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Generational Dynamics Web Log for 11-Nov-07
Markets fall as torrents of CDO exposures bolster fears of new credit crunch

Web Log - November, 2007

Markets fall as torrents of CDO exposures bolster fears of new credit crunch

British investors panicked on Friday on a rumor that Barclays Bank (Barclays Plc) would have to write down $10 billion in overpriced securities. Panic selling drove Barclays stock shares down 9% on the London Stock Exchange before trading was suspended. Trading resumed after a company spokesman said, "There is absolutely no substance to these rumours," and the stock closed down 2½% for the day.

The Barclays rumors spread after Wachovia Bank announced, on Friday morning, $1.7 billion in writedowns.

In fact, there have been some $64 billion in writedowns from a number of large financial institutions, including Citigroup, Merrill Lynch, Morgan Stanley, Goldman Sachs, JPMorgan Chase and Bear Stearns.

A new report from Morgan Stanley predicts that the writedown will total as much as $500 billion.

Do you believe that's all it will be, Dear Reader? At the beginning of the year it was going to be nothing, then it would be a few hundred million, then a few billion, and now $500 billion. Do you see a trend here?

What's being written down is credit derivatives (Credit Default Swaps (CDSs) and Collateralized Debt Obligations (CDOs)) that were devised by brilliant PhD financial engineers who discovered that they could turn high-risk subprime mortgage loans into AAA rated securities.

Now that real estate prices have been falling, and the number of mortgage foreclosures has been surging, it turns out these credit derivatives are worth a lot less -- 50%, 10% -- of what the financial engineers said they'd be worth. Some have turned out to be worthless.

There are some $750 trillion in various credit derivatives in the financial portfolios of institutions around the world, based on figures from the Bank of International Settlements. Even if only 10% of them are written down 50% (an optimistic assumption), that's still $37.5 trillion writedowns, where the global GDP is just $45 trillion. (Corrections made on 13-Nov)

Where are all these $750 trillion in credit derivatives? Nobody wants to admit it, but a good guess is that they're in the portfolios of tens of millions of businesses and individuals that have invested in "high-yielding bonds," so that "their money can work for them by earning more money."

Hiding the truth

That's why all these institutions are desperately trying to avoid having to sell off their assets. There's widespread fear that if there's a major sale of CDOs, then a "market price" will be established, and that will force other institutions to "mark to market" -- write down their assets to the market price, which in many cases is "nearly worthless."

However, events are conspiring to force more and more huge chunks of near worthless CDOs to be written down. In just the last few days:

Citibank's "M-LEC" superfund has apparently collapsed. You're recall that the purpose of the That's the reason for these SIVs (structured investment vehicles) and the "M-LEC," or Master-Liquidity Enhancement Conduit, structures was to allow Citibank and other banks to sell these worthless securities to each other at artificially high prices. This would create a phony, fraudulent "market price" which could then be used for "mark to market" purposes. Apparently Citibank has been unable to get other banks to invest the $75 billion required to start the M-LEC up.
In the last few weeks, the ratings agencies -- Moody's, Fitch and S&P -- have been re-evaluating their ratings on hundreds of CDO contracts, including securities that they'd previously given AAA ratings to.
This can create a domino effect. Many institutions are not permitted -- either by law or by charter -- to invest in anything other than AAA-rated securities. If these securities are downrated, the many institutions holding them will have to sell them, once again establishing a "market price" that will apply to other similar CDOs.

Prices of ABX-HE series 07-2 for various risk levels on 9-Nov-2007. The lowest risk levels are at the top. (Source: Markit.com)

The ABX indexes have continued to fall, almost continuously. What's especially significant is that the AAA and AA rated indexes have been collapsing. The ABX indexes are proxies for mortgage-backed credit derivatives, but have no legal or regulatory role, so they could be simply ignored by everyone.
What's happened is that the fall in the ABX indexes has been so dramatic that it's been widely reported in the media, causing a lot more investors to openly question why CDOs aren't being re-evaluated by the ratings agencies. Thus, the fall in the ABX indexes has been part of the environment that has pressured the ratings agencies to downgrade worthless securities, and has pressured financial institutions to revalue their assets.

