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Generational Dynamics Web Log for 18-Feb-08
Pundits are now referring to a spreading "subprime virus"

Web Log - February, 2008

Pundits are now referring to a spreading "subprime virus"

Each week, the virus spreads to more banks and investors around the world.

I used an analogy several times last year. Here's how I described it in November:

"Think of the world economy as a huge, enormous bloated mansion made of wood, with all kinds of additions tacked on all over the place. Think of the CDOs as millions of termites that are eating away at the insides, so that another piece of the mansion falls off into the ravine almost every day.

The Fed and other central banks have been running around the mansion with hammers and glue and nails, patching things up as fast as they can, trying to keep ahead of termites. They've been pretty successful with their hammers and glue and nails in postponing the inevitable, even bloating the mansion up a little more, but they can't keep up with the termites.

[What's happening] is that the hammers and glue and nails aren't working, and it won't be long now before the entire mansion collapses into the ravine."

Cartoon depiction of the "subprime virus" destroying a bank by removing its supporting pillars. <font face=Arial size=-2>(Source: livemint.com)</font>

Cartoon depiction of the "subprime virus" destroying a bank by removing its supporting pillars. (Source: livemint.com)

The mainstream media, along with various analysts and financiers, are now using a similar kind of analogy: They're comparing the subprime crisis to a bird flu pandemic that's spreading around the world.

The comparisons can be quite imaginative. A recent WSJ opinion piece by Charlie McCreevy, EU commissioner for the internal market and services, begins as follows:

Curing the Subprime Virus

In the new Will Smith movie "I Am Legend," the central character finds himself seemingly alone in New York, struggling to find a cure to a virus that has infected the world. Judging by some of the reactions to the current financial market turmoil, there are those in the U.S. who think that they are in a similar situation, dealing with a crisis that has decimated Wall Street. The difference, though, is that they are not fighting this crisis alone.

As our intrinsically interconnected economies show, no one can remain immune to shocks in any part of the globe. The virus launched by the underpricing of risk has spread with extraordinary speed across the Atlantic. Very few people saw that a majority of the mortgage-backed securities engineered in the U.S. were in the hands of EU financial institutions. The critical point, though, is that rather than work alone in our separate laboratories, the subprime mess shows why we have to work together and find global solutions."

McCreevy's opinion is well supported by other European officials, who claim that Europe has become fully infected by the virus:

Damage to European economies may prove deeper than officials acknowledge

"The extent of Europe's infection from the U.S. subprime mortgage virus is becoming clearer....

But there are growing signs that the credit crisis and U.S. slowdown have hit Europe deeper than policy makers seem willing to acknowledge. Hopes that the euro zone can remain partly insulated from a U.S. housing bust and recession are receding. ...

Any suggestion that Europe was weathering a U.S.-focused downturn seemed wide of the mark.

While attention largely centered on a plunge in confidence among U.S. service firms in January, German, Spanish and Italian service sectors also recorded their first contraction in years.

Financial markets are waking up also to the idea that it may be dangerous to use the relatively robust ECB economic forecasts as anything other than an interest rate pointer.

"The market is becoming aware that the crisis in the United States will indeed have an adverse impact on growth in Europe," said Heino Ruland, strategist at FrankfurtFinanz in Germany.

European stock markets have had one of their worst January performances on record and entered bear market territory in the course of that month. The FTSEurofirst lost another 4 percent last week.

"We now see a deterioration in the euro area," said Luca Paolini, strategist at Credit Suisse. "If anything, the risks are higher in the euro area than in the U.S. - where expectations are already very low. And you still don't have a policy response from the ECB."

The ECB president, Jean-Claude Trichet, acknowledged the darkening economic horizon after the bank left interest rates unchanged again at 4 percent on Thursday, even as the Bank of England cut its benchmark rate again by a quarter of a percentage point.

"If I take all the data, they confirm risks lie to the downside," Trichet said at a news conference."

