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Generational Dynamics Web Log for 8-Mar-08
Fed expands liquidity injections as bond market becomes "utterly unhinged"

Web Log - March, 2008

Fed expands liquidity injections as bond market becomes "utterly unhinged"

With foreclosures surging and jobs disappearing, anxiety is increasing.

Intraday Dow Industrials chart and final results for Friday, March 7, 2008

Intraday Dow Industrials chart and final results for Friday, March 7, 2008

Stock markets around the world plummeted on Friday, with Wall Street falling to 52 week lows (actually, 73 weeks for the Dow Industrials), as the leaking credit and housing bubbles generated several new rounds of bad news:

The total number of (non-farm) jobs in the United States fell by 63,000 in February, after falling by 22,000 in January. Even Pollyanna economists are now saying, "Ummmm, I guess that means we're in a recession after all." Actually, this job report is really devastating, and signals a serious downturn. Ironically, the unemployment rate fell to 4.8% from 4.9% because so many people have given up looking for a job and have left the job market.

The number of foreclosures has reached the highest level in decades. And as I described in "Cities and towns need to start helping themselves," the wave of foreclosures has hardly begun, and will get much worse during the next 18 months. Today, 6% of all mortgages are delinquent, and 2% are in foreclosure.

The saga of the "autoline" bond insurers continues. This situation has been just "a few days" away from resolution for a couple of months now. I'm not even going to try to summarize what's been going on; you just need to remember that the last time I wrote about them, I compared what's going on to entering the Twilight Zone.

The credit crunch is getting steadily worse, though it doesn't make the headlines that it used to. It's almost impossible to sell debt securities, and when you can it's at substantially higher interest rates than before. According to one news story:

"The markets have become ``utterly unhinged,'' William O'Donnell, a UBS AG government bond strategist in Stamford, Connecticut, wrote in a note to clients today. A lack of liquidity has ``led to stunning air-pockets in price levels.''
Investors are realizing that banks have little room to make new investments amid rising losses and a flood of unwanted assets, said Scott Simon, head of mortgage-backed bonds at Pacific Investment Management Co. The world's top banks have reported more than $181 billion in asset writedowns and losses, been stuck with $160 billion of leveraged buyout loans, and bailed out $159 billion of structured investment vehicles.
``Everything is telling you the financial system is broken,'' Simon, whose Newport Beach, California-based unit of Allianz SE manages the world's largest bond fund, said in a telephone interview today. ``Everybody's in de-levering mode.''"

New waves of risk aversion are sweeping the credit markets, and it's spreading to all kinds of lending.
Financial analysts and pundits keep saying things like, "This is crazy. Why is everybody so afraid? This will pass in a few months, and things will be back to normal."
It amazes me to hear things like this. It's not just risk aversion: It's credibility. Every major bank, every major financial institution has been lying for months -- about the CDOs in their portfolios, about giving AAA ratings in return for fat fees, and so forth. The deception and fraud has been almost universal, to the point where the stench is almost unbearable.
Why on God's Green Earth would anyone believe anything that any financial institution says today? How stupid would you have to be to believe something that Citibank or Merrill Lynch tells you today? Nobody believes a liar, even when he's telling the truth.

In mid-December, the Fed and several international central banks announced a plan to end the "credit crunch." Central banks around the world announced a new "Term Auction Facility (TAF)" program that would allow banks to use whatever securities they have in their porfolios as collateral to bid for dollars at low interest rates.

On Friday, the TAF program substantially expanded. The intent is to permit banks to obtain enough cash so that they would be willing to lend money out again, bringing interest rates down.

The original TAF program worked pretty well for a while, reducing the impact of the credit crunch for the holiday season and year-end closing, but obviously it didn't work for much longer, since interest rates are back up again. This TAF expansion looks like a move of desperation, and it remains to be seen whether it helps the situation at all.

The fear is that banks will take advantage of the expanded TAF to obtain additional cash, but they'll hoard it, just as they've been hoarding the other cash they have available. Why? Because they have no idea how much their assets are worth, since asset-backed securities like CDOs have continued melting down. And because they have no confidence that if they lend to someone else, they'll be able to get their money back. And because they may have to repay loans of their own.

Remember that even money market funds are being frozen these days, often unbeknowst to the investors until they actually try to extract money, because the auctions used for auction rate securities are failing. So banks are holding on to every cent possible.

Margin calls and forced selling

There's a problem that's been going on for a few months now, and has been getting much worse recently, so it's worth describing.

