Wednesday, July 11, 2007

If You've Got Big Cajones............


Investment Landfill…The Last Word

By Paul Tustain
We have hit upon a very rough - albeit questionable – method of identifying the next big failure in the CDO/CDS market. It may be coincidence, but if we had used this method a few months ago, it would have shown us to look first at Bear Stearns.
Why? Our sources indicate that Bear Stearns only has problems with those CDOs issued in respect of Mortgage Backed Securities created in 2005 and 2006. This is logical. Those CDOs were issued nearest to the peak of the US housing market, so they have the least cushion. Older CDO issues should have more headroom before defaults become a problem.
This would suggest that it is those firms who were late to the CDO party who should be in the deepest water. The following data was published by Standard & Poor's in a 2005 report entitled "CDO Spotlight: Update To Sizing Collateral Manager Participation In The US Cash Flow CDO Market." This table shows the ranking — by size of liabilities — of CDO managers at the end of 2004 and in the autumn of 2005.
Bear Stearns jumped from nowhere at the end of 2004 to 13th place. It was late to the party, in other words. But it got very busy very fast.
We do not pretend to understand these statistics fully, and we would strongly advise all interested parties to examine the original report for themselves. But what is of interest is that the data seem to illustrate how Bear Stearns aggressively sought market share starting in 2005, which could be why it found itself one of the first to be in some trouble, as subprime loans began to default.
If our crude theory holds true, then the data might point to imminent distress for a few hedge funds or other institutional investment portfolios. It would be a remarkably prescient analysis by Standard & Poor's if that were to be the case. But of course it might be complete coincidence, too. Maybe Bear Stearns has better risk management, and so it is first to see where things are going wrong. Maybe other providers adopted different measures to protect their exposed funds. Who can tell?
By the way, the data only concerns cash-flow CDOs. The synthetic part of the CDO market is not included. The synthetic market is bigger.
Long Term Capital Management failed in 1998. It was the last truly serious financial collapse which threatened the U.S. financial system. When LTCM went under, the bail-out fund required was $3.65 billion. The fund itself was leveraged to about $125 billion of assets using a similar style of wheel-financing to the one described above for Bear Stearns' hedge funds.
There was also the presence of off-balance sheet devices called interest rate swaps — not so different in principle from the CDS described above.
The recent rescue package announced for Bear Stearns smaller fund has been announced at $3.2 billion. We believe the overall liabilities of both funds are in the $20-$25 billion range.
Back in 1998 LTCM was ploughing a lonely furrow. Its investment view was something to do with Russian bonds and the Japanese Yen. It was off the main investment spectrum, and there were few copy-cats putting the same market view into action in the same way.
That is where things are very different this time. The data produced by Standard & Poor's above show just how conventional a strategy Bear Stearns has been following — all of it trailing the worldwide boom in housing markets. Many banks and funds are involved. Perhaps they are not quite so exposed as Bear Stearns, but it is only a matter of degree. This makes the size of the problem potentially much larger, and of much greater risk to the whole financial system.
How large? Well, there are about 6,000,000 subprime mortgages in the USA. They typically result from re-financing deals - topping up to utilise whatever equity has accumulated in a house, usually to pay off credit card debt; so they stay near 100% debt-to-equity. The average house price in the USA is about $190,000, but we can reduce that to $150,000 on the assumption that we're at the lower end of the market. That gives us a principal sum of $900 billion. Every 1% drop in home values, therefore, would reduce the theoretical value of the underlying mortgages by about $9 billion. Obviously, most of these mortgages will avoid default. But the mortgages, themselves, are just the beginning of the credit derivative daisy chain that threatens to unravel. We cannot forget that Wall Street has constructed multiple layers of credit derivatives atop these mortgages.
Depending upon who's counting, the world's investors now hold somewhere around $1 trillion worth of credit derivatives, at market value. But since the notional value of these arcane financial instruments exceeds $25 trillion, no one really knows how large the potential losses could become during a panic.
Now you can see the difference in scale between LTCM and the subprime bust. This may be 20 times worse than LTCM. And it's getting worse - daily.
At a time like this, we should not underestimate the skill of people like Ben Bernanke at the US Federal Reserve in underpinning the financial system. They have been remarkably effective at organising the lifeboats over many years and many crises. On the other hand the Bear Stearns episode could be the beginning of wider systemic difficulties.
Here at BullionVault we think the Bernankes of this world will one day fail.
The result will be a credit squeeze. Bond issues will be pulled, bank loans recalled, and business activity will sharply decline for lack of funding. The first two of these have certainly started — with a rash of failed issues at the end of June. Will these risks be contained? We don't know.
We don't seriously expect that by some fluke we will identify the tipping point as it happens; that would be too lucky. Yet we feel compelled to share our views on the current situation with you. Clearly we're biased against excessive leverage, and against too much financial ingenuity, too.
That's why we're in the physical gold bullion business. We believe that real physical gold is a sensible insurance against today's increasingly weird financial system. It has been astonishingly reliable in that role in the past.
But this time, who knows?

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