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Having The Market Meltdown
For additional questions, visit avoid the credit crunch
This information is a successor in an article I wrote on October 11, 2007 where I suggested the credit crunch could be far worse than most people believed understanding that the affect stock market trading, the financial system, economic vitality and inflation may be significant. Inspire the week after Thanksgiving weekend in addition to being I contemplate last week's market sell-off and this also week's dramatic rally, I recognize that this stresses have raised more evident and i also can't help but contemplate what might be in store for next year.
For the positive side we're almost six years into an expansion plus the US economy continues to grow albeit at a slower pace. Unemployment remains low except in sectors in connection with housing yet it is edging up. Corporate profits have already been good this holiday season nonetheless they declined a little within the third quarter. Before first weeks time of November stock market trading indices were at or near in history highs, regarded late trading continues to be increasingly volatile. The credit crisis of August now looks like it's simply a problem for that financial sector to manage. The Fed has lowered rates 3 x indicating it wishes to protect the economy. At first glance everything is looking OK.
But look in the surface mnblkjhq and the picture changes. The financial lending crunch has lost its crisis atmosphere however, many sectors with the credit markets remain paralyzed. This paralysis is now affecting businesses and consumers in areas apart from property. Equity investors are nervous as evidenced through the stock market's extreme volatility. The Dow was 1,000 points off its all time high plus the S&P 500 being down year-to-date, though both bounced back on rate of interest cut hopes. The housing sector is at a deep recession moving towards a depression. Declining home values are siphoning off vast amounts of consumer wealth while rising food and energy costs are eating into family budgets. Unemployment is edging up in numerous states and consumer confidence reaches a two-year low. Consumer inflation is 3.6% year-to-date and edging higher. Over it all, we're entering an election year and geopolitical events tend to be more unstable and dangerous than to remain since WWII.
As consultants, companies and senior executives our job might be aware about what's happening on earth, anticipate how events might impact our clients or our businesses and stay in front of the curve by subtracting action to mitigate identified risk. We can't relax simply because everything's running nicely now. We've got to look ahead at what might or will not be.
I see seven interrelated threats that business people, senior executives and Boards of Directors should understand, anticipate and cover so that you can minimize the negative consequences should more than one ones becoming reality. The main threat is the growing depression because depending on how sooner or later it unravels it could possibly produce any one or higher from the other six - depression, recession, inflation, stagflation, legislative action unfavorable to business and geopolitical crisis. This is the businessman's effort presenting the facts in a fashion that enables other interested parties to make a sense of it all.
The financing Markets
Probably the greatest risk on the economy and our businesses lies in the credit markets. As the credit markets have calmed down since crisis atmosphere of August, the underlying problem still exists as evidenced through the deficit of liquidity from the capital markets as well as the huge write downs being taken at public banking companies. It is now understood that the ultimate harshness of the financial lending crisis still remains to wear, and individuals are beginning to realize that for the way it unfolds it might cause all or any of recession, inflation, stagflation and geopolitical upheaval.
Now it's clear which the lots of of debt underlying the earth economic climate reaches chance of unwinding due to collateral defaults. The primary focus from the matter are Collateralized Debt Obligations, or CDOs. CDOs are derivative securities, just as created from another asset. Trillions of dollars of such instruments are intended and sold within the last six years. In line with Satyajit Das, one of several world's leading experts in derivative securities for more than 20 years, $1.00 of real capital supports $20.00 to $30.00 in loans. Which means each dollar is leveraged 20 to 30 times! He estimates derivatives outstanding being $485 trillion, or eight times global gdp of $60 trillion. The scary thing is always that nobody can tell for sure who holds this all paper.
The problem is global plus there is only a limited amount the Fed and other central banks are capable of doing to deal with it. This is due to a lot of the problem is in the unregulated shadow banking system[1] thought as the entire alphabet soup of highly levered non-bank investment conduits, vehicles and structures. The effects of securitization is that credit risk moved from regulated entities where maybe it's observed to places where it turned out unregulated and hard to observe. Without regulators to keep an eye on cross-border flows and quality standards, investors didn't really understand what we were looking at buying or what it really was worth.
