Friday, December 5, 2008
The Financial Black Hole
"This has become essentially the dark matter of the financial universe" - comparing it to the dark matter discovered in astrophysics.”
Chris Wolf, hedge fund operator, quoted in FORTUNE, October 7.
"The big problem is there are so many public companies- banks and corporations, and no one really knows how much exposure they have to CDS (credit default swap) contracts."
Morgan Stanley derivatives salesman (Frank Partnoy) quoted in FORTUNE (ibid.)
The latest news in The Financial Times has not been encouraging as their headline ('Index Points to Record Default Threat', p. 13, Dec. 2) continues to warn of the unfolding crisis in CDS or "credit default swaps". As described by Chris Wolf, the "dark matter of the financial universe".
Following on from the FT article, alarm bells should be ringing as the Mrkit iTraxx Crossover index rose over 1000 basis points for the first time since its creation and meanwhile, in the U.S., the main credit default swaps indicator (for 125 companies) rose to 271 basis points.
Some of the world's leading investment grade companies now look to be in danger of default according to CDS prices.
What are these esoteric instruments and why are we at such risk from them, especially their being embedded in the mortgage securities market? That is what I want to explore in this blog entry. This entails understanding what the associated term “toxic debt” means and how it factors into the unfolding economic catastrophe that we behold. Almost all of it is tied up in these “credit default swaps”. The sum total of these esoteric financial “black holes” is now estimated to be no less than $55 TRILLION. (See,e.g. 'AIG's Complexity Blamed for Fall' in The Financial Times, Oct. 7, 2008 and 'The $55 TRILLION QUESTION' FORTUNE, October, p. 135).
TO comprehend why these CDSs comprise toxic debt we need to delve into some financial history. In particular, a move made in the 1980s known as “securitization”. Up until then, the banks were the primary holders of mortgage debt. With a government deregulating “green light”, however, banks were able to offload these mortgages (whose defaults always cost the banks dearly) to Wall Street. There, clever people gathered millions of mortgages from across the country and repackaged them into entities called “collateralized mortgage obligations” or CMOs.
These were then inserted into bond funds which were sold to cautious investors as “safe” instruments. After all, bonds are supposed to be safer than stocks, right? Wrong! Bonds, such as U.S. Treasurys are – by virtue of having the name and backing of the U.S. government behind them. But not bond funds, which can be loaded with all manner of financial tripe that can engender losses over the short or long term.
As an example, most bond funds in the 1980s and 1990s were loaded with IOs, or inverse only strips, as well as inverse floaters, and CMOs (referred to as “toxic waste” in bond trader parlance). The IOs pay only mortgage interest. Inverse floaters, meanwhile, pay more when interest rates FALL than when they rise. All these tricks were used to try to juice up yields to lure investors. That, along with touting them as “government securities” - since legally speaking mortgage securities are “government –backed” but that doesn’t mean your investment is FDIC-insured! In this way, the bond fund purveyors could get people to think they were making safe investments when nothing could be further from the truth.
My own wife was in one of these bond funds as part of a 401k “Life cycle” fund about ten years ago. I noticed every quarter, despite being in “bond funds”, she was losing more than $800 each quarter and getting no company match (because they aren’t obliged to match in the case of losses). Upon further scrutiny, I discovered the bond funds were laden with IOs and inverse floaters as well as CMOs. I immediately had her exit the Life Cycle thing and put all her 401k money into fixed income assets. Fortunately, she acted in time – as otherwise she likely would have lost more than 30% with the post-9-11 downturn.
We now move ahead to the late 1990s, and CMOs have transmogrified into CDOs (collateralized debt obligations) though the basic meaning is the same. Again, these represented millions of repackaged mortgages now sold as “securities” as part of bond funds.
Sometime in the early 2000s, a gaggle of “quants”- gifted mathematical types based in investment banks- got the idea for a creation that could juice up huge profits for their banks, and based on unregulated derivatives. Thus were born the “credit default swaps”. These were basically devised as “side bets” made on the mortgage securities market and the performance of the CDOs therein.
We all know what a “side bet” is. For example, if you travel to a Vegas Sports book, you will find you can not only make bets on a particular game, say Giants beating the Patriots in the Super Bowl- but also ancillary happenings to do with the game. For example, one can bet on: how many first downs the Giants will make in the first quarter, or how many sacks the NE defenders will make in the game, or how many rushing first downs a particular player will make – say Sammy Morris of the Pats. Any and all side bets are feasible.
In the case of the CDS realm, side bets were allowed on all sorts of things, such as whether particular CDOs would lose money, or the interest rate (average) on a segment of them would drop one half percent, or whether there would be at least 100,000 foreclosures in the third quarter of the financial year.
In the case of the credit default swap, all that was needed to make the bet formal was a counter-party. Thus, the “party” renders the bet and the amount wagered, and the counter-party takes the bet. The actual exchange, as already noted, was often done on cell phones and no formal records other than what the cell phone statement showed were available.
Now, the investment banks’ quants realized that the bets as such might not grab the interest of the mainstream banks they needed to buy into them. After all, the banks could LOSE on many of these bets and it would be to their unending detriment. Thus, the quants took the CDSs and repackaged them along with regular mortgage securities – with CDOs, into what they called “structured investment vehicles”. Or SIVs.
