The Rising Risk of a Systemic Financial Meltdown

[teomaxxx]

From a guy, who has been almost 100% right (for two years already) on the money on current crises.


"The Rising Risk of a Systemic Financial Meltdown:
The Twelve Steps to Financial Disaster
by Nouriel Roubini


Why did the Fed ease the Fed Funds rate by a whopping 125bps in eight days this past January? It is true that most macro indicators are heading south and suggesting a deep and severe recession that has already started. But the flow of bad macro news in mid-January did not justify, by itself, such a radical inter-meeting emergency Fed action followed by another cut at the formal FOMC meeting.

To understand the Fed actions one has to realize that there is now a rising probability of a "catastrophic" financial and economic outcome, i.e. a vicious circle where a deep recession makes the financial losses more severe and where, in turn, large and growing financial losses and a financial meltdown make the recession even more severe. The Fed is seriously worried about this vicious circle and about the risks of a systemic financial meltdown.

That is the reason the Fed had thrown all caution to the wind - after a year in which it was behind the curve and underplaying the economic and financial risks - and has taken a very aggressive approach to risk management; this is a much more aggressive approach than the Greenspan one in spite of the initial views that the Bernanke Fed would be more cautious than Greenspan in reacting to economic and financial vulnerabilities.

To understand the risks that the financial system is facing today I present the "nightmare" or "catastrophic" scenario that the Fed and financial officials around the world are now worried about. Such a scenario - however extreme - has a rising and significant probability of occurring. Thus, it does not describe a very low probability event but rather an outcome that is quite possible.

Start first with the recession that is now enveloping the US economy. Let us assume - as likely - that this recession - that already started in December 2007 - will be worse than the mild ones - that lasted 8 months - that occurred in 1990-91 and 2001. The recession of 2008 will be more severe for several reasons: first, we have the biggest housing bust in US history with home prices likely to eventually fall 20 to 30%; second, because of a credit bubble that went beyond mortgages and because of reckless financial innovation and securitization the ongoing credit bust will lead to a severe credit crunch; third, US households - whose consumption is over 70% of GDP - have spent well beyond their means for years now piling up a massive amount of debt, both mortgage and otherwise; now that home prices are falling and a severe credit crunch is emerging the retrenchment of private consumption will be serious and protracted. So let us suppose that the recession of 2008 will last at least four quarters and, possibly, up to six quarters. What will be the consequences of it?

Here are the twelve steps or stages of a scenario of systemic financial meltdown associated with this severe economic recession.

First, this is the worst housing recession in US history and there is no sign it will bottom out any time soon. At this point it is clear that US home prices will fall between 20% and 30% from their bubbly peak; that would wipe out between $4 trillion and $6 trillion of household wealth. While the subprime meltdown is likely to cause about 2.2 million foreclosures, a 30% fall in home values would imply that over 10 million households would have negative equity in their homes and would have a big incentive to use "jingle mail" (i.e. default, put the home keys in an envelope and send it to their mortgage bank). Moreover, soon enough a few very large home builders will go bankrupt and join the dozens of other small ones that have already gone bankrupt thus leading to another free fall in home builders' stock prices that have irrationally rallied in the last few weeks in spite of a worsening housing recession.

Second, losses for the financial system from the subprime disaster are now estimated to be as high as $250 to $300 billion. But the financial losses will not be only in subprime mortgages and the related RMBS and CDOs. They are now spreading to near prime and prime mortgages as the same reckless lending practices in subprime (no down-payment, no verification of income, jobs and assets (i.e. NINJA or LIAR loans), interest rate only, negative amortization, teaser rates, etc.) were occurring across the entire spectrum of mortgages; about 60% of all mortgage origination since 2005 through 2007 had these reckless and toxic features. So this is a generalized mortgage crisis and meltdown, not just a subprime one. And losses among all sorts of mortgages will sharply increase as home prices fall sharply and the economy spins into a serious recession. Goldman Sachs now estimates total mortgage credit losses of about $400 billion; but the eventual figures could be much larger if home prices fall more than 20%. Also, the RMBS and CDO markets for securitization of mortgages - already dead for subprime and frozen for other mortgages - remain in a severe credit crunch, thus reducing further the ability of banks to originate mortgages. The mortgage credit crunch will become even more severe.

Also add to the woes and losses of the financial institutions the meltdown of hundreds of billions of off balance SIVs and conduits; this meltdown and the roll-off of the ABCP market has forced banks to bring back on balance sheet these toxic off balance sheet vehicles adding to the capital and liquidity crunch of the financial institutions and adding to their on balance sheet losses. And because of securitization the securitized toxic waste has been spread from banks to capital markets and their investors in the US and abroad, thus increasing - rather than reducing systemic risk - and making the credit crunch global.

Third, the recession will lead - as it is already doing - to a sharp increase in defaults on other forms of unsecured consumer debt: credit cards, auto loans, student loans. There are dozens of millions of subprime credit cards and subprime auto loans in the US. And again defaults in these consumer debt categories will not be limited to subprime borrowers. So add these losses to the financial losses of banks and of other financial institutions (as also these debts were securitized in ABS products), thus leading to a more severe credit crunch. As the Fed loan officers survey suggest the credit crunch is spreading throughout the mortgage market and from mortgages to consumer credit, and from large banks to smaller banks.