U.S. ingenuity: Within the post dot com bubble and 9/11 realm of ultra low interest rates, US Banks saw their net interest margins shrink along with their loan volume which negatively impacted profits. To ensure the banks developed ingenious methods for creating significant fee income by bundling volumes of consumer (some of them low income) and leveraged buy-out loans into just what are called Asset Backed Securities (ABS) to be removed to institutional investors like "bonds". The investors then begin using these ABSs as collateral for an additional high-yielding debt instrument known as a Collateralized Debt Obligation. These CDOs were snapped up by Asia and Mid-East governments, hedge funds and pension funds searching for rated high-yield instruments by which to fit their mountains of emerging markets cash. Financial engineers built towers of securitized debt with mathematical models that were fundamentally flawed, while managers overloaded on high-yield debt instruments they didn't understand. All as you go along the banks pocketed huge fees while shifting trillions of dollars of risk off their balance sheets and in the hands of investors. Approximately last year alone Wall Street bankers (such as the money center commercial banks) generated $27.4 billion in fee income from the origination, securitization and sale of exotic Asset Backed Securities.
Because of low interest the united states and Japan most CDOs were bought with borrowed money. In other words, borrowed money bought borrowed money. Because of high credit scores the CDOs might be used as collateral for more borrowing. These triple borrowed assets were then used as collateral for commercial paper purchased by risk adverse money market funds. When the assets underlying these securities start to default in thousands (sub-prime loans), the CDOs lose value plus the institutions holding them incur losses. And because no person knows definitely that's holding this paper everybody is fearful of agreeing to new counterparty risk. The financial lending markets become illiquid and several banking companies finish up holding huge amounts of CDOs which is why there is absolutely no or limited market.
Asset Backed Security basics: Let's take collateralized mortgage obligations (CMOs) since they are the perfect to learn. Within their simplest "pass through" form banks along with lenders originate loans, warehouse them for just a brief time, package them into a bond, contain the bond rated and selling the text to investors. Rather than earning money from the net interest margin in the lifetime of the root loans, the originators earn origination fees and payments from servicing rights. Investors who buy CMOs are actually purchasing future cash flow on the underlying loans' principal and interest payments. As the CMO is rated by the rating agencies the investment price equals the near future earnings discounted with a yield consistent with the rating on the bond. The luxury of this system for the originator is usually that the fees are made front, the servicing rights produce an ongoing source of fee income unless sold, the credit risk is moved to the investor and the investment proceeds allow the originator to create still more loans. The investor gets a rated instrument which has a yield appropriate on the rating.
The role of rating agencies: Ratings on bonds convey an agency's assessment from the odds of default. Investors depend on ratings when creating investment decisions because of the rating agency's history. By way of example, spanning a 21 year period Moody's AAA rated bonds demonstrated a .79% chance of default by year 10. From the asset backed securities world similarly rated loans or bonds are combined in a portfolio, then put into different tranches together with the riskiest tranches using first loss, receiving the smallest credit history and providing the highest yield. Similarly the smallest amount of risky tranche takes the final loss, receives the best credit history and will be offering the minimum yield. In this way a portfolio consisting of B rated individual securities might be packaged to provide senior tranches that receive an a or perhaps AAA rating and junior tranches that get a junk rating.
Bubble trouble: Nowadays double bubbles drove US economic growth through providing unprecedented liquidity towards markets: 1) asset securitization, that include subprime loans; and two) the shadow banking system, thought as hedge funds, pension funds and the whole alphabet soup of highly levered non-bank investment conduits, vehicles and structures like ABSs, CBOs, CDOs, CLOs, CMOs, SIVs and CDSs. The joint growth of the two of these bubbles was grounded from the irrational belief that home prices would forever increase regardless of affordability, and entry to capital at low interest could be unlimited because holders of "safe" asset backed commercial paper would forever roll their investments. Belief from the former proved unfounded in 2007 when subprime loan defaults soared, which caused a de facto are powered by the cisco kid banking system as investors refused to roll their asset backed commercial paper holdings and demanded their money back.