The "subprime virus" analogy has also spread to an opinion column in the Hong Kong's South China Morning Post, which has this:

"A virus that kills its host quickly is generally a failure. Once the host dies, the virus has trouble spreading.

A host that is moving around - interacting with and breathing on other hosts - is much more useful than one that is dead. A host that is not even aware that it is carrying a virus is even better.

The subprime loan market looked for a while to be a very effective virus. It spread rapidly from bank to bank, making each host a little sick, but not ill enough to prevent it from passing on the subprime assets to a bunch of other banks.

If fact, before any banks even realised they were carrying anything infectious, they had virtually all been contaminated.

And now it looks as if the subprime virus is about to demonstrate that it is actually too effective, since it has started killing off its hosts. One or two of them have succumbed, and more will soon follow.

Quarantines are now in place, and no one in their right mind will be engaging in any activity where they are likely to be exposed to the contagion. But it's a little too late.

And where do viruses come from? The ones that give us the flu and other illnesses have been around forever and simply evolve into one form or another. But this doesn't seem to be a great explanation for the subprime virus. The subprime virus was created by people. Imagine the evil computer hacker who creates a virus to be distributed over the internet or through e-mail.

Picture a bunch of guys in jeans and dirty T-shirts, sitting around late at night staring at their computer screens, coming up with ideas to effectively infiltrate the world's biggest financial institutions, with no concern for the impact they may have on everyone else. Now replace jeans and T-shirts with pinstripe suits and you have the answer: investment bankers.

No computer hacker has ever made anywhere near as much money as the investment bankers who invented the subprime virus, nor have they ever done anything like the harm that these guys did. Computer hackers are punished, and so will the investment bankers.

Some of them will receive only small bonuses this year, perhaps in the mere hundreds of thousands. Some of them may not be able to buy a new car. And some may even have to forgo the skiing holidays they had planned, at least until the end of the peak season."

This business about bonuses is a good point, because one can see story after story about how the people who perpetrated the fraud that caused the credit bubble are being very careful to make sure the funding stays in place for their bonuses.

I recently posted a murder-suicide story, where a subprime mortgage executive of a bankrupt company bashed his wife's head in, and them jumped off a bridge to his death.

I quoted the following astonishing paragraph from one of the news accounts:

"On Tuesday, the company filed a petition in bankruptcy court to pay $1 million in bonuses to Buczynski, two other senior officers, and Fieldstone's remaining workers so that the company could wind down its affairs and shutter the business."

These guys are up to their necks in wholesale corruption, but the one part of the whole mess that the perpetrators have inoculated against the subprime virus are their own bonuses, rewards and other perks.

Here's a little anecdote that someone posted online in December of last year:

"My son works at a hedge fund. They lost $100 million in August, $500 million in October. This month the loss will be about $1.3 billion. All these losses are being kept off the books. He is green under the ears so can't give me much other information, but he does know this -- there WILL be bonuses this year, and no layoffs are on the horizon. The world no longer makes sense."

And a recent article in the Telegraph starts with a headline that I'm sure is supposed to as ironic as are allowed in news headlines:

City bonuses weather the credit crisis

"City bonuses in London were not affected as strongly by the credit crisis as first predicted, according to London-based employment monitor Morgan McKinley.

From a survey of 220 financial services professionals in the capital, 80pc said they received a similar or higher bonus last month, than in January last year, while 70pc said their bonus either matched or exceeded their expectations. ...

He said: "Following on from a record bonus round in 2006/2007, speculation surrounding this year's bonuses was enormous, particularly given the significant volumes of write-downs by banks in the last quarter of the year. ...

The average salary in the sector rose 5pc in January, to Ł53,246 (over $100,000)."

Whew! I'm glad the financial execs aren't suffering at least!

