Monday view: Government-created monster starting to show its teeth

The near collapse of two Bear Stearns hedge funds has lifted the rock on our 21st century mutant capitalism, exposing the bugs beneath to a rare shock of naked light. When creditors led by Merrill Lynch forced a fire-sale of assets, they inadvertently revealed that up to $2 trillion of debt linked to the crumbling US sub-prime and "Alt A" property market was falsely priced on books.

Even A-rated securities fetched just 85pc of face value. B-grades fell off a cliff. The banks halted the sale before "price discovery" set off a wider chain-reaction.

"It was a cover-up," says Charles Dumas, global strategist at Lombard Street Research. He believes the banks alone have $750bn in exposure. They may have to call in loans.

Not even the Bank for International Settlements (BIS) has a handle on the "opaque" instruments taking over world finance.

"Who now holds these risks, and can they manage them adequately? The honest answer is that we do not know," it said.

Markets have been wobbly since the surge in yields on 10-year US Treasuries, the world's benchmark price of money. Yields have jumped 55 basis points since early May on inflation scares, the steepest rise since 1994. It infects everything; hence that ugly "double top" on Wall Street and Morgan Stanley's "triple sell signal" on equities.

Wobbles are turning to fear. Just $3bn of the $20bn junk bonds planned for issue last week were actually sold. Lenders are refusing "covenant-lite" deals for leveraged buy-outs, especially those with "toggles" that allow debtors to pay bills with fresh bonds. Carlyle, Arcelor, MISC, and US Food Services are all shelving plans to raise money. This is how a credit crunch starts.

"This is the big one: all investment portfolios will be shredded to ribbons," said Albert Edwards, from Dresdner Kleinwort.

The BIS had warned days earlier that markets were febrile: "more risk-taking, more leverage, more funding, higher prices, more collateral, and in turn, more risk-taking. The danger with such endogenous market processes is that they can, indeed must, eventually go into reverse if the fundamentals have been over-priced. Such cycles have been seen many times in the past," it said.

The last few months look like the final blow-off peak of an enormous credit balloon. Global M&A deals reached $2,278bn in the first half, up 50pc on a year. Corporate debt jumped $1,450bn, up 32pc. Private equity buy-outs reached $568.7bn, up 23pc. Collateralised debt obligations (CDOs) rose $251bn in the first quarter, double last year's record rate.

Leveraged deals are running at 5.4 debt/cash flow ratio, an all-time high. As the BIS warns, this debt will prove a killer when the cycle turns. "The strategy depends on the availability of cheap funding," it said.

Why has such excess happened? Because global liquidity flooded the bond markets in 2005, 2006, and early 2007, compressing yields to wafer-thin levels. It created an irresistible incentive to use debt.

What is the source of this liquidity? Take your pick. Goldman Sachs says oil exporters armed with $1,250bn in annual revenues have been the silent force, sinking wealth into bonds; China is recycling $1.3 trillion of reserves into global credit, a by-product of its policy to cap the yuan; Japan's near-zero rates have spawned a "carry trade", injecting $500bn of Japanese money into Anglo-Saxon bonds, and such; the Swiss franc carry trade has juiced Europe, financing property booms in the ex-Communist bloc. And, all the while, cheap Asian manufactures have doused inflation, masking the monetary bubble.

The deeper reason is the ultra-loose policy of the world's central banks over a decade. They "fixed" the price of money too low in the 1990s, prevented a liquidation purge to clear the dotcom excesses, then kept rates too low again from 2003 to 2006. Belated tightening has yet to catch up.

Don't blame capitalism. This is a 100pc-proof government-created monster. Bureaucrats (yes, Alan Greenspan) have distorted market signals, leading to the warped behaviour we see all around us.

As the BIS notes tartly in its warning on the nexus of excess, this blunder has official fingerprints all over it. "Behind each set of concerns lurks the common factor of highly accommodating financial conditions" it said.

Rebuking the Fed, it said Japan and Europe have turned sceptical of the orthodoxy that central banks can safely let asset booms run wild, merely stepping in afterwards to "clean-up".

The strategy leads to serial bubbles, creates an addiction to easy money, and transfers wealth from savers to debtors, "sowing the seeds for more serious problems further ahead".

If you think we are too clever now to let a full-blown slump occur, read the BIS report.

"Virtually nobody foresaw the Great Depression of the 1930s, or the crises which affected Japan and south-east Asia in the early and late 1990s. In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a 'new era' had arrived," it said.

