Everyone has now been affected by the market turmoil or rising gas and food prices or a reduction in the value of their home or all of the above.
It is all about the mispricing of risk. It has been actively occurring since the inception of financial vehicles that are called "derivatives." All the big boys at the big investment banks are in on it. So are the guys at the Fed and Treasury (they came from the big investment banks). In this decade, large pools of debt used to fuel the Leveraged Buyout Frenzy were accumulated by taking Mortgage-backed securities (MBS), dividing them into parts called "tranches", repackaging and then selling them.
The problem resides in the fact that all these pools not only include high rated mortgages (prime with good to great credit scores), they also include equal parts of subprime loans (bad credit scores) and Alt-A loans (no income verification). These are then packaged into investment bond vehicles called Collateralized Debt Obligations, Collateralized Loan Obligations and Collateralized Mortgage Obligations. Even though each of these "derivatives" have high levels of loans with questionable performance standards, they were rated AAA by all of the ratings agencies.
Many investment programs such as state pension programs, union pension programs, money market funds etc, are allowed to buy only AAA rated securities, and they bought these because they had a higher yield than other "safe" securities. US Treasury notes are AAA. The ratings agencies, with a little encouragement from the big investment banks, rated these obviously risky securities the same as US Treasury bonds.
Well, as you may have noticed, we have recently had a little downturn in real estate values in this country. This has created a landslide of foreclosures and late payments on loans. Since the performance on these "derivatives" is predicated on people paying their mortgage payments, uninterrupted, the ratings on all of these "derivatives" are actively being downgraded to A, BBB, or worse. Now, any investment program designated to only have AAA rated securities must sell what isn't rated AAA, at a loss, because the market won't bear the full value. If you have money in any investment program that bought derivatives, your value (principal) is now declining.
What's worse is there has been no active market for any of them since last summer.
Most of these derivatives have no buyers, so their essential worth is somewhere around $0.
Since there are no buyers, the accounting rules used by all the banks, brokerage firms, hedge funds and private equity funds allows them to claim that there are "no observable inputs", meaning there is no current market for them. Because there are "no observable inputs", the holders of these "securities" are allowed to move them from active balance sheets, "Level 1" accounting, meaning they must, at the end of the day, balance its worth just like you with your checkbook, to an area of financial accounting called "Level 3".
"Level 3" accounting allows the holder to claim the value of whatever product they designate "with no observable inputs". So, if a brokerage firm has a CDO they invested $1,000,000 into, they can still claim it has $ 1,000,000 of value if they move it into "Level 3". Even if there are no buyers, which means it may be worth $0.
In reality, most of these derivatives have some value, and the only reason there are no buyers is because anyone who may invest in these is smart enough to know we are nowhere near the bottom of the decline in housing prices. Since we are nowhere near the bottom, it is hard to estimate how many foreclosures, thus defaults on mortgages, there will be. Each of these derivatives will retain some value, but it is hard for anyone to see now if it keeps 10% of its value, or 50% of its value.
Consider this: In 2007 Global GDP (Gross Domestic Production) was in the neighborhood of $52 Trillion. The amount of "derivatives", and the bets made on them, total somewhere near $600 Trillion. More than 91% of all derivatives are traded outside of any regulatory agency, in one on one transactions, much like a blackjack table at a casino. The value that has been placed on them is not "marked to market", meaning they are not bought and sold on the open market, thus credibly determining value, but are labeled for value by the issuing investment bank. Almost all of these "derivatives" are not on the active accounting sheets of the investment banks, but rather are "off-balance sheet". The biggest name most of us know who used these accounting principles was Enron.
Since most derivatives are traded in one on one transactions, there are two entities fortunes tied to that "bet". You could be on the winning side of the"bet', yet still not get paid if the other side is insolvent. This is called counterparty risk. If the holder of the derivative is claiming full value in "Level 3", and knows they cannot get paid because the counterparty to their "bet" will be insolvent should they be forced to pay, should the holder of the derivative be allowed to claim full value in "Level 3"? Hence, this is the real question about the whole Bear Stearns debacle, and I have seen no one in the mainstream press ask about this.
If you have been paying attention, the fortunes of the reinsurers, such as Ambac and MBIA have turned down considerably. This is due to their having to pay claims on the derivatives which banks, hedge funds and investment banks took out on them. Essentially, it seems as though neither of these companies have anywhere near the amount of money needed to cover the losses on these derivatives. Many of these "wraps" as they are sometimes called, are known as Credit Default Swaps, or CDS. CDS, and all things similar, are soon to go the way of the derivatives they were meant to provide support for.
There is no way for Ambac or MBIA to survive. Both are initiating lawsuits now, claiming that the loans underlying the derivatives they wrote insurance policies for were fraught with fraud, which they could not have known about.
Many banks have "Level 3" holdings that exceed their hard assets by several times. Soon, most of the financial institutions with "Level 3" holdings will be forced to start bringing them into "Level 1". Even with only a 50% loss, many banks will be in a position of losses exceeding capital by 3, 4, or more times.
What will be really interesting is this - China bought close to $1 Trillion of MBS Securitizations with 2005 and 2006 originations from the US. Anyone want to take a stab at how much they are worth now? How upset will they be with a 20% loss? 30% loss? A 50% loss?
They aren't the only foreigners to have these. What do you think was all the fuss with the German banks a few months ago? Germany has already nationalized two banks who had significant exposure to the US real estate market.