Fourth, while there is serious uncertainty about the losses that monolines will undertake on their insurance of RMBS, CDO and other toxic ABS products, it is now clear that such losses are much higher than the $10-15 billion rescue package that regulators are trying to patch up. Some monolines are actually borderline insolvent and none of them deserves at this point a AAA rating regardless of how much realistic recapitalization is provided. Any business that required an AAA rating to stay in business is a business that does not deserve such a rating in the first place. The monolines should be downgraded as no private rescue package - short of an unlikely public bailout - is realistic or feasible given the deep losses of the monolines on their insurance of toxic ABS products.

Next, the downgrade of the monolines will lead to another $150 billion of writedowns on ABS portfolios for financial institutions that have already massive losses. It will also lead to additional losses on their portfolio of muni bonds. The downgrade of the monolines will also lead to large losses - and potential runs - on the money market funds that invested in some of these toxic products. The money market funds that are backed by banks or that bought liquidity protection from banks against the risk of a fall in the NAV may avoid a run but such a rescue will exacerbate the capital and liquidity problems of their underwriters. The monolines' downgrade will then also lead to another sharp drop in US equity markets that are already shaken by the risk of a severe recession and large losses in the financial system.

Fifth, the commercial real estate loan market will soon enter into a meltdown similar to the subprime one. Lending practices in commercial real estate were as reckless as those in residential real estate. The housing crisis will lead - with a short lag - to a bust in non-residential construction as no one will want to build offices, stores, shopping malls/centers in ghost towns. The CMBX index is already pricing a massive increase in credit spreads for non-residential mortgages/loans. And new origination of commercial real estate mortgages is already semi-frozen today; the commercial real estate mortgage market is already seizing up today.

Sixth, it is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200 plus subprime lenders that have gone bankrupt. This, like in the case of Northern Rock, will lead to depositors' panic and concerns about deposit insurance. The Fed will have to reaffirm the implicit doctrine that some banks are too big to be allowed to fail. But these bank bankruptcies will lead to severe fiscal losses of bank bailout and effective nationalization of the affected institutions. Already Countrywide - an institution that was more likely insolvent than illiquid - has been bailed out with public money via a $55 billion loan from the FHLB system, a semi-public system of funding of mortgage lenders. Banks' bankruptcies will add to an already severe credit crunch.

[teomaxxx]

Seventh, the banks losses on their portfolio of leveraged loans are already large and growing. The ability of financial institutions to syndicate and securitize their leveraged loans - a good chunk of which were issued to finance very risky and reckless LBOs - is now at serious risk. And hundreds of billions of dollars of leveraged loans are now stuck on the balance sheet of financial institutions at values well below par (currently about 90 cents on the dollar but soon much lower). Add to this that many reckless LBOs (as senseless LBOs with debt to earnings ratio of seven or eight had become the norm during the go-go days of the credit bubble) have now been postponed, restructured or cancelled. And add to this problem the fact that some actual large LBOs will end up into bankruptcy as some of these corporations taken private are effectively bankrupt in a recession and given the repricing of risk; convenant-lite and PIK toggles may only postpone - not avoid - such bankruptcies and make them uglier when they do eventually occur. The leveraged loans mess is already leading to a freezing up of the CLO market and to growing losses for financial institutions.


Eighth, once a severe recession is underway a massive wave of corporate defaults will take place. In a typical year US corporate default rates are about 3.8% (average for 1971-2007); in 2006 and 2007 this figure was a puny 0.6%. And in a typical US recession such default rates surge above 10%. Also during such distressed periods the RGD - or recovery given default - rates are much lower, thus adding to the total losses from a default. Default rates were very low in the last two years because of a slosh of liquidity, easy credit conditions and very low spreads (with junk bond yields being only 260bps above Treasuries until mid June 2007). But now the repricing of risk has been massive: junk bond spreads close to 700bps, iTraxx and CDX indices pricing massive corporate default rates and the junk bond yield issuance market is now semi-frozen.


While on average the US and European corporations are in better shape - in terms of profitability and debt burden - than in 2001 there is a large fat tail of corporations with very low profitability and that have piled up a mass of junk bond debt that will soon come to refinancing at much higher spreads. Corporate default rates will surge during the 2008 recession and peak well above 10% based on recent studies. And once defaults are higher and credit spreads higher massive losses will occur among the credit default swaps (CDS) that provided protection against corporate defaults. Estimates of the losses on a notional value of $50 trillion CDS against a bond base of $5 trillion are varied (from $20 billion to $250 billion with a number closer to the latter figure more likely). Losses on CDS do not represent only a transfer of wealth from those who sold protection to those who bought it. If losses are large some of the counterparties who sold protection - possibly large institutions such as monolines, some hedge funds or a large broker dealer - may go bankrupt leading to even greater systemic risk as those who bought protection may face counterparties who cannot pay.