And now for the big one.
On Thursday evening, ratings agency Standard & Poor's slashed its ratings of the securities in Carina CDO Ltd, a CDO managed by State Street Bank. Carina was originally a $1.5-billion CDO issued in September 2006.
S&P's re-evaluation lowered the rating of one AAA class to BB, and the rating of another AAA class went down 18 notches to CCC-minus.
Now, you may recall that when the Bear Stearns debacle broke in June, Bear bailed out its two defaulting hedge funds, pouring $2.3 billion dollars of its own money into the hedge funds, when it could simply have let them default, and sold off the assets. But Bear was apparently extorted into bailing them out because selling off the assets would have gotten the ball rolling on re-valuing worthless CDOs. In the end, Bear Stearns announced that the hedge funds were almost worthless, a month later.
Well, there's none of that silliness with State Street Bank and the Carino CDO. State Street quickly announced the following: "State Street acts as collateral manager for approximately $6 billion in CDO assets. State Street is neither the trustee to nor the underwriter of any of these CDO assets, and a decision to accelerate a CDO and liquidate the collateral portfolio resides directly with the CDO's senior investors."
In other words, State Street won't do what Bear did. If the investors want to sell off and liquidate the assets, they're free to do so.
So on Friday, there was the Wachovia news and there was the Barclays rumor, described at the beginning of the article, and there was widening speculation that the Carino asset selloff would trigger a "fire sale" of CDO assets owned by other banks. Such a fire sale would end up causing the dreaded widespread CDO re-evaluation that everyone's been dreading.
It's not known what immediate impact the Carina selloff will have. The scenario that most people are worried about is that it will trigger the domino effect previous mentioned, one selloff leading to another, causing panic to spread, as early as next week. On the other hand, some of the "best" financial minds in the world are spending the weekend looking for ways to prevent that kind of meltdown, or rather to stall it for a little longer. We'll see.

A month ago I wrote about a new accounting rule FASB Statement 157, which requires companies to clearly designate which of its assets are "marked to market," and which are "marked to model." The latter categorization is called "Level 3," and it refers to assets which can only be valuated by means of a computer algorithm dreamed up one night by a financial engineer looking to increase his own commissions.
FASB Statement 157 becomes effective next week, on November 15. In the following months, companies are going to be required by this accounting rule to clearly identify how much they have in "Level 3" marked to model assets, and this will further pressure these companies to provide realistic prices for them.

What's interesting about the above list is how many different things are piling up at once. It seems to me that the domino effect has already begun, albeit slowly, and is speeding up. The days where "all bad news is good news" seem to be over.

How did we get here?

Before going on to further consequences, it's worthwhile to stop, take a breath, and recall how we got here.

This is a generational thing. There is nothing new about this. People who say that this is "new" or "different" are fooling themselves.

If you go back through history, there are many small or regional recessions. But since the 1600s there have been only five major international financial crises: the 1637 Tulipomania bubble, the South Sea bubble of the 1710s-20s, the bankruptcy of the French monarchy in the 1789, the Panic of 1857, and the 1929 Wall Street crash.

When comparing these international financial crises, the details are always different, but they're all remarkably similar in the following ways, as described in "The bubble that broke the world": A debauched and perverted use of credit, occurring at exactly the time that the survivors of the previous financial crisis have all died or retired; a huge asset bubble; the securitization of credit; and an upsurge in corruption. All of those elements are enormously present today.

Not only that, but in each previous case there was an invented certificate or security that could be bought and sold and which, in the end, turned out to be worthless: tulip futures, shares in South Sea company, "assignats" based on lands confiscated from French clergy, railway shares in 1857, and stock shares in 1929. Today it's CDOs.

In fact, we've been discussing debauched abuse of mortgage credit, but the same can be said for many other forms of credit -- prime mortgages, auto loans, credit cards, consumer loans and commercial real estate loans, for example. Problems with these forms of credit haven't yet made the front pages, but they will before long. It isn't mortgages that are the problem; the problem is with Boomers and Xers.

From the point of view of Generational Dynamics, we're waiting until a "generational panic" triggers the inevitable collapse. The asset bubble MUST collapse; the credit securities (CDOs) WILL become worthless; the corruption MUST be punished.

Almost no one alive today has any personal memories of the Great Depression. People in the Boomer generation are narcissistic and arrogant, and have no idea how to run the world, since their parents took care of everything. The people in Generation-X are worse.

Arrogant Boomers are content to let other people take care of things so they can sit back and criticize, as they criticized their parents during the 1960s, and criticize each other today. The youthful nihilistic Xers show contempt for all caution and have no fear of anything, even their own destruction, and devised the huge credit bubble that close to bursting today.

An anecdote in the comment section of a blog entry in a Financial Times blog from a couple of days ago gives a good example.

This anecdote tells of a conversation with someone from the Fitch ratings agency who was explaining why their high ratings for CDO securities were so good. The ratings are assigned by means of a computer software algorithm that takes into account the creditworthiness of the homeowner (as measured by his FICO score), and assumes that home prices will continue to increase, as they have "for the past 50 years":

"We were on the March 22 call with Fitch regarding the sub-prime securitization market’s difficulties. In their talk, they were highly confident regarding their models and their ratings. My associate asked several questions.

FPA: “What are the key drivers of your rating model?”

