From: [EMAIL PROTECTED]
Date: September 27, 2007 4:34:31 PM PDT
To: [EMAIL PROTECTED]
Cc: [EMAIL PROTECTED], [EMAIL PROTECTED], [EMAIL PROTECTED],
[EMAIL PROTECTED]
Subject: Fwd: The Credit Crisis Could Be Just Beginning
When you add it all up, a single dollar of "real" capital supports
$20 to $30 of loans. This spiral of borrowing on an increasingly
thin base of real assets, writ large and in nearly infinite variety,
ultimately created a world in which derivatives outstanding earlier
this year stood at $485 trillion -- or eight times total global
gross domestic product of $60 trillion.
Without a central governmental authority keeping tabs on these
cross-border flows and ensuring a standard of record-keeping and
quality, investors increasingly didn't know what they were buying
or what any given security was really worth.
That is why the current market volatility is much more profound
than a simple "correction" in prices. It's a gigantic liquidity
bubble unwinding -- a process that could take generations ...
See what's new at AOL.com and Make AOL Your Homepage.
From: "Jim S." <[EMAIL PROTECTED]>
Date: September 27, 2007 4:02:28 PM PDT
To: [EMAIL PROTECTED]
Subject: The Credit Crisis Could Be Just Beginning
Reply-To: [EMAIL PROTECTED]
"The most common way people give up their power is by thinking they
don't have
any."-- Alice Walker
http://www.thestreet.com/s/the-credit-crisis-could-be-just-
beginning/newsanalysis/investing/10380613.html?puc=_tscana
*The Credit Crisis Could Be Just Beginning*
By Jon D. Markman
Special to TheStreet.com
9/21/2007 6:40 AM EDT
Satyajit Das is laughing. It appears I have said something very
funny, but I
have no idea what it was. My only clue is that the laugh sounds
somewhat pitying.
Trading Center
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 other
tomes. As a
developer and marketer of the exotic instruments himself over the
past 30 years,
he seemed like the ideal industry insider to help us get to the
bottom of the
recent debt crunch -- and I expected him to defend and explain the
practice.
I started by asking the Calcutta-born Australian whether the credit
crisis was in
what Americans would call the "third inning." This was pretty
amusing, it
seemed, judging from the laughter. So I tried again. "Second
inning?" More
laughter. "First?" Still too optimistic.
Das, who knows as much about global money flows as anyone in the
world, stopped
chuckling long enough to suggest that we're actually still in the
middle of the
national anthem before a game destined to go into extra innings.
And it won't
end well for the global economy.
Ursa Major
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.
Like an ex-mobster turning state's witness, Das has turned his back
on his old
pals in the derivatives biz 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 with math models that were
fundamentally flawed.
"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."
The Liquidity Factory
Das' view sounds cynical, but it makes sense if you stop thinking
about mortgages
as a way for people to finance houses and think about them instead
as a way for
lenders to generate cash flow and to create collateral during an
era of a flat
interest rate curve.
Although subprime U.S. loans seem like small change in the context
of the
multitrillion-dollar debt market, it turns out that these high-
yield instruments
were an important part of the machine that Das calls the global
"liquidity
factory." Just like a small amount of gasoline can power an entire
truck given
the right combination of spark plugs, pistons and transmission,
subprime loans
became the fuel that underlies derivative securities that are many,
many times
their size.
Here's how it worked: In olden days, like 10 years ago, banks wrote
and funded
their own loans. In the new game, Das points out, banks
"originate" loans,
"warehouse" them on their balance sheets for a brief time, then
"distribute" them
to investors by packaging them into derivatives called
collateralized debt
obligations, or C.D.O.s, and similar instruments. In this scheme,
banks don't
need to tie up as much capital, so they can put more money out on
loan.
The more loans that were sold, the more they could use as
collateral for more
loans, so credit standards were lowered to get more paper out the
door -- a task
that was accelerated in recent years via fly-by-night brokers that
are now
accused of predatory lending practices.
Buyers of these credit risks in C.D.O. form were insurance
companies, pension
funds and hedge-fund managers from Bonn to Beijing. Because money
was readily
available at low interest rates in Japan and the U.S., these
managers leveraged
up their bets by buying the C.D.O.s with borrowed funds.