Ninth, the "shadow banking system" (as defined by the PIMCO folks) or more precisely the "shadow financial system" (as it is composed by non-bank financial institutions) will soon get into serious trouble. This shadow financial system is composed of financial institutions that - like banks - borrow short and in liquid forms and lend or invest long in more illiquid assets. This system includes: SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short term liquid liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks these non-bank financial institutions don't have direct or indirect access to the central bank's lender of last resort support as they are not depository institutions. Thus, in the case of financial distress and/or illiquidity they may go bankrupt because of both insolvency and/or lack of liquidity and inability to roll over or refinance their short term liabilities. Deepening problems in the economy and in the financial markets and poor risk managements will lead some of these institutions to go belly up: a few large hedge funds, a few money market funds, the entire SIV system and, possibly, one or two large and systemically important broker dealers. Dealing with the distress of this shadow financial system will be very problematic as this system - stressed by credit and liquidity problems - cannot be directly rescued by the central banks in the way that banks can.

Tenth, stock markets in the US and abroad will start pricing a severe US recession - rather than a mild recession - and a sharp global economic slowdown. The fall in stock markets - after the late January 2008 rally fizzles out - will resume as investors will soon realize that the economic downturn is more severe, that the monolines will not be rescued, that financial losses will mount, and that earnings will sharply drop in a recession not just among financial firms but also non financial ones. A few long equity hedge funds will go belly up in 2008 after the massive losses of many hedge funds in August, November and, again, January 2008. Large margin calls will be triggered for long equity investors and another round of massive equity shorting will take place. Long covering and margin calls will lead to a cascading fall in equity markets in the US and a transmission to global equity markets. US and global equity markets will enter into a persistent bear market as in a typical US recession the S&P500 falls by about 28%.

Eleventh, the worsening credit crunch that is affecting most credit markets and credit derivative markets will lead to a dry-up of liquidity in a variety of financial markets, including otherwise very liquid derivatives markets. Another round of credit crunch in interbank markets will ensue triggered by counterparty risk, lack of trust, liquidity premia and credit risk. A variety of interbank rates - TED spreads, BOR-OIS spreads, BOT - Tbill spreads, interbank-policy rate spreads, swap spreads, VIX and other gauges of investors' risk aversion - will massively widen again. Even the easing of the liquidity crunch after massive central banks' actions in December and January will reverse as credit concerns keep interbank spread wide in spite of further injections of liquidity by central banks.

Twelfth, a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy. Market prices include a large illiquidity discount on top of the discount due to the credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Capital losses will lead to margin calls and further reduction of risk taking by a variety of financial institutions that are now forced to mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit. The triggering event for the next round of this cascade is the downgrade of the monolines and the ensuing sharp drop in equity markets; both will trigger margin calls and further credit disintermediation.

[teomaxxx]

Based on estimates by Goldman Sachs $200 billion of losses in the financial system lead to a contraction of credit of $2 trillion given that institutions hold about $10 of assets per dollar of capital. The recapitalization of banks sovereign wealth funds - about $80 billion so far - will be unable to stop this credit disintermediation - (the move from off balance sheet to on balance sheet and moves of assets and liabilities from the shadow banking system to the formal banking system) and the ensuing contraction in credit as the mounting losses will dominate by a large margin any bank recapitalization from SWFs. A contagious and cascading spiral of credit disintermediation, credit contraction, sharp fall in asset prices and sharp widening in credit spreads will then be transmitted to most parts of the financial system. This massive credit crunch will make the economic contraction more severe and lead to further financial losses. Total losses in the financial system will add up to more than $1 trillion and the economic recession will become deeper, more protracted and severe.

A near global economic recession will ensue as the financial and credit losses and the credit crunch spread around the world. Panic, fire sales, cascading fall in asset prices will exacerbate the financial and real economic distress as a number of large and systemically important financial institutions go bankrupt. A 1987 style stock market crash could occur leading to further panic and severe financial and economic distress. Monetary and fiscal easing will not be able to prevent a systemic financial meltdown as credit and insolvency problems trump illiquidity problems. The lack of trust in counterparties - driven by the opacity and lack of transparency in financial markets, and uncertainty about the size of the losses and who is holding the toxic waste securities - will add to the impotence of monetary policy and lead to massive hoarding of liquidity that will exacerbates the liquidity and credit crunch.

In this meltdown scenario US and global financial markets will experience their most severe crisis in the last quarter of a century.

Can the Fed and other financial officials avoid this nightmare scenario that keeps them awake at night? The answer to this question - to be detailed in a follow-up article - is twofold: first, it is not easy to manage and control such a contagious financial crisis that is more severe and dangerous than any faced by the US in a quarter of a century; second, the extent and severity of this financial crisis will depend on whether the policy response - monetary, fiscal, regulatory, financial and otherwise - is coherent, timely and credible. I will argue - in my next article - that one should be pessimistic about the ability of policy and financial authorities to manage and contain a crisis of this magnitude; thus, one should be prepared for the worst, i.e. a systemic financial crisis."

[teomaxxx]

the most immediate problem now is with these capital insurers:

""America's biggest mortgage bond insurers collectively need a $200 billion (Ł101 billion) capital injection if they are to maintain their key AAA credit ratings, a figure that dwarfs a plan by New York regulators to put together a capital infusion of up to $15 billion, a leading ratings expert said yesterday."

and

""Banks worldwide may need to raise as much as $143 billion of additional reserves to satisfy regulators if bond insurer rating cuts trigger downgrades for the securities they guarantee, Barclays Capital analysts said.""


and:

"Everyone thinks they're looking at the cliff over Armageddon," said Ed Rombach, senior derivatives analyst at Thomson Financial. "If you think the write-downs have been bad so far, the next write-downs could be twice as big."

