February 29th, 2008

Credit Crisis Broadens — Price Controls, I say!

Posted in Money by ed

The Murdoch (formerly Dow Jones) Industrials were down over 300 today as two weeks of horrible financial news finally crushed a somewhat stubborn stock market.

This is funny. And accurate — re “Collateralized Mortgage Obligations” based purely on pools of subprime mortgages.

(Note, however, that “Collateralized Debt Obligations” are based on diversified pools of bonds, loans and miscellaneous debt instruments. The many CDOs I worked on this decade were structured to hold no more than 4% or so of mortgage bonds, and often, especially lately, to prohibit subprime mortgage bonds. Thus, the problems with CDOs are not as simple or as corrupt as the problems sketched so well in the link above.)

That is: the credit crunch crippling the economy and trashing markets worldwide is much broader and deeper a problem than that of non-performing and/or illiquid mortgage bonds.

The past two weeks have been the worst for the credit markets since August, as new sectors of the system tightened up. More and more it seems to me there is no market cure. And the regulators at the US federal level seem handcuffed by the laissez faire doctrines on which they were raised.

Captain and crew of the S.S. Free Market going down with the ship.

Fed Chairman Ben Bernanke “testified” before the House and Senate on Weds and Thurs. Deer in the headlights. Not his fault. The rock and hard place are recession and inflation (commodities going crazy, oil hitting $103 today, all the food stuffs near record highs).

The Fed has only one basic tool and can’t treat both contraction and inflation at the same time. Has to choose. Clearly now — after dicking around August thru December — has chosen to try to stimulate “growth.” Inflation left to fester likely will, unless the commodities turn and drop, as Bernanke said he expected they soon would (under global contraction pressure).

(But there may be problems with Bernanke’s hopes that inflation will subside:

– The commodity boom is due in good part to the explosion of activity in Asia and Latin America. Thus less likely to subside simply because of a slowing US economy.

– The continuing collapse of the dollar (all time low against the Euro this week) — caused in good part by the Fed’s easing on interest rates (which makes things like US treasury bonds less attractive to foreign investors) — makes anything produced under a foreign currency more expensive here. Price inflation then an effect of the Fed’s attempts to stimulate “growth.”
– The sudden turn in oil, in particular — which was in the $80s only a few weeks ago and by most pundits due to continue heading south — may be geopolitical: Israel has been on record since last summer that April 2008 is the line in the sand on Iran. Some people still expect air attacks then. A reason to stockpile oil (and/or secure pricing thru future contracts) now. Despite economic slowdown.

If the commodities do not soon cool off, we will indeed have stagflation: simultaneous contraction and inflation, which usually don’t concur since one usually cures the other.

And the Fed will soon have shot all its bullets.

Thus Bernanke looking caught in the headlights yesterday and Weds. That look was just one reason the markets tanked today.)

For months, since July, the essence of the credit crunch had been confidence. Complicated by illiquidity.

Now insolvency raises its head, as the credit crisis broadens and writedowns (balance sheet losses based on depressed market values of the wounded s-f bonds) mount.

Today a blue ribbon panel estimated that the total toll of the subprime mortgage bond mess alone may be $400 billion …

Two weeks ago UBS (big swiss bank) estimated $203 billion in losses would accrue should the bond insurers fail to be recapitalized …

(Measure the preceding two items against the approximate total of writedowns/losses so far taken in the structured finance universe: about $160 billion.)

And yesterday the second biggest US insurer AIG wrote down a staggering $11 billion for its last quarter, helping trigger today’s pell mell crash.

Also: For two weeks the municipal bond markets have been crushed and frozen — a terrible blow to economic life because the interest rates municipalities pay here get reset very short-term (weekly, monthly), at auctions where the bonds are turned over, and these auctions have been boycotted this month by the increasingly credit-challenged banks.

Thus the gov’tal entities that issue “municipal bonds” are suddenly experiencing the very same kind of “ticker shock” that homeowners who took out adjustable rate mortgages have been hit with the past two years as their mortgage payments adjusted up to match higher interest rates. Eg, the Port Authority of NY and NJ, widely reported, went from low single digits to near 20% on some large debt last week.

Terrible — but it draws attention. And seems to have helped spur the New York regulators to work out bond insurer crisis.

The municipal bond crisis was precipiated by the bond insurer problem, you see.

And (good news?) it seems to me the bond insurer problem has been solved — even though the news yesterday and today was screaming that the recapitalization plan for hte second largest insurer, Ambac (ABK), was falling thru.

It seems clear to me that it’s not falling thru — that the spanked rating agencies are simply going thru all the proper motions, and that now (midweek) that they’ve told the banks etc what they have to do to tweak the recap plan, the banks etc will spend the weekend doing that, and come out on Monday or so with a revised plan that satisfies the rating agency “comments”. And Ambac will be recapitalized.