So if you follow the bouncing ball, borrowed money bought borrowed
money. And
then because they had the blessing of credit-ratings agencies
relying on
mathematical models suggesting that they would rarely default,
these C.D.O.s were
in turn used as collateral to do more borrowing.
In this way, Das points out, credit risk moved from banks, where it
was regulated
and observable, to places where it was less regulated and difficult
to identify.
Turning $1 Into $20
The liquidity factory was self-perpetuating and seemingly
unstoppable. As assets
bought with borrowed money rose in value, players could borrow more
money against
them, and it thus seemed logical to borrow even more to increase
returns.
Bankers figured out how to strip money out of existing assets to do
so, much as a
homeowner might strip equity from his house to buy another house.
These triple-borrowed assets were then in turn increasingly used as
collateral
for commercial paper -- the short-term borrowings of banks and
corporations --
which was purchased by supposedly low-risk money market funds.
According to Das' figures, up to 53% of the $2.2 trillion of
commercial paper in
the U.S. market is now asset-backed, with about 50% of that in
mortgages.
When you add it all up, according to Das' research, a single dollar
of "real"
capital supports $20 to $30 of loans. This spiral of borrowing on an
increasingly thin base of real assets, writ large and in nearly
infinite variety,
ultimately created a world in which derivatives outstanding earlier
this year
stood at $485 trillion -- or eight times total global gross
domestic product of
$60 trillion.
Without a central governmental authority keeping tabs on these
cross-border flows
and ensuring a standard of record-keeping and quality, investors
increasingly
didn't know what they were buying or what any given security was
really worth.
A Painful Unwinding
Here is where the U.S. mortgage holder shows up again. As subprime
loan default
rates doubled, in contravention of what the models forecast, the
C.D.O.s those
mortgages backed began to collapse. Because these instruments were
so hard to
value, banks and funds started looking at all C.D.O.s and other
paper backed by
mortgages with suspicion, and refused to accept them as collateral
for the sort
of short-term borrowing that underpins today's money markets.
Through late last month, according to Das, as much as $300 billion
in leveraged
finance loans had been "orphaned," which means that they can't be
sold off or
used as collateral.
One of the wonders of leverage is that it amplifies losses on the
way down just
as it amplifies gains on the way up. The more an asset that is
bought with
borrowed money falls in value, the more you have to sell other
stuff to fulfill
the loan-to-value covenants. It's a vicious cycle.
In this context, banks' objective was to prevent customers from
selling their
derivates at a discount, because they would then have to mark down
the value of
all the other assets in the debt chain, an event that would lead to
the need to
make margin calls on customers who are already thin on cash.
Now it may seem hard to believe, but much of the past few years'
advance in the
stock market was underwritten by C.D.O.-type instruments that go
under the
heading of "structured finance." I'm talking about private-equity
takeovers,
leveraged buyouts, and corporate stock buybacks -- the works.
So the structured finance market is coming undone; not only will
those pillars of
strength for equities be knocked away, but many recent deals that
were predicated
on the easy availability of money will likely also go bust, Das says.
That is why he considers the current market volatility much more
profound than a
simple "correction" in prices. He sees it as a gigantic liquidity
bubble
unwinding -- a process that can take a long, long time.
While you might think that the U.S. Federal Reserve can help
prevent disaster by
lowering interest rates dramatically, as it did Wednesday, the
evidence is not at
all clear.
The problem, after all, is not the amount of money in the system
but the fact
that buyers are in the process of rejecting the entire new risk-
transfer model
and its associated leverage and counterparty risks.
Lower rates will not help that. "At best," Das says, "they help
smooth the
transition."
~~~
[Jon D. Markman is editor of the independent investment newsletter,
"The Daily
Advantage." While Markman cannot provide personalized investment
advice or
recommendations, he appreciates your feedback; click here to send
him an email:
http://apps.thestreet.com/cms/rmy/feedback.do?authorId=1100162
Click here for more stories by Jon D. Markman
http://find.thestreet.com/cgi-bin/texis/author/?au=A1100162 ]
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