Rose Soup

Learning The Recession

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This information is a successor for an article I wrote on October 11, 2007 by which I suggested that this depression could be far worse than the majority of people believed understanding that the impact on stock exchange trading, the economic climate, economic vitality and inflation may be significant. It is now the week after Thanksgiving weekend so when I contemplate last week’s market sell-off and this also week’s dramatic rally, I’m sure that this stresses have raised more evident and i also can’t help but contemplate what might easily be up for grabs for the coming year.

On the positive side we are almost six years into an expansion plus the US economy is maintaining growth albeit with a slower pace. Unemployment remains low except in sectors related to housing yet it is edging up. Corporate profits have already been good this year nonetheless they declined a lttle bit inside third quarter. Prior to the first full week of November the stock exchange indices were at or near in history highs, regarded late trading has become increasingly volatile. The credit crisis of August now looks like it’s a problem for that financial sector to control. The Fed has lowered interest levels thrice indicating it really wants to protect the economy. At first glance the situation is looking OK.

But look within the surface mnblkjhq  and also the picture changes. The financial lending crunch has lost its crisis atmosphere but some sectors from the credit markets remain paralyzed. This paralysis is actually affecting businesses and consumers in areas apart from real-estate. Equity investors are nervous as evidenced with the stock market’s extreme volatility. The Dow was 1,000 points off its in history high plus the S&P 500 was even down year-to-date, though both bounced back on interest rate cut hopes. The housing market is at a deep recession moving towards a depression. Declining home values are siphoning off immeasureable consumer wealth while rising food and pricing is eating into family budgets. Unemployment is edging up in many states and consumer confidence are at a two-year low. Consumer inflation is 3.6% year-to-date and edging higher. Over it all, we are entering an election year and geopolitical events are definitely more unstable and dangerous than they’ve been since WWII.

As consultants, companies and senior executives our obligation might be aware about what’s happening on the globe, anticipate how events might impact our clients or our businesses and turn into ahead of the curve through action to mitigate identified risk. We simply cannot relax even though everything is running smoothly now. We have to look ahead at what might or will not be.

I see seven interrelated threats that businesses, senior executives and Boards of Directors should understand, anticipate and policy for so that you can minimize the negative consequences should one or more advisors become reality. The primary threat could be the growing recession because depending on how eventually unravels it might cause anybody or even more with the other six – depression, recession, inflation, stagflation, legislative action unfavorable to business and geopolitical crisis. This is a businessman’s effort to present the details in a fashion that enables other your list to make a sense of all this.

The financial lending Markets

Perhaps the greatest risk for the economy and our businesses lies in the finance markets. As you move the credit markets have calmed down ever since the crisis atmosphere of August, the underlying problem still exists as evidenced with the lack of liquidity inside the capital markets and the huge write downs being taken at public finance institutions. It is now understood how the ultimate severity of the finance crisis still remains to be seen, and individuals are beginning to understand that for the way it unfolds it could actually result in any of recession, inflation, stagflation and geopolitical upheaval.

Now it’s clear how the wide range of of debt underlying the world financial state reaches risk of unwinding due to collateral defaults. At the heart of the matter are Collateralized Debt Obligations, or CDOs. CDOs are derivative securities, as in created from another asset. Trillions of dollars these instruments are intended and sold within the last six years. As outlined by Satyajit Das, one of the world’s leading experts in derivative securities for over Twenty years, $1.00 of real capital supports $20.00 to $30.00 in loans. Actually each dollar is leveraged 20 to 30 times! He estimates derivatives outstanding for being $485 trillion, or eight times global gdp of $60 trillion. The scary thing is the fact that nobody can tell beyond doubt who holds pretty much everything paper.

The issue is global plus there is a limited amount the Fed and other central banks can perform to deal with it. For the reason that most of the challenge is in the unregulated shadow banking system[1] looked as the whole alphabet soup of highly levered non-bank investment conduits, vehicles and structures. The result of securitization is that credit risk moved from regulated entities where maybe it’s observed to places where that it was unregulated and hard to observe. Without regulators and keep track of cross-border flows and quality standards, investors didn’t really really know what we were holding buying or just what it was actually worth.

