Read it and (Get Ready to) Weep

A friend pointed me in the direction of this article; and while I don’t understand all the banking/investment jargon, I get enough to increase my concern over the economic situation in the USSA.

The article is titled Banks Fight to Postpone Day of Reckoning. Some snippets:

The U.S. trade deficit with the rest of the world leapfrogged in recent days: aside from goods and services, we are now importing “consensus based crisis management” from Japan. Out of fear that a cleanup of bad loans would trigger widespread defaults, Japanese banks got themselves deeper and deeper into trouble by hushing up the problems. We are talking about the crisis at Bear Stearns’ subprime hedge fund. The crisis shows that major adjustments on how the market prices risks are overdue; this may have negative implications for stocks, bonds, commodities as well as the dollar.

Bear Stearns is a leading provider of services to hedge funds; it is also one of the largest originators of subprime backed Collateralized Debt Obligations (CDOs). CDOs are what their name implies: a security backed by collateral. CDOs are created when mortgages with various risk profiles are grouped into different tranches or segments. Amongst others, Bear Stearns would create a CDO in a bundle according to a client’s specifications. Indeed, Bear Stearns would work with a rating agency, such as Moody’s, to obtain the desired rating (a practice likely to face more scrutiny as some allege that Moody's no longer acts as an independent rating agency, but as a syndicator in the offering). The explosive demand in this sector has attracted ever more creative structures. Investors should have grown concerned when dealmakers started suggesting that one can create a higher grade security by grouping together a couple of lower grade securities; it is rare that 1+1 equals 3. As these instruments have grown more complex, the clients buying these instruments often do not have a full understanding of what they buy.

How do you make a bestseller better? You introduce leverage. Not only can leverage be introduced in the credit derivatives that define some of these securities, but brokers eager to attract hedge fund business may also accept CDOs as collateral to lend money. The hedge fund now attracting so much attention is Bear Stearns’ High-Grade Structured Credit Strategies Enhanced Leverage Fund; it was launched only 10 months ago; it shall be noted that Bear Stearns did not put much of its own money into the fund, but supplied many of the CDOs. $600 million in invested capital was boosted with borrowings of about $6 billion. The collateral provided by the fund had the highest ratings by Moody’s. However, a high rating does not assure that the CDOs are liquid, i.e. that they can be sold off on short notice. This became painfully clear as bets of the fund were creating heavy losses and some lenders asked for more collateral for the loans extended; in the industry, this is called a margin call. Bear Stearns told other lenders, including Merrill Lynch, J.P. Morgan and Citigroup that the fund was unable to provide more collateral. On a side note, it is rather grotesque that Merrill, J.P. Morgan and Citigroup are amongst the larger investors in a fund managed by Bear Stearns; Bear Stearns put little of its own money into the fund.

In the brokerage industry, when a margin call is not met (when the borrower cannot provide sufficient collateral), the broker may seize the collateral and liquidate open positions. While a forced sale of the collateral may be painful for the borrower, it protects the system as a whole. Such forced sales happen all the time in the futures market, where positions are “marked to market” every day to evaluate the profitability and risk of open positions.

But the CDO market is not a regulated futures market; there is no daily market price that would allow one to assess the value of the collateral. .... In the case of Bear Stearns’ fund, Merrill Lynch sent bid sheets to numerous parties, soliciting prices for their holdings; as everyone knew that Merrill wanted to get rid of the securities at any price to cut its losses, it is fair to assume that the prices offered were significantly below the value assumed for the collateral.

As Merrill went public with its plan to auction off the collateral, others tried to rescue the fund. There was talk that Citigroup would inject $500 million; Bear Stearns might inject $1 billion. And the Blackstone Group was very interested in supplying much needed capital. Blackstone’s offer required the brokers to abstain from further margin calls for 12 months. Such restrictions may be common in the private equity world that Blackstone is active in, but was not acceptable to Merrill. As the rescue plan fell through, Merrill stated it would go ahead with its auction yet again. In the meantime, J.P. Morgan was front running Merrill by trying to unload collateral they held for the Bear Stearns fund. When all was said and done, it wasn’t clear how much which broker was able to sell; but the sales were halted once again, and the parties seem to have agreed on an ‘orderly unwinding’ of the positions.

In our assessment, this had the hallmarks of the biggest financial crisis since the bailout of Long Term Capital Management; in 1998, the Federal Reserve (Fed) coordinated a bailout that led to the orderly unwinding of a fund that threatened the stability of the financial system. But this time is different: the instruments involved are so complex that journalists have had difficulty relaying the issues to the public; but the multiple calling and canceling of auctions by Merrill highlight the behind the scene maneuvering to avoid a fallout to the rest of the industry and beyond.

The risk to the financial system was not merely that some large brokerage firms may have been forced to write down a couple of hundred million dollars – they may still have to do that. But had the fire sale gone through, market values would have been available to the securities sold. This in turn would have forced other lenders to revalue the collateral they hold; and as the collateral is worth less, the brokers will lend less money. That would have triggered further margin calls, further forced liquidations. When hedge funds implode, they tend to sell off more liquid assets first; at the end of the sale, the prices of the liquid assets are depressed, yet the fund may still be left holding illiquid securities. .... Too many leveraged investors have become complacent because [of] the low volatility we enjoyed in recent years. Aside from the short-term volatility, the high leverage employed by many hedge funds would need to be reduced permanently. As speculators pare down their leverage, they sell off assets to raise cash.

In our assessment, the well-intended attempts to unwind the Bear Stearns fund in an orderly fashion are highly problematic. The fund’s problems have clearly shown that the credit extended to the industry is too large. The bankers involved commit similar mistakes as bankers in Japan in the 1980s and 1990s, where clearly bad loans were kept afloat with artificial means; those involved had the best intentions, but caused over a decade of pain to Japanese banks, corporations and consumers.

A few days back, I came across an article that revealed that many pension funds across the country have been investing into CDOs. One person actually stated that they were a way to get back some of the losses from the dot-com bust. Given what the economic trends are showing lately, I’d say it’s time to buckle up. And buy more silver and gold.