I strongly suggest to adjust your portfolios, since there are still a lot of money to be made by playing this "shit hit the fan" scenario

[teomaxxx]

Originally Posted by teomaxxx

the most immediate problem now is with these capital insurers
......
"Everyone thinks they're looking at the cliff over Armageddon," said Ed Rombach, senior derivatives analyst at Thomson Financial. "If you think the write-downs have been bad so far, the next write-downs could be twice as big."

and this problem with monoline insurers will be solved rather sooner then later, cause municipal markets are seizing up:


"-Multiple muni issuers see notes fail at auction
By Joan Gralla

NEW YORK, Feb 12 (Reuters) - U.S. muncipal bond issuers were hit with "multiple" failures of auctions of their paper paper on Tuesday, industry sources said, as investors were concerned about the safety of the bond insurers backing the debt.

As a result, states, counties, cities and towns around the nation now are being forced to pay sharply higher short-term interest rates.

Investment banks including Merrill Lynch (MER.N: Quote, Profile, Research), Citigroup (C.N: Quote, Profile, Research), Goldman Sachs Group Inc (GS.N: Quote, Profile, Research) were involved, according to the industry sources.

With cash at a premium, banks increasingly are reluctant to tie up their capital, and several of these players for the past few weeks have had to mop up supplies of unwanted muni auction-rate paper, explained one of the sources.

Spokesmen for Merrill and Goldman declined comment. A Citi official could not immediately comment on the muni auctions but noted that on Monday Citi confirmed the failures of other such instruments, including student loan asset backed paper.

On Feb. 12, two muni auctions failed, and experts said that was the first time this had ever happened. Conditions have only worsened since then, they explained.

Rates for auction-rate paper are reset periodically, and an auction fails when no buyer can be found and the dealer does not take it back.

One muni issuer whose Tuesday auction failed was the Maryland State and Health and Higher Educational Facilities Authority, the conduit for Anne Arundal Health debt due in 2029, added one source, who provided the CUSIPs for the debt.

The other was California Statewide Communities Development Authority auction-rate for Childrens Hospital Series B that matures in 2032, said the source"


Once monoline insurers are done, there is another and bigger Armageddon in making, "credit default swaps (CDS)" - protection against corporate defaults. Better not to know much about them, cause it will make you sick.

[ADL Colin]

I read most everything Roubini writes. It is a good read and one of many possibilities. As the article states it is a "possibility" and he is careful in how he states that. Economic forecasting is still mostly "dismal".

[teomaxxx]

Originally Posted by ADL Colin

I read most everything Roubini writes. It is a good read and one of many possibilities. As the article states it is a "possibility" and he is careful in how he states that. Economic forecasting is still mostly "dismal".

the only one problem I have with him, that main part of "possibilites" from his estimates 0,5-1 year ago, were shown to be correct. I really dont want to see this current "shit hit the fan" scenario happens too, but I dont see any clear way out of this mess.

[teomaxxx]

Originally Posted by teomaxxx

the most immediate problem now is with these capital insurers:

""America's biggest mortgage bond insurers collectively need a $200 billion (Ł101 billion) capital injection if they are to maintain their key AAA credit ratings, a figure that dwarfs a plan by New York regulators to put together a capital infusion of up to $15 billion, a leading ratings expert said yesterday."

and

""Banks worldwide may need to raise as much as $143 billion of additional reserves to satisfy regulators if bond insurer rating cuts trigger downgrades for the securities they guarantee, Barclays Capital analysts said.""


and:

"Everyone thinks they're looking at the cliff over Armageddon," said Ed Rombach, senior derivatives analyst at Thomson Financial. "If you think the write-downs have been bad so far, the next write-downs could be twice as big."

I strongly suggest to adjust your portfolios, since there are still a lot of money to be made by playing this "shit hit the fan" scenario

Credit markets are seizing up, since noone belives in AAA rating bullshit anymore...thats what you get, when you try to play bullshit game like goverment regulators, banks, rating agencies continue so...
They better kick the rating agencies for a downgrades of monoline insurers or it will backfire much stronger...

http://www.reuters.com/article/ousiv...080303?sp=true

No fix seen in Congress for locked-up debt markets

WASHINGTON (Reuters) - Little is being done in Congress or the Bush administration to repair a collapse of trust in private securitized debt markets that is threatening sectors beyond its origin in the subprime mortgage crisis.

Student loans are being hit as are the auction-rate bond markets used widely by municipal governments to help finance vital everyday projects such as roads, schools and parks.

Capital freezing up in these markets and possibly others could cause long-term damage to the financial system and the economy, some economists and lawmakers say.

While Congress and the White House focus on short-term steps to shield Americans from rising foreclosures and crack down on mortgage brokers, no major legislation is on offer to deal explicitly with the dysfunction spreading though the capital markets.

"There's been a lot of talk about it, but we don't have a legislative package together at this point," Sen. Byron Dorgan, a North Dakota Democrat, said in an interview.

Committee Chairman Christopher Dodd, speaking on the Senate floor last week, expressed concern about local governments' finances being hurt by auction-rate market failures.

Warning that some student loan programs were shutting down due to lack of capital, the Connecticut Democrat pointed to "a crisis of confidence that has serious consequences."

