Sub-Prime Market Earthquake is Felt Worldwide

The shock waves emanating from the sub-prime mortgage earthquake are now spreading around the financial world. The collateral damage is being unveiled so quickly that it is difficult keeping up with all the collapsed hedge funds, injured banks, and defaulting mortgage brokers. It is difficult to make sense of all of this, partly because financial reporting in today’s business publications is almost non-existent. Reporters usually repeat what is in some company’s press release, and only a few with experience and investigative instincts can really go below the surface and make sense of things. To be fair to the reporters, this crisis is a bit different, because the hedge fund industry is deliberately and obstinately opaque. Hedge funds reveal little about what they own or how much they borrow. That iron curtain of information about hedge fund exposures is making this crisis much worse.

And it is a crisis ”“ probably the defining financial event of this decade, which will impact global economic growth for the next few years at least. Most of the time, financial markets are in offensive mode. Investors are happy to put their money into assets with varying degrees of risk, and banks are happy to lend money to investors for this purpose. Every so often, the financial markets become defensive, and investors start worrying about whether they could lose money on their investments not just from market risk (changes in interest rates or FX rates, for example), but from credit risk, where a default could devastate the value of an investment portfolio.

Global financial markets are now in full defensive mode. The global financial plane has set down on the runway with its reverse thrusters roaring, and the pilots are hoping just to keep the plane from skidding off the surface. The outcome is uncertain, and clearly not all passengers are going to survive this forced landing. Just to complicate things, there is an earthquake underway that threatens to rip apart the runway; it all depends on how far the runway is from the epicenter of the earthquake.

Or, to put this analogy in more practical terms, it all depends on the extent to which the global financial markets are at risk from the sub-prime mortgage mess, because that is the epicenter of the earthquake. Don’t be fooled by what Treasury Secretary Henry Paulson said yesterday; the sub-prime mortgage mess is not ”œcontained”. Problems are spreading to all sorts of financial sectors. Let’s look at these shock waves market by market.

The Epicenter

Real people who have real problems meeting their mortgage payments in the U.S. are at the very center of this financial crisis. These are decent people who in past markets would not have been able to get a mortgage, but in the free-wheeling mortgage circus of the past five years they’ve been able to obtain loans with very beneficial terms such as no proof of employment. They were given low teaser rates that are now setting at much higher market rates, but these are higher than current market rates, because they have to compensate the banks for the cost of providing the low teaser rate in the first place. Depending on which mortgage executive is admitting to what, anywhere from 15% to 25% of these borrowers are behind on their payments to the bank, or in foreclosure. These are very high default rates historically, and given the hundreds of billions of dollars of sub-prime mortgages that have been booked, there is a serious amount of money that is going to be lost.

At the epicenter, it is best to remember we are talking about direct credit losses from customer defaults on the loans they were given. As we move further out to the concentric shock waves, this pure default risk is not a problem, at least not yet. In the outer fringes, the problems relate to portfolios that need to reduce leverage, and to investors and bankers retreating from reckless lending policies in place for most of the past five years.

Wave 1 ”“ Sub-Prime Investors

In olden days (about 10 years ago), the bank that made the mortgage would hold on to it and bear the burden of these credit losses. But in the past decade a whole new market has arisen that securitizes these mortgages, by bundling together thousands of them, and then selling the cash flows as bonds. Large, institutional and presumably sophisticated investors can buy these bonds, almost all of which were rated by S&P or Moody’s as AAA because the great bulk of the mortgages in the bond were rated highest quality prime, and only a small portion were sub-prime mortgages.

Bear Stearns, the New York investment bank, announced a few weeks ago that two of its hedge funds had invested in these types of bonds, and the hedge funds were now broke. If the investments had only a small percentage of these sub-prime mortgages, how could the entire hedge fund go under? The answer here is the miracle of leverage. Bear Stearns for one of its funds had raised about $600 million in cash from investors, but then borrowed over $5 billion more from banks to leverage up the profits in the fund. This leveraging is routine in the hedge fund business, and is the main reason why so much debt has been taken on in recent years in the financial markets. All it took therefore was a not unusual 10% devaluation in the value of $6 billion in bonds to wipe out the $600 million in cash equity in the entire fund. The real problem here is that a not terribly large change in value can act as a force of destruction through leverage.

