Are markets hurricane-proof?
Most of us would never give a moment's thought to strange financial products with names like credit default swaps or collateralised debt obligations.
But please stifle that yawn, because whether you know it or not you probably have a stake in these things 鈥 and they could have an effect on your wealth.
There are trillions and trillions of dollars of these investment products held by banks, insurance companies, pension funds and hedge funds all over the world.
And if there were suddenly a collapse in the market for them 鈥 and people who know think that's possible 鈥 well, that could be painful for all of us.
In fact there have already been over the past few weeks, which stemmed from difficulties experienced by providers of riskier mortgages 鈥 known as sub-prime loans 鈥 in the US.
A number of hedge funds have experience humungous losses on their holdings of collateralised debt obligations related to these sub-prime loans.
Now I know that will sound like Mandarin to many of you. But a credit default swap is really just an insurance contract.
They started life as a way for banks who'd lent money to a company to protect themselves against the risk of that company running into difficulties.
But over the past few years, this market has evolved away from its roots in insurance into a giant speculative market, in which investors with no loans to a company are speculating on the ability of that company to pay its debts.
What has really put rocket fuel into the CDS market has been the development of the related market in collateralised debt obligations, or CDOs.
So what on earth is a CDO? Well, they are often described as bonds, but they are not normal bonds, in that they are not direct borrowing by a government or a company.
The way to think of a CDO is as a specially prepared financial product created by chucking a load of other financial products into a melting pot.
So let's say you chuck the debt or even the credit default swaps of a bunch of companies into this cooking pot. Now out of that the master-chefs at the investment banks can prepare a variety of new financial products that match the tastes and needs of particular investors.
That might be an investment with a lower than average risk of the loan going bad. Or it might be one with a higher risk of default but a much more generous interest rate.
But here's the thing. Because they are a confection of lots of other financial products, they are fearfully difficult to analyse and to value.
And just imagine how difficult it is to put a price on the more complex CDOs, such as those manufactured purely out of other CDOs, which believe it or not are called CDOs squared.
There are also CDOs cubed and others to the power of N - just thinking about those makes me feel dizzy
Anyway, hundreds of billions of pounds worth of these things have been created and sold to professional investors.
Here's what worries central bankers and regulators, who are supposed to police the global financial markets to pre-empt a calamity.
First that the existence of the insurance contracts, the credit default swaps, is encouraging careless lending by banks, because they know that if the loans go bad someone else will pick up the tab.
Second that if there were a sudden collapse in investor confidence, for whatever reason, CDOs would be impossible to sell and their price would collapse in a dangerous way.
Third that losses incurred by investors in the event of such a price-collapse could bring down banks or other institutions vital to the smooth running of the financial system - on which we all depend.
How likely is such a market meltdown? Not huge, according to Thomas Huertas, a sort of lifeguard of the banking system at the City watchdog, the . He told me that the FSA is encouraging banks to simulate the effects of a massive markets shock 鈥 the financial equivalent, say, of a dirty bomb in London 鈥 to see whether they would survive.
While not being complacent, the FSA is confident that our major institutions are founded on strong foundations. It matters to all of us that he鈥檚 right.
I'm 
颁辞尘尘别苍迟蝉听听 Post your comment
There is actually a long article yesterday in CITY A.M. (a financial newspaper) about this.
Seems to me that UK's situation is different from that of the USA.
UK's sub-prime market seems to have a much less per centage of the total mortgage market, and relatively speaking, it is much more difficult to borrow here in UK. Trust me, I銆have friends in property development area.
I am not saying we should not worry about this, I just think UK won't be badly affected by this.
JPF:
If it is more difficult to borrow in the UK then it follows that more UK borrowers would need subprime loans not less. All thing being equal, it implies a bigger percentage of subprime loans in the UK compared to the US.
Besides, as Robert Preston states, the financial reach of your bank/pensions fund etc. is global. So the exotic financial products situation in the US has a bearing on your personal wealth regardless of your physical location.
But what do I know, I'm not an economist.