Like many in Congress, however, Dodd said the first priority must be to stem the home foreclosure wave that has already engulfed tens of thousands of Americans and could affect millions more over the next two years.

As urgent as the foreclosure crisis is, some economists say it is equally important for lawmakers to take a hard look at how to fix the broken secondary market for mortgages and other debt.

CREDIT MARKET SHUT DOWN

"People need access to mortgages to buy homes and our credit markets have shut down," said Lawrence Lindsey, a former senior economic adviser to President George W. Bush.

Unless global investors' trust in securitized debt can be restored and steady flows of investor capital replenished to finance new mortgages and other loans, the mortgage industry's future and home values are in long-term jeopardy, he said.

Lindsey, now head of a private economic advisory firm, told a Senate Finance Committee hearing last week: "None of the plans now being suggested, either by the current president or by those (hoping) to be his successor have this as the focus ... The real solution to the housing problem is to find a new and sustainable housing finance system."

The secondary debt market has exploded in size and complexity over the past decade, with Wall Street churning out an alphabet soup of new products such as asset-backed securities (ABS) and collateralized debt obligations (CDOs).

Profits derived from the basic process of securitization -- transforming ordinary debt into finely tuned investment vehicles -- was highly profitable until the past year or two. Now the same banks that assured Washington for years that everything was under control are losing billions of dollars.

"Some of this is of their own doing," Dorgan said. "Those markets created such sophisticated instruments and securitized things that many people don't even understand them."

Many of the institutional investors who bought securitized debt did not understand them, as is now clear. They trusted the judgment of others, such as credit rating agencies and bond insurers. But much of that trust was misplaced and now demand for many securitized debt instruments is soft, said Lindsey.

SEAL OF APPROVAL

In the vacuum left behind by diminished faith in credit raters' opinions, Lindsey suggested forming a "Federal Board of Certification" to give a seal of approval to private securitized debt, offering investors the same confidence they still have in much of the government-chartered debt markets dominated by Fannie Mae (FNM.N: Quote, Profile, Research) and Freddie Mac (FRE.N: Quote, Profile, Research).

The board would be formed from a variety of federal regulators with banking oversight, including the Federal Reserve and the Treasury Department, Lindsey suggested.

"This does not involve a federal guarantee ... All the certification board would do is assure investors," he said. "I can think of no single action by the government that could do more to restore confidence in the mortgage lending process."

Lindsey's concern about restoring credibility along the securitization chain of loan originators, securitizers and investors is shared by Dodd and Democratic Rep. Barney Frank.

Frank, chairman of the House Financial Services Committee, has pushed a bill through the House to give home loan borrowers more rights to sue securitizing institutions, an idea known as assignee liability.

Late last year, Dodd tentatively proposed a similar and tougher Senate measure. But the Senate has been slower to act, while Wall Street and mortgage bankers have been lobbying to block any form of widened assignee liability.

In an interview, Michigan Democratic Sen. Debbie Stabenow called Lindsey's testimony "interesting."

Like Dodd, she stressed addressing the foreclosures issue first. "We'll start there. But I think it's now spreading out into all kinds of other areas -- student loans, small business loans," said Stabenow, a finance committee member.

"There's a lot of discussion going on as to what extent we should get involved. But I hear across the board ... that the issue is lack of stability and lack of trust in the markets as a whole. We're trying to figure out what's appropriate."

[ADL Colin]

Investment Outlook
Bill Gross | March 2008

No Country for Old Maids

There?s a parlor card game most boomers know as ?Old Maid.? It could?ve just as easily been labeled ?Crotchety Old Bachelor? I suppose, but then we all know why it wasn?t ? men owned the playing card companies and still do. But it was a fun game for Eisenhower generation kids to play and unlike ?War,? involved a surprising amount of skill and human interaction. If you had the ?Maid? the object was to dump it on someone else, but doing that involved numerous deceptions not totally unlike today?s shenanigans involving our capital markets and their imploding financial conduits. First of all, you had to pretend you didn?t have it in your hand. A calm, ?no problem? facial expression was a requisite, but then you still had to entice your opponent on your left to pull the old lady out of a handheld mini-stack of perhaps 6 or 7 of your remaining cards. Placing ?the card? at either end was one tactic, but the most successful maneuver always seemed to be exposing one edge of a middle card just a little bit higher then all the rest ? the bait. Once dumped, you could breathe a temporary sigh of relief until, until?well until it was your turn to draw again from that all too suspicious player on your right.



Old Maid now has a second life mimicking our financial markets, and at PIMCO we?ve played it frequently in our Investment Committee over the past several months. ?Who?s got the ?Old Maid??? we ask over and over again ? not to make us feel good that we don?t ? but to make sure we won?t draw it when its holder tries to pass it on. This shunned lady in asset form was originally identified as a subprime mortgage, aggregated into levered financial conduits which in turn were guaranteed to be AAA hotties either via their securitized structures or the solemn pledge of monoline insurance firms. No Old Maids in those hands, investors were assured; they were Babes with a stacked deck. Ah, but Father Time has a way of exposing plastic surgery and there have been implants aplenty in recent years. Most of the silicone to be sure involved mortgage-related assets ? first the subprimes, then the Alt As, and now perhaps even levered primes. Yet those that claim that the Old Maid necessarily resides in a deck composed of mortgage loans are missing the larger point. This parlor game is best defined by leverage and not the assets that have been dealt out to more than willing players over the past decade. That subprimes have garnered the headlines is only because they were the asset class that failed first. Now as the U.S. economy slows to what Alan Greenspan labels ?stall speed,? levered structures holding commercial loans, and auto and credit card receivables are the new Babes in waiting ? waiting to be exposed for what some of them could be: Old Maids with collagen carelessly injected by Moody?s and S&P.