The second problem is that the banks that lent the $5 billion to Bear Stearns changed the rules. In order to lend this much money, the banks had all the assets of the fund assigned to them as collateral in case the value of the fund’s assets ever fell significantly. When the crisis began, and they saw that 10% of the value of this collateral could disappear, they did some worst-case scenarios and realized that potentially much more damage might occur. They demanded more collateral from Bear Stearns, which really meant that Bear Stearns had to sell some of the fund assets at a time when prices were heading downward. That only makes the price depreciation accelerate, and before you know it ”“ poof! ”“ $600 million of equity is wiped out.

Yesterday two more investors in hedge funds alerted the markets to a similar problem. Radian Group Inc. and MGIC Investments claimed that about $1 billion in investments in sub-prime mortgages were now worthless. It’s not yet clear whether leverage played a role in this problem as well. What is really noteworthy is that both of these companies are mortgage insurers ”“ their business is to protect investors who hold mortgages. What does that say about the mortgage market when the insurers themselves are starting to take sizeable losses?

Wave 2 ”“ Alt-A Investors

A step above sub-prime mortgage borrowers is the Alt-A category. These borrowers do not have the high credit scores and solid payment history of prime borrowers, so they fall into an A- category. It was only two weeks ago that market experts were insisting that there was no contagion in this category from sub-prime problems.

Countrywide Financial, the largest mortgage lender in the U.S., said last week that indeed Alt-A and even prime mortgages were now experiencing a surge in late payments. Yesterday, American Home Mortgage Investment Corp, which specializes in Alt-A mortgages, announced that it no longer had liquidity to continue making new mortgages. This has stranded thousands of potential borrowers with nearly $500 million in mortgages waiting in the pipeline. AHM’s problem is an investors’ strike combined with a lenders’ strike. The investors that bought the securities holding AHM mortgages are demanding that AHM buy back these securities because of the unexpected default rates. On top of this, the banks that lent money to AHM are shutting down access to this credit, and companies like AHM can’t stay in business without the banking industry’s support.

The banks are back-tracking not just because they understand how damaging these high default rates can be, but because they are running stress tests on the mortgage markets and coming up with much higher damages from worst-case scenarios than they had previously thought. Also, some of these big financial institutions, like UBS in Switzerland, and CNA Corp., have announced substantial losses of their own from sub-prime mortgage investments. Top bankers in these institutions are losing their jobs, and there is nothing like a banking executive being put out on the street to elevate the fear level of all bankers.

So much for Henry Paulson’s view about containment. The U.S. now has thousands of borrowers with good credit who cannot get a mortgage.

Wave 3 ”“ High-Yield Bonds

High-Yield corporate bonds are long term debt obligations that receive an S&P or Moody’s credit rating below investment grade. In other words, they have a significantly higher risk of default than investment grade bonds. They therefore offer a higher yield, but in recently years the difference in the interest rates on poor quality versus high quality debt has shrunk dramatically, so that recently this ”œspread” was at historically low levels.

That is now changing. The market is ”œrepricing risk”, according to Henry Paulson, and part of that process involves investors selling some of the low quality paper and moving into safer investments.

Macquarie Fortress Investments is a hedge fund managed by Macquarie Bank of Australia. This fund invests in high-yield corporate bonds, not in sub-prime mortgages. Yesterday this fund announced that it has lost about 25% of its value, because it was ”œforced to sell assets to reduce borrowings.” It’s our old friend leverage at work again, this time in a pernicious way. The fund simply had borrowed too much money in comparison to its cash equity ”“ the amount actually put in the fund by investors. Depending on the leverage ratio, it would not take that big a decline in the value of the high-yield bonds to wipe out 25% of the equity of the fund.

Yet another casualty in this market is Sowood Capital Management LP, managed by a former hedge fund guru from the Harvard University endowment, which has been the premier hedge fund investor among university endowments. Harvard even put in $500 million of its own endowment into this fund when it was started a few years ago. The fund has now lost $1.5 billion, or 50% of its equity, seemingly from leveraged investments in high-yield instruments. Sowood Capital has now been purchased at a deep discount by Citadel Investments, a so-called vulture hedge fund that specializes in scooping up distressed hedge funds, and which can continue in this business as long as its banks continue to provide financing.

