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when panic rules « Previous | |Next »
August 19, 2007

The image of the crisis in global financial markets is no longer that of a wrecking ball, as it was in the Asian crisis of the late 1990s. It is now that of a big wave of panic and turmoil threatening to swamp the shore of the money markets where a Darwinian ethos rules. As does uncertainty.


This increasingly looks as if it is more than a rash of mortgage lending to Americans who were in the habit of falling behind in their mortgage repayments. The loses suffered by the unregulated hedge funds are too great for that. Debt markets have tightened up. Measurable credit risk is being repriced. Banks no longer trust other investment banks or mortgage companies. Fear of the unknown is causing the market to panic.

There is little accountability in the financial system, the shadows are everywhere, and people are offloading their junk credit packages (collateralized debt obligations or CDO's) It's a classic example of market failure. Corpses, identified as those of the masters of the universe, are floating in the water.

Bernanke & Co and the US Federal Reserve have lost a lot credibility with their “subprime is contained” story. Now they are trying to sell the “housing is contained” story.

Should the Federal Reserve be bailing out hedge-fund managers? Should it reassure investors and save some money managers from well-deserved oblivion. Well that would be great for the masters of the universe on Wall Street wouldn't it.

Update: 20 August
Will the Federal Reserves recent discount rate operation re-liquify totally frozen credit markets? Can the credit problems, which are creating the market turmoil, be solved by liquidity injections? I'm not sure. Paul Krugman, in his recent It’s a Miserable Life op-ed in the New York Times, describes the situation as one in which:

many investors, spooked by the problems in the mortgage market, have been pulling their money out of institutions that use short-term borrowing to finance long-term investments. These institutions aren’t called banks, but in economic terms what’s been happening amounts to a burgeoning banking panic.On Friday, the Federal Reserve tried to quell this panic by announcing a surprise cut in the discount rate, the rate at which it lends money to banks. It remains to be seen whether the move will do the trick.

He comments that the problem, as many observers have noticed, is that the Fed’s move is largely symbolic. It makes more funds available to ... old-fashioned banks — but old-fashioned banks aren’t where the crisis is centered. And the Fed doesn’t have any clear way to deal with bank runs on institutions that aren’t called banks.

| Posted by Gary Sauer-Thompson at 09:21 AM | | Comments (10)


Clearly last week's liquidity crisis in the US and Europe was one of the ramifications of the popping of the US housing bubble.

The rising housing market was the mainstay of the U.S. economy following on from the dot com stock market bubble meltdown in 2000. Of course the recession was held off (postponed?) by dropping interest rates down to 1%. A lot more hot (speculative) money entered the real estate market inflating prices. Some of this cheap money (interest rates below the real rate of inflation?) was channeled into sub prime mortgages.

I read that Moody's had rated a lot of the sub prime mortgage backed bonds as AAA. Sarkozy criticised them for not accurately rating the bonds, however he was defending the now tainted reputation of the European banking establishment - scammed by the Americans to the tune of hundreds of billions of dollars. The bank owned investment funds that bought the bonds were fully aware of the risk however the bonds were asset backed and in a rising market they had little to worry about. If the mortgagee got into trouble the real estate would be sold (at a higher price than bought) to pay off the debt and the mortgagee was likely to walk off with a capital gain.

When the market tanked and did not recover the investment funds holding the bonds would have become concerned about the value of the assets backing the bond paper. With the market being depressed for sometime now, and sub prime mortgagees defaulting in large numbers the bonds became hard to unload. The associated risk is hard to price because of the uncertainty over how much sub prime debt will be defaulted and the real value of the assets backing the debt going into the future. Banks will normally only lend up to 85% of the purchase price to cover themselves against price declines, most include insurance, however I read that many sub prime mortgages were issued without any of these protective measures.

It was interesting to see how the ECB and the US fed reserve handled the liquidity crisis last week. We can be sure that the lights remained on well into the night in Paris, New York, Frankfurt, Rome, etc, while banks responded to the Fed/ECB call to assess their exposure (locked up capital) to sub prime US mortgage debt (confidentiality assured of course). It was like the ECB was calling for a show of hands so it could identify the dumb and the stupid. Most came forward and where assisted (bailed out) to the tune of 95 billion Euros. The next day more came forward and even more funds had to be released.

I think it's fair to say that the European and Asian banking elites have been of the view that US monetary policy in recent years has been reckless and irresponsible. After this unpleasant incident the US credit market is going to find it harder to attract offshore funds. In the current environment both institutional and private investors will be more cautious and demand higher returns. As an example, day after day last week the CEO of RAMS declared that their loan book was rock solid, 100% insured with few defaults, however in the market they still couldn’t find any takers to fund their debt.

I guess that Wall Street cowboys begged the US Federal Reserve big time to act to help it of the hole it had dug for itself during an massive easy money boom under the Alan Greenspan's easy money culture era.

Ben Bernanke, the Reserve's chairman, did oblige--by going beyond pumping tens of billions of dollars into money markets when he cut the rate at which the central bank provides short term credit to finacial institutions by a 0.5 percentage point. It 's a minimal move as it still leaves the fund rate--the rate at which banaks leand to one another---static or unchanged.

These financial cowboys are a Darwinian breed.I see that Babcock and Brown are going round the place saying that when the deal pipeline shortens (or narrows) experienced players rise to the fore and lesser firms drop out. It's all about the short list, the shortening margins and the capital shoot-out.

So the US Federal Reserve is not bailing out the financier cowboys yet. They are still left dangling, paying for their own mistakes, knowingly made.