U.S. ingenuity: Inside the post dot com bubble and 9/11 arena of ultra low interest rates, US Banks saw their net interest margins shrink along with their loan volume which negatively impacted profits. And so the banks developed ingenious means of creating significant fee income by bundling volumes of consumer (many of them low income) and leveraged buy-out loans into what exactly are called Asset Backed Securities (ABS) to be removed to institutional investors like “bonds”. The investors then begin using these ABSs as collateral for another high-yielding debt instrument called a Collateralized Debt Obligation. These CDOs were snapped up by Asia and Mid-East governments, hedge funds and pension funds searching for rated high-yield instruments by which to park their mountains of emerging markets cash. Financial engineers built towers of securitized debt with mathematical models that had been fundamentally flawed, while managers overloaded on high-yield debt instruments they did not understand. All along the way financial institutions pocketed huge fees while shifting trillions of dollars of risk off their balance sheets and into your hands of investors. Roughly this past year alone Wall Street bankers (like the money center commercial banks) generated $27.4 billion in fee income from your origination, securitization and sale of exotic Asset Backed Securities.

Due to low interest in america and Japan most CDOs were bought with borrowed money. Quite simply, borrowed money bought borrowed money. On account of high credit scoring the CDOs may very well be used as collateral for further borrowing. These triple borrowed assets were then used as collateral for commercial paper purchased by risk adverse money market funds. When the assets underlying these securities set out to default in huge numbers (sub-prime loans), the CDOs lose value and also the institutions holding them incur losses. And furthermore, as no one knows for sure who is holding this paper most people are fearful of accepting new counterparty risk. The credit markets become illiquid and plenty of loan companies finish up holding a lot of CDOs in which there isn’t a or limited market.

Asset Backed Security basics: Let us take collateralized mortgage obligations (CMOs) being that they are the simplest to comprehend. Within their simplest “pass through” form banks along with other lenders originate loans, warehouse them for any brief time, package them into a bond, develop the bond rated then sell the bond to investors. As an alternative to making money from your net interest margin above the life of the underlying loans, the originators earn origination fees and payments from servicing rights. Investors who buy CMOs are in fact purchasing future profit from the underlying loans’ principal and rates of interest. Considering that the CMO is rated because of the rating agencies the acquisition price equals the long run earnings discounted to some yield in conjuction with the rating with the bond. The main advantage of this technique towards originator could be that the fees include front, the servicing rights present an ongoing method to obtain fee income unless sold, the financial lending risk is used the investor plus the investment proceeds allow the originator to create still more loans. The investor turns into a rated instrument using a yield appropriate for the rating.

The role of rating agencies: Ratings on bonds convey an agency’s assessment with the possibility of default. Investors make use of ratings when producing investment decisions as a result of rating agency’s track record. By way of example, more than a 21 year period Moody’s AAA rated bonds demonstrated a .79% probability of default by year 10. Within the asset backed securities world similarly rated loans or bonds are combined in a portfolio, then put into different tranches using the riskiest tranches taking the first loss, receiving the lowest credit rating and supplying the highest yield. Similarly the least risky tranche takes the very last loss, receives the biggest credit history and will be offering the smallest yield. Like this a portfolio consisting of B rated individual securities is usually packaged to present senior tranches that receive an A or even AAA rating and junior tranches that be given a junk rating.

Bubble trouble: In recent times double bubbles drove US economic growth through providing unprecedented liquidity towards markets: 1) asset securitization, especially subprime loans; and 2) the cisco kid banking system, defined as hedge funds, pension funds as well as the whole alphabet soup of highly levered non-bank investment conduits, vehicles and structures like ABSs, CBOs, CDOs, CLOs, CMOs, SIVs and CDSs. The joint growth of both of these bubbles was grounded inside irrational belief that home prices would forever increase no matter what affordability, and use of capital at low interest rates would be unlimited because holders of “safe” asset backed commercial paper would forever roll their investments. Belief from the former proved unfounded in 2007 when subprime loan defaults soared, which caused a de facto run on the shadow banking system as investors refused to roll their asset backed commercial paper holdings and demanded their cash back.

