Friday, March 16, 2007

What A Credit Derivative Looks Like - In Color

If you have been reading my postings for a while, you are familiar with my views on mortgage debt, RMBS, CDO, CDS, CPDO, ABCD and all such derivative and structured finance acronymia. It's all coming to a boil right now, but for the most part it's really, really dry stuff - except for the hardcore types who get heart palpitations just thinking about variations in GNMA experience ratios.

I usually include a graph or two in order to be more, ahem...graphically explicit, but inherently the process of presenting derivative finance is tortuous. Humor helps, but I have been told - in no uncertain terms - that my version tends heavily to sarcasm instead of wit.

So, today being the weekend and all, I will take it easy and let a picture do the blogging - about 1.000 words' worth as the Chinese say.

For your viewing pleasure and thoughtful consideration you will find below a picture of several thousand tightly packed units used in the issuance of all those MBS, CDOs, CDSs, etc.

Housing Developments in Perris, CA (Gooble Earth, alt. 10.481 ft)

Perris, California is the "zip code" with most mortgage default notices in the state, according to the LA Times. If you have to commute to L.A. it's one hour to go, two to come back. According to the story, a typical house in one of those "developments" goes for around $330.000 right now, though some hopeful sellers still ask over $370.000. Seems pricey to me from this altitude...

Sadly, this type of sardine-can real estate exploitation is not unique to California or even just the US. If you have visited the south of Spain you know what I mean.


  1. I find it very strange that free citizens choose to live in places like Perris, Ca. Any normal town with apartment complexes, small shops, restaurants and maybe some public transit seems so much more enjoyable and full of freedom.

    At least from a far, places like Perris look like penal colonies to an European city person like me

  2. Dear mane,

    I don't think they have a real "choice" - according to the LA Times article they escaped bad neighborhoods in LA to raise their kids. But since they were mostly lower middle-class working people, they could not really afford the prices ($350-400.000) under normal borrowing conditions.

    They bought because they qualified for no money down, low initial "teaser" rate mortgages, that are now re-setting higher - and they can't afford the payments any longer.

    I was is Andalusia, Spain recently. The whole Costa del Sol, from Gibraltar all the way to Almeria is one huge penal colony for Norte-Europeano vacationers. What they have done (and are still doing) to that once beautiful country is beyond description. I have never in my life seen more construction cranes.

    There is crash coming there, too, big time.


  3. Recently US politicians have been discussing potential legislation to address the subprime issue. Is there a possibility that the federal govt will step out in front and bail out investors and borrowers in the subprime market? Specifically, what is to prevent the federal govt utilizing the FHA, GNMA or FNMA from stepping in and buying up defaulted loans instead of allowing them to go to foreclosure staving off a major decline in house prices?
    Or do you think enough damage has already been done to bring the whole US debt pile tumbling down?

    I remember being convinced in 2002 and 2003 that the dotcom bust would surely bring on a recession and deflationary spiral yet the federal reserve was able to pour enough liquidity into the market and lower rates sufficiently to reflate the economy and financial markets.

    Because of US dollar hegemony, the ability of the US govt to issue debt and finance spending whether on foreign wars or domestic programs seems virtually infinite. Furthermore, US major trading partners have had no choice but to go along or risk their own massive recessions and accompanying social unrest.

    I think it is important not to overly discount the potential role of fiscal policy in addition to examining monetary levers available not only to the federal reserve but foreign central banks as well. I believe the federal reserve in 2002 and 2003 discussed the possibility of allowing opening market operations in the mortgage debt market in order to stimulate the economy. I believe rather than opt for this overt action on the part of the federal reserve which would have required a change in the federal reserve mandate, they chose to use the carry trade to effectuate the same result.

    I also find it interesting that the derivatives market has grown so much over this period as well. It seems to me that if things go wrong in the derivatives market again there is nothing to stop the federal reserve from coming in and monetizing any potentially defaulting debt spirals to make sure that there is always sufficient liquidity. In this regard, I find it fascinating that Greenspan continues to periodically scold the investment banks for failing to properly document derivatives transactions. Well I guess if you can't keep track of the records for derivatives transaction you won't have a problem because you will never be able to sort out where the liability exists in case of a crisis.

    While I agree that in the long run this is not a sustainable global financial model, the bursting of one bubble always seems to give rise to a new opportunity to inflate another bubble.

  4. Dear anonymous,

    Thank you kindly for your thoughtful and extensive comments.

    I believe there are very limited fiscal and monetary policy choices available to the US right now.

    Another round of drastic interest rate cuts and/or debt monetization operations, will severely undermine the value of the US dollar at a time when it is no longer the only obvious choice for global reserve currency status. The euro is gaining credibility all the time ans can no longer be talked away with silly comments like "Old Europe", "Eurosclerosis", etc. Dollar hegemony is one mis-judgment away from a dollar rout.

    Furthermore, I strongly doubt that such moves would achieve anything positive, anyway. With its manufacturing base completely emasculated, what is there to borrow for in the US? To "invest" in what? In any case, with the personal saving rate now negative, more debt is impossible. There is no more earned income to service more debt. From now on, more debt will be "Ponzi" debt.

    As far as fiscal policy is concerned, the US needs to get serious about re-building