In 1929, the crash occurred because of forced selling of stocks by investors who needed to meet margin calls. That is, brokers loaned money to investors to purchase stocks, using the purchased stocks as collateral for the loans. Once the market fell about 20% from its peak, brokers were making margin calls, meaning that investors had to come up with cash to pay off the loans, and the only way they could do that is to sell off their stocks. As each day's sales pushed the stock market lower, more stocks had to be sold to meet margin calls, leading to extremely heavy sell volume and a stock market crash.

This time, as of Friday, the market closed 17% down from its peak on October 9, but there haven't been any news stories of forced selling of stocks (although that may happen at any time).

Instead, we're seeing story after story of forced selling of bonds and securities.

Let's take a look at one particular example, the hedge fund firm Carlyle Capital Corp., which has missed several margin calls this week. Here are some excerpts from the story:

"Carlyle Fund Gets Default Notice After Margin Calls

March 6 (Bloomberg) -- Carlyle Group's publicly traded mortgage bond fund failed to pay margin calls, prompting creditors to seek immediate repayment, as the burning subprime mortgage market scorches investors in even the highest-rated debt. The stock fell 58 percent.

Carlyle Capital Corp. missed four of seven margin calls yesterday totaling more than $37 million, the Amsterdam-listed fund said today in a statement. The company expects to get at least one more notice of default related to the margin calls.

Started by David Rubenstein in 1987, Carlyle expanded its mortgage investments last year, selling $300 million of shares in Carlyle Capital. The fund used loans to buy about $22 billion of AAA rated mortgage debt issued by Fannie Mae and Freddie Mac, securities that Carlyle says have the ``implied guarantee'' of the U.S. government. Even those bonds have slumped, leading to the failure of hedge funds led by Peloton Partners LLP.

``The credit crisis is spilling over to the next asset class, agency bonds,'' said Philip Gisdakis, senior credit strategist at UniCredit SpA in Munich. ``There's never just one cockroach. If you see one highly leveraged hedge fund going bust, then there's another on the way.''"

Let's take a look at what's been going on in this case.

Carlyle sold "$300 million of shares" in its hedge fund last year. That means that investors gave Carlyle $300 million in cash to invest in other things. That would be like you putting money in the bank or investing in a money market fund or some other investment. You hope to get your money back when you need it, plus some interest or profit or dividend.

"The fund used loans to buy about $22 billion of AAA rated mortgage debt." And so, doing a little math, you get that Carlyle bought $22 billion in securities, paid $300 million in cash, and borrowed $21.7 billion in loans to complete the purchase.

Since the housing bubble had previously still been growing, they expected the $22 billion in mortgage-backed securities to increase in value -- say to $24 billion. In that case, the investors who had invested $300 million might hope to get perhaps $325 million back, or an 8.3% gain on their investment.

Instead, the housing bubble started leaking, and the $22 billion in securities started FALLING in value, rather than increasing.

The banks that had loaned Carlyle $21.7 billion to purchase the securities saw that their collateral was diminishing, and made margin calls demanding $37 million in cash.

Now, this problem didn't just start last week. It started in August with the nightmare credit crunch that has been driving events. Let's take a look at a couple more paragraphs from the story:

"The Carlyle fund sold $900 million of assets in August and received a $100 million loan facility from parent Carlyle Group. Since then, Carlyle Capital has sold almost $1 billion of non- residential mortgage-backed securities to cut debt and also received a $150 million credit line from Carlyle Group. It didn't say how much of that credit line it had used.

Carlyle said in today's statement that margin prices requested for securities weren't ``representative of the underlying recoverable value'' of the notes. ``Unfortunately, this disconnect has created instability and variability in our repo financing arrangements,'' [Carlyle fund CEO John] Stomber said."

So the Carlyle fund has been pretty desperate since August, and has been trying to get hold of cash any way it can, in order to meet margin calls.

Index prices of high-quality ABX-HE-AAA- 07-2 credit derivatives and lower-quality ABX-HE-A 07-2 credit derivatives from Sept 4, 2007, to March 7, 2008 <font face=Arial size=-2>(Source: Markit.com)</font>

Index prices of high-quality ABX-HE-AAA- 07-2 credit derivatives and lower-quality ABX-HE-A 07-2 credit derivatives from Sept 4, 2007, to March 7, 2008 (Source: Markit.com)

You're seeing the meaning of "leverage." When you use $300 million to purchase $22 billion in securities, then you stand to make astronomical amounts of money if the value of the securities goes up. But -- and this is the big but -- if the value of the securities goes down, then you lose astronomical amounts of money.

But what about the last paragraph in the quote above -- where Stomber is whining that the margin call was unfair because the assumed values of the securities weren't "representative of [their] underlying recoverable value." How do you determine today's value those securities that Carlyle purchased for $22 billion?

