While we were in there the dealer told us that someone in town had already bought $900,000 worth. Do they know something I don't?

50 oz of gold in 1928 = 50 oz of gold today. 50 piles of stock certificates from 1928 = zilch today. You can melt down gold and it is still gold, you light paper on fire and it's ash forever ;)

The hedge funds are out of the direct supervisory purview of the central banks. There is no legal way a central bank can open up the public purse to allow a hedge fund to borrow emergency funds.

The central banks can make cheap money available to their commercial banking members, and in an emergency organize meetings among bankers. Maybe they can encourage these banks to step up their financial support for a hedge fund, but no bank is going to increase its risk in a desperate situation no matter what the central bank says. In the best of circumstances, as in the case of Long Term Capital Management, the central bank can help the commercial bankers arrange an orderly liquidation of the customer.

There is a quasi-systemic event underway here. Not in the sense that one hedge funds fails and drags down another, but in the sense that one hedge funds marks its portfolio down substantially based on real prices it is able to get, and then the rest of the market must mark their portfolios down accordingly. I don't see how the central bank can stop this process, which is the market doing what it is supposed to do.

Make 600 more posts like this one, as one Artappraiser said to me, 4 years ago.

I'm wondering when you say:

"In most cases, the bonds are rated AAA not because they are backed only by a small proportion of subprime loans, but because the same collateral backs other, subordinated bonds that will absorb losses on the underlying loans before the AAA bonds take a hit. It's extremely common to have AAA bonds backed entirely by subprime loans."

What(who) has the collateral here? I've seen analyses that show the subprime mixed in with the prime, as a kind of dilution of a CDO. But you seem to be saying that the subprimes stand between the primes(AAAs) and the collateral, and yet the AAA's are prime, still while the subprimes, in the mantle of the CDO, are also.

I don't doubt Wall Street's alchemy but how do they break down the tranches of these issues so that you know what you own?

http://mauberly.blogspot.com/

The fallout of the US subprime mortgage market hit the German banking sector on Monday as IKB, a specialised lender to smaller companies, and Commerzbank, the country's second-biggest bank, warned they would be hit by losses from risky property loans.

IKB became one of the biggest European casualties of the subprime market's woes as it ousted its chief executive and issued a profit warning.

http://agonist.org/comment/reply/44720/124780

http://mauberly.blogspot.com/

From a Reuter's article:

Simon Adamson, an analyst at credit research firm CreditSights, said that banks had generally failed to explain their obligations stemming from such structured finance deals.

"This announcement from IKB will confirm the fears of a lot of investors that we don't really know what the scale of the problem is," he said.

"If you look through banks' annual reports you will not find information to tell you what this potential liability is and that is one of the main reasons that the market has been so worried recently."

Adamson also said that the IKB case showed how quickly sub-prime problems could get out of control. Just 10 days ago IKB had confirmed its profit goal for the year.

However, credit rating agencies played down the prospect of ripples from the United States endangering the country's top-tier banks.

"We don't see any significant impact on the big German banks directly from U.S. sub-prime mortgage problems," said Stefan Best, an analyst with rating agency Standard & Poor's, which recently surveyed big German banks about their exposure.

Thomas von Luepke, chief German banks analyst at ratings agency Fitch, said much depended on whether the U.S. problems spread to the country's real estate market generally and the U.S. and European economies.

"Most German banks are well-positioned to digest any shock of a limited size," von Luepke said.

German financial watchdog BaFin, which oversaw the IKB rescue, said the deal ensured there would be no fallout for the country's banking system.

http://www.reuters.com/article/gc06/idUSWEB538920070730?pageNumber=2

http://mauberly.blogspot.com/

If you buy the sub-prime tranche of some of these CDOs you're getting "equity", as defined by the bond, which means you are last in line if any of the cash flows don't come in as modeled. The Aaa tranche is first in line, and I understand that some of the complaints being raised about the tardiness of the ratings agencies to downgrade these issues comes from the Aaa tranche holders. They want the downgrade so that provisions will be triggered that accelerate payments to the top levels, leaving the equity portion with even less protection.

The issue of IKB's mark to market losses should be simple. If these are securities that have allowed IKB to book mark to market gains straight to net income rather than to the equity account, than they have to book losses to net income as well. They can complain all they want about whether the losses will reverse over time, but they shouldn't have accepted mark to market accounting if they didn't want to take the hit from these losses until the instruments matured or were sold. They should have kept them in an investment portfolio, not a trading portfolio.

