Financial Armageddon for Dummies

[IdahoMauleMan]

@Scylla

No. I’m kind of taking Paulson and Bernanke at their word that that’s what’s needed. It’s not stock though that we’re talking about though it’s debt instruments (though there may be some equities tied up with some of it.)

The 700 billion is what they figure is needed to unwind the leverage and allow the holding institutions to meet their collateral requirements without undue hardship or collapse. After that, ideally these instruments price themselves at some as yet undetermined but efficient (or efficientish) market price.

That market price will likely be significantly lower than the discounted hold to maturity price the government has paid. The liquidity than helps the credit markets recover. Housing and mortgage markets stabilize and the doomsday assumptions built into this efficient-ish market price improve. Everything gets better and then the market rallies so that this price increases to or past what the government paid and then the whole market, including the government becomes liquid, and everybody’s happy again.

I know that sounds fishy, but that’s the way it works most of the time. These credit crunches are relatively rare.

Yes. By ‘Stock’ I didn’t mean traded equities. I meant ‘Stock’ as in stockpile. As in ‘stock’ and ‘flow’.

Walk me through a scenario where we don’t do this. In that scenario, some private capital must trickle in slowly, or some bold banks will start lending to one another, albeit much smaller amounts at punitive terms. Or perhaps data will start trickling in month after month showing lower default rates than is currently built into mark-to-market pricing.

Is it possible we’ll still get there, only it might take a little longer? Without any government intervention. I completely get the effects of dried up business-to-business credit, but somebody must be willing to lend to somebody at hard-money rates. Even if it’s 7% overnight LIBOR rates, that’s still not Zimbabwe.

What happens if we just leave well enough alone?

[Polerius]

@Scylla

That’s not definitively answerable. A combination of factors most likely with market saturation being the predominant one.

So, there was a bubble in the bond market (or CDO market)?

If there was a bubble, then shouldn’t people *expect *to lose money when the bubble bursts? Why weren’t the head honchos and financial gurus running these companies (like Lehman) ready for the bursting of the bubble?

Also, what do you think about what this articlesays:

What is driving the fall of AIG … is not mortgages or real estate (directly), but fears that AIG’s huge, global credit-default swap positions will unravel. The $62 trillion dollar credit derivatives market is 50 times the size of the subprime mortgage derivatives market, and is indeed larger than the entire global economy.

To the untrained eye (i.e. me) the potential collapse of a $62 trillion market seems terrifying. Is it as potentially bad as it sounds, or is the $62 trillion figure an artificial number that doesn’t mean much in practical terms?

On a side note: how can you have a market that is larger than the entire global economy? Is it because people are just betting with lots of money on events that don’t have as much underlying value? For example, if a couple of kids are playing marbles, with the winning kid getting all the marbles, two adults observing the kids can bet $10,000 on the outcome of the game, which is much higher than the value of all the marbles in the neighborhood. Is this at all close to how we can have a derivatives market that is larger than the entire global economy?

[Polerius]

On a practical note, if we assume that the bailout will pass, how can someone (an individual investor) profit from this bailout? Will some companies’ stock prices skyrocket because the government will buy their bad debt?

Which surviving companies have the most bad debt and therefore stand to gain the most from the bailout?

[Scylla]

@NinetyWt

So, someone must have some idea of what this maturity price is/could be?

Yup, again, Bill Gross wrote an article about it in last week’s Barrons where he explains the process. It’s complex, but straightforward. He offered to do it all for the Government, free of charge.

Bill is the most successful fixed income manager in the world, and is generally considered pretty good at this sort of thing.

I’d say you want a couple of different people doing the calculations, and checking them against one another.

This part should not be a problem.

[Scylla]

@IdahoMauleMan

Yes. By ‘Stock’ I didn’t mean traded equities. I meant ‘Stock’ as in stockpile. As in ‘stock’ and ‘flow’.

No prob.

Walk me through a scenario where we don’t do this. In that scenario, some private capital must trickle in slowly, or some bold banks will start lending to one another, albeit much smaller amounts at punitive terms. Or perhaps data will start trickling in month after month showing lower default rates than is currently built into mark-to-market pricing.