Wave 4 ”“ Asset-Backed Securities

Asset-backed securities are even further removed from sub-prime mortgages. These securities act like bonds, composed of thousands of small loans made to finance automobile purchases, or retail purchases using credit cards.

Bear Stearns runs the Bear Stearns Asset-Backed Securities Fund, which has $900 million in assets, less than ½ of 1% of which are sub-prime mortgages. This fund also has $50 million invested in cash, a 5.6% cash ratio which is about average for such funds. The fund has no debt whatsoever, so leverage does not come into the picture. Yesterday Bear Stearns announced it was halting all investor withdrawals for this fund. Apparently investors in the fund were so worried about the name Bear Stearns that the redemptions were forcing asset sales, which Bear Stearns as manager felt was inappropriate. None of the assets is in default, and Bear Stearns’ logic is that it should wait out the current turmoil in the market rather than enter into forced liquidations. The rules of such funds can force the investors to sit and wait for indeterminate periods before they can get their money out. It’s another example of the market freezing-up, and it’s a case also of contagion, this time through the sour reputation of the Bear Stearns brand.

The Seismologists

Registering the strength of the earthquake are any number of marketable securities and indexes trading on public exchanges, measuring such things as the credit-worthiness of bonds issued by banks. As an example, the iTraxx Crossover Series 7 Index consists of the bonds of 50 European companies, each bond worth Euros 10 million in value with a five year maturity. If you buy a contract, you are purchasing insurance protection against the risk of default in these bonds, so the higher the purchase price, the greater the perceived risk of default. Yesterday the contract value jumped Euros 59,000 to a total cost of Euros 459,000. Compare this to the contract size of Euros 10 million, and you get the idea that the market thinks the default risk for these European companies has jumped to 4.59% over the 5 year maturity of the bonds. That’s an extraordinarily high default rate, on the level of junk debt.

Similar indexes around the world are showing a sudden jump in the cost of protection against default. The prices in the secondary market for bonds issued by Bear Stearns, Merrill Lynch, Goldman Sachs and other Wall Street banks have now fallen so low that they are trading like junk debt.

All these measures and trading instruments show the same thing: credit default risk is considered to be dramatically higher in the market now compared to even a month ago; spreads between poor quality and high quality paper are widening, and the contagion is seeping into newer areas of the market.

The Regulators

Other than the U.S. Secretary of the Treasury, how come other regulators, such as central bankers, haven’t come to the rescue of the market with press statements of reassurance, urgent meetings of banking executives, extended lines of credit to commercial banks, or other similar measures?

One reason may be that the speed of the collapse of the credit markets has caught many observers by surprise. Second, it is critical to remember that the epicenter of the earthquake, and the hedge fund industry that is clustered around the epicenter, are not regulated by the central banks or agencies such as the SEC or Financial Services Authority in London. Like the rest of us, the central banks know very little about what the hedge funds own or even how much they have borrowed.

This is a crisis that is happening in an information vacuum, which means that rescuers will be in short supply and operating with limited tools.

How bad could it get?

This crisis could metastasize into something very serious. Many more hedge funds could disappear, the banks can become panicky over calling for more collateral (thus forcing even more sales of assets in poor market conditions), and the real spillage into the economy of normal people, such as those Alt-A borrowers who now cannot obtain mortgages, could push the U.S. into a recession. Once the U.S. succumbs, China will not be far behind.

This scenario is possible but it is very hard to rate its likelihood, because we simply don’t know much about the exposures of the hedge fund industry, which is the sector which is the source of contagion since it touches so many different markets.

Another possibility that would be far preferable is one in which the announcements of problems taper off in the next week or two, and then disappear altogether. In this best of circumstances, the financial markets will still be left in paralysis for many weeks or months before credit risk-taking can resume. Moreover, it is highly unlikely even then that the markets will return to the ”œgolden age” of unlimited and ill-advised credit that well-known leveraged buyout king Henry Kravis was bragging about just a month ago. There has been too much damage already for the hedge fund and private equity industries to be able any more to swagger and bully their way into obtaining mega-billion dollar loans.