There are circumstances where mark to market losses in an investment portfolio, if big enough, require public disclosure. I don't know if that is the issue here. If as you suggest the bank hid the mark to market losses, wherever they were supposed to be booked, from the supervisory board, then there are much more serious issues of fraud involved.

Like I say, it's all a bit murky at the moment, but the supervisory board say they weren't told about the exposure, the head of the asset management arm has been sacked and a special auditor has been appointed to look into the Rhineland Funding vehicle. I suspect things will become clearer when they actually publish their results in two weeks.

As for the mark to market stuff, they don't have a choice under International Financial Reporting Standards, which are compulsory for European banks like IKB. All securities must be accounted for at fair value, which in almost all cases means mark to market. The difficulty is that CDOs are extremely illiquid, especially the riskier tranches, so ascertaining a market price isn't always easy. There's much more leeway for disguising mark to market losses, and conversely it's easier to get caught out by sudden market movements like in the last few weeks.

Giving IKB and its management the benefit of the doubt (in other words, since we don't have complete information yet), let's suppose that the securities in questions were extremely illiquid CDOs.

A month ago, the head of asset management and the head of risk management, as well as all executives above them, would have had no reason to mark down these securities. They might have been using an internal mark to model process, or they simply were receiving rough valuation quotes from brokers who were talking to other banks that also had no reason to suspect anything other than Aaa rated value.

There would therefore be no reason to alert the Supervisory Board, other than through some broad measure of possible significant capital hits caused by stress testing the portfolio beyond the 2 or 3 stand deviation results given by their value at risk models. Best practices do require such stress testing, so management should at least have the argument that they routinely measure and report possible big losses from unanticipated events.

Suddenly one of these unanticipated events occurs. Countrywide alerts the market to deterioration in Alt-A and even prime mortgage portfolios, and the two Bear Stearns hedge funds investing in sub-prime collapse. Banks and investors start selling off their sub-prime tranches, and in an illiquid and pressured market, there are now real prices out there being reported by the brokers. IKB must use these real prices for its new mark to market values, and where it has been using internal models in the past, any newly-available real prices would supervene the model results.

All this brings about a dramatic reduction in the theoretical value of the securities, necessitating a hit to income and notification to the Supervisory Board. People are sacked, even if they could honestly say "we alerted you to this possibility in our monthly stress-testing reports covering extreme events".

So that would be my logical and mitigative explanation from IKB's management of what really happened. I guess we'll have to see if this corresponds to the reality once more facts emerge.

That would more or less make sense if it were just balance sheet investments, although they were still saying there were no problems just two weeks ago, and subprime/CDO prices have been falling for a lot longer. Apparently IKB were taking subprime exposure long after the market began tanking. But there were clearly serious issues with the conduit as well, hence the audit. The whole crisis was precipitated by the off balance sheet conduit's inability to roll its commercial paper, creating a liability for IKB itself. I've seen the rating report for the conduit (disclosure - I'm a financial journalist covering the European securitisation market). The vehicle was 94% invested in CDOs and CLOs. I'm not accusing IKB of anything at this stage, it's just that there's something missing from the picture that you can piece together from the various public pronouncements by IKB and the parties involved in the bailout. I'm going to be doing my best to find out what it is next week.

If an off-balance-sheet entity was housing CDOs and CLOs, then it becomes problematic as to what oversight IKB really had. Much depends on its legal ownership of this vehicle, as well as its actual and perceived (by the market) moral responsibility for keeping the entity healthy.

But if it is one step removed from the bank proper, then the need to report things to the Supervisory Board becomes even murkier. The risk here may fundamentally be reputation risk for the bank, and the bank may have had no expectation that it was to run day-to-day risk management functions for this entity.

Oh no, IKB definitely ran it day to day. The vehicle, Rhineland Funding, is managed under contract by IKB Credit Asset Management, whose head was fired last week. IKB also provided the liquidity under a standard arms length liquidity facility and likely owns the (minimal) equity, but because the vehicle's credit enhancement is provided by third parties, FASB considers those parties to own the vehicle for balance sheet purposes.

I think I see what you are saying. Is this different from what they were doing years ago with what we called toxic waste-inverse floaters or is it the same?

http://mauberly.blogspot.com/

I think I now see what is going on today that is different. Today you can have AAA rated debt instruments backed entirely by subprime paper(BBB or less rated).