There’s a lot of disagreement here as to what would happen. I honestly don’t know.

Is it possible we’ll still get there, only it might take a little longer? Without any government intervention. I completely get the effects of dried up business-to-business credit, but somebody must be willing to lend to somebody at hard-money rates. Even if it’s 7% overnight LIBOR rates, that’s still not Zimbabwe.

What happens if we just leave well enough alone?

It might be better, or we might go into a deep recession or a depression. My guess is that the “rescue” helps less the longer it takes to materialize.

[foolsguinea]

So, this is all because the market disappeared for a kind of security that didn’t even exist 15 years ago? And people can’t play bond-trading games with your mortgage?

Yeah. I say Suck It Up. Bunch of worthless crybaby parasites.

[Cervaise]

@Scylla

Imagine if you were a professor of 19th Century French Literature, and everybody’s eyes glazed over any time you talked about it.

Suddenly there’s a worldwide Baudelaire crisis that threatens everybody, but nobody understands “Les Fleurs Du Mal.”

I know you think you’re funny, but this is no joking matter. A Baudelaire crisis could bring the whole thing crashing down. You won’t be laughing when you’re waiting for your turn to spend three seconds sucking on a dry horse hoof for your breakfast.
Seriously, thanks for the lucid explanation. Sort of makes the posturing of the presidential campaigns, both of them, look a little silly.

[foolsguinea]

So, what about Jeffrey A. Miron’s view that

Further, the current credit freeze is likely due to Wall Street’s hope of a bailout; bankers will not sell their lousy assets for 20 cents on the dollar if the government might pay 30, 50, or 80 cents.

?

[China_Guy]

Scylla, some good points but you also miss a few key elements. May I share experience from the 97 Asian flu and emerging market crisis? BTW, I used to work for Swiss bank as an analyst and on the equity derivatives desk, then the institutional desk of Lehman’s fixed income in Hong Kong in 1996, and from my convertible bond/warrants desk perch at Nikko watched the unraveling of the Asian equity and debt markets, and then left the biz.

And I would second the recommendation to read Bill Gross’ view.

Lessons I learned the hard way in 1997/98
#1 - corporate credit ratings mean jack in times of financial stress. Right now, the global economy is on the abyss. A company that was historically triple-A may not be now. Reality and the credit rating agencies have quite a lag. To use an extreme example, how long did Lehman’s keep it’s credit ratings even though tehy always been the firm on the edge and it was painfully obvious last summer they were struggling.

#2 - credit ratings on bonds mean jack shit in times of finanacial stress. Go back through any crash in history and bond floors don’t hold. Something they don’t teach you for your Series 7. Think of it this way, all bonds have a deep out of the money short put option imbedded. In good times, that short put is so out of the money that it’s meaningless, in bad times you crash though the theoretical bond floor and suddenly that short put is being exercised. I wrote a feature article on the lessons of convertible bonds in the Asian Crisis for the International Finance Review.

#3 - assuming that the credit rating agencies like Moody’s and S&P etc truely value the risk is asinine. Unfortunately, most of the Street got caught out by this. The rating agencies are hugely culpable in this mess. Again, to think of it simplistically, the first $500B in CDO’s was probably a good do for everyone, but at some point the volumes went over a critical mass and the assumptions for that first $500B were no long valid. Buddy of mine at UBS said that they had hundreds of risk managers on the beach looking at grains of sand when the Tsunami hit. That shit never would have been allowed at Swiss Bank Corp, who’s risk control was legendary but dismantled because it prevent greater profits once the SBC/UBS shotgun marriage took place.

If you go back to your AA bond example. You’ll notice in the last 6 months that 2 different AA rated bonds with virtually identical terms and maturies have most likely traded significantly differently. That’s because they are both based on different underlyings. In times of stress one AA company or bond is not fungible with another. Again, goes back to what works in a bull market does not necessarily hold true for a bear.

#4 - You’ve got the right framework with your fire sale (clearing level), market price and hold to maturity price. However, these bonds can not be clearly valued. Just ask AIG, who wrote so much insurance on stuff they thought would never be called. The bonds are made up of variables of essentially individual debt - such that even with a big pool one can’t with a strong degree of confidence in these economic times be able to predict what the maturity price will be. That’s a big reason why the bonds are illiquid.