Changing models, changing ratings: As sub-prime loan defaults rose in 2007, in contravention from the rating agencies' mathematical models, CMOs began to collapse. As defaults accelerated the rating agencies were instructed to review their models. On July 10, 2007 the rating agencies changed their models and downgraded many CMOs. This caused panic and uncertainty among CMO investors along with the contagion quickly spread to all or any other kinds of CDOs.
Uncertainty and risk: Investors considered the default distributions with the ratings for their asset backed securities were much like the default distributions of the person assets backing them. Following your mass downgrade of July 10th investors concluded these were mistaken. Investors will no longer knew for certain the default distribution of what they owned. Whatever they did know could be that the model where they based their investment decisions had developed into wrong. When Investors are not aware of what they have no idea of there's uncertainty. Uncertainty differs from risk. Risk may be quantified and diversified, uncertainty cannot. Uncertainty causes investors back off with the result that asset backed securities finance industry is essentially frozen, bid-ask spreads are wide and "indicative" (not firm) and lots of investors say they simply are afraid any ABS risk. It is a killer for that shadow banks.
Banking from the shadows: Unlike insured, regulated real banks, shadow banks fund themselves to a large degree with uninsured commercial paper that might or will not be backstopped by liquidity lines from real banks. The cisco kid banking system is particularly prone to a run which is when commercial paper investors refuse to flip their investment when their paper matures. That causes the shadow banks to tap their back-up liquidity lines with real banks and/or liquidate assets at fire sale prices. Itrrrs this that happened in July and August as outstanding asset backed commercial paper plunged $300 billion and the Libor spread in the Fed Funds rate widened by 50 basis points. The financial lending markets had effectively frozen.
Cosmetic fix for a structural problem: That led to the Fed's 50 basis point cut inside discount rate on August 17th plus the Fed Funds rate on September 18th and October 16th which are created to create liquidity within the credit markets. But all they did was calm the markets, not create the liquidity. The reasons were three fold: 1) banks hate to borrow from the discount window as the Fed has become seen as lender of final measure (read troubled bank); 2) the discount rate remained a 50 basis point premium above the Fed Funds rate; and 3) ever since the rating and pricing models for securitized debt had proven to be faulty, the genuine banks were aiming to decrease contact with the cisco kid banks, not increase it.
Frozen Solid: As subprime mortgage defaults increased and agencies lowered their ratings, investors, banks and funds began taking a look at all derivative backed paper with suspicion, refusing to just accept it as being collateral for the short-term commercial paper that gives liquidity to today's money markets. It's estimated that 53% of $2.2 trillion US commercial paper has become backed by assets, and 50% with the assets are CDOs. That is over $500 billion in commercial paper backed by CDOs. As of November 2nd collateralized commercial paper had declined for 11 straight weeks inside an amount totaling $300 billion or 25% from the amount outstanding by the end of July. Further, up to $300 billion in leveraged finance loans were "orphaned" simply because they could not be sold or used as collateral (which means they must take place in portfolio on the lender's balance sheet). Large segments from the credit markets were frozen solid.
What to do now: We know the amount of securitized debt the general public institutions hang on their balance sheets, plus it comes from many immeasureable dollars. But these amounts don't take into account the off-balance sheet exposure these institutions must the highly leveraged special purpose companies they established to create, buy and trade this paper, as well as to the non-public hedge funds that borrowed from the banks and represent counterparty risk as well. In the third quarter a lot of the public institutions took large write-downs from the derivatives held on their own balance sheets, including Citigroup, WAMU, Lehman Bros., Merrill Lynch, Deutsche Bank, UBS and Countrywide. However, the write downs cost you simply a fraction in their Level 2 and Level 3 assets[2] to ensure the fear is much more should be down on paper as underlying collateral defaults increase.