Meanwhile the largest insurer, MBIA (MBI) has been funded and seems okay for now. And Wilbur Ross and Warren Buffet are each throwing billions at the muni biz, thru other healthier insurers, looking to scoop up a low-risk profitable business. (IN the end Ambac and MBI may fade, but the municipal bond world will be fine. it’s clear the regulators will not allow it to be otherwise.)

The bond insurers are in trouble because they began to insure the AAA-rated tranches of CDOs and similar in the 90s and thus got hit with a ton of claims this past year as the subprime etc mess sprang forth.

And the biggest banks worldwide are recapitalizing them because otherwise that $203 billion in s-f bonds that UBS estimated two weeks ago will have to be written down if the bond insurers get downgraded on the very same banks’ balance sheets. Thus the choice for the banks was: fork up approx $5 billion in cash credits now (to recapitalize the insurers) or write down $203 billion (sooner than) later.

So: I think both the municipal bond problem and the threat of that particular $203 billion in writedowns — I think both of these should fade next week. Once that $203 billion is clearly okay, the banks might begin showing up at the muni bond rate auctions again … THEN AGAIN: the markets today traded as if I’m wrong, as if the Ambac deal was dead. It’s not, I’m pretty sure.

(In the old days the rating agencies helped to craft a CDO deal, for example. Otherwise you’d have the bank put it together, then send it to the agency, and the agency would say, No no no, there’s a million things wrong here. So it was just efficiency — not collusion — that led the banks to involve the agency in the structureing of the deal early on. But now since the subprime blow up the agencies have been spanked with conflict-of-interest charges and the like.

So here, with this Ambac recap plan, we had something of a formal folly: the banks LAST weekend structured the plan, with NO rating agency input. Then on Monday formally sent the plan to the rating agencies. Who in midweek made their comments as to its insufficiencies. And today we were told that the banks are back to the drawing board — just one more reason the markets crashed today.

But in reality it’s just the normal process of agency input being incorporated — or so I believe. And I’m sure both the regulators and the banks (worried about that $203 billion) are going to do whatever’s needed to settle Ambac down.


When everyone is insolvent, no one is insolvent. Ie, the game is over. The market ceases. The music stops.

The answer may be radically anti laissez faire: price controls on the many classes of wounded structured finance bonds that are the heart of the problem.

It would be a radical admission that the system has failed to the point where there is no market cure for trillions of dollars worth of wounded (illiquid and perhaps non-performing) assets that are the blood of the global financial system.

Price controls mean: Regulators assign paper minimum values to the wounded classes of bonds, so the parade of nearly nonsensical yet crushing paper loss “writedowns” ends, and so the wounded bonds are allowed to live out their lives in peace, probably producing more interest and principal than the writedowns (influenced by harshly reduced “market values”) imply.

OR:  The Price Control move could be achieved simply by repealing a recently instituted accounting rule that required institutions to mark these largely illiquid “bonds” to a largely non-existent market.

The nonsense news cycles (eg yesterday’s AIG announcement) would stop. The banks would begin lending (swapping credits) again. The fiscal and monetary cures would begin to work on the housing and other economic problems.

I suggested this in August because it was clear then how wide and deep the crisis would be. Back then I suggested 90 days. Now: two years (which would allow most of these bonds to wind up and be paid off, as they will).

(Re the last parenthetical above: Even though a CDO, for example, typically may be written to mature in 20 or 30 years, in reality the parties to the deal (the bank and the portfolio manager and the buyer of the bonds) typically go in thinking of winding the deal up within two to four years. It’s rare to want to continue longer because the economic environment is likely to change enough within a few years to render the reason for entering the deal moot. CDOs are problem solvers, and after a few years or so the problems will either be gone or need an updated solution …)

(It was clear to me in August how deep and painful the “subprime mess” would be because I happened to have worked at the heart of structured finance — the wall street firm credited with inventing modern securitization in the 80s — drafting CDOs and other s-f bonds, and a fair amount of bond insurance agreements and policies, most of this decade.)

Nota bene: The Fed in a small quiet way made the Price Control move last fall (September if memory serves) when it enlarged the list of types of assets it would accept as collateral in the “repurchase agreements” by which it controls interbank lending rates.

That is: the Fed said it would start accepting assets theretofore banned — certain structured finance bonds and the like — which at the time were illiquid (no secondary market trading) and thus had “market values” of more or less zero.

Yet the Fed began “buying” them near face value from the wounded banks etc holding them, giving the banks cash credits in return. Then, days or weeks later, the Fed sold the same wounded bonds back to the same banks — thus completing the round trip that is a “repurchase agreement”.

Net effect: a way to give strapped banks cash credits in exchange for worthless (by mkt value) bonds. A way to help the banks limp thru a liquidity crisis caused by the crisis of confidence in s-f bonds triggered by the blow up of the mortgage bonds.

How different is the pretense behind this sudden willingness of the Fed to swap worthless (by market value) s-f bonds in its repo agreements from the pretense of assigning minimum markable values to wounded bond classes in a broad price control program?

What else to do when the Market has no clothes?

“All right — Everybody! Out of the pool!

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