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Thursday, August 09, 2007

The EVENT!!!

Overnight BNB Paribas suspended several hedge funds, the composition of which was similar to the Bear Stearns funds. This triggered a panic. No one wanted to extend credit at prevailing rates. Overnight LIBOR shot up about 50 basis points.

The ECB (Euro Central Bank, got a currency, need a bank!!) plopped over 100 billion out there to try to prevent worse effects. Bloomberg article. By definition, central banks are the lenders of last resort.

LIBOR is a commonly used ARM index (in different terms), so rising LIBOR rates have a direct effect on US loans, and the effect is not a good one. I watched the BNB Paribas news drive the overseas markets down, which had been rising nicely until then. It also will have a hefty impact on US indexes.

These are not the first overseas funds to be taken out by Asset-Backed Security (ABS) problems, but it's the ongoing nature of the problem which is creating nerves. Everyone is trying to clear, and the effort will slowly drive down commodities and other assets. Basically you have a cash-fueled speculative craze that is slowly unwinding as everyone tries to get to a safe cash-rich position, and these types of moves always do have a net deflationary impact. The goldbugs are not likely to be all that happy for a while.

I have written over and over again in this blog that the problem with commercial paper (CMB and LBO) is worse than that with mortgages, and the unwinding in that will have a far more immediate impact on the economy.

Highly leveraged hedge fund trading (and currency carries) have created the same sort of far-flung chains of lending that prevailed in the late 20's. When a highly leveraged trader gets into trouble, such a trader is forced to sell even under disadvantaged terms. It amounts to a widespread margin call. Now the international situation is quite different than in the 20s right now (all though risk factors are emerging), and central banks will respond differently. I am not predicting a huge depression - but individuals should be aware that clearing debt and maximizing cash is important to prepare for such periods. The ability to borrow always tightens up, and if you can borrow, rates are likely to move higher for almost all borrowers.

Calculated Risk will undoubtedly have excellent discussion. Other blogs I watch for financial perspectives are Mover Mike and Oraculations. They are not financial blogs per se, but both gentlemen have experience in the industry and are independent thinkers. Both already have significant posts up.

I want to stress again that several years of exceedingly lax underwriting standards are what is really causing the ABS problem, and by extension, the overall borrowing prolobem. It was not speculation which caused the 1929 stock price break, but the breakdown of the reporting system on the exchange. This led to an inability to move to rational positions, because no one knew what trading was really occurring.

Just as it was then, no one now can safely model what will happen, because when you start writing a bunch of loans with weak appraisals and don't bother to verify income and/or assets, you have no way to assess risk factors. So once trouble hits, it is extremely difficult to reprice such pools accurately. An overleveraged trading operation facing a margin call can afford to take a one-time loss, but from there it must be able to consolidate and move to rebuild. Because of the lack of correct pricing, such operations are now being forced to sell off more and at worse prices than would be necessary if they could figure pricing correctly, but these very sales will become a self-fulfilling prophecy triggering a race to the bottom

Right now the effect on the US exchanges is being moderated by the weakening dollar, which is creating some oportunities to buy profit- generating operations at a net discount compared to other currencies. This will not persist forever, and the companies which have the best long-term prospects are those that actually do produce a profit. Treasury prices have dropped a bit (raising net yields), so there is an opportunity there for some buyers.

Bank of Korea raised rates overnight. Bank of England was rumored to be planning a rate increase. If the US doesn't match, it will hurt the US dollar even more. The Canadian loonie has been strengthening against the dollar, but I have (perhaps mistakenly) developed an uneasy feeling about it. So much of Canadian trade is conducted with the US that it is hard to conceive that the Canadian economy won't be hurt by the situation.


Comments:
MOM - do you really think that the freeze of the BNP Paribas funds is what drove the interbank rates up and precipitated the ECB intervention? There have been several similar events over the last few weeks. Why is this one different?
 