The subtext is that you bake slumps into the pie when you let credit booms run wild. You can put off the day of reckoning, as the Fed did in 2003, but not forever, and not without other costs.

So the oldest and most venerable global watchdog is worried enough to evoke the dangers of depression. It will not happen. Fed chief Ben Bernanke made his name studying depressions. He will slash rates to zero if necessary, and then - in his own words - drop cash from helicopters. But his solution is somebody else's dollar crisis.

On it goes. Perhaps governments should simply stop trying to rig the price of money in the first place.

OK, first, I know that Ambrose is something of a gold-bug. True ‘nuff.

But some of what he says is quite true in here.

Some quick background:

The problem inside these Bear Stearns hedge funds is twofold:

1. They’re using very high leverage ratios. If you or I were investing in stocks and our brokers allowed us to trade on margin, about the most we’d be able to margin would be 2:1 — ie, we’d be able to buy twice as much stock as we had cash in the account *for certain stocks*. If we were buying solid, reputable companies with solid books and an established history, we could put down $0.50 per dollar of stock we bought.

For a new, untried, small-cap company that is like many of the dot-com startups in the late 90’s, the SEC now requires that guys like you or I put down $1.00 for every $1.00 of stock we buy. ie, there is no margin allowed on these stocks any more.

If you or I were buying commodities contracts or such, we could get a 10:1 ratio, as long as our position was profitable. As soon as the position turned on us, we’d either have to put up more money to cover the shortfall, or our broker would try to call us *once* — and if he couldn’t get in touch with us, he’d sell out our position until our account met margin requirements.

Bear Stearns was leveraged somewhere between 15:1 and 20:1 on some of these hedge fund assets. Merrill was making a margin call as soon as they started to figure out that the securities in Bear’s hedge funds weren’t worth so much any more.

Merrill did try to sell some of the better quality stuff in the Bear fund: they got, as Ambrose indicates, only $0.85 per dollar of indicated value. The “crap” in the fund was reported to receive bids as low as $0.15/dollar.

This is HIGHLY important for reasons I will explain next.

2. What is in these hedge funds? Some of the assets are CDO’s (collateralized debt obligations) and CDO-squareds (CDO-like beasts made up of other CDO’s of varying credit qualities, derivatives and non-cash instruments).

I could bore you to tears with a bunch of financial “engineering” jibbery-goo, but I won’t. Instead, I’ll put this in terms most everyone can understand.

Let’s say you own some stock in some company. Let’s not worry about which company — let’s just say it is a widely known company — eg, Microsoft, IBM, Dupont, GM, whatever. Pick a big, well known company.

Let’s say you’re asking the bank for a loan, and the bank wants to know what your assets are. Part of what you own is this stock, so you look up the price of the stock, you multiply by how many shares you own, and wha-la, there’s how much that stock is worth, right?

If the banker wants to challenge you on that asset you own, you point to the market, and say “I could sell that stock right now for the price indicated, therefore that stock is worth that amount of money.” Period, end of discussion. Whoever was challenging you pretty much has to shut up at that point. The market spoke and it said what your stock was worth.

Clear so far? Market people have a term of this type of valuation mechanism: “mark to market” — even if you didn’t sell the stock, when you wanted to value that asset you owned, you turned to the market, viewed what the stock was selling for at that moment in time and the market was the ultimate arbiter of what that asset is worth.

This is NOT how the contents of these hedge funds are valued. These CDO’s and CDO-squared trade very, very rarely, and the market isn’t “deep” (ie, there aren’t a lot of buyers even in good times) and there is no way you can just pull up a web page and say “So what is this thing currently trading for?”

Instead, these assets are valued by what is known as “mark to model” — some whiz-kids wrote up a computer program, installed it on a computer in the hedge fund, and this program looks at current interest rates in the market, the performance of some of the crap inside the CDO’s and CDO-squared, and spits out a number saying “This here asset is worth $XXX.nn”

These numbers are complete fantasy, of course. An asset is worth what a willing buyer is willing to pay a willing seller. That’s it. Everything else is just talk.

What happened when Merrill tried to sell some of these CDO’s and CDO-squareds is that the buyers became a real market: Merrill was putting these assets up for sale, trying to get what the model(s) indicated was the current value of the CDO’s/CDO-squared.

And the buyers in the market said “The model is BS. Here’s what we’re offering.”

That’s a real market. When a seller is desperate, the buyers don’t step right up and say “Golly, we feel sorry for you — here, lemme offer to make you whole.” Nooooo. The buyers smell blood in the water, and they look to get something at a good price — the same as any retail shopper wants to do during a going-out-of-business sale.