The angle on this story that interests me is how these US hedge funds managed to scam so much investment money from offshore. Because the people behind the hedge funds were Harvard PhD educated Wall Street financial whizzes they gained the confidence of investors?

Some of the small institutions which reported loses are listed below. Of course the larger institutions would not make their exposure public fearing a run on funds which would exacerbate their liquidity problems.

Dutch investment bank NIBC, reports €137m in sub-prime losses.

UBS, Swiss investment bank, warns profits will be hit by sub-prime losses.

Canada's fifth largest bank, CIBC, writes off C$290m in US mortgage credit losses.

$1bn Australian hedge fund Basis Capital revealed it had lost an estimated 80% of its value.

U.S. subprime losses leave German state-owned bank with €8.1 billion charge.

The US economy partied on a shit load of foreign investment money. Exactly how much contribution did $2.5 trillion of sub-prime lending make to US GDP? What's the foreign exposure to sub-prime lending? As far as credit worthiness, America Inc may be now seen as a somewhat less secure investment proposition.

There is an article by Richard Bookstabber in Time Magazine on the highly complex systems of financial markets. Bookstabber, a senior insider in the world of financial derivatives, has written a book A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation. So he was one of the masters of the universe as he spent his career designing derivatives, working on Wall Street and running a hedge fund.

What Bookstabber says is rather interesting in the light of the views of the rose-colored glasses set:

Here's the recipe for a CDO: you package a bunch of low-rated debt like subprime mortgages and then break the package into pieces, called tranches. Then, you pay to play. Some of the pieces are the first in line to get hit by any defaults, so they offer relatively high yields; others are last to get hit, with correspondingly lower yields. The alchemy begins when rating agencies such as Standard & Poor's and Fitch Ratings wave their magic wand over these top tranches and declare them to be a golden AAA rated. Top shelf. If you want to own AAA debt, CDOs have been about the only place to go; hardly any corporation can muster the credit worthiness to garner an AAA rating anymore. Here's where the potion gets its poison potential. Some individual parts of CDOs are about as base as bonds can be — some are not even investment grade. The assumption has been that even if the toxic waste bonds really stink, the quality tranches can keep the CDO above water. And life goes on.The problem is that CDOs were untested; there was not much history to suggest CDOs would behave the same way as AAA corporate bonds.

No one keeps watch over this kind of leverage. No regulator knows how much leverage the hedge funds have or how that leverage is changing. The financial markets that have been constructed are now so complex, and the speed of transactions so fast that apparently isolated actions and even minor events can have catastrophic consequences.

For the rose-colored glasses set on Wall Street it's all just a flash in the pan. With the Federal Reserve and other central banks stepping in to ease supposedly short-term liquidity concerns, and the global economy apparently humming along nicely, they are confident the turmoil of recent weeks will turn out to be yet another buying opportunity.

They say that stocks are "cheap," and that those who view themselves as connoisseurs of value would be foolish to skip all the bargains on offer. This is the world of Greenspan's "irrational exuberance".

David Walker, comptroller general of the US, recently issued an unusually downbeat assessment of his country’s future in a report. He says:

The US government is on a 'burning platform' of unsustainable policies and practices with fiscal deficits, chronic healthcare underfunding, immigration and overseas military commitments threatening a crisis if action is not taken soon.

It could be argued that US trade and budget deficits, together with an unprecedented increase in the US money supply, have destabilised the world financial system.

This challenges the views of hucksters, androids and financial screen jockeys who deny that hedging strategies have created markets that are unstable and dangerous. Markets are self-regulating, just like airconditioners apparently.

Thanks for the info. It looks like in the coming months the Fed will lower interest rates in an attempt to reinflate the housing bubble.

Merkel came out a few days after Sarkozy to complain about the lack of regulation and transparency in the US finance industry. We can assume that French and German banks were heavily exposed to US subprime debt. We're seeing an erosion of trust and confidence in US financial instruments around the world. A lot of foreign investors exposed to subprime will be feeling like they've been mugged by Wall Street.

Australia is in a different situation to the US. Glenn Stevens, the Reserve Bank of Australia's governor, told parliament's House of Representatives economics committee on Friday that his chief concern was Australia's climbing rate of inflation. He said:

We are clearly very fully employed, and we are getting a stimulus from the rest of the world which is quite powerful. We are at a point where we are certainly more worried about inflation being too high than we would be about inflation being too low.

Inflation is climbing towards the very top of the RBA's 2-3 per cent target band

one would hope that Bernanke at the US Federal Reserve would act to protect the mechanics of the financial system and not the participants.

The financial firms, with their PhD's, mathematical skills and street smarts go themselves into this. They can get themselves out of it.

I found this graphic helpful in explaining subprime mortgage lending.

The New York Times account is a good one. It clearly shows the process of the selling of home loans to investment banks, who then turn it into mortgage backed securities and then on sell it onto Wall Street investors in the US mortgage market.

I see that Monday's AFR editorial is anti-regulation re the financial markets:

the answer to the sub-prime crisis is not to re-impose onerous minium desposts that price many good people out of the market, or to restrict the operations of financiers and ratings agencies whose financial alchemy transformed high-risk mortgages into triple-A rated securities.The markets can take their own action and have already increased the price of risk.

Don't you love that phrase 'financial alchemy transformed high-risk mortgages into triple-A rated securities' when it has melted down.

The editorial then backtracks from its free market ethos and celebration of the money making geniuses:

The answer is to shine a light on the flaws in the securitised debat market and encourage greater vigilance and transparency, to minimise the risk of it recurring in different clothing

Doesn't 'greater vigilance and transparency' imply regulation?

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