People's reactions. It's the drip, drip, drip factor along with everything else. No one knows what else is pending, and the Germans already bailed out one bank. So now a French bank. After a while people get nervous, what with not being able to get their hands on their money. I wonder how much money is going into a lot of these right now?

Plus, there was a lot of news yesterday, mostly lenders pulling products. And I think anyone who understands the industry is waiting with great anxiety for FNMA's next move which will likely be a hefty tightening. As the markets tighten the value of the current exotic loans drops, because the probability that they will face a reset or a recast and be unable to refi out of it.

In addition, the mortgage insurers are reporting some worrisome numbers. This also would make everyone believe that mortgage insurance will tighten, which will also lessen the probability of being able to refi out of trouble.

The Mortgage Lender Imploder site keeps track of a lot of news related to the downward spiral.

Bottom line is, whatever these bonds were worth two weeks ago, the reasonable expectation is that they are now worth less. It's a continuum - once you set one of these negative factors to work, you don't see the market effect in the numbers for two to three months, but you do know it is there. That, in turn, causes more tightening, and so it goes.

The high-return tranches were the most risky tranches, and one way or another, many funds were invested in those high-yield instruments. So a small downward move in the overall market - say 3-5%, disproportionately reduces the value of their holdings.

This stuff is often packaged up as CDOs and the like, but to get the yield you are always working with the more speculative tranches. Highly leveraged funds working with highly leveraged investments is not a recipe for stability.
 
This is almost exactly like the Long Term Capital Management collapse of several years ago when two Nobel Prize winners and John Meriwether, the famed Salomon Brothers bond trader and genius managed their "black box" system into total collapse in one day. The Fed bailed the assholes out (one of the "too big to fail" deals) but they were out of biz. The "black box," meaning that all tactics, strategies, and holdings were secret and nobody could tell what the hell they were doing, should always be a red flag, but ain't. The LIBOR (London Interbank Offered Rate) is really no more than a guide because the rate is in the eye of the beholder rather than in any real London Bank. A sudden change in the rate (like now) affects mortgages and exchange rates. Bottom line is that we have over leveraged (buying shit with almost no money) risky derivatives that blew up. Again.
 
Yep. We do not learn from our mistakes.
 
"black boxes"...it would be interesting to know what is under the covers of the models used to evaluate risk for mortgage pools. I'd think the most important single factor would be the assumptions about correlation--to what extent, for instance, are defaults in one area of the country independent of those in another area of the country, or defaults in one income stratum independent of those in another income stratum? (Less independent than they thought, clearly.) I also wonder to what extent housing price trends are used in the models--clearly, actual behavior is reflexive, with a positive feedback loop such that lower housing prices lead to more defaults which lead to lower housing prices...
 
I wrote about the Fitch model a few days ago. It looked to me like stone knives and bearskins.
 
Call me PollyAnna; but, we have been through the S&L crash, the Asian Tigers crash, and the High tech bubble. Each time the central banks and goverments manage to prevent a major economic crash. Which is not to say that a lot of money was not lost. But, it seems to me that those 'crashes' were a zero-sum games. Every dollar lost was gained by someone else (e.g. Black Boxes).
In the absense of analysis of the power of central banks, especially when they coordinate their actions, it is impossible to predict(i.e.posit probablities) in any scientific way.
 
I am shocked, shocked, to find that all these genius types from all the right places constructed models based on past performances. This is called "back testing" a method so discredited that the CFTC demands that a back tested fund must reveal the back testing and sometimes the CFTC will just shut them down. Period. LTCM with two Nobel winners and the superstud bond trader in history went bust on a "back tested" formula. Apparently the SEC has no such requirement. Not to reveal how corrupt I am but I once used a 13-1/2 minute moving average to prove that a commodity would rise. There is so much wrong with this entire thing, but always remember that both parties have major hitters from all stock brokerages, investment banks, and trading desks. I have no idea how to correct this.
 
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