Market for credit derivatives may be collapsing - 28-Jun-07 - Generational Dynamics

The SEC is opening multiple investigations into the abuse of CDO investments, following last week's Bear Stearns debacle, with the result that investors are being scared away from new CDO investments.

The investment landscape has changed dramatically in the last few days. You'll recall that I discussed how Bear and many other financial institutions have their assets in these credit derivatives known as collateralized debt obligations, or "CDOs." The collateral for these debt obligations has been the mortgage payments owed by individual homeowners or investors, but as the number of foreclosures has been increasing, the intrinsic value of the CDOs has fallen.

Thus, as I discussed, these CDOs have a presumed market value that the banks and hedge fund companies are claiming, but if anyone actually tries to sell them, they may get only 50 cents on the dollar, or less. This downward trend is expected to continue, as the real estate market crisis continues to spread. This means that the value of assets claimed by many of today's hedge funds far exceed their real market value.

The Bear Stearns debacle ended in a major cover-up of the credit derivative world. A major motivation for everyone baling out the hedge fund was to avoid a fire sale of all the hedge fund assets, including the CDOs. Such a fire sale would have established a market price for CDOs and would, by the "mark to market" regulations, require ALL hedge funds in ALL financial institutions to revalue their assets according to the fire sale prices, resulting in a domino effect of hedge fund failures.

According to a report from JP Morgan, the market for new CDOs is collapsing. A month ago, $20 billion in new CDO investments were offered to investors; today it's only $3 billion, and the terms are far less attractive.

That's only part of the retribution that high-flying deal makers are beginning to feel.

A front-page article in Wednesday's Wall Street Journal is entitled "How Wall Street Stoked The Mortgage Meltdown." It specifically blames Wall Street firms, naming Lehman Brothers Holdings Inc. as the worst of the offenders, of adopting the policies that have led to the proliferation of subprime mortgage loans and resulting foreclosures.

How much are the CDOs overvalued? According to one analyst, referring to last week's canceled auction of the Bear Stearns hedge funds assets: "The banks were not prepared to bid over 85% of face value for CDOs rated 'A' or better. God knows how low the price would have dropped if they had kept on going. We hear buyers were lobbing bids at just 30%." He's referring to the higher quality 'A' grade CDOs -- not the low-grade 'BBB-' CDOs, where investors may be even more reticent.

He adds, "We don't know what the value of this debt is because the investment banks shut down the market in [the Bear Stearns] cover-up so that nobody would know. There is $750 billion of dubious paper out there in the form of CDOs held by banks that have a total capitalisation of $850 billion."

If you enjoy financial nerd humor, you might want to check out the new commentary by Bill Gross, head of the PIMCO bond fund, the world's largest.

He says sarcastically that "this Paris Hilton charade of a crisis, is really so much more than just a 3 or 27 day lockup in the LA County jail":

"Those that point to a crisis averted and a return to normalcy are really looking for contagion in all the wrong places. Because the problem lies not in a Bear Stearns hedge fund that can be papered over with 100 cents on the dollar marks. The flaw resides in the Summerlin suburbs of Las Vegas, Nevada, in the extended city limits of Chicago headed west towards Rockford, and yes, the naked (and empty) rows of multistoried condos in Miami, Florida. The flaw, dear readers, lies in the homes that were financed with cheap and in some cases gratuitous money in 2004, 2005, and 2006. Because while the Bear hedge funds are now primarily history, those millions and millions of homes are not. They’re not going anywhere…except for their mortgages that is. Mortgage payments are going up, up, and up…and so are delinquencies and defaults. A recent research piece by Bank of America estimates that approximately $500 billion of adjustable rate mortgages are scheduled to reset skyward in 2007 by an average of over 200 basis points [that is, 2%]. 2008 holds even more surprises with nearly $700 billion ARMS subject to reset, nearly ľ of which are subprimes. ... If delinquencies lead to defaults and then to lower home prices, then we have problems and the potential for an extended – not a 27-day Paris Hilton sentence."

Day by day we're seeing in practice what was predicted theoretically by last year's article on "System Dynamics and Macroeconomics," and followed with an essay that I wrote on "A conundrum: How increases in 'risk aversion' lead to higher stock prices," based on work by Harvard economist named Robert J. Barro. Briefly, the people in the generations that survive the previous crash (in this case, the 1929 crash) become extremely risk-averse, and refuse credit. As those generations disappear (retire or die), the younger generations become risk-seeking, and increasingly use debt and credit abusively. The abusive use of credit actually increases the total amount of money in circulation, so that money is poured into BOTH stocks and bonds, so that they both participate in the bubble.

The abuse of credit has been trending upwards for decades now, mainly pursued by members of the Boomer generation and Generation-X, who have no personal memory of the 1930s Great Depression, and saw no need to avoid high levels of risky investments.

But now things are changing. These Boomer and Xer investors are beginning to panic because they see that risky investments in subprime mortgage loans are making people homeless, and they're seeing that this is spreading to their own high-flying investments in hedge funds.

For the first time, many of them are seeing financial disaster. It hasn't happened to them yet, but they can see it coming.

Within just the past few days, this has caused a major turnaround. Fearless investors and financial institutions are turning risk-averse in massive numbers.

Just as the abusive use of credit "created" money, pouring huge amounts of liquidity into the market place, the return to risk aversion is now pulling massive amounts of liquidity out of the marketplace.

Before closing, let's not forget China, whose entire economy has been in a long-term bubble, and whose Communist leaders are scared to death of a a stock market panic.

Recall that a sharp fall in the Shanghai stock market index triggered worldwide repercussions in February. This is possibly the most volatile stock market in the world. Here are the closing values for the Shanghai Composite index since the beginning of the month:

The index today is very close to where it was at the start of the month, but with huge variations in between.

From the point of view of Generational Dynamics, the world is overdue for a new generational stock market panic, leading to a new 1930s style Great Depression. It's possible that this panic will start on Wall Street, possibly triggered by the CDO problem. But I still think that it's also highly likely that the panic will begin in China, and spread from there to the rest of the world. (28-Jun-07) Permanent Link
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Generational Dynamics Web Log for 28-Jun-07
Market for credit derivatives may be collapsing

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Generational Dynamics Web Log for 28-Jun-07 Market for credit derivatives may be collapsing

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Generational Dynamics Web Log for 28-Jun-07
Market for credit derivatives may be collapsing