The same can't be said of many cities and towns, as municipal bonds are being attacked by a particularly virulent strain of the subprime virus, according to the Financial Times:

"The subprime virus has mutated. It has now infected the municipal bond market. The same issues that roiled the asset-backed commercial paper market in the autumn are cropping up again. Liquidity risk turns out to be a bigger problem than credit-focused investors had reckoned with. And liquidity risk can be fatal. Look at what happened to structured investment vehicles, a market that shrivelled away.

Municipal issuers tap the capital markets in several ways and all of them now look under varying degrees of stress. Auction rate securities, a $330bn market according to JPMorgan Chase, have coupons that reset periodically at auctions. Now a few are failing, in part because of jitters around the insurers that support the credit ratings of municipal debt. There has to be a good chance that this type of funding vehicle, like SIVs, will lose its raison d’ętre.

What are the implications? First, issuers will have to dig deeper in their pockets. When auctions fail, some of them face resets on their coupons, inflicting varying degrees of pain on budgets. Then they have the continuing headache of restructuring their debt. Converting it into some form of structured debt could be tough since that is likely to require funding commitments from banks. Meanwhile, the rating agencies are likely to start worrying about the increased debt servicing load the issuers could face."

The above is a story about "auction-rate securities," an arcane investment vehicle that few people ever heard of. They have that name because the interest rates investors bid on the opportunity to invest in them, and the investor who demands the lowest interest rate wins the auction bid.

These are the same auction-rate securities that are used by student loan companies. I discussed these a few days ago in "'Credit crunch' domino effect is now affecting student loans."

The problem is: Nobody wants to bid on them any more, thanks to contagion from the "subprime virus." Now, municipal borrowers will have to pay much higher interest rates to fund their schools and hospitals, and those rates will be passed on to local taxpayers. Local taxpayers were, of course, the first to get the subprime virus, when they purchased or refinanced their homes using subprime mortgages; now they get to suffer a new round of the virus.

In the above article, I described through the mechanism of Step 1 through Step 4 how the "subprime virus" spread from a formerly obscure bond insurer (Ambac) to a very visible student loan organization in Michigan.

According to an article in the NY Times, the problem is getting more serious by the day (or perhaps I should say, "the flu victims are getting sicker every day"):

New Trouble in Auction-Rate Securities

"SOME well-heeled investors got a big jolt from Goldman Sachs this week: Goldman, the most celebrated bank on Wall Street, refused to let them withdraw money from investments that they had considered as safe as cash.

Types of auction-rate securities <font face=Arial size=-2>(Source: NY Times)</font>

Types of auction-rate securities (Source: NY Times)

The investments at issue are so-called auction-rate securities, instruments at the center of the latest squeeze in the credit markets.

Goldman, Lehman Brothers, Merrill Lynch and other banks have been telling investors the market for these securities is frozen — and so is their cash.

The banks typically pitch these securities to corporations and wealthy individuals as safe alternatives to cash, investors said. The bonds are, in fact, long-term securities. But the banks hold weekly or monthly auctions to set the interest rates and give holders the option of selling the securities.

Only this week almost 1,000 of these auctions failed. The banks also refused to support the auctions, leaving many investors wondering when they will get their money back.

“Investors have lost confidence in the liquidity of these instruments,” said G. David MacEwen, the chief investment officer for fixed income at American Century Investments, a mutual fund company. “These types of instruments depend on new investors showing up to own the securities.”

The $330 billion auction-rate market is dominated by municipalities and other tax-exempt institutions like the Port Authority of New York and New Jersey, which had issued some auction securities and had its interest rate soar to 20 percent on Wednesday. Closed-end mutual funds, student loan companies and corporations also issue such securities."

Notice that the situation described in the above article is very serious, because it means that the subprime virus is spreading from these banks to their clients -- corporations and wealthy individuals.

These examples show how the credit crisis is spreading, not just from bank to bank, but from banks to all investors. No corporation and no investor is safe these days, except those whose assets are in cash or US Treasuries.