Actually, I'm not sure exactly what index is being used to valuate those securities, but it's probably the ABX index, which measures the values of mortgage derivatives, or something like it. We used to write about the ABX index all the time, when it was the new and fashionable thing to do. But the ABX index is really old news now. But even though it's gone off the radar screen, it's still been out there -- falling and falling and falling, as you can see from the above graph.

And when this index falls, then the valuation of the mortgage derivatives in people's portfolios also falls an equivalent amount.

Notice that this is quite different from stocks. If you have stocks in your portfolio, then it's easy to get a current valuation for them -- just look at their current share prices on the stock exchange.

But these mortgage derivatives that Carlyle invested in have no stock market. Carlyle has to find a "mark to market" value for them, and the only way to get a market value for them is to use an index like ABX which, itself, is based on estimates provided by other financial institutions. So Stomber is complaining that the ABX index (or whatever index he's using) is being unfairly computed. Well, that's the only thing he CAN say, isn't it?

The securities that Carlyle had invested in are not stocks (obviously). They are credit derivatives known as "credit default swaps (CDSs)." These are insurance policies that someone might buy if they're afraid that some company might go bankrupt and default on its debt bonds. But what's really weird and bizarre is that the CDSs themselves become securities that can be bought and sold.

(For those interested in the math behind the creation of CDOs from CDSs, see "A primer on financial engineering and structured finance.")

There are some $750 trillion in credit derivatives in portfolios around the world, of which some $50-100 trillion are CDSs.

These CDSs are now falling in value, and have been doing so ever since the the credit crunch began in August. Since many of these financial firms obtained these CDSs on margin, they've been facing margin calls. They have to come up with cash to meet the margin calls, and often they have to sell off the CDSs at fire sale prices to get the necessary cash. This pushes the ABX and other indexes down, causing more losses and more margin calls and more forced selling.

Collapsing credit default swaps (CDSs)

The above example involved mortgage-backed securities, and we all know that anything involving the housing market these days is suspect.

But the problem is not "contained" to the mortgage market. It's spread all over the place, including to commercial debt. This is what we've previously described as the "subprime virus," spreading from place to place, including corporate bonds.

In an article entitled "Credit Swaps Thwart Fed's Ease as Debt Costs Surge," the writer describes how even the strongest corporations are being hit by the subprime virus, thanks to the collapse of CDSs. General Electric Co. (GE), one of the strongest corporations in America, has to pay $17 million dollars more on its debt than a year ago.

The article gives all the details, which you can read there if you want. Here we'll just give a few highlights.

As CDOs started failing last year, banks purchased CDSs as a hedge.

These commercial CDSs are based on the CDX index, which is similar to the ABX index, but for commercial bonds.

The high volume of these purchases started driving the cost of these CDSs higher.

Since we're talking about illiquid securities, they're valued by means of an index that's applied across a broad spectrum of corporate entities. Valuations for individual CDS contracts for specific corporations (like GE) are computed using the index and other factors, feeding that data into a very complex mathematical valuation models -- known as "correlation models" -- implemented on someone's desktop computer, probably as an Excel macro.

Now here's the stunner - you're not going to believe this:

"Banks bought more contracts on indexes containing GE's swaps after CDO pricing models broke down, sending the so-called default correlation to more than 100 percent last month from 60 percent in July....
The programs, which computed the value of the highest-rated portions of CDOs, implied that all companies in the CDX index would default if just one did....
So-called correlation models used to value them have become unreliable in the fallout from the U.S. subprime mortgage crisis. Last month some showed the odds of a default by an investment- grade company spreading to others exceeded 100 percent -- a mathematical impossibility...."

Did you get that? The bottom line is that these models "compute" that the probability of GE default is greater than 100% -- which is indeed a mathematical impossibility.

Speaking as a mathematician and a programmer, it's astounding to me that these models can compute impossible results. That means that (a) they weren't written properly; (b) they weren't tested properly, or at all; and (c) they were wrong about everything. That is, if the formulas could be so wrong that they compute a probability greater than 100%, then the formulas must be wrong in other cases as well, possibly all cases.
At any rate, now you can see why people are saying that the market has become "utterly unhinged."

And so, you can see why John Stomber of the Carlyle fund was whining that the ABX valuations were unfair. He was saying that the particular mortgage derivatives he invested in were based on debt of of quasi-governmental mortgage lenders, Fannie Mae and Freddie Mac, and that therefore a different set of rules should apply.

But you can't say in the middle of a baseball game that it's unfair for you to be allowed only three strikes and you're out. You can't change the rules in the middle of the game. If the Carlyle fund had made money under the rules, Stomber wouldn't be complaining. In fact, nobody complains when everyone's making money in a bubble, but everyone complains when they start losing money after the bubble starts bursting. That's why it's so dangerous to invest in a bubble.