Are there any clues provided by the stock market? Equities have taken a severe battering in the past two weeks once the extent of the sub-prime problem became known. Stocks like Mizuno Bank of Japan have dropped 10% or more merely from announcing some losses in their investment portfolios. In the case of American Home Mortgage Investment Corp., that stock has fallen 90% amid market rumors that the company is facing bankruptcy.

The good news is that almost every indicator of stock market strength shows that the markets worldwide are very oversold, and thus they are ready for a one or two week bounce back. That may be indicative as well of some stability forthcoming in the credit markets, and maybe ”“ just maybe ”“ a market meltdown can be avoided, at least for now. If so, we are left at least with some temporary paralysis in the debt business, giving the markets enough triage time to sort out the irretrievably doomed from the walking wounded, and a little bit more time to ask how this disaster came about.

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Numerian is a devoted author and poster on The Agonist, specializing in business, finance, the global economy, and politics. In real life he goes by the non-nom de plume of Garrett Glass and hides out in Oak Park, IL, where he spends time writing novels on early Christianity (and an occasional tract on God and religion). You can follow his writing career on his website,

33 CommentsLeave a comment

  • The duckpins starting to line up with the collapse of the sub-prime market forces on to reflect on the failure of the Creditanstalt in Vienna in 1931, which at the time was felt to be of only minor importance. Of course, it did trigger the collapse of other banks throughout Europe, then the US and the elsewhere around the globe. The collapse of this middle rank bank is now thought to be the epicenter of the start of the Great Depression. Can the Fed try to pull the bacon out of the fire now that it’s completely destroyed its options by supporting Bush’s rash tax programs for the last six years? Without crashing the dollar? Any takers?

  • I’ve greatly enjoyed your last few threads about the economy and (potential?) depression. You boil complex and confusing econ-speak into easily understood and logical pathways I can follow. Keep it up.

    As an aside, I’m damn glad I invested a hedge into rare gold coins last year. It might take a hit in a meltdown, but at it doesn’t burn up like paper.

  • I have to admit, in all the time I’ve been writing about financial or economic topics, I haven’t had to use the D word. But lately the risk of a very serious recession has risen, and perhaps something worse. There’s a tipping point where excessive debt overcomes everyone’s efforts to keep wages and spending up. We may be at that point. In the Depression of the 30’s gold went down in value like everything else, though this might have been caused by the U.S. government’s cancellation of the direct link to the currency.

  • are largely consonant with the central banks. Same with private equity and managed funds. They are just not going to let this fall much. There will have to be something that they cannot control for this to fall very far.

    I still believe that the phenomenon of the “central bank bought recovery” is intact, but it is fraying somewhat.

    We shall see.

  • 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 😉

  • “Large, institutional and presumably sophisticated investors can buy these bonds, almost all of which were rated by S&P or Moody’s as AAA because the great bulk of the mortgages in the bond were rated highest quality prime, and only a small portion were sub-prime mortgages.”

    This is somewhat misleading. 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.

    A pertinent addition to this post would be some mention of the bailout this week of IKB Industriebank by the German government and banking system. The Mittelstand bank ran into trouble last week when a multi-billion off-balance sheet vehicle it provided liquidity to ran into trouble. It turns out this vehicle was invested heavily in CDOs, bonds backed by a pool of other bonds. Many of these CDOs were backed by subprime mortgage bonds, which spooked investors in the short term debt issued by the vehicle. This in turn spooked lenders to IKB, prompting the government to broker a rescue package reminiscent of the Long Term Capital Management bailout in the late 90s. The remarkable thing about the situation is that there are apparently no credit losses yet in the fund, and the only significant losses on IKB’s own balance sheet are mark to market losses. Yet the market was spooked enough to necessitate a Eu3.5bn intervention. The issue is complicated by the fact that it seems IKB’s management hid the mark to market losses (or perhaps the extent of the exposure) from the supervisory board.

  • 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?

  • 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.

  • 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.

  • 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.

  • 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.

  • 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.

  • “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.”