Fitch: They responded, FICO scores and home price appreciation (HPA) of low single digit (LSD) or mid single digit (MSD), as HPA has been for the past 50 years.

FPA: “What if HPA was flat for an extended period of time?”

Fitch: They responded that their model would start to break down.

FPA: “What if HPA were to decline 1% to 2% for an extended period of time?”

Fitch: They responded that their models would break down completely.

FPA: “With 2% depreciation, how far up the rating’s scale would it harm?”

Fitch: They responded that it might go as high as the AA or AAA tranches."

This phone conversation took place on March 22. At that time, the Fitch representative was explaining how wonderful their models were, even though they assumed that real estate prices would keep on increasing.

Who the heck are these people? Are they totally nuts? You mean that they didn't know, on March 22 of this year, that the real estate bubble was bursting? How could they not know?

These are supposed to be brilliant, highly skilled financiers. How did I know in 2004 that there was a housing bubble, and I said so. (That was in the article where Fed Chairman Alan Greenspan said that there's no housing bubble, but even if there were, it would be a GOOD thing, because homeowners have been refinancing the mortgages, and that gives the homeowners a lot more money to spend. Ha, ha.)

How did I know, in 2005, that the housing bubble was about to burst, which is the one and only reason why I sold my condo and moved into an apartment?

How did I know these things, if these financial geniuses at Fitch didn't even know on March 22 of this year?

I just can't get over this. I listen to CNBC or I read articles in WSJ by Greg Ip, or I read statements by Ben Bernanke, and I constantly have to ask myself, how is it possible that I can see what's going on and these people can't? Am I hallucinating? Am I insane? Am I nuts? Is it really possible that all these people are so dumb that they can't see what's right in front of their faces, and I'm the only person who isn't? Is that even conceivable?

And then there's my article, "How to compute the 'real value' of the stock market," which shows that the stock market is overpriced by a factor of 250% today, same as in 1929.

One of the graphs from that article is the following, which is an updated version of a graph I've been showing people and posting for years:

S&P 500 Price/Earnings Ratio (P/E1) 1871-2007

S&P 500 Price/Earnings Ratio (P/E1) 1871-2007

Now, no one in his right mind can look at this graph and not see immediately that the stock market is going to crash. The P/E ratio will drop below 10, as it did in 1982, for example, and the stock market will fall to Dow 4000 or lower. This has been perfectly obvious to me since I first constructed a version of this graph in 2002, and started telling people we were headed for a new 1930s style Great Depression.

And there isn't even any doubt. This MUST happen. Why, why, why am I the only person who sees this? Why do I have this "superpower," which has turned into an obsession, and which has brought me nothing but grief, contempt and sadness?

I started studying generational theory shortly after 9/11, when I picked up a copy of The Fourth Turning, by William Strauss and Neil Howe. Out of that came Generational Dynamics and this web site.

The Fourth Turning, written in the early 1990s, predicted that people would become incredibly stupid in this decade (although Strauss and Howe didn't use the word "stupid," that's what it amounts to). But I never could have believed that it would be this bad. How could so many people be so stupid?

I read the various economics blog on the internet.

I read Nouriel Roubini's blog, Michael ("Mish") Shedlock's blog, the Calculated Risk blog (with Tanta), the Sudden Debt blog, the MinyanVille blog, and others.

All of these people post analyses of things going on -- the latest jobs reports, the latest currency exchange rates, real estate foreclosure rates, interest rates, housing inventories, etc. They paint dark pictures of what's going on, but they never say what's coming next. Do they believe that we can get out of this mess? They never say that. Do they believe that there's going to be another 1930s style Great Depression? They NEVER say that.

The most they ever say is that we might have a repeat of the Panic of 1987, which was hardly a blip to the economy. In fact, from the point of view of Generational Dynamics, it's called the false panic of 1987, since the stock market was actually underpriced at that time. One other person said that the worst we were headed for was a repeat of the Panic of 1892. I think he was joking, but I'm not sure. "1929" is the word that may not be uttered.

I was mocking Professor Nouriel Roubini a few weeks ago, for bragging about how clever he was, a year ago, to predict that the housing bubble would cause a "hard landing" in the economy. Well, what the hell, how did I know that in 2005? All of these guys (and Tanta) are supposed to be top-notch experts. They seem to know a lot of details, but they have no idea of what's going on -- the big picture. Why is that?

I don't expect the man on the street to look at the above P/E1 graph and understand it. Lots of people don't have those skills. But hell, we're not talking about the man in the street. We're talking about financial engineers with PhDs in economics and mathematics. We're talking about a Princeton University professor of economics, for heavens sake. Why don't any of them know what's going on or, if they do, why don't they say so?