I wonder if we'll ever get back to a simpler world where investment is in companies that do real things rather than in shifting liabilities around.
It's a bit like carbon trading.. I learn't recently that the traders have already made about a billion euros out of this... Once just can't help but feel that this money might actually have been better invested in clean technologies.
JPF, you are a funny person. If this does collapse we, in this country, will be no better off than the Americans or rest of the world. As for UK's subprime market I believe it is greater than 10% of the current market and borrowing in the UK are you for real? Unemployed people can get mortgages. Wake up and smell the coffee.
It is reassuring that the FSA are confident that major institutions have strong foundations. I mean Equitable Life was such an institution wasn't it?
i found a very good site on subprime news. it might be handy for you all:
Non-conforming mortgage securities accounted for 30% of issuances last year - so our subprime sector is plenty big enough.
You think it's hard to borrow money in the UK? I don't think so. Look at this:
"Ian Giles, Director of Marketing at Kensington, said: 鈥淭he buy to let market is changing. There continue to be real opportunities presented by buy to let, but with house prices continuing to increase, interest rates rising and rental yields remaining fairly static, it is becoming much harder for new investors to enter the market. Kensington have recognised this and built a product to help more borrowers benefit from the sector. If you have enough extra income at the end of each month to service the mortgage on an investment property, why should you be constrained by rental yields? This product will empower a new breed of buy to let investor, but it is just the start, and our customers can look forward to more innovations from Kensington in the near future.鈥 "
The Bear Stearns debacle is a point in case. It illustrated that CDO's cannot be quickly liquidated at the assumed (over-valued) price. Banks and other institutional investors are in denial about this. They would rather keep the CDS/CDO carousel going forever. Trouble is that the carousel will stop going round one day. When that happnes banks and others will have to face up to the true book values of these financial instruments. I don't know what will happen to my pension fund savings but I'm expecting the worse.
I would like to mention that Mr. Aaron Krowne, a 30-something research librarian from Atlanta Georgia, has been working hard to educate us on this and related issues since early this year.
Indeed he first pointed out the importance of a key chart from the ABX exchange (published by Markit), when about a week later this was picked up by The Economist. The chart documented the exploding cost of CDS insurance that foreshadowed the collapse of a number of US subprime mortgage originators. Now his Mortgage Lender Implode-O-Meter web site, , that has to now registered some 93 such collapses is under siege from a SLAPP suit, an effort to suppress his team's efforts to inform the public on the subprime mortgage crisis.
We feel that our humble blogging sector (there are only a few dozen of us specializing in the housing bubble) works something like 18th century pamphleteers, and is an important supplement to our conventional colleagues in institutions like the 大象传媒. I'd like to indulge in a bit of gentle chiding to the effect that we've been concerned with this particular story for half a year. But more than that, perhaps you could remember us in your thoughts or prayers, according to taste. We are all too easy to suppress.
Cheers, John McLeod, Halifax, Canada
I have been reading about this impending crisis for a number of months now and what concerns me is not this on its own but other conditions that are existing in the world financial markets. Twice already this year other events have caused world markets to significantly drop temporarily and with this combined we could be heading for a major global financial event with repercussions that will last for years to come.....
Hilarious comment about friends in property development. I too have friends who are flogging dodgy mortgages for all they're worth and have been doing so for the last six or seven years in the UK, forgetting about the knock-on effect from the USA subprimes' deroute!
I think we are going to hear a lot more about CDOs. This is not just a subprime mortgages issue, every kind of loan in the world ends up in a CDO these days. It is financial alchemy at its greatest. Subprime may well just be a shot across the bow before corporate defaults start to hit CDO funds too. Most of the investors in them either: (a) have no idea what they are (yup, pension trustees get sucked in by the sharp-tongued suits too); or (b) have a massively asymmetric financial incentive to speculate rather than leave alone (hedge funds and banks). When probems begin, as they just have, the rush for the exit will be (already is behind the scenes) dramatic.