    You’re getting confused by the jargon here. [The following is a simplification, but explains the general principle] What owns the collateral is a special purpose vehicle, which then issues multiple tranches of secured bonds. The bondholders have security over the collateral, which can be pretty much anything that generates contractual cashflow – mortgages, bonds, credit cards, real estate. Each class of bondholders has security over the whole collateral portfolio, but different classes have differently ranking claims. The most senior bondholders, with AAA rated bonds, have the most senior claims – if the notes default, nobody else will be repaid until they are fully repaid. Then the second highest bondholders (rated AA, say) will be paid. And so on down the capital structure until you run out of principal. Things are more complicated for CDOs, which are much more structured, but the principle remains broadly the same. There’s a threshold and if losses remain below that then the bondholders will be repaid fully. The rating of a bond depends on both the quality of the collateral and the level of the threshold. You can have a triple-A rated bond backed by utter junk if the threshold is high enough.

  • 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.

  • Looking this weekend at how the market finished in NY on Friday August 3, it does not look like my preferred scenario is going to pan out. 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. Bear Stearns on Friday afternoon chilled the market when an executive said in a conference call that the current situation reminded him of the 1998 Long Term Capital Management crisis, and that Bear Stearns was squirreling away cash just in case. Financial markets work on the exact opposite assumption – that big players have ready access to cash.

    The mortgage company Indymac announced it no longer will make anything but prime mortgages that can be sold to Fannie Mae and Freddie Mac, because the secondary market for mortgages is frozen. To put this in perspective, many decades ago in the U.S. most mortgages were made by commercial banks and savings & loans, who kept the mortgage on their books until maturity and absorbed any credit losses themselves. Alongside them were the Congressionally-sponsored agencies Fannie Mae and Freddie Mac, which buy mortgages to help the market grow, and which also guaranty against loss of credit risk for mortgages they choose not to buy. These two agencies are de facto central banks in the U.S. – in the large world of mortgages, they are like a lender of last resort. In the 1990’s they exploded their activity and ignited the housing boom that really took off when Greenspan pushed rates too low for too long in 2003.

    Then there is the secondary market, consisting of Wall Street banks packaging mortgages into securities and selling them to large institutional investors around the world (you can bet the Chinese central bank owns tens of millions of U.S. securities backed by mortgages). It is this market which in 2004 took over for Fannie and Freddie when these agencies got into accounting trouble, but the secondary market had much, much weaker standards and allowed mortgages to be booked that had little opportunity of full repayment. 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.

    So now we have a secondary mortgage market that is at a standstill and no one knows how to jump start it. Fannie and Freddie are no longer as aggressive as they used to be, which means that other than what they can buy or guarantee, the only mortgages that will be booked will be those the commercial banks are willing to hold on until maturity. That is a very small percentage of the total mortgages that have been done this past decade.

    There is simply no way that this can be thought of as “contained” from the financial markets or even the economy. The U.S. economy probably cannot afford the blow of its largest financial engine suddenly shutting down. The Fed certainly cannot tell U.S. commercial banks to open the spigot and start booking and holding on to many more mortgages, because the commercial banks have already bloated their balance sheets with high risk loans to private equity firms and hedge funds. Moreover, the Fed has been warning Congress privately of just this sort of scenario developing with the unlimited expansion that had been granted Fannie Mae and Freddie Mac.

    This is precisely what sophisticated investors will be digesting this weekend, whether it shows up in the financial press or not. Next week’s trading has the potential to be uglier than what we have seen so far. Let’s hope not, because true panic selling in the stock market (which believe me, we have not seen so far this year), is an event with powerfully negative economic consequences in its own right.

  • August 2, 2007, 8:27 am
    10 Reasons There Won’t Be a Recession WSJ blog

    ISI Group has had one of the more bearish economic forecasts on the street. That, and the fact Ed Hyman and Nancy Lazar, the firm’s founders, have relatively good track records, make it worth reading when they provide 10 reasons there won’t be a recession, as they did Wednesday:

    1. It’s too early… Not enough time yet for excesses to build up
    2. No wage-price spiral
    3. Bond yields are coming down.
    4. ISI’s GDP model is not projecting recession
    5. The lower dollar is turning around the trade deficit
    6. Developing economies are booming
    7. Global short-term interest rates are just 4.5%.
    8. Lots of liquidity; global broad money growth is up 10%
    9. Profits have been strong in part because labor costs are restrained
    10. Inventories are low

    –Greg Ip
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    interesting (cough republican cough comments)

  • 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.

  • 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.

  • 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.

  • 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.

  • “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.

  • 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.

  • “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.