Just several years ago this does not seem to have been the case. An old collateralized mortgage obligation(CMO) was structured from a pool of mortgages. These were not subprime to begin with. The subprime market had not got started then.

At that time you looked at the how the pool of mortgages would pay off(this would have been based on the behavior of hundreds of other similar pools already issued).

You divided up groups of investors as to who would get principle and /or interest first, then next, then again and so on. You issued securities based on that. These were called tranches of the CMO.

Maybe, way at the end, you created something with some possible cash flow, something like an option on interest rates, that paid something if rates went to a certain level.. This was called a floater that someone could hedge rates with.

The AAA tranche got its money first, etc. The floater or rate option at the end came to be called ‘toxic waste.’ This was because it was sold to unsuspecting controllers of city governments as high yield paper.

Today, what they are doing is quite different, with CDOs or collateralized debt obligations. They take a pool of subprimes which have little or unknown credit history and they just make an order of who gets paid first, second and so on. The AAAs get paid first out of the trash. In essence, they make a AAA instrument out of trash, based on a model of when the trash will pay off. But they have little default or paydown history for these things. Especially for the ‘liars loans’ made in the last few years.

It is even possible to take the last securities in the series above, package them with other similar last securities from other similar series, and make a AAA instrument out of them, based on who gets what first.

http://www.sabbatarian.com/Content/FirstAndLast.html

http://mauberly.blogspot.com/

That's pretty much it, but you should drop the "subprime" label when talking about the rating of bonds, as it confuses things. The distinction is between investment grade (BBB- and above) and speculative grade (BB+ and below).

It's very much like a CMO in general - remember, these loans were expected to perform, on average. As you say, one of the problems with the ratings was the lack of performance history through a downturn, industry wide, for the types of loans that were/are being securitised. Even the BBB bonds are supposed to be able to withstand a minor downturn.

"It is even possible to take the last securities in the series above, package them with other similar last securities from other similar series, and make a AAA instrument out of them, based on who gets what first."

Indeed, although again the basis of investment isn't usually that it will default and you'll get paid in the end, it's that the CDO won't itself default because you'll only experience a handful of defaults in the underlying portfolio. Here the problem is more that the risk of one subprime mortgage bond defaulting is highly correlated with other subprime bonds defaulting, more than the rating agencies assumed for some reason, and so CDOs backed entirely by subprime become almost a binary risk.

"but you should drop the "subprime" label when talking about the rating of bonds, as it confuses things. The distinction is between investment grade (BBB- and above) and speculative grade (BB+ and below). "

http://mauberly.blogspot.com/

I looked for some traction on the day of your article. And we did have a bit of a rally Thursday. Friday it was given back. Now they still could bounce it from these levels. But this is starting to look ugly. And there is a lot of room to fall.

"The news just isn't slowing down to allow the market to obtain traction for even a relief rally of any length of time or distance."

Monday I would look for the TV people to give various sermons on the mount and even prophetic works, as addenda to their current gospel.

http://mauberly.blogspot.com/

"Credit standards simply collapsed in the U.S. mortgage market because no one really owned the credit risk of default any more, except for the final purchaser of the secondary market securities, and they were (apparently) fooled by the ratings agencies (S&P, Moody's) who put Aaa ratings on these securities. "

It's important to bear in mind that bonds (apart from CDOs, perhaps)that were rated AAA are almost certainly not going to default, even now. They may get downgraded to AA or A, but the rating agencies still think they're going to pay off. In most cases the AAA bonds haven't even been downgraded - it's only the lower classes of bonds. So the main "fooling" going on was the belief that AAA securities would always stay AAA, an idea which to be fair the rating agencies have pushed quite hard with quarterly reports on ratings stability emphasising how much more stable structured finance ratings were than corporate ratings.

The critical issue facing the economics profession is whether a sea-change is underway in the global economy that they are completely missing. All of their assumptions, textbooks, teaching, and models are built on the post-WWII experience of the business cycle. This experience teaches them that as the economy grows, supply cannot match up to demand at some point. Then pricing pressures appear, especially in the labor market, and the Fed responds with higher rates. As the economy overheats, interest rates ultimately reach a point where demand suddenly dries up and a recession ensues. Business cuts back on supply and eventually the cycle repeats itself.