More to come........
It is all about the mispricing of risk. It has been actively occurring since the inception of financial vehicles that are called "derivatives." All the big boys at the big investment banks are in on it. So are the guys at the Fed and Treasury (they came from the big investment banks). In this decade, large pools of debt used to fuel the Leveraged Buyout Frenzy were accumulated by taking Mortgage-backed securities (MBS), dividing them into parts called "tranches", repackaging and then selling them.
The problem resides in the fact that all these pools not only include high rated mortgages (prime with good to great credit scores), they also include equal parts of subprime loans (bad credit scores) and Alt-A loans (no income verification). These are then packaged into investment bond vehicles called Collateralized Debt Obligations, Collateralized Loan Obligations and Collateralized Mortgage Obligations. Even though each of these "derivatives" have high levels of loans with questionable performance standards, they were rated AAA by all of the ratings agencies.
Many investment programs such as state pension programs, union pension programs, money market funds etc, are allowed to buy only AAA rated securities, and they bought these because they had a higher yield than other "safe" securities. US Treasury notes are AAA. The ratings agencies, with a little encouragement from the big investment banks, rated these obviously risky securities the same as US Treasury bonds.
Well, as you may have noticed, we have recently had a little downturn in real estate values in this country. This has created a landslide of foreclosures and late payments on loans. Since the performance on these "derivatives" is predicated on people paying their mortgage payments, uninterrupted, the ratings on all of these "derivatives" are actively being downgraded to A, BBB, or worse. Now, any investment program designated to only have AAA rated securities must sell what isn't rated AAA, at a loss, because the market won't bear the full value. If you have money in any investment program that bought derivatives, your value (principal) is now declining.
What's worse is there has been no active market for any of them since last summer.
Most of these derivatives have no buyers, so their essential worth is somewhere around $0.
Since there are no buyers, the accounting rules used by all the banks, brokerage firms, hedge funds and private equity funds allows them to claim that there are "no observable inputs", meaning there is no current market for them. Because there are "no observable inputs", the holders of these "securities" are allowed to move them from active balance sheets, "Level 1" accounting, meaning they must, at the end of the day, balance its worth just like you with your checkbook, to an area of financial accounting called "Level 3".
"Level 3" accounting allows the holder to claim the value of whatever product they designate "with no observable inputs". So, if a brokerage firm has a CDO they invested $1,000,000 into, they can still claim it has $ 1,000,000 of value if they move it into "Level 3". Even if there are no buyers, which means it may be worth $0.
In reality, most of these derivatives have some value, and the only reason there are no buyers is because anyone who may invest in these is smart enough to know we are nowhere near the bottom of the decline in housing prices. Since we are nowhere near the bottom, it is hard to estimate how many foreclosures, thus defaults on mortgages, there will be. Each of these derivatives will retain some value, but it is hard for anyone to see now if it keeps 10% of its value, or 50% of its value.
Consider this: In 2007 Global GDP (Gross Domestic Production) was in the neighborhood of $52 Trillion. The amount of "derivatives", and the bets made on them, total somewhere near $600 Trillion. More than 91% of all derivatives are traded outside of any regulatory agency, in one on one transactions, much like a blackjack table at a casino. The value that has been placed on them is not "marked to market", meaning they are not bought and sold on the open market, thus credibly determining value, but are labeled for value by the issuing investment bank. Almost all of these "derivatives" are not on the active accounting sheets of the investment banks, but rather are "off-balance sheet". The biggest name most of us know who used these accounting principles was Enron.
Since most derivatives are traded in one on one transactions, there are two entities fortunes tied to that "bet". You could be on the winning side of the"bet', yet still not get paid if the other side is insolvent. This is called counterparty risk. If the holder of the derivative is claiming full value in "Level 3", and knows they cannot get paid because the counterparty to their "bet" will be insolvent should they be forced to pay, should the holder of the derivative be allowed to claim full value in "Level 3"? Hence, this is the real question about the whole Bear Stearns debacle, and I have seen no one in the mainstream press ask about this.
If you have been paying attention, the fortunes of the reinsurers, such as Ambac and MBIA have turned down considerably. This is due to their having to pay claims on the derivatives which banks, hedge funds and investment banks took out on them. Essentially, it seems as though neither of these companies have anywhere near the amount of money needed to cover the losses on these derivatives. Many of these "wraps" as they are sometimes called, are known as Credit Default Swaps, or CDS. CDS, and all things similar, are soon to go the way of the derivatives they were meant to provide support for.
There is no way for Ambac or MBIA to survive. Both are initiating lawsuits now, claiming that the loans underlying the derivatives they wrote insurance policies for were fraught with fraud, which they could not have known about.
Many banks have "Level 3" holdings that exceed their hard assets by several times. Soon, most of the financial institutions with "Level 3" holdings will be forced to start bringing them into "Level 1". Even with only a 50% loss, many banks will be in a position of losses exceeding capital by 3, 4, or more times.
What will be really interesting is this - China bought close to $1 Trillion of MBS Securitizations with 2005 and 2006 originations from the US. Anyone want to take a stab at how much they are worth now? How upset will they be with a 20% loss? 30% loss? A 50% loss?
They aren't the only foreigners to have these. What do you think was all the fuss with the German banks a few months ago? Germany has already nationalized two banks who had significant exposure to the US real estate market.
More to come........
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