The fall of Nasdaq and tech stocks

OK, enough ranting about that subject. Let's turn to the stock market this week.

Anxiety was pretty high on CNBC most of this week, as pundits and financiers sought to reassure each other with phrases like, "I think every company is moving as quickly as possible to get their writedowns completed," or "The worst of the credit crunch is over," or "A couple more weeks of bad news, and then we'll get back to business as usual," or "It's just the financials dragging the stock market down; the tech stocks look like real winners."

Oops, well that wasn't true by the end of the week, as the Nasdaq and other tech stocks fell sharply. The tech-heavy Nasdaq index has been spiking up all year, and lately the index has been principally supported by four stocks: Apple, Google, RIMM (Research in Motion), and Amazon. But on Friday, all four fell sharply.

One CNBC pundit (I wish I had made a note of his name) was close to tears over Google, which fell over 4% on Friday. "I just can't understand it. Google has been doing well this year, and the fundamentals haven't changed, so why oh why is it falling now?" Ya think he has some Google shares he's been counting on?

A poster on one online forum gave his reasons "Why Google deserves its share price and more." He explains, "I've been reading articles about how Google is overpriced ever since their IPO, and ... [all] of them are wrong, and I'll explain why." He explains why Google has the best search engine, good PR, great free services, a great business model. Saying that "MSN and Yahoo suck," he concludes, "Google is one of those rare companies that comes along and kicks everyone's ass for a very long time, and I'm not getting off the bus anytime soon."

Now the problem with this argument is that it doesn't provide any reason that Google's share price is worth it. Let's assume that everything he says is correct; then the same argument could be used to justify a share price of $600, $6000 or $6 million. Is Google worth $6 million a share? According to the above "reasoning," it is.

Google has a price/earnings ratio of about 60. There's no way it's worth the $600+ share price, by a long shot. But we've seen this show before, haven't we? There were lots of "googles" in 2000, all of them "rare companies" that were "kicking everyone's ass," and they all fell on their faces in the Nasdaq crash.

Financial pundits have been talking about getting past the "bad news," and getting back to "business as usual." It never seems to dawn on them that bubblehead logic is not "business as usual." We will never return to the mania of just a few months ago.

The mania has been driven by Boomers and Xers. Not having lived through the Great Depression, they have no idea what's going on, or how to handle it. Now they're beginning to panic, because they're over their heads in debt, threatened with bankruptcy and losing their homes. Their stock market investments are based on raw emotion. The events of the last few months have frightened them, and all it will take is one little push to send them over the edge into full-scale panic.

Can Ben Bernanke save the world again?

On August 17, I posted an article entitled "The nightmare is finally beginning." I indicated that we were now on the road to a stock market crash in the near future. The exact timing couldn't be predicted, but the speculation was that it would happen by the end of September.

Well, it didn't happen, and so I got what I deserved for speculating. But hey, I'm a Boomer, and like other Boomers, I never seem to learn my lesson. So I'm going to speculate once again.

Fed Chairman Ben Bernanke "saved the world" last time, by lowering the discount rate on August 17, and then lowering interest rates by an unexpectedly large ½% on September 18. Investor anxiety dissolved into euphoria, and drunken investors pushed the stock market bubble up to a historic high of Dow 14164 on October 9.

The euphoria died on October 15 with the M-LEC announcement. When the Fed lowered interest rates again on October 31, not only did it not restore the euphoria, it appeared to increase the level of dread.

And so, today, we're back at the point where I originally wrote, "The nightmare is finally beginning."

Can Ben Bernanke "save the world" again?

Bernanke is no fool, as many people seem to believe he is. As I wrote in "Bernanke's historic experiment takes center stage," Bernanke has a specific strategy for handling this situation.

The only problem is the Bernanke's strategy cannot possible work, and the fiasco of the October 31 interest rate reduction is already a significant failure in his strategy.

Does he have any ammunition left? I don't believe he can do much by himself, but he might seek help from two other sources:

There have been some rumors that there's going to be a big joint announcement next week by Bernanke and US Treasury Secretary Henry Paulson. The objective will be to "save the dollar," which has been falling precipitously on international currency markets.

When I wrote the article, "The bubble that broke the world," one conclusion that I reached was that China would at some point decide it's to China's advantage to help the American economy, in order to protect China's economy. Thus, sooner or later I would expect some kind of joint announcement by Bernanke and the Chinese. Although I think that it's still way too early for such an announcement, such an announcement may come sooner or later.

The point is that Bernanke can only "save this world" this time with something significant and dramatic.

From the point of view of Generational Dynamics, nothing can work in the long run. Just take another look at the price/earnings (P/E1) graph earlier in this article. All the Fed can do is stall a little longer. (11-Nov-07) Permanent Link
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