In each cycle, however, the U.S. economy has encumbered itself at all levels (individual, corporate, municipal, state, and federal government), with larger amounts of debt. The overall price level continues to rise as well. What if there is a point where the U.S. cannot absorb any more debt because lenders perceive that the risks of default are simply too high? What if also the amount of defaults and credit losses exceeds what has been experienced in previous recessions, and the whole financial industry is infected by a series of systemic defaults that shuts the credit markets down for an extended time? Then you get a severe, prolonged recession, or depression, until the debt overhang is wiped out. Prices collapse during such events.

The U.S. last experienced this in the 1930's, and then several times in earlier decades, so no economist is around with the primal fear of a depression to provide real insights.

Here, today, we are witnessing the collapse of an entire and critical segment of the U.S. financial markets. It did not come about just because the Fed raised interest rates, but because of a sea-change in perception about default risk. The Fed can lower rates in response, and this will provide temporary comfort to the stock market, but the Fed really cannot change the fundamentals at work here. There are about $800 billion of sub-prime loans booked this decade, and up to 25% of these loans are in default. There is an additional $300 billion in Alt-prime, and up to 5% of these loans are in default. Other debt markets like high-yield bonds are so leveraged that these markets are witnessing investor strikes as well, even though defaults haven't risen (yet).

Maybe all this will work out, and maybe a recession can be avoided. But if the debt crisis doesn't resolve itself soon, the ISI 10 points become meaningless. You can't force people to lend money if the credit risk of default is viewed as too high, no matter how low the Fed pushes interest rates, or whether the economy is avoiding other excesses like labor shortages, high inventories, or whether traditional models don't forecast a recession yet.

I have to particularly disagree with the international arguments. The two engines of global growth have been the U.S. as buyer and China as seller. India is playing a secondary role as seller. If the U.S. buyers are tapped out, the international global economy must and will recede. At that point, some of the corrupting and corrosive debt that has fueled China's growth will be revealed as yet a second gigantic pool of default risk alongside the U.S. excesses.

Which is to say, the world is not and has not been in this decade "awash with liquidity". The world has been awash with debt, much of it granted through the securitization process under which no one takes responsibility for the credit risk. Consequently credit standards have been washed down the drain with all this "liquidity". Loan proceeds have been confused with revenue and income, and created the illusion of wealth for many, most egregiously by the private equity partnerships. Rising asset markets have disguised all the bad debt being created, and have bailed out the failures so far. But that tide is now receding and the sludge being revealed is ugly indeed.

construction spending out of the GDP, much of which is leveraged, you will see the growth rate over the last recovery is unimpressive. In just this respect, debt has driven this recovery in ways that are not modeled in the ISI 10 view.

The current view looks at debt as increasing during a recovery because of demand. It does not look at debt as driving demand. But in the last recovery it seems to have been a primary driver. Also during the turndown in '01 and '02, household debt did not contract.

So there are reasons for saying that debt has taken on a life of its own and is a primary economic driver. The Fed and other central banks seem now to be engines of this life and are playing a much larger role in the way a recovery unfolds and carries on.

Hence, the notion of a "central bank bought recovery", which now seems to be at the mercy of fraudulent and parasitic lending, i.e., subprime here, and unknown practices in China.

http://mauberly.blogspot.com/

"Which is to say, the world is not and has not been in this decade "awash with liquidity". The world has been awash with debt, much of it granted through the securitization process under which no one takes responsibility for the credit risk. "

Woah. Somebody does take the credit risk, it's just not the person responsible for originating the loans. The main problem from this angle is the wave of people taking the credit risk without really understanding it, simply because the bonds were a relatively liquid source of yield at a given rating level. There was so much money looking to be put to work in credit that it drove yields down across the board and reduced tiering, making some risks completely mispriced.

The credit risk is still there and has not gone away. More than likely it rests with the purchasers of the securities. But the responsibility for analyzing the credit risk before a mortgage was booked, and then accepting it or rejecting it, became diffuse if not forgotten. This is the point Greenspan kept missing when he extolled the beauties of risk diversification through securitization. You can literally follow the demise of the importance of credit risk to banks by their gradual reduction of the credit officer function; credit officers weren't deemed necessary if the loans weren't being kept on the books of the bank. As a result, bad deals became acceptable loans, and unthinkable credit practices (no documentation loans, negative amortization) became the norm because no one really "owned" the risk while the loans were under review.