As far as regulators and banks go, what are they going to say, 鈥淐ripes, we鈥檙e all toast!鈥 or 鈥淢ove along, there鈥檚 nothing to watch here.鈥 A collapse of the CDO market is likely to have as big an impact on global lending and borrowing as a 2%+ rise in base rates. No more discount mortgages, no more 0% car loans, no more private equity bonanza, and no more unsolicited credit card application forms clogging up your letter box! There鈥檚 a silver lining to everything.
The article makes a good job of painting CDOs as some financial dark tricks that no one understands, and I think it is a little unfair. Firstly, CDOs parcel out the risk of the underlying collateral in such a way that many of the investors in CDOs actually take a much lower risk than if they invested directly in, say, mortgages. Ratings agencies are involved in verifying which investors gets how much of the risk, and the result is that most CDOs are highly rated instruments (better than many corporate bonds), and the market for them very liquid. Only a small proportion of the CDO tranches (the "equity", which takes the residual risk) is usually unrated, pays high yields and is high risk and highly illiquid. As with any such instruments, there are regulatory safeguards, so your pension fund is not allowed to invest a huge portion of the fund in them. What's more, the high quality tranches that they DO invest in are not only on par with corporate or even government bonds as a standalone investment, they are often exposed to different sectors (consumer debt for example) which are not correlated to the same extent with the overall market, and therefore *reduce* the overall portfolio risk. As for CDO squareds and cubed, by definition this is much a smaller part of the market, as a CDO of CDOs requires there to be a number of "vanilla" CDOs to invest in for it to exist.
All that said, and as the article points out, financial innovation such as CDOs and CDSs seen on a makro level may have helped to translate the "wall of money" into some bad credit decisions, creating exposures that would have been avoided a few years ago. The added complexity may mask this fact, and it also makes it more difficult to work out who gets hit when the crunch comes. But if fund managers have been doing their jobs, the market based nature of this should in theory have spread the risk wider than in similar situations in the past. And basically, the root cause is not financial innovation, but excess liquidity. Money will always seek a return. CDOs are just the flavour of the day.
James Howard Kunstler has been warning about the dangers of CDOs etc.. for a number of years. But there are much more worrying things going on that are pushing the whole house of cards towards the edge of a giant waterfall.... Search for him and read on...
Following on from a brief explanation of CDOs, CDSs are not as crazy as all that either. They simply allow you to separate out the risk (and risk premium) of a reference credit from the risk-free component. So, for example, by taking out CDS protection you can convert your portfolio of Vodafone bonds to (more or less) the same risk profile (and coupon) as gilts, without having to sell the Vodafone bonds (an advantage if they are committed elsewhere, for example). The protection seller, conversely, can match the added risk with a bunch of gilts to synthesise the Vodafone bonds, without having to buy any. Yes, some will "financial engineer" these into weird and wonderful structures that has nothing to do with such aims, but as a financial instrument they are much simpler than, for example, equity options. Their value is closely related to the risk premium of the underlying credit. So when the market prices in a certain risk of default in Vodafone bonds, you can pretty much derive the value of the CDS from the risk component of this price. Pretty simple, I would have thought... Someone else might know otherwise?
dos it hapen in mexico
Look. Since 15th of August 1971 we've based our whole civilisation on exponentially increasing levels of debt.
What could possibly go wrong with that?
Ok, so we've seen the tsunami on the horizon, got out of funds, shares etc and got our money in cash. Where is safe to keep it? Bear Stearns is having trouble but HSBC Holdings is a bigger mortgage lender, so which banks are safe from trouble in the impending collapse? Any ideas will be read by me with interest, thanks. P.F.
I am 100% sure, that the man in the street will, in the next few years , be a lot poorer. All assets, bar farmland ,are in my view way over valued. When these assets stop going up, they will fall and hard.All you have to do is look back in history, IT IS IN BLACK AND WHITE.I have made good money on shares, and property, [all sold now.] Cash is what you want, and you will not need interest cos you will buy goods for less, year on year. Good luck all.