That this topic as I?ve described it might seem to resemble a ?LOL? New Yorker Magazine cartoon involving a most serious topic is hopefully forgivable. Sometimes you have to laugh at the human comedy in order to comprehend it. But let there be no mistake: this description of Old Maids and PIMCO?s Investment Committee?s attempt to avoid holding one is serious business and the game playing does involve some of the same skills that little kids learned by playing cards generations ago. Pretend that you don?t hold the Maid? Banks have been playing that game for nearly 12 months now and only recently have entered the confessional to expose some of their sins. Are the monolines showing any of their cards? No ? just ask MBIA?s CEO ? they?re doing just fine thank you. ?But by the way,? he?ll say, ?take a card, one of these good ones on the end or maybe the one in the middle with the exposed edge.? Bank loans for sale by Wall Street at distressed prices? Nah, those Harrahs and Clear Channel loans are money good ? ?as a matter of fact all of the $150 billion or so we have in inventory are great assets? the banks will say. We?ll just hold on to these maids ? unless you pay 95 cents on the dollar that is. Don?t wanna take a loss you know.



And so the game goes on and on. Its most recent twist involves an asset class known as Auction Rate Preferred Stock and the astounding revelation that its holders didn?t even know they were playing cards to begin with. Holders of ARPS ? mostly wealthy investors, but also the likes of Bristol-Meyers and other visible corporations ? thought they were holding AAA assets with money market liquidity. In this case, most of the assets probably are AAA, but the liquidity has suddenly evaporated, transforming them from a 30-day to potentially a 30-year asset. The assets on these Maids it appears are real but they have come with a marriage license. Whoops! Another Old Maid in masquerade.



The investor?s task, however, is not to pillory or even desert the game, but to accomplish three primary tasks: 1) continue to ask ?Who?s got the Old Maid??, 2) understand and forecast the game?s economic and policy consequences, and 3) formulate a portfolio (to paraphrase Will Rogers), that maximizes the return on capital as well as the return of capital.



To elaborate on #2, it seems obvious that players are getting tired of playing games and that a prolonged period of risk aversion and deleveraging of our global shadow banking system lies ahead. Tighter lending standards, reduced risk budgets, and increased regulatory scrutiny all promise to produce a reduction in the growth rate of lending. Mortgage credit, for instance, grew at 10%, then 11%, then 13%+ annualized rates during the shadow?s heyday just a few years past. Now, despite the obvious rescue efforts of the Federal bureaucracy (much of which is aimed at preventing a contraction of mortgage credit), it promises to grow at tiny single-digit rates due to diminished housing starts and a buyer?s strike of significant proportions. Similar trends lie ahead for consumer credit, and importantly, commercial lending which heretofore has held up the investment side of the GDP ledger.



Slow credit growth is a harbinger, however, for slow economic growth (if any) and that in turn leads to the necessity for low short-term interest rates for an extended period of time. I think Ben Bernanke knows that restarting the U.S. growth engine almost by definition requires nominal GDP growth of 5%. He?d prefer that nominal rate be composed of 3% real and 2% inflation, but desperate times sometimes require compromise: 2% real and 3% inflation may be the best he can hope for in 2009 as soaring commodity prices and a declining dollar add to the equation?s complexity. If so, a bond investor should expect a prolonged, several year period of low short-term rates (Fed Funds averaging 2½%) with vulnerability on the intermediate and long-term portions of the U.S. curve due to inflationary fears and the diminishing support of foreign central banks and SWFs. If, as a bond investor, I expected 3% inflation (2% in 2008 ? higher in the out years), a 3% 5-year Treasury would not seem very appealing. Nor, I should add, would a 3.80% 10-year or a 4.65% 30-year bond.



This leads me to #3 on my list of action plans. What should an investor do ? desperately trying to avoid the Old Maids, yet trapped with good Treasury cards at yields inappropriately low in a mildly inflationary future environment? The answer lies in managing a transition to riskier assets while being acutely aware, as my CIO partner Mohamed El-Erian is quick to point out, that such a transition will be characterized by technical purges of Old Maid and even higher quality assets that in many cases produce price levels significantly below what might at first seem reasonable. Minsky moments ? the unwinding of levered assets ? produce as many surprises on the downside as do $5 million dollar homes in Silicon Valley and NASDAQ 5,000 point stocks on the upside. Patience and cognizance of flows, El-Erian counsels, are as critical to the equation as is the recognition of the Old Maids in the first place.



