There seems to be a lot of confusion about the nature of the crisis that is consuming our financial markets. I thought to start this thread to clear some of this up.
What are we dealing with is something called a “credit crunch” or a “liquidity crisis.” There is a lot of talk about “bad mortgages” or “bad debt” or “bad CDOs.” How could we have written this “bad” debt?
The first fundamental bit of confusion usually comes over the meaning of the term “bad.” Chances are that when you hear a debt is “bad” you interpret this to think that it’s in default, or not paying or not likely to pay.
While some of these securities and mortgages are “bad” in this sense, this is not what is generally meant when people are talking about the billions of dollars of bad debt choking the financial market.
These mortgages and debts have all been securitized into bonds and bond-like instruments, and they trade in the financial markets. A bond is said to be “bad” if it becomes illiquid, that is, you can’t trade it.
The vast majority of the debt that we are talking about is still paying interest, is not in default, and is not expected to be in default. It is simply illiquid.
To understand this one needs to know that bonds typically trade much differently than stocks. Bonds tend to be held for longer periods of time and don’t necessarily trade every day. Imagine if GE stock traded only once every couple of months, and you get the picture.
The way traders trade bonds is by doing something called discounting, usually off a treasury. Treasuries tend to trade all day every day, so if you can figure out how a given bond compares to treasury you can simply watch the treasury price and interpret that price movement towards your bond. Another way to do it is to find a bond that traded recently that is similar to the bond you own. If that bond traded up, chances are your bond is worth more, too. This is why ratings are important. If your bond is rated AA, you can watch how other bonds with this rating trade and figure out what a fair price for your bond is.
One might say, for example, that AA rated bonds are trading 200 basis points off their treasury upon observing a 30 year corporate bond compared to a thirty year treasury. A basis point is simply 1/100th of one percent. So, if the thirty year treasury is paying 4.36% and a AA rated bond is paying 6.36% you know that the AA rated bond is trading 200 basis points off the treasury.
Now, if you have a AA rated bond that is a ten year bond, you can use this information to price your bond. You might see that the 10 year treasury is paying 3.74% and therefore interpolate that your bond shoud be priced to yield 5.74% Not all AA rated bonds are equal. Some have features in them, calls, sinking funds, and other things that may make them more or less valuable then other AA rated bonds. You adjust your price based on this. You make comparisons to other bonds which have traded to confirm or adjust this price. This is why ratings are important.
That’s how bonds are priced and that’s how they trade. If you have an investment portfolio that contains bonds you may see your price change month to month even though not a single bond of that issue has traded hands. There are services that due this for traders and firms and issue guesses as to what the price of a bond would be if it traded. The largest of these is JJKenney.
For the most part, this is what traders and the financial community are talking about when they say a bond is “good” or “bad.” They are not talking about it’s ability to pay which is its “credit” but its ability to trade which is its “liquidity.”
A “good” bond is a liquid bond. This means it trades reasonably often and it trades reasonably predictably and with strong adherence to its benchmarks. You can simply look at a treasury and know what your bond is worth by comparison. More importantly, everybody else knows it too. Because of this you will be able to find a good and predictable price for your bond and sell it at that price pretty easily.
A “Bad” AA bond might be the scum of the AA universe. It might have weird call features (when it can be redeemed.) It might lack collateral or seniority. It might not trade that often and when it does it might trade 200 basis points off its treasury one time and 250 basis points off the next time.
All things being equal you would prefer AA rated bonds that are good from a liquid sense.
To give you a good analogy, say you want to spend 25k on transportation. That 25k could buy you a Prius of which there are millions on the road, or a Delorean of which there are few. Pretending for the moment that these cars are equal in terms of their transportation value, which would you want?
Probably, you would want the Prius. If you chose the Delorean, don’t trade bonds. It’s easy to buy and sell a Prius. Buying and selling a Delorean isn’t. It’s a specialty item that doesn’t trade all that often. If you buy a 25k Prius today and you decide to sell it in six weeks, you shouldn’t have too much trouble getting your 25k back. You might have a tougher time finding someone to buy your Delorean.
From a liquidity standpoint Prius is good, Delorean is bad.
Bonds work the same way.
For a long long time mortgage backed securities were very very good. A securities dealer with an inventory of CDOs (a packaged mortgage backed bond) was like a car dealership full of Prius’.
Very suddenly it became like holding a dealership full of Deloreans.
Now remember, for purposes of our analogy there is no difference in the transportation value of a Prius versus a Delorean. They are both the same.
The bad debt is bad in the sense that nobody wants to own it, nobody knows how to price it, and there is not a market for it.
Until they get rid of it, they can’t do business with each other. If they can’t do business with each other that means money get’s “tight.” Credit is simply not available. Businesses can’t borrow money. Individuals can’t borrow money. Liquidity seizes up, transactions grow scarce, inventories can’t get replaced, people get fired, and the whole economy grinds to a halt.
What you have then is a depression.
The “bailout” is simply a proposal to buy some of this delorean type debt. The government will hold it, collect interest and when liquidity resumes they can sell it back to the market.
In the past, like the S&L bailout, the government made a profit doing this.
So, the bailout is not the government spending money the way it does if it buys a tank. It will receive interest and will likely be able to sell this debt back to the market when liquidity resumes, likely at a profit.
That’s the mechanics of the crisis and the proposed solution. Questions?