India has been hard hit by the credit crisis, and downbeat article in an Indian investors' publication highlights the anxiety:

"No light at end of tunnel as yet

"The developed markets have seen a full-blown credit crunch since August. Even exceptional intervention by the US Federal Reserve has done little to ease the situation

It’s now a full year since the first cracks appeared in the US subprime mortgage market. ...

A lot has happened since then. The first reactions to what has now come to be known as the subprime crisis were pretty hopeful: it was seen as a problem in one corner of a huge global financial system.

But later revelations showed how the subprime virus has spread from one bank to another because of fancy derivatives. The developed markets have seen a full-blown credit crunch since August, and even exceptional intervention and interest rate cutting by the US Federal Reserve has done little to ease the situation. Some of the world’s best-known banks have seen profits tumble; the Chinese government has rescued many of them.

One year later, the US stands on the brink of recession and most other major economies face the prospect of lower growth this year. The problem has proved to be far more serious than what most believed a year ago.

The passage of a year has done little to improve matters. There is still little clarity about how deep the rot in the Western banking system is. The US Federal Reserve had initially estimated the potential subprime losses at $100 billion. That has proved to be way off the mark. The write-downs by banks till now have already topped the $150 billion mark. This week, the G-7 group of rich nations said credit-related losses could touch $400 billion.

If losses do indeed cross $400 billion, a lot of banking capital will be at risk. And this will affect the ability of banks to lend, leading to an even worse credit crunch. The worst prognosis is that the US could eventually slip into a Japanese-style deflationary spiral, with contracting asset prices and a wobbly banking system.

It is hard to say whether the darkest fears will prove to be true. But there is little doubt that the credit crisis has punctured several oversized egos in the financial system. While the calls for heavy government regulation of banks are a bit overdone, the events of the past few months have shown that banks are fragile institutions which need to be handled with care.

Else, their problems can pull down entire economies. It’s clearly too early to write off the entire Western banking system. But the past year has provided sobering lessons."

Sobering lessons indeed, but lessons that politicians, journalists, financiers, analysts, brokers and pundits have not yet fully learned.

And so, I guess perhaps I should change my "termites in a mansion" analogy that I began this article with.

"Think of the world economy as a huge, enormous, bloated hospital-city, with all kinds of research labs and workrooms and clean rooms and executive apartments. Think of the CDOs as trillions of "subprime virus cells" that have begun to infect people, so that another room in the hospital-city becomes infected each day.

The "financial virus engineers" have been working in the research labs to manipulate the virus cells to make money from them. They found ways to make make money and inoculate themselves, so they'd be safe, but their efforts freed the virus to spread faster throughout the hospital to other people, who become extremely sick, vomiting all over the place.

The Fed and other central banks have been running around the hospital with Tamiflu and disinfectant spray, trying to stop the spread of the virus. They've been pretty successful with their disinfectant spray and Tamiflu, postponing the inevitable, even allowing the "financial virus engineers" to collect their year-end bonuses, but they can't keep up with the virus.

Now influenza experts have been startled to discover that the "subprime virus" is mutating, and developing a resistance to Tamiflu, something that they had previously thought was impossible.

And so, what's happening is that the disinfectant spray isn't working on the subprime virus, and the Tamiflu isn't working either because the subprime virus has developed a resistance to it, and it won't be long now before everyone in the hospital becomes deadly sick from the subprime virus -- except for the "financial virus engineers" and their friends, who inoculated themselves, and now sit around in the executive apartments having parties with call girls."

Naaah. I like the analogy about the termites better. However, that stuff about the bird flu virus becoming resistant to Tamiflu appears to be true. (18-Feb-08) Permanent Link
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Generational Dynamics Web Log for 18-Feb-08 Pundits are now referring to a spreading "subprime virus"

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Generational Dynamics Web Log for 18-Feb-08
Pundits are now referring to a spreading "subprime virus"