Three reasons why we are not at clearing price levels: First, no one can value these bonds to maturity value with any kind of confidence. Second, assuming these bonds can be valued to maturity, the big holders of these bonds know they are truely (instead of theoretically) bankrupt if they change the mark to market to the clearing levels or real maturity value. Third, massive systemic risk - if the global economy really “craters” in McCain parlance, then whatever value you have for the bonds now is going to be further haircut.

What the government needs to do is first create a liquid market at clearing levels as a buyer of the last resort. In other words, if the mark to market/theoretical value/value to maturity of debt is 50 cents on the dollar, then the government should haricut that offer 40 cents (and get concessions like warrants, compensation caps, etc from the companies that tap into the pool). This starts the market back on the way to liquidity.

Foolsguinea - I would definately agree with that view. The government needs to make it really painful for the firms that have this radio active waste taken off of their books.

[slaphead]

@Polerius

So, there was a bubble in the bond market (or CDO market)?

If there was a bubble, then shouldn’t people *expect *to lose money when the bubble bursts? Why weren’t the head honchos and financial gurus running these companies (like Lehman) ready for the bursting of the bubble?

I think if people at the top are ready for the bubble to pop, it’s not really a bubble. You only get a proper Tulip/South Sea scenario when all the major market participants are absolutely convinced they can make a riskless killing by buying stuff at 200% of underlying value and offloading it to some other chump at 400%. The mechanics of the meltdown are different this time round, but the psychology is the same.
If people were ready to lose money, things wouldn’t have got this far. They all thought their CDSs and other hedges would backstop any drop in prices. Even the few people who stepped up to the plate expecting a wicked fastball were taken by surprise when the diesel locomotive came at them from the mound.

[GSV_Consolation_of_Dreams]

Thanks to Scylla for starting this thread.

My question concerns banking. Like everyone, I have a few accounts here and there. With banks being sold around the world now for seeming fractions of their former worth, or collapsing, I’m worried that my money could be lost.
Not likely, I know. I haven’t heard of anyone actually losing their life savings yet.
I have heard that the “CDS price” of a bank, gives an indication of their exposure to risk of “bad debt”. Is there somewhere I can go and compare the CDS prices of various banks?

[accidentalyuppie]

Scylla, I wanted you to know that you have really helped me in the past two weeks, thanks for taking the time to write this post and some of your others

[ShibbOleth]

Scylla, thanks for taking the time to try and explain this. It’s greatly appreciated.

@Scylla

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?

You kind of lost me here. So the bad debt precludes all business from being done, or simply constricts the “blood flow” to such a degree that a panic results and suddenly everyone is afraid to touch/rate any bond?

Follow up questions for Scylla and China Guy:

• What, if anything, could have prevented us from getting into this jam?
• If someone waved their magic wand and put you in charge tomorrow, what would you do to fix this and make sure it didn’t happen again?

[John_Mace]

Nothing to add here, just wanted to say thanks for the thread-- it’s a good read.

[Gary_Kumquat]

@Scylla

In the past, like the S&L bailout, the government made a profit doing this.

Do you have a cite for that?

[JXJohns]

@Polerius

On a practical note, if we assume that the bailout will pass, how can someone (an individual investor) profit from this bailout? Will some companies’ stock prices skyrocket because the government will buy their bad debt?

Which surviving companies have the most bad debt and therefore stand to gain the most from the bailout?

I haven’t seen an answer to this yet so I will raise it again. What can the individual who has some liquidity to invest, do in order to profit from this?

[gonzomax]

@Scylla

Yup, again, Bill Gross wrote an article about it in last week’s Barrons where he explains the process. It’s complex, but straightforward. He offered to do it all for the Government, free of charge.

Bill is the most successful fixed income manager in the world, and is generally considered pretty good at this sort of thing.

I’d say you want a couple of different people doing the calculations, and checking them against one another.

This part should not be a problem.

