrage or conduit vehicles; structured investment vehicles (“SIVs”). The vehicles purchase high quality securities like AAA or AA rated CDOs and fund them with short-term borrowings (usually, commercial paper (“CP”) issued to money market funds). $1.2 trillion or 53% of the $2.2 trillion commercial paper in the US market is now asset backed, around 50% by mortgages. When investors now buy assets, the dealers automatically ask: “would you like debt with that?”
The New Liquidity Factory 2
Banks traditionally wrote and funded their loans. In the new money game, banks “originate” loans, “warehouse” them on their balance sheet for a short time and then “distribute” them to investors using CDOs. Banks require less capital, as they don’t hold the loan for its full term. The process encouraged declines in credit standards. The game relies on the ongoing liquidity of the market for securitised debt.
When the loans are sold, the bank effectively receives the difference between the interest on the loan and the return demanded by the investor “upfront”. As loans are sold off, more loans must be written. Ever larger volumes are necessary to maintain profitability forcing banks to rely on brokers. In the new money game, banks increased loan volumes, reduced capital available to absorb risk and lowered the credit quality of their loans all at the same time.
Insurance companies, pension funds, asset managers, banks, and private clients are buyers of credit risk. Hedge funds moved into the credit markets in search of higher returns based on leveraged structured credit instruments. The high returns came with additional risks – a lack of liquidity and complexity of the securities. Buyers from Switzerland to Slovakia, Boston to Beijing bought up credit risk. A feature of credit investing was that the complexity and risk of structures was inversely related to the understanding of the investor being sold it.
In the new liquidity factory, investors did the borrowing - hedge funds borrowed against investments; traders borrowed cheap money (especially yen at zero interest rates) to fund high yielding assets in the famous carry trade. Financial engineering disguised leverage so that an investor’s balance sheet today does not tell you the amount of leverage being employed.
The new liquidity factory is self-perpetuating. If you bought assets with borrowings then as the asset went up in price you borrowed more money against it. In an accelerating spiral, asset prices rise as debt fuels demand for the asset. Higher prices decrease the returns forcing the investors to borrow more to increase returns. Bankers became adept at stripping money out of existing assets that had appreciated in price, such as homes. In the USA, UK and Australia – the fast debt nations - home equity borrowing funded a frantic debt addiction.
[continued at the link]
The Credit Crisis Could Be Just Bullshit
I don’t know about the economy, but I do predict that the term “epic beer market” has entered the unofficial FreeRepublic idioms, and will live on for the next few years as anything happens in the economy.
If not true - “we’re all gonna die!”
If true - we’re screwed anyway, so let’s party till we die.
;-)
Damnit, don’t sip your panic: gulp it!
Wench! Bring this fair lad another flagon of panic. Do not tarry, bring it hence!
all this gloom and doom but does anybody have any safe havens?.......anything we can do NOW to minimize the impact?
So we sold foreigners a bunch of worthless paper for their cold, hard cash? Color me simple, but a bunch of broke Chinese and Saudi "investors" doesn't break my heart.
bttt
Saved for tomorrow.
If I remember correctly, people on Galveston Island said the same thing in September of 1900 about warnings of a coming storm.
I remember something similar right before the French Revolution. All the nobility, Royal Family, and the rest of the French country were stuck with mounds of debt. Their lives existed entirely on credit and excaberated the already serious financial crisis that France had to deal with.
If anyone has read Carolly Erickson’s books in regards to Marie Antoinette and Josephine Bonaparte, it provides a thorough background in the society they lived in and what caused the major financial crisis. There are a lot of similarities when it comes to society today and society then.
It's about time for a downswing anyway, just waiting for a trigger to make it happen.
The credit problem may play a large part in it, but I think the balance of trade with China is what will bring everything crashing down.
You can only shift your manufacturing to another country for so long, buying everything from them basically on credit before it comes back to bite you.
I dumped almost all my stocks today and am waiting with cash to snatch up bargains after the bottom drops out.
The only question will be when and where is the "bottom" and when and what to buy.
The Great Depression started with a bank failure in Vienna.
What did that have to do with us?
Well, we found out.
Foreign investors hold way, way too much US debt; the US government has been spending way, way too much and has gone much too deep into debt, for decades.
Sooner or later this has to catch up with us.
I have no idea, though, how the chips will all fall out...
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