> A number of hedge funds have
> experienced humungous losses on their
> holdings of collateralised debt
> obligations related to these
> sub-prime loans.
In business, it is often the case that if one person looses their money, someone else has gained it. The dollars and pounds aren't burned in a furnace, so if they ever existed, they still exist after the hedge funds have lost it. And if they never really existed in the first place ... well who would be fool enough to give a hoot about the loss of a thing which isn't there at all?
I'm much more afraid of global warming than I am of bankers who tie themselves up in Gordian knots, then complain about their predicament to the rest of us. However, I can see your point, and we must make those who are in a position to cause the problems wholly responsible if the problems come about. In other words, individuals who are hansomely rewarded for taking responsibility for ensuring our wealth should feel the full force of our anger should they fail to do so. Who can suggest some king-sized incentives (or disincentives for that matter)?
In my opinion, enduring poverty might be the most fitting punishment for thier greed!
I have been following this discussion for some time now and have a simple question: does an ordinary, low-paid worker with a small mortgage and a modest amount of debt have to worry about this situation? (i.e., when and if this happens, will the ripple effect reach that far) I was in negative equity in the early 1990's - am I going there again???
Sorry I don't understand what the problem with hedge funds making humungous losses is supposed to be? That's their job; to take on risk where many others don't. If they succeed they get excellent returns, if they don't they go belly up (and hedge funds go belly-up regularly, this is nothing new or exciting). What happens to them is more a concern for the fund managers (out of a job), and their unit holders. Sometimes these unit holders may be pension funds, but since pension funds are exposed to pretty much every asset class they will more likely than not be exposed to the winning side of the speculative deal, so the net effect for them is zero.
Yes the hedge funds are in the business purely for speculative reasons, but that is not a bad thing. Speculation adds liquidity to the market, which is a good thing.
Worrying about the positions of hedge funds is the same as worrying about the relative performance of two poker players facing each other off, a la Bond and Le Chiffre in Casino Royale. Money is just shfiting from one person to another, it doesn't disappear.
>In business, it is often the case >that if one person looses their >money, someone else has gained it. >The dollars and pounds aren't >burned in a furnace, so if they >ever existed, they still exist >after the hedge funds have lost it.
This is a common fallacy. There is no "Law of Conservation of Money". The present value of finacial instruments depends on supply and demand, the liquidity of markets, and people's perception of value. Thus value is not fixed, and value can be destroyed or created when a financial instrument is liquidated to turn it in to cash.
Interesting discussion and I think a few points to be clarified.
Re, Jacques Cartier: 鈥淭he dollars and pounds aren't burned in a furnace, so if they ever existed, they still exist after the hedge funds have lost it鈥 and, Michael Doney: 鈥淢oney is just shfiting from one person to another, it doesn't disappear鈥.
This is the most widely misunderstood concept in economics. The whole point is, money does disappear. Up in smoke, poof! Where does it go? Money heaven. If house prices fall where does that money go? If the stock market falls, where does that money go (the tiny proportion of those that profit from short-sales aside)? It goes to money heaven. Same thing with CDOs. Money was created out of thin air and it disappears as quickly. People wake up one morning and place their 鈥榝ull faith and credit鈥 in an asset and value it higher than they did the day before because the sun is shining (or they read an article on the 大象传媒 website that says house prices will go up forever!) The next day they lose their job or interest rates go up and they have to sell, suddenly everyone is gloomy and house prices go down 鈥 where does that money go? It disappears.
Chris S wrote 鈥渂asically, the root cause is not financial innovation, but excess liquidity. Money will always seek a return. CDOs are just the flavour of the day.鈥
I agree with you, but do you not think CDOs actually play a more active role? I think the whole problem with CDOs is they are not a passive bystander in all this, they are specifically the instrument that has created all the liquidity, the central bank鈥檚 have just provided benign conditions through loose monetary policy. CDOs are the 21st century source of the Keynesian money-multiplier: lending institutions can manufactrure debt/credits (money to you and I) almost out of thin air as they can immediately sell-on any loans they make via securitisations, which CDO funds gobble-up. Lending institutions used to have standards, which created a natural limit (however loose) on the quality of the loans they made 鈥 they had skin in the game. In stark contrast, the CDO system actively encourages poor quality lending as loan originators get paid on volume, and in fact get paid higher fees on lower quality loans 鈥 there is an incentive to make bad loans! CDO funds love low quality debt as they make bullish assumptions about default rates, get higher lending spreads, taking their 鈥榩erformance鈥 fees based on higher returns 鈥 gambling with other people鈥檚 money. The poor sap underling investors are blindsided by the sales sharp-talk and the comfort of the ratings agencies, who get paid a fortune to rate these products (ratings which they are beginning to sheepishly back away from as they come to realise how many of the underlying assumptions of their valuation models are flawed).
CDOs work 98% of the time (in theory), until they don鈥檛 and they go broke. We are in that 2% tail. Investors in the lower tranches of CDOs have written catastrophe insurance against housing, credit cards, auto-loans, and corporate lending. They will likely lose most / all of their money and this will threaten the values of the tranches above them, IF ONLY through a sudden desire for liquidity 鈥 the AAA tranches may not 鈥榙evalue鈥, but every financial disaster in history was precipitated by a sudden desire for liquidity, NOT a sudden drop in 鈥榲alue鈥. If investors lose their appetite for the lower portion of CDOs (which it looks like they are), the whole CDO cannot be structured, hence there is no demand for the underlying loands i.e. lots of loans that would have been made, cannot be made. Borrowers can鈥檛 borrow, mortgages can鈥檛 be refinanced.
This is fractional reserve banking where the fractional reserve is zero 鈥 i.e. the potential to create (and destroy) liquidity is infininte, SPECIFICALLY because of the 鈥榓lchemy鈥 of CDOs.
The reason we care is because, as the manager of one of the Bear Stearns funds currently going belly up stated at a marketing presentation a year ago 鈥淲e are not a hedge fund, we are a bank.鈥 He was not far off the mark. When banks go under we should all care because the financial system is at risk.
#20 "[A hedge fund's job is to ..] take on risk where many others don't". If it were that simple we could all do it. The selling point of hedge funds is usually that they claim to get a higher risk-adjusted return, by employing clever hedging. Anyone can take big gambles.
"Money is just shifting from one person to another, it doesn't disappear". Others have made a similar comment, and I think this is based on a confusion between money and value. If your house burns down, and you don't have insurance, it's gone. Your deed is a worthless piece of paper, and no one is richer for it. It's similar if you have to write off a loan because the borrower can't pay it: it's gone. The borrower is in theory richer by the same amount, but that makes no difference to him or her, because he/she couldn't repay it anyway. If you're at the risky end of a mortgage CDO, you take the first hit from all mortgages that are written off. Your "money" does indeed vanish.
As someone who knows little bit about CDS, CDOs and their squared versions, (only little, I repeat), it always puzzles me. It's all about mitigating risk from one part to another party. That is Bank A sells risk of certain asset, and Bank B buys that risk, and moves to somewhere else. It may be possible that the risk appears at Bank A's door stpes once again, in a very different name!
And about UK's sub-prime mortgage market, it may be small. But ever heard of ripple effect???
(I am not saying we are facing serious risk, but the risk is always there!)
Neil:
> where does that money go?
> It disappears.
No misunderstand here, Neil. Here鈥檚 one for you - what is the difference between money that has disappeared in a crash and money that has not already disappeared? Answer: no difference at all, because the units of money never "appeared" in the first place. A thing that never appears can hardly be said to disappear.
If these "instruments" peddled by banks are in danger of acquiring near-zero value, it is because they have no use to anyone anymore and few economists would lament the loss of something that is useless.
Cheers,
Jacques
Jacques, I think I kind of understand (and agree with you) in a philosophical sense, and there are a lot of people who would agree in terms of the only true money is gold, but I am really talking about monetary economics/finance in the 21st century 鈥 and this is where I strongly disagree. In a fractional reserve banking economy, where 鈥榤oney鈥 only has value through government fiat, banks create money as a book entry. They can lend pretty much as much as they like (literally creating money), as long as they maintain their capital adequacy ratios. The whole danger of the CDO-system is that capital adequacy has become irrelevant and there is no limit to the amount of lending that can be made, i.e. money that can be 鈥榩rinted鈥. I agree with you philosophically that this has no value 鈥 but tell that to the people who invested $1.2bn in the two Bear Stearns funds! Tell that to the person you buy a house from when the transfer comes from the building society and he says 鈥渢hat鈥檚 not real money鈥! Tell that to the checkout girl at Tesco when you get your debit card out to pay for your groceries. Unfortunately, this IS real money and banks manufacture it. I don鈥檛 like it either, but unfortunately, we have to live with it.
In terms of the CDO funds that are rapidly losing value, think of them as a kind of insurance contract 鈥 they did have value once, but now the risk they insured against has come to pass (a collapse in the US sub-prime mortgage market), they are now essentially valueless. This does not mean they didn鈥檛 once serve a purpose, but unfortunately, because the people who packaged them, sold them and those that invested in them didn鈥檛 really understand the risk, these selfish and greedy people now threaten the whole financial system. Bear Stearns essentially borrowed 25 times their investor capital to provide insurance against a collapse in the US housing market.
The primary problem, as always is leverage 鈥 unwinding of leveraged positions destroys value, as things that do still have value/utility get sold down in the rush for cash. 鈥淚f you can鈥檛 sell what you want to, sell what you can鈥 is an old market adage.
This means that in a rush for the exits, as speculators sell down assets to pay off their borrowing, all assets fall in price. This could be shares in the South Sea Company in 1720, shares of Radio Corporation of America in 1929 as margin calls hit the market, it could be CDOs today as hedge funds and investment banks need to reduce their leverage, or it could be 2 bedroom flats in Manchester as buy-to-let investors can鈥檛 refinance their mortgage. Whatever form it takes, de-leverging destroys value in a vicious downward spiral 鈥 and lots of people, not just economists, lament that.
> Unfortunately, this IS real money and banks
> manufacture it. I don鈥檛 like it either, but
> unfortunately, we have to live with it.
Yes, but I鈥檓 afraid that the whole idea of 鈥渞eal鈥
money is way off the mark. Sorry for stating the
obvious.
> CDO funds 鈥 did have value once, but now the risk
> they insured against has come to pass (a collapse
> in the US sub-prime mortgage market), they are now
> essentially valueless 鈥 The people who packaged them,
> sold them and those that invested in them didn鈥檛
> really understand the risk, these selfish and greedy
> people now threaten the whole financial system.
Yes again. That is why _strong_ disincentives are my favourite
way of dealing with them. Going back to my original post, do you
have an sugestions on how we can make these people go broke fast?
> It could be 2 bedroom flats in Manchester as buy-to-let
> investors can鈥檛 refinance their mortgage.
Neil, now you鈥檝e got me drooling! It is up to every person
to isolate themselves from 鈥渢he depression鈥 as best they can.
The plan is to get some food in the loft, pay the mortgage
down and a have small pile of cash to mop up some of those
buy-to-let deals when they crash down. Bring it on, I鈥檓 ready.
When it's all blown over in a few years, we'll be quids
in instead of those graspers in the City.
And don't worry - as you can see, every cloud has a silver
lining, and it won't be as bad as the second world war.
For general public financial market is mystery with loads of complex products, which guarantee to take care of your financial insecurities. however, considering fragile history, it never heal any pain rather than left big scares on various part of life.
FSA should need to work towards making this market simple, which can be understood by general public.
To Chris S
The problem with CDS trading is not the vanilla pricing of the instrument (which itself is finger in the air stuff as recovery rates and default curves are just theory), it is the fact that one corporate default can be multiplied many times into the credit market. There is not one Vodafone bond underlying each Vodafone CDS traded. We have not been through a full credit cycle since the explosion of CDS volumes, I think is it the uncertainty of the multiplying effect of CDS that makes people nervous.
Tough times are ahead, and a large percentage of the UK population will see their biggest "asset", become their biggest liabilty, when the housing market goes. The only thing permanent about the housing market is the debt attached to it. The New Labour economic miracle (and they talk of affluence and stability) is a fallacy. We produce less and spend more; compare this to China, where people produce and save (lots). It is a recipe for disaster.
Jacques, I think we are in (almost) complete agreement! :-) Although you鈥檝e still lost me slightly on the what is 鈥渞eal鈥 money issue? You鈥檙e either being too obvious, or too complex for me! Can you explain a little?
As far as suggestions for strong discincentives for people taking unnaceptable levels of risk, that is a very good question, and one we are likely to hear a lot more of in the months ahead. For my 鈥榯uppence鈥 worth, although I dislike encouraging more government intervention, the fact that governments鈥 deliberate and asymmetrical manipulation of interest rates actually creates these periods of unnacceptable risk taking, they should take a much firmer line against those that abuse the system, and balance the incentive-disincentive structure up a little, which as you point out, is completely out of line.
However, there is a fine line between legitimate assumption of measured risk (which should be encouraged) and downright 鈥榖et-someone-elses-ranch鈥 Wild West finance. Probably the current angst towards Private Equity companies is because they seem to show too much of the latter?
Maybe the only way would be to prosecute the perpetrators of the deals / funds that, when they blow-up, they individually and specifically threaten the stability of the whole financial system? E.g. Bear Stearns and its managers personally, given their recent (entirely foreseeable) debacle, should be fearing a court case and potential fines that would materially hurt the company and the individuals whilst handing them a life-long ban on marketing and or managing similar products.
A good idea in principle, but I fear practical application would be very tricky.
I'm no expert in all things financial but as an insurance man, this strikes me as being the same kind of wishful thinking as happened in London in the early 80's. People were convinced that they would lay off their liabilities with reinsurance making money at every step of the placement. Unfortunately a spiral built up as it was very difficult to monitor everything (LMX Spiral). A similar sort of thing is happening with these CDO squared etc. All is good until there is a problem at the bottom then it burns up through the spiral and everyone who thought they had sold their risk on finds out that they get it back and on a worse basis than if they had just taken on the debt from the ground up. Correct me if I'm wrong but I just see it being a very sharp correction once it goes. Selling on risk is fraught with danger as those buying it usually dont have the full picture and dont ask the questions they would if writing it directly.
When the value of a financial instrument suffers, regardless of its nature, including hard assets, everyone along the promise line suffers a loss. Government regulators and member banks have a dismal history in regulating currency. Because of Federal Reserve practices of creating money out of nothing and allowing member banks to leverage these funds without anything other than backing of the full faith and worth of the U.S. taxpayer, precedent is set for creating other financial instruments with fractional values. The collapse of financial instruments from the Great Depression, Junk Bonds, Financial Derivetives, Savings and Loan crisis, Dot Com bust, all have in common a real or perceived value that has been leveraged into eternity. I have witnessed all of these events and predict that sub -O- lending will become an international crisis. Americans have been living on credit for too long. I believe that we see our money as not worth a damn, so spend it now and pay later with cheaper $. The reverse could happen; a depression, where liquidity is squeezed out of the economy and Dollars will have some value. No one can predict.
The question that intrigues me the most is: what happens to money? When homeowners cannot pay on their notes The S&l's can't pay the banks responsible for putting up the money for the loan. Now the banks are in trouble for issuing loans based on fractional deposits. Wall street now has paper coming back with consistently declining value because these CDO's were made with a lot of baited promises. Eventually this paper will reflect it's true worth but everyone along this line has lost money in the quest. Lets face it, If all of the debts of the world were paid today there would be no money left in circulation. We know this is not going to happen.