And so we have a few hedge funds in trouble, and we have some corporate debt in trouble, and we have many money market funds with frozen funds, without the investors even knowing it.

Then there's the "cockroach theory," as quoted by one financial analyst in the story above: "There's never just one cockroach. If you see one highly leveraged hedge fund going bust, then there's another on the way." That's how the domino effect works, and that's how the vicious deflationary spiral works.

The point I'm making is this: This cycle of "losses -> margin calls -> forced selling -> losses -> margin calls -> forced selling ..." occurred with stocks in the 1929 crash. So far we haven't seen it with stocks.

But we HAVE seen it with CDSs. And we're seeing it more and more, as the tens of trillions of dollars of these continue to unravel.

And so it's possible that the initial panic that we'll see won't be a stock market crash, but a bond market crash or, more specifically, a CDS "market" panic and crash. In fact, that panic may already be in progress, but without a public market like the NY Stock Exchange, it might happen in slow motion.

However, that's a distinction without a difference, because a stock market crash would immediately follow any significant panic in CDSs. Furthermore, with the Dow Industrials at 52 weeks lows (17% below their highs), a stock market panic might begin soon anyway.

Capitulation

The magic word that I always hear on CNBC is "capitulation." A typical conversation on CNBC might be where one pundit or journalist or analyst says to another, "That looks like capitulation!" "Wow, is it really capituation?" "Yes, it might be, but we can't be sure yet." "Wow. Well, if it is, then the stock market will start going up again."

I'm not entirely certain what "capitulation" is supposed to mean. It's something like this: The market is generally going down (a bear market), but it will reach bottom when everybody capitulates (gives up) and decides that it's never going to go up again. That's when it goes up again.

If you're like me, then you couldn't read the above paragraph without laughing, just as I couldn't write it without laughing, but that's the fantasy world that these people on CNBC live in.

At any rate, regular readers of this web site know that this "capitulation" concept is impossible, since it would mean reflating the housing and credit bubbles.

After the 1929 crash, the market didn't start rising again until 1933, so I suppose we can call that "capitulation." At any rate, it took four years then, and it's a long way off today.

Financial analysts, pundits and journalists are saying, with great authority, that no matter what happens now, things will be back to normal in a year or so. The rationale is that the only people who are really being hurt are those who have made leveraged buys and are facing forced selling to meet margin calls. According to this reasoning, if you can make non-leveraged buys of stocks and securities and just hold on to them, then you'll be ok in a year or so. Apparently there are still quite a few investors doing that.

John Kenneth Galbraith's 1954 book The Great Crash - 1929, contrasted the 1929 with previous panics:

"A common feature of all these earlier troubles [previous panics] was that having happened they were over. The worst was reasonably recognizable as such. The singular feature of the great crash of 1929 was that the worst continued to worsen. What looked one day like the end proved on the next day to have been only the beginning. Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few as possible escaped the common misfortune." (p. 108)

Galbraith shows what happened after the initial crash on October 24, 1929: "In the first week the slaughter had been of the innocents," in the second week it was "the well-to-do and the wealthy" who were slaughtered (p. 113), and then more and more people were sucked into ruin during the years that followed.

"The fortunate speculator who had funds to answer the first margin call presently got another and equally urgent one, and if he met that there would still be another. In the end all the money he had was extracted from him and lost. The man with the smart money, who was safely out of the market when the first crash came, naturally went back in to pick up bargains. ... The bargains then suffered a ruinous fall. Even the man who waited out all of October and all of November, who saw the volume of trading return to normal and saw Wall Street become as placid as a produce market, and who then bought common stocks would see their value drop to a third or fourth of the purchase price in the next twenty-four months. ... The ruthlessness of [the stock market was] remarkable." (p. 109)

Many times, I've used the phrase "Principle of Maximum Ruin" to refer to Galbraith's observation that the 1929 crash was "ingeniously designed" to ruin the maximum number of people to the maximum extent possible.

At the time that I made up that phrase, I really didn't completely understand how it would pan out. It's really incredible to see the Principle of Maximum Ruin in action. I can't stop shaking my head in astonishment. (8-Mar-08) Permanent Link
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Generational Dynamics Web Log for 8-Mar-08 Fed expands liquidity injections as bond market becomes "utterly unhinged"

Margin calls and forced selling

Collapsing credit default swaps (CDSs)

Capitulation

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Generational Dynamics Web Log for 8-Mar-08
Fed expands liquidity injections as bond market becomes "utterly unhinged"