These were then sliced and diced and sold to the mainstream, Main Street banks as safe securities. To make this “kosher” so to speak, bond rating companies (like AIG) were asked to give a bond rating and preferably the safest (AAA) to signal to the mainstream Banks these were A-OK purchases.
Despite the fact that the rating agencies had not the faintest or foggiest clue what the SIVs contained, they sold the things to the banks and the banks happily bought them up unaware of what was actually in them. By 2003 the total of credit default swaps in the financial system was estimated to be around $6 trillion. By August of this year, it had reached $55 trillion.
That is, $55 trillion in hidden and subjective financial BETS buried into mortgage securities as SIVs, with no formal tracer available! Couple this now to a bona fide debt, such as a car loan or mortgage from approved bank or mortgage loan company. Everything is spelled out in detail so that even a person of average intelligence can see what he or she is getting into.
In the case of the mortgage, for example, a full amortization schedule -table is available to show monthly payments, and the principal vs. interest. There is no guessing, no doubt. The debtor knows his obligations and what he has to do to make good on them.
By contrast, with the CDS (credit default swaps) nothing is known other than that the instrument has some subjective worth at one time. But HOW MUCH? TO WHOM? We have no clue since none of the esteemed quants who invented them knows where the “bodies are buried” so to speak! I am not even sure, if they were compelled to complete a typical ISO-9000 process form, they could replicate exactly HOW their esoteric instruments were created!
What we see here, and which is abundantly evident even to the most hard-core libertarian ideologue, is that credit default swaps and the instruments into which they have been buried and disseminated are indeed “toxic waste” by any rational financial measure. I am not even sure one can call them “debt” – although to the banks that now have them on their books they represent humongous debt! Since each quantity of these things lowers the value of the bank’s assets by some factor, and increases its liability.
To make this more understandable I refer to the graphic at the top of this entry- which compares two banks with roughly the same volume of assets, but different equities – since one bank (A) has fewer CDS.
Now, since banks owning the instruments into which credit default swaps have been buried will not readily disclose their extent, then it stands to reason one bank – say Bank A – cannot know how much “bad debt” or “toxic assets” the other one owns or has on its books. If this is the case, a bank with relatively higher equity (Bank A in Fig. 1- at top) will be unwilling to lend capital to a bank for which the toxic asset volume is unknown. After all, if it lends in good faith then the other banks fails because of the higher CDS proportion, it will have only itself to blame.
It is this unknown which has directly engendered the current credit freeze. Because no bank knows the volume of CDS any other holds, it cannot know the extent of any other bank’s equity position or credit worthiness. Thus, has the LIBOR rate recently exploded – this is the London Interbank Offered Rate- which is a measure of bank to bank lending confidence. It most certainly will not begin to go down, reflecting higher lending confidence, until some agent steps in and proceeds to buy all the CDS now on the banks’ books.
WHO is in the position to do this? Well, certainly no private entity has the resources! The only one is the government, and more specifically the quasi-governmental entity known as the Federal Reserve which can, if it must, create enough money by fiat to buy all the CDS and get rid of this toxic sludge once and for all.
Now, some libertarians will no doubt exclaim ‘Why not just do nothing?’ but in asking that they are clearly not cognizant of the degree of financial collapse that would precipitate from such folly. We are talking here of credit seizing up everywhere! No more money for student loans, at any price, no loans for businesses to meet payroll or plant improvement and you can forget about any expansions! No money for home construction, to purchase new cars, to do home renovations, to re-fi a mortgage……NADA! In effect, as Nobel Prize winning Princeton economist Paul Krugman has noted, one would usher in a Second Great Depression – and this one – by virtue of the global banking effects, would make the first look like the proverbial walk in the park.
Hence, bottom line, there is no option. The $55 trillion must be purged and it must be done before banking collapses proceed like falling dominoes. Now, no one is arguing here that full value must be paid for all those toxic assets, I mean even 20 cents on the dollar would be better than nothing – though even that would add $11 trillion to the existing bailout deficit. But doing nothing is not an option, and only the most financially obtuse, who have no remote clue of what is transpiring now, would even propose it.
Finally, in the wake of this catastrophe - which will probably take four to five more years to unfold- it is clear that all the credit default swaps which caused this mess need to be outlawed. Further, all derivatives, irrespective of where or how they are used, need to finally come under SEC regulation.
We cannot afford another event like the credit default swap mess, ever again! For stock investors, the future will be bloody bleak as Stephen Roach noted in his 'Market & Investing' FT column three days ago. As he notes the "post-bubble" world will see a very anemic recovery. Not any of this market bursting forth back up to where it was within months, or even years....possibly decades.
In the long deleverage process, with all asset bubbles punctured, no fund or stock will be able to jack up yield by using tricks such as stacking investments with derivatives, IOs or other crap. People simply won't buy them. In the future investment world the snake-bitten will reach only for what is understandable and transparent.
In a way this is a good thing since the stock market was always designed more as a financial casino for the wealthy, not for ordinary Jacks and Janes to park their precious retirement money.