Still, we would both agree that value is returning to many parts of the bond market. If an investor requires 5%+ yields to compensate for future inflation, then they can increasingly be found in authentic AAA assets ? not disguised Old Maids. There?s not a hint of plastic surgery in agency-backed FNMA and FHLMC mortgages at 5¾%, although their actual ages (average lives) may be somewhat in doubt. Similarly, SBA government-guaranteed loans at LIBOR+ 125 basis point yields are beginning to entice, as are some of those bank loans when priced in the high 80s as opposed to 95 cents on the dollar. If capitalism is a going enterprise ? and we think it is ? then investors will eventually return to play similar, perhaps more conservative games ? much as they have in the past. And if Washington gets off its high ?moral hazard? horse and moves to support housing prices, investors will return in a rush. PIMCO wants to sit at this more attractive return table ? to provide an attractive return on your money (no matter what the asset class) as well as a return of your money. No Old Maids. No silicone AAA ratings. And ladies ? no crotchety old bachelors either. The game, as well as the name of the game, is changing. It?s no country for Old Maids anymore.





William H. Gross

Managing Director

[cykoe6]

Good article. His analysis seems quite good although with so many factors involved it is hard to predict the outcomes. Obviously non financial global events will play a big part in the equation as well. There is no doubt that these are uncertain times from a financial perspective.

[teomaxxx]

Originally Posted by teomaxxx

Credit markets are seizing up, since noone belives in AAA rating bullshit anymore...thats what you get, when you try to play bullshit game like goverment regulators, banks, rating agencies continue so...
They better kick the rating agencies for a downgrades of monoline insurers or it will backfire much stronger...

and another good one, since credit markets are seizing up really fast, on friday there was a blowout of 2bn fond in UK, on monday there was blowout of TMA, yesterday there was blowout of Carlyle Capital Corp.

"Bernanke's dilemma is starting to get some play in the mainstream press, with CNBC noting that while The Fed has been "slashing rates" and flooding the market with "liquidity" the market hasn't recovered (and in fact has cratered) and the credit markets are in worse shape than in August, with the malaise now spreading into virtually every corner including supposedly-"safe" instruments such as Auction Rate municipals. And Bloomberg said the following today:


"March 6 (Bloomberg) -- Credit trading models used by Wall Street have gone haywire, raising company borrowing costs even as Federal Reserve Chairman Ben S. Bernanke cuts interest rates."
Well duh. As I've said repeatedly you cannot fix a junkie's problem by offering him heroin! Bernanke needs to decide whether he is going to address the willful regulatory ignorance emanating from The Fed and other banking system regulators or whether he prefers to have the credit markets seize up piece by piece, margin call by margin call, until we finally force into the open the institutions that are insolvent - the hard way.

Down the latter road lies a rerun of the 1930s or a Japan-like situation, with both being brought about by precisely the same sort of regulatory refusal to force market participants to face reality.

The bad news is that I fear that Bernanke has very little time left to get off his kiester as the market is choosing for him. He's wasted the last six months running the old Greenspam playbook but unfortunately this is not LTCM where you literally have one institution that got in trouble - this is much more serious as the we quite literally have all areas of the credit markets seizing up because trust has been destroyed.

What's worse, Bernanke and his Fed have destroyed confidence in our currency by willfully refusing to address the root cause of the problem and that is being reflected in the DX.

The irony of this is that the longer Bernanke fiddles with his bullcrap "rate cut" nonsense trying to shove more heroin at the junkie, the worse the dollar craters and the more inflationary pressure this puts back into the economy through higher import costs, with the most important of those being the energy complex! The Dollar broke 73 today - south!

Bluntly: Bernanke cannot control this situation with more "liquidity" or "rate cuts", and the more he jawbones the more the dollar reacts by sinking further into the quicksand, taking back - with interest - what he is attempting to "give."

from:
http://market-ticker.denninger.net/2...tion-mess.html

Regulators are running out of time....

[marcop]

I remember reading the 2005 Year in Preview issue of The Economist--the first issue of that year. There was a long article on the coming real estate bubble bust, and the subsequent damage that would wreak on the economy as a whole.

What I don't get is that if a widely read and well-respected journal like The Economist reported on the problem so long ago, how come a lot of these banks, mortgage lenders, home building companies, were unprepared/still over-building/holding dangerous positions, etc., when the shit hit the fan?

[marcop]

BTW, I thought things were out of control when the price of property in my neighborhood started going through the roof: the place where I'm renting was valued at $435k in early 1998, and sold in the spring of 2005 for $1.35M. The condos next door went from $300k to $800k in the same time frame.

And most telling of all, several girls I'd shot around 2004/5 told me they were getting their real estate licenses. I think a couple even left the biz to sell real estate... they're probably back sucking cocks and taking facials now.

[Socks]

Can you find out and let us know? We're looking for facial targets all the time around here

[VikingMan]

These people look bored.

[VikingMan]

QUOTE=marcop;13886863]I remember reading the 2005 Year in Preview issue of The Economist--the first issue of that year. There was a long article on the coming real estate bubble bust, and the subsequent damage that would wreak on the economy as a whole.

What I don't get is that if a widely read and well-respected journal like The Economist reported on the problem so long ago, how come a lot of these banks, mortgage lenders, home building companies, were unprepared/still over-building/holding dangerous positions, etc., when the shit hit the fan?[/QUOTE]

Because they are staffed by bots.

[teomaxxx]

another great article from Roubini:

A Generalized Run on the Shadow Financial System
Nouriel Roubini | Mar 17, 2008
Since the onset of the liquidity and credit crunch last summer this column has been arguing that monetary policy would be impotent to address such a crunch because, in part, of the existence of a non-bank ?shadow financial system?. This system is composed of conduits, SIVs, investment banks/broker dealers, money market funds, hedge funds and other non bank financial institutions.