On Charley Rose last night the financial experts said that the bottom for housing will be at about 50 percent of the rate 2 years ago. Homes are dropping 20 percent a year. These financial papers include a lot of transitional foreclosures. They had not bottomed . That would have us overpaying for them. The housing cost will eventually stabilize ,some time in the future and at a lower rate. So we would never get it all back and would take a loss.

[treis]

@Scylla

Having so modelled them, one creates a series of PSA assumptions for the prepayments, default rates and credit-worthiness of the guarrantors (if any.) One can then do a present value calculation for the sum of the anticipated cash flows. If this is done correctly and the issues are purchased at or below this present value than the government cannot lose money by simply holding the asset through maturity. There is no guarranty that the market value will exceed that value before final maturity. If it does, the government can sell it for a profit. If it doesn’t they hold it.

No offense, but this is a load of shit. The people that originally bought/made these loans made the same calculations, and they’ve lost their shirts. The bonds, as you call them, are so complex that it’s impossible to accurately gage the risk of default. This is is the root of the problem. It’s very likely that the Fed will be buying securities at a price that gives them a very high risk level, and relatively low potential returns. No private company is going to be happy with that trade off, and that’s why no one is buying these bonds.

[Maeglin]

Not much time to add too much detail, since unlike in fixed income trading, we are very busy here in consumer credit.

I don’t work at a trading desk, but my industry is somewhat parallel to this. Credit card issuers package receivables into bond-like instruments and sell them, and they have to fund their receivables by borrowing money daily on the open market. So this credit crisis hits us on both ends: people spend less and don’t pay their bills, our funding costs go up, and the liquidity crunch makes it much harder for us to sell our packaged receivables to other financial institutions.

Nevertheless, please correct me if I am wrong. The following is kind of simplistic, but I hope it is illustrative.

One issue that I know Scylla understands but only touches on obliquely is that many firms that owned debt-backed securities were heavily leveraged. They borrowed a great deal of money to finance the purchase of these assets. You have a couple of nuts to crack: how much can you afford to pay to borrow money to purchase an asset given its anticipated future cash flows and how can you create a corporate structure to meet the regulatory capital requirements? In a world where the cost of capital is relatively low and the returns to these assets are relatively high, a bank can make a lot of money if it can structure itself creatively and borrow a fortune.

And you’ll never guess who all of the banks lent to and borrowed from. Yeah. Each other. So at the same time as their assets become devalued due to the mark-to-market accounting rules, the banks have to put up more and more capital to support the mutual web of loans they have to each other. They can’t borrow more capital from each other because they are all pretty much in the same boat.

The system works really well when one or two investment banks had a crappy year and can go around with a tin cup to the others (except Bear). But the breakdown occurs when pretty much everyone is in the same situation. The web of loans to each other all get called in around the same time due to the contraction of the value of everyone’s assets, which no one can unload right now as Scylla describes. So at the same time, every bank needs to come up with great gobs of cash but there is no one out there with the capability to lend it anymore.

Except the government.

Either it can lend the money or it can take the dead weight off the banks’ balance sheets so that they can become liquid again. This has been admirably described already.

The point is, this is such a massive clusterfuck because it is happening to everyone at exactly the same time. The degree of the seriousness is most of all a function of the rules & requirements that govern our financial system. It is not really an issue of greedy bankers defrauding Main Street, and lord, I loathe that expression. Because borrowing was cheap and CDOs had great returns, there was tons of money to be made.

But when there are roofies in the Kool Aid and everyone drinks it at the same time, well, you can guess what will happen.

[Voyager]

@Scylla

This one’s my fault. Sorry. For our purposes every bond has three prices. The first is it’s liquidation or “fire sale” price (if you had to sell it today, what could you get for it.) The second is its hold to maturity price (If you hold onto it and collect interest and get money back at maturity, and discount the sum of those future cash flows to their present value than what number is that) The third is the market price (If you examine current market conditions, and take your time, sell it for a reasonable price what should that number be.)

If these bonds are held to maturity, who is supposed to pay them off and how? In normal bonds the issuer pays, either through assets or by rolling them over. Are the mortgages that back them all supposed to be paid off by then or does the issuer just pay? Would there be a danger that the mature prices was not realistic if there was a significant default rate for the underlying mortgages?
Or would this be handled by insurance from AIG?