Indeed, in October and November the write-downs have accelerated with Citigroup, Merrill Lynch, JP Morgan Chase, Bank of America, Wachovia, Freddie Mac while others all announcing multi-billion reserves for expected losses. Up to now over $66 billion in provisions for losses have been announced and much more is expected. Two seen CEOs have already been fired, Citigroup and Freddie Mac happen to be downgraded, may cut their dividends and so are raising capital to meet minimum regulatory requirements. The issue of leverage in the declining companies are that losses are amplified. As value goes down other assets has to be sold (usually for way less than) to keep covenants. When derivatives can be purchased for way less than, accounting rules require that every similar assets inside the debt chain be reduced from the same discount. This quickly drains more liquidity through the system making the worldwide liquidity situation worse.
Nobody knows definitely to what extent any entity is exposed so everybody is not wanting to handle new counterparty risk. This is why the finance markets remain only 1 dose of not so good from panic. The finance markets also impact stock market trading which until recently been on part been driven by CDO type instruments which are beneath the heading of "structured finance" (LBO, MBO, stock buy-backs), by corporate liquidity created through the issuance of asset backed commercial paper and by the securitization gains reported by publicly traded banks, funds along with other banking institutions. If deals don't get done, if corporate liquidity dries up or if banks, mutual funds as well as others continue reporting large losses on derivative securities, industry is vulnerable to a sell-off as we have witnessed inside first and third weeks of November.
Deflating bubbles: Thus market place volatility might be more than a correction. It truly is concern with a gigantic liquidity bubble deflating. The Fed cannot prevent this by lowering rates or injecting liquidity considering that the problem is not the amount of money inside the system. Sixty that investors are questioning the whole risk transfer model and it is associated leverage and counterparty risk. The August credit crisis failed to vanish entirely, truly moved off of the top of the page. Think about this - huge amounts of dollars of investment grade CDOs are held by state and native pension funds. These funds are generally restricted legally to buying only investment grade paper. What happens if your investment grade CMO held in a pension fund portfolio is downgraded to non-investment grade or even junk status? The fund is forced to promote these securities, most certainly at a discount. For this reason many individuals who understand the extent that the world economy has been backed up by debt are generating risk mitigation a high priority. Some examples are people with the Federal Reserve and Treasury Dept.
Contagious crunch: As being the enterprize model for your securitization of subprime mortgages ceased to operate, that asset class imploded. In lieu of being contained because the Wall Street and Beltway authorities predicted, Wall Street soon began repricing other classes of financial risk assets (credit card and car finance portfolios, etc.) to raised risk premiums (lower valuations). Nevertheless the contagion has stopped being on a portfolios of securitized assets.
The housing recession is clearly being exacerbated by a mushrooming mortgage crunch as lenders raise credit standards reducing loan amounts. And as the monetary burden from housing goes in family budgets lenders are starting to discover increased plastic card and auto finance delinquencies and defaults requiring increases in reserve requirements because of these asset classes. When reserve requirements increase lending fails and terms read more onerous. Rates, extra fees and penalties increase, credit limits are reduced and grace periods are shorter. They are early signs and symptoms of a classic consumer credit crunch. The buzz to all credit markets toward less and even more expensive credit would have been a continue the economy in 2008. The amount of the drag is basically anyone's guess for the reason that subprime meltdown puts the economy in uncharted waters.
A companion article titled "The Seven Threats for a Business in 2008" is going to be published this date and will explain the wide ranging impact which the market meltdown could have on the general economy as well as your business specifically.
[1] Shadow Banking Product is a term coined by Paul McCulley of PIMCO
[2] Level 3 Assets are assets for which there is no market. Level 2 Assets are assets which is why there's a thin, erratic market. Nevertheless there is no reliable rate for these assets, accounting rules and securities regulations let the institutions to find out value using internal valuation models. Consequently a CDO could possibly be valued at .95 at one institution while at another institution that same CDO could possibly be valued at .90.
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