All these institutions look similar to banks because they are highly leveraged and borrow short and in liquid ways and invest or lend long and in illiquid ways. This shadow financial system is, like banks, subject not only to credit and market risk but also to rollover or liquidity risk, i.e. the risk deriving from having a large stock of short term liabilities (relative to liquid assets) that may not roll over if creditors decide to withdraw their credits to these institutions.


Unlike banks this shadow financial system does not have access to the lender of last resort support of the central bank as these are not depository institutions regulated by the central banks. What we are now observing ? with the case of Bear Stearns and the recent disaster among SIVs, conduits, run on a number of hedge funds and money market funds is a generalized liquidity run on this shadow financial system.


The response of the Fed to this run has been radical and in the form of the extension of the lender of last resort support to non bank financial institutions. Specifically, the new $200 bn term facility allows primary dealers ? many of which are non banks ? to swap their toxic mortgage backed securities for US Treasuries; second, the Fed provided emergency support to Bear Stearns and following the purchase of Bear Stearns by JPMorgan, is now providing a $30 bn plus support to JPMorgan to help the rescue of Bear Stearns; finally, now the Fed is allowing primary dealers to access the Fed discount window at the same terms as banks.


This is the most radical change and expansions of Fed powers and functions since the Great Depression: essentially the Fed now can lend unlimited amounts to non bank highly leveraged institutions that it does not regulate. The Fed is treating this run on the shadow financial system as a liquidity run but the Fed has no idea of whether such institutions are insolvent. As JPMorgan paid only about $200 million for Bear Stearns ? and only after the Fed promised a $30 billlion loan ? this was a clear case where this non bank financial institution was insolvent.


The Fed has no idea of which other primary dealers may be insolvent as it does not supervise and regulate those primary dealers that are not banks. But it is treating this crisis ? the most severe financial crisis in the US since the Great Depression ? as if it was purely a liquidity crisis. By lending massive amounts to potentially insolvent institutions that it does not supervise or regulate and that may be insolvent the Fed is taking serious financial risks and seriously exacerbate moral hazard distortions. Here you have highly leveraged non bank financial institutions that made reckless investments and lending, had extremely poor risk management and altogether disregarded liquidity risks; some may be insolvent but now the Fed is providing them with a blank check for unlimited amounts. This is a most radical action and a signal of how severe the crisis of the banking system and non-bank shadow financial system is. This is the worst US financial crisis since the Great Depression and the Fed is treating it as if it was only a liquidity crisis. But this is not just a liquidity crisis; it is rather a credit and insolvency crisis. And it is not the job of the Fed to bail out insolvent non bank financial institutions. If a bail out should occur this is a fiscal policy action that should be decided by Congress after the relevant equity holders have been wiped out and senior management fired without golden parachutes and huge severance packages.

[teomaxxx]

Originally Posted by teomaxxx

I strongly suggest to adjust your portfolios, since there are still a lot of money to be made by playing this "shit hit the fan" scenario

seeing all that topics on current "shit hit the fan" situation, there is a bump for this thread. I tried to warn you guys....

[RayBonga]

[teomaxxx]

another outstanding article from Roubini - everyone need to listen Roubini instead of the
dipshits who have been wrong at every step, while he has be almost 100% proven to be correct.


http://www.rgemonitor.com/blog/roubi...h igh_as_ever

[pigman]

People the economy is fine.

[woj]

cliff notes on all that?

[Vick!]

cliff notes?

[bronco67]

Wow, that was depressing. I was waiting for him to get to the part where Lord Humungus roams the highways raping our women and stealing our gas.

[Darkland]

Originally Posted by Vick!

cliff notes?

No offense but WTF...

I get so fucking tired of this mentality. Shit is going down and it has been for awhile. I have been warning my friends and family for about 6 months now that this was coming. And you know what? They didn't seem to fucking care or thought I was making shit up. Guess they believe me now.

I mean really... Cliff Notes! Are you that stupid or willfully ignorant that you have to have someone paint you a picture so you don't have to think for yourself or waste your oh so precious time learning something?

Wake the fuck up people and educate yourself for crying out loud. It is this very attitude of looking for short cuts that got us into this mess.

You want cliff notes, how about the cliff notes to a better way of life? It's called credit and look how well it is working out now. I mean, blame who you want to, or believe what you need to about the situation going on right now, but don't presume someone should tell you what this shit is all about and what it should mean to you. You either really care and read it or you don't.

We fucked this shit up! You did! I did! They Did! WE ALL DID! Some more so than others but the truth of the matter, everyone was happy to lay in the bed they made until shit started falling apart.

</rant>



BTW... My anger is not directed at you... You just happened to be the diving board I dove off of.

[ADL Colin]

nice bump. roubini has been one of my top bookmarks the past year

[sltr]

Originally Posted by teomaxxx

another outstanding article from Roubini - everyone need to listen Roubini instead of the
dipshits who have been wrong at every step, while he has be almost 100% proven to be correct.


http://www.rgemonitor.com/blog/roubi...h igh_as_ever

hi teomaxx, can you cut & paste this article please? i get an unauthorized to view message.

thx!