Cart (0)
VIDEOThe Hot Potato Market
By
Bennet Sedacca Mar 24, 2008 12:47 pm
Fed hides problem assets on own balance sheet.
 |
|
Banks and mortgage originators created trillions of dollars of subprime mortgages in recent years. Wall Street alchemists took the loans and packaged, sliced and diced them into Collateralized Debt Obligations (CDOs). These bonds made their way onto the balance sheets of the dealers themselves, banks, money market funds, hedge funds and the rest of the financial community.
In a typical CDO structure, the AAA tranche holder is the first to receive income and the last to absorb mortgage defaults of the underlying collateral. BBB, BB and equity tranche holders are the first to suffer losses. Click here for more details on CDO tranches.
Generally speaking, when 30-35% of mortgages backing a CDO become impaired (90+ days delinquent, in foreclosure or have been repossessed) the AAA tranche holder begins to feel the pains of default. Sadly, the majority of the subprime loans made in 2006 and particularly in 2007 never should have been made in the first place. Whether or not this was predatory lending or poor decision making on the part of the borrower and lender is a question I will leave for regulators and politicians.
This is how credit cycles typically end. Lenders tend to make the best loans in the early part of a credit cycle and the poorest quality loans at the end of the cycle. Banks were actually warned by regulators in 2005 (Credit Risk Management Guidance For Home Equity Lending) to tighten their lending standards. But greed took over and we now are left with the ‘subprime crisis.’
Approximately $175 billion of these securities have been written off, seriously damaging the balance sheets of major financial institutions around the globe, forcing Citibank (C), Merrill Lynch (MER), UBS (UBS), Morgan Stanley (MS) and others to raise money in the global capital markets just to maintain acceptable balance sheet ratios. These losses forced Bear Stearns (BSC) into the hands of JP Morgan (JPM) last weekend in a Fed-led rescue.
Imagine you were a counterparty to Bear Stearns in a Credit Default Swap -- a bet on the default of some underlying bond -- or another derivative, and Bear Stearns failed. Imagine you owned many of the same assets Bear would be forced to liquidate during bankruptcy.
This is just like one big game of ‘Hot Potato.’ If the forced liquidations don’t occur, you still hold the security, and so long as you don’t have to mark it to market, you don’t have to take a write-down.
If the forced liquidations do occur, everyone begins to wonder who will be left holding the potato as the music stops.
The Bernanke Fed to the Rescue
The Fed has tried many new strategies to stem this tide of defaults.
It's are clearly afraid -- as am I -- of systemic risk, whereby when one large institution fails and a daisy chain starts since many firms own the same securities that brought the first firm down in the first place.
Imagine for a moment you're one of five holders of an esoteric CDO -- the hot potato -- and you start tossing it around the room. You have the potato when the music stops and you have to mark the security to market as opposed to pricing it to ‘management’s best guess.’ The problem here is that not only do you have the hot potato, but all the others have the same problem on their hands. And the unwinding process begins.
Many of these securities are so esoteric that they are not salable and not even able to be priced, let alone traded.
Since the credit crisis began in earnest last summer, the Fed first resisted the temptation to save the financial markets and instead focused on price stability and economic data. During the autumn of 2007, the credit contagion began to spread. Now it has spread to the mortgage insurers such as Ambac (ABK), MBIA (MBI) and Financial Guarantee Insurance Corporation, or FGIC.
It has spread to money market funds that have forced firms such as SunTrust (SUNT) and Legg Mason (LM) to step in so their funds wouldn't ‘break the buck.’ We've seen the Auction Rate Security market freeze up. Part of this market, particularly levered municipal bond fund, is likely to remain frozen for a very long time.
The municipal market temporarily went into disarray. Credit default swaps exploded in price, only to contract drastically after the Bear rescue. The preferred stock and hybrid markets temporarily went into disarray. Upwards of 250 mortgage originators have failed according to www.ml-implode.com.
Countless subprime bailout packages have been floated and now we have a $150 billion fiscal bailout package coming towards us in May.
Whew! That is an awful lot of news to come from such a simple issue as subprime lending.
So let’s take a look at what the Fed has done since August 2007, when Governor Poole said the Fed would not respond to financial market conditions. Of course its tone has changed - as is should have.
We've been living in an asset-based economy for over a decade now. The system is hopelessly over-leveraged from the consumer to the U.S. Government. The dollar has plunged, although it may have put in a sort of short term bottom with a corresponding short-term top in commodities. Just this past week, the FOMC cut the Federal Funds target rate to 2.25%.
Federal Funds Target Rate Chart
Click to enlarge image
Not only has the Federal Funds rate collapsed, but so have the yields of Treasury Bills. At one point on Thursday, ultra-short term Treasury Bills actually went to a negative yield (click here for more detail). Most Treasury Bills inside six months yield less that 1.00% per annum, so it seems that while ‘cash is trash,’ investors simply don't care what they earn in T-Bills so long as they can avoid credit risk.
This can be viewed in two distinctly different ways; either the buyers of T-Bills are overpaying, or that they are correct to avoid credit risk at any cost. My view lies somewhere in the middle.
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