Changing models, changing ratings: As sub-prime loan defaults rose in 2007, in contravention on the rating agencies’ mathematical models, CMOs started to collapse. As defaults accelerated the rating agencies were made to review their models. On July 10, 2007 the rating agencies changed their models and downgraded many CMOs. This caused panic and uncertainty among CMO investors and the contagion quickly spread to everyone other types of CDOs.

Uncertainty and risk: Investors considered that the default distributions with the ratings on their own asset backed securities were just like the default distributions of the person assets backing them. Following the mass downgrade of July 10th investors concluded they were mistaken. Investors don’t knew for sure the default distribution of what they owned. The things they did know was that the model where they based their investment decisions had ended up being wrong. When Investors are not aware of the things they do not know there may be uncertainty. Uncertainty differs from risk. Risk is usually quantified and diversified, uncertainty cannot. Uncertainty causes investors to step back which means that asset backed securities finance industry is essentially frozen, bid-ask spreads are wide and “indicative” (not firm) and plenty of investors say they only do not want any ABS risk. It is a killer for that shadow banks.

Banking inside the shadows: Unlike insured, regulated real banks, shadow banks fund themselves with a large degree with uninsured commercial paper which could or may not be backstopped by liquidity lines from real banks. The shadow banking method is particularly vulnerable to a run and that is when commercial paper investors will not rollover their investment when their paper matures. That causes the cisco kid banks to tap their back-up liquidity lines with real banks and/or liquidate assets at fire sale prices. This is exactly what happened in July and August as outstanding asset backed commercial paper plunged $300 billion plus the Libor spread on the Fed Funds rate widened by 50 basis points. The financial lending markets had effectively frozen.

Cosmetic treatment for a structural problem: That led to the Fed’s 50 basis point cut inside discount rate on August 17th as well as the Fed Funds rate on September 18th and October 16th that have been designed to create liquidity inside credit markets. But all they did was calm the markets, not create the specified liquidity. The reasons were three fold: 1) banks hate to gain access to from the discount window as the Fed has become described as lender of final option (read troubled bank); 2) the discount rate remained a 50 basis point premium above the Fed Funds rate; and 3) now that the rating and pricing models for securitized debt had been shown to be faulty, the real banks were planning to decrease experience of the shadow banks, not increase it.

Frozen Solid: As subprime mortgage defaults increased and agencies lowered their ratings, investors, banks and funds began looking at all derivative backed paper with suspicion, refusing to take it collateral for that short-term commercial paper that provides liquidity to today’s money markets. Around 53% of $2.2 trillion US commercial paper is currently backed by assets, and 50% with the assets are CDOs. Which is over $500 billion in commercial paper backed by CDOs. As of November 2nd collateralized commercial paper had declined for 11 straight weeks inside an amount totaling $300 billion or 25% from your amount outstanding by the end of July. Further, as much as $300 billion in leveraged finance loans were “orphaned” because they could not be sold or used as collateral (this means they need to take place in portfolio around the lender’s balance sheet). Large segments on the credit markets were frozen solid.

What: We understand just how much securitized debt the population institutions hold on their balance sheets, and it also comes from many billions of dollars. But these amounts usually do not are the reason for the off-balance sheet exposure these institutions have to the highly leveraged special purpose companies they set up to create, buy and trade this paper, or the individual hedge funds that borrowed from your banks and represent counterparty risk also. Inside third quarter the majority of the public institutions took large write-downs from the derivatives held them selves balance sheets, including Citigroup, WAMU, Lehman Bros., Merrill Lynch, Deutsche Bank, UBS and Countrywide. However, the write downs add up to merely a fraction of these Level 2 and Level 3 assets[2] hence the fear is the fact additional must be written down as underlying collateral defaults increase.

