Financial Alchemy Conjured Credit Crunch

Editor's Note: This article is a collaboration between Bennet Sedacca and Professor Rob Roy. It first appeared on Minyanville on February 8, 2008, and, in light of recent events, has been republished for the benefit of the Minyanville community.

Over the past several years, my firm has highlighted the risks in the sub-prime sector, lax lending standards and the housing bubble that peaked in 2005. The residual effects of these have been vast and continue to support my view that debt unraveling is not yet contained.

Housing is clearly in a near-death spiral, with inventories rising on months of available supply basis despite many homeowners de-listing their homes in hopes of a turnaround. Here in Orlando, 5 years' worth of available home lot inventory is waiting for developers. According to my firm's industry sources, a real turnaround in housing on a macro level is unlikely to begin before 2009-2010. This is sobering stuff, to be sure, but the truth usually is in the markets.

Abnormal events are magnified with financial leverage, and even normal events can become catastrophic with large amounts of leverage. This is clearly seen with the sub-prime and other low quality loans that were packaged into Collateralized Debt Obligations (CDOs), then sold off to institutional investors thirsty for higher returns.

Other financial "alchemy" -- courtesy of Wall Street’s greatest quantitative minds -- included upwards of $300 billion of Structured Investment Vehicles (SIVs). The SIVs took in a lot of mortgage paper (both commercial and residential), added some leverage to the recipe, and then issued a package of commercial paper/equity/junior notes/senior medium term notes (MTNs). These investments (We use this word loosely and prefer ‘derivatives’) were ‘stress tested’ for normal delinquency rates. Of course, now they realize that these aren't normal times. 

My firm believes it's dangerous to use history as a guide in today’s complicated environment. Instead, we believe we're now making financial history, and, when we look back 20 years from now, we will see today as the unwinding of the "Great Debt Experiment."

Which leads me to the greatest risk of all: Counterparty risk. Counterparty risk, simply defined, is the risk that the other party in an agreement will default.