  • NEW YORK (AP) — U.S. stocks headed for a sharply lower open Thursday after a French bank said it would stop calculating net asset valuations for three of its hedge funds that have had struggled to find liquidity in the U.S. subprime mortgage market.

    Bonds rose, with the yield on the benchmark 10-year Treasury note falling to 4.80 percent from 4.89 percent late Wednesday.

    The announcement by BNP Paribas sent European stock markets lower and stirred concerns that problems among subprime borrowers, those with weak credit, would further roil Wall Street, which has managed a rally this week. Investors have seen wide swings in stocks as investors have worried about not only subprime markets but also about the tightening of credit.

  • San Francisco Chronicle, Carolyn Said & Kelly Zito, August 9

    Need a mortgage this month? It’s going to be harder – and more expensive – to get one. In the past week, turmoil in the mortgage markets has caused increasing problems for home buyers in the Bay Area and around the nation.

    Kurt Herrenbruck, a mortgage planner with Fishman Financial Group in Berkeley, saw one client’s financing evaporate in the space of three days last week.

    “The client is well-heeled, with (a high credit score), and $500,000 in the bank, making an owner-occupied purchase with a 25 percent down payment,” Herrenbruck said. “He needs a no-doc loan (meaning he cannot provide documents to prove his income) because of an employment hiccup.”

    Herrenbruck said Wednesday he found two lenders willing to make a no-document loan. But by Thursday it was down to one. And Friday, when his client’s offer was accepted, there was none. “He can’t buy even though he had the strongest profile of any no-doc: superlative credit, money in the bank and a whopping down payment.”

    The story underscores how skittish Wall Street investors are causing a ripple effect that hurts multitudes of people buying or selling houses.


    “In the Bay Area, a substantial number of homeowners have jumbo loans because prices are so high,” said David Berson, chief economist for Fannie Mae in Washington, D.C. For prime borrowers who need conforming loans under the $417,000 limit, there is not much change in the market, he said. But for everyone else, the changes are substantial.


    Duncan said jumbo loans are carrying interest rates of 7.5 percent to 8 percent, 1 to 1.5 points higher than a month ago. “This is a big run-up, and we expect it to significantly delay the housing recovery, if it stays there for a while,” he said.

    “Vanity, Vanity, all is Vanity.”

  • Stocks tumble as French bank reacts to home loan worries
    By Jeremy W. Peters
    Thursday, August 9, 2007

    U.S. Stocks dropped sharply as soon as trading opened Thursday after a French bank, BNP Paribas, suspended operations of three of its funds in the wake of turmoil in the American market for home loans and the European Central Bank and the Federal Reserve injected cash into the financial system because of tightening credit markets.

    The Dow Jones industrial average fell more than 200 points, or 1.5 percent, while the Standard & Poor’s 500-stock index and the Nasdaq composite index were down just as much. Stocks remained volatile through the morning, and at 11:15 a.m., the Dow was down about 120 points. The S.&P. 500 was off by about 1 percent, while the Nasdaq had recovered most of its losses.

    Asked at a news conference this morning whether he thought the turmoil in the subprime lending market could put a chill on credit in the broader economy, President George W. Bush said, “The fundamentals of our economy are strong,” adding, “I’m told there is enough liquidity to enable the system to correct.”

    The latest upheaval on Wall Street came after a sell-off in Europe, which was prompted after BNP, the largest publicly traded bank in France, became the latest European lender to announce problems linked to the worsening credit market in the United States, where several large companies have already announced losses.

    A German central bank meeting was under way to discuss details of a rescue package for the lender IKB, another victim of exposure to the crisis in subprime lending.

    Jonathan Mullen, a spokesman for BNP, said that the credit squeeze in the United States had made it impossible to calculate the value of the underlying assets of the funds and that the bank was obliged by market conditions to halt holders of the funds from cashing out or new investors from buying shares in the funds.

    “It’s quite exceptional to suspend funds, and it means that people can’t buy in or sell out of the funds,” Mullen said. “But we hope this is going to be temporary and that the market will come back.”

    Mullen said that about one-third of the funds were exposed to subprime loans but that those investments were in high quality parts of that market. “We’ve seen no degradation in the quality of these assets, none of which have been put on watch for a downgrade,” Mullen said. “This is just a technical problem about liquidity.


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