Indeed, in October and November the write-downs have accelerated with Citigroup, Merrill Lynch, JP Morgan Chase, Bank of America, Wachovia, Freddie Mac as well as others all announcing multi-billion reserves for expected losses. To date over $66 billion in provisions for losses are actually announced and much more is anticipated. Two high profile CEOs have been fired, Citigroup and Freddie Mac are already downgraded, may cut their dividends and they are raising capital to fulfill minimum regulatory requirements. The consequence of leverage in a declining companies are that losses are amplified. As value falls other assets have to be sold (usually at a discount) to keep covenants. When derivatives are traded at a discount, accounting rules require that similar assets inside debt chain be reduced through the same discount. This quickly drains more liquidity in the system making the worldwide liquidity situation worse.

No one knows for certain to what extent any entity is exposed so so many people are not wanting to handle new counterparty risk. This is the reason the financial lending markets remain only 1 little not so good away from panic. The finance markets also impact trading stocks which until recently been on part been driven by CDO type instruments which are in the heading of “structured finance” (LBO, MBO, stock buy-backs), by corporate liquidity created throughout the issuance of asset backed commercial paper and by the securitization gains reported by publicly traded banks, funds as well as other banking institutions. If deals don’t end up being done, if corporate liquidity dries up or if banks, mutual funds and others continue reporting large losses on derivative securities, the market industry is liable to a sell-off even as we have observed in the first and third weeks of November.

Deflating bubbles: Thus niche volatility is a lot more than a correction. It really is concern about a gigantic liquidity bubble deflating. The Fed cannot prevent this by lowering interest rates or injecting liquidity because the dilemma is not the amount of money from the system. The catch is that investors are questioning the full risk transfer model as well as associated leverage and counterparty risk. The August credit crisis didn’t go away, truly moved away from the top of the page. Think about this – vast amounts of dollars of investment grade CDOs are held by state and native pension funds. These total funds are generally restricted legally to committing to only investment grade paper. How are you affected when the investment grade CMO held in a pension fund portfolio is downgraded to non-investment grade or perhaps junk status? The fund is forced to sell these securities, definitely for a cheap price. This is why lots of people who be aware of the extent that the worldwide economy continues to be supported by debt are making risk mitigation a top priority. Included in this are people for the Federal Reserve and Treasury Dept.

Contagious crunch: Since the business structure for your securitization of subprime mortgages ceased to be effective, that asset class imploded. Instead of being contained because Wall Street and Beltway authorities predicted, Wall Street soon began repricing other classes of financial risk assets (plastic card and auto finance portfolios, etc.) to higher risk premiums (lower valuations). Even so the contagion is no longer tied to portfolios of securitized assets.

The housing recession is clearly being exacerbated by way of a mushrooming mortgage crunch as lenders raise credit standards minimizing loans. And as the emotional stress from housing gets into family budgets lenders are beginning to view increased credit card and car loan delinquencies and defaults requiring increases in reserve requirements for these asset classes. When reserve requirements climb lending goes down and terms read more onerous. Rates of interest, late fees and penalties climb, credit limits are reduced and grace periods are shorter. They are early signs and symptoms of an antique credit rating crunch. This look in all of the credit markets toward less and even more expensive credit has to be continue the economy in 2008. How much of any drag is very anyone’s guess as the subprime meltdown puts the economy in uncharted waters.

A companion article titled “The Seven Threats to Your Business in 2008″ are going to be published this date and can explain the opportunity impact how the recession should have about the general economy along with your business specifically.

[1] Shadow Banking Strategy is a phrase coined by Paul McCulley of PIMCO

[2] Level 3 Assets are the types assets which is why there isn’t a market. Level 2 Assets are those assets in which you will find there’s thin, erratic market. As there is no reliable cost of these assets, accounting rules and securities regulations enable the institutions to discover value using internal valuation models. As a result a CDO could be valued at .95 at one institution while at another institution that same CDO could be valued at .90.

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