There is a great deal of talk about how "bad" derivatives allow the economy to create money without control, and loans that are worthless. The simple fact is that the uptake of such instruments are the result of the "creativity/stupidity" of a market that is awash with money. The root cause of this is increased savings by export rich countries and their central banks, and (in personal sector at least) increased borrowing by those who confuse low inflation affordability with low interest rates. The money multiplier is not primarily controlled by bank reserves, but by market rates (set by afore mentioned propensities to save and borrow). And when the savings and borrowing behaviour shifts, the multiplier circle starts spinning until supply and demand balances out. Western consumer, chinese central bank, western credit market, western consumer, and so on.
It does not go on for ever, only until credit has expanded to match up demand and supply (as in any market, you get overshoots and bubbles). Reserve requirements/base rates are merely an attempt at adjusting the supply of credit that is channeled through banks and thereby influencing the market rate. Because the increase in money supply has so far mostly led to asset inflation, not monetary inflation, the central banks have not had reason to serously test this lever, perhaps it is less effective than before, but it still exists.
From this perspective CDOs are not inherently different from bonds, they create money in much the same way. When bank lending and traditional credit markets are exhausted as channels, and there are still savings "left", it will find new ways of reaching the borrowers. CDOs, PE bridging loans, synthetic bonds.
Nor is there any great theoretical leap from CDOs to bond and equity markets, which split the risk of financing corporate assets between shareholders and various layers of bondholders and other lenders, in a very similar way to what a CDO does for other collateral. You can create very complicated networks of credit without CDOs. And there is no huge difference between selling a CDS contract and owning a corporate bond. Blaming these instruments is like blaming the dot com boom on the existence of shares and equity markets.
What we are seeing is nothing new, it's classic overshoot/bubble behaviour. Investors swallow bullish default/liquidity assumptions and risk models because they are desperate for yield in a market flooded with money. They take out CDS contracts without checking how likely it is that they can source the bond in the case of a default. In this process they misprice risk, and the credit supply overshoots, like it has done many times before CDOs became popular.
Chris S, of all the points made here, the key is the dispute about whether or not CDOs are passively involved as an outlet for investment in an already overliquified global economy (which it seems just about everybody other than the US Fed takes as fact), or whether in fact CDOs are specifically responsible for helping to create this excess liquidity.
This is not a black and white issue, as there is a lot of circularity in the process, and they serve both purposes in the above context. Disagreement must surely arise from the degree of emphasis placed on these two roles.
I would contend that CDOs, at the very least, serve a far different role from traditional corporate bonds and equity financing . The latter allow companies to raise finance from investors (who already have money to invest) for general corporate purposes. This is not a credit creation process, unless specifically banks are lending money in this process.
Securitised loans and the CDOs that buy them can also be sold to investors who already have money, but the specific purpose of securitisation and CDOs is to enable the banking system to extend credit to the economy beyond the level that a more traditional fractional reserve banking system would allow them to.
This is the difference between corporate bonds and equities: CDOs specifically serve the purpose of credit creation, whereas corporate bonds and equities (in general) serve the purpose of diverting already existing investor funds for general corporate purposes.
Would you agree or disagree with this point?
This system is peculiarly supportive of asset backed lending, and hence, specifically encourages asset inflation. I agree that if the securitisation/CDO system had not existed we would be experiencing a very normal boom-bust cycle. But, there is no way we would be quite so deep in the subprime issue as we are now, where many recent loans have literally been criminally bad 鈥 an act that the nature of the CDO market specifically encourages. Despite their pro-cyclical nature, individual banks and syndicates of banks do have limits they cannot go beyond and have little incentive to make downright stupid loans. The CDO system has virtually no limit, and is actually self-sustaining, due to the cycle of asset inflation (often regarded as 鈥榮aving鈥) and further lending it creates.
Self-sustaining that is, until it goes pop and there is a 鈥榬un鈥 on it. In this respect, I would argue that the CDO system is not to be compared with corporate bond and equity financing, but with the banking system in aggregate, and hence CDOs have specifically had their role in creating the excess liquidity and are not just another instrument caught up in it.