And make no mistake — that’s what is going on here: the Bear funds would be going out of business if Merrill sold off the assets to meet a margin call. No one in their right might would pay $1.00 per $1.00 of valuation. Everyone is going to be looking for a bargain.

OK, ‘nuff theory. Here’s where the fear is starting to ramp up:

A bunch of hedge funds, pension funds, investment banks, etc, are holding the bag on these CDO’s and CDO-squareds. They’re all mark-to-model. If Bear hadn’t coughed up $3.4B to make the margin call that Merrill is asking for, then the contents of Bear’s fund would have set the price expectations for a LOT of other CDO/CDO^2’s out there. And suddenly, a whole lot of funds that might have been leveraged might have been getting their own margin calls, asking them to either put up a lot more cash, or sell their assets.

The problem here isn’t just the mark-to-model, and it isn’t just the leverage. It is the combination of the two.

Let me put it in common homeowner terms: Let’s say you have a no-money-down mortgage on a house. The real estate market was hot-hot-hot when you bought the place, but suddenly, toxic waste is discovered in your neighborhood. All your neighbors are also carrying no-money-down mortgages too.

So the first guy to get a call from his bank is the guy with the ultra-premium house in the neighborhood. The bank says they want him to deposit 20% of the house’s value, or otherwise the bank will foreclose on the house and sell it.

The other homeowners in the neighborhood hear this and start to panic — if this first house goes on the market and doesn’t sell at the high valuation price (because the number of people who want to pay top dollar for executive homes in neighborhoods known to contain toxic waste is surprisingly low...), then as the asking price keeps going down, down, down, other people in the neighborhood might start getting calls from their mortgage lenders too.

If people had put down 20% up front, they wouldn’t be getting a call from a banker until the prices really dropped drastically. If they owned their houses outright, they wouldn’t be getting any calls at all.

Let’s say the toxic waste thing turns out to be easily fixed. All the people who were foreclosed by their banks are going to be bitter — because if they just didn’t have the bank breathing down their necks, they could have hung on through the little toxic waste flap, and come out of it with no harm, no foul.

But because they really didn’t control the disposition of the property, their actions were forced by the lender.

If these hedge funds weren’t leveraged to the hilt, they could just sit back and wait until this sub-prime flap was over. If the CDO’s were traded like stocks, the margin lenders might be more confident in letting the hedge funds slide. But because we have a combination of a market that will plummet when the first CDO’s are actually traded, and we have extreme leverage... we have a very, very bad witches’ brew of fiscal stupidity here.

Possibly a 1929-like brew.

The problem is, no one really knows what is inside those CDO’s and (especially) the CDO-squareds. There is scant ability to really evaluate the risk here, thanks to the whiz kids who created these CDO’s and CDO-squareds to deliberately add some “toxic waste” sub-prime mortgage debt in with some investment grade mortgage debt.

Sorry, my previous reply was cut short:

As to Ambrose’s evaluation of the sources of liquidity: he’s spot-on. The Yen carry trade (borrow Yen at slightly over 0% APR and convert it into $USD or Euro’s) has been a huge source of liquidity for the last six years.

Greenspan injected huge amounts of liquidity into the US market after 9/11.

And China has boatloads of dollars as a result of our incredibly high trade deficit and current account deficit with China. One of the ways China has sought to ameliorate this, and deliberately keep long-term interest rates low in the US (which helps keep the consumer spending) has been to buy US Treasuries in the 10 year range. The 10 year T is used as the benchmark for a wide variety of loans.

Gold won’t cure this right now. There isn’t enough gold in the world to replace the current levels of liquidity without everyone taking a huge haircut in valuation levels.

But at some point, the liquidity merry-go-round is going to stop. The Yen carry trade is already no longer as lucrative as it was as the Bank of Japan started to raise interest rates. The PRC has indicated that they’re going to start diversifying their debt portfolio, which is banker-speak for “we’re not going to buy quite so many US Treasuries any more”, which will result in interest rates on T’s going up a bit.

There are hedge funds in the EU who have invested (heavily) in US mortgage debt who are going to get a rude surprise (if they haven’t already). If they’re leveraged to US investment banks, then the BIS might start getting involved. I’m not too worried about what the BIS has to say at this point. Right now, I’m more interested in what Fitch’s, Moody’s and S&P start doing in how they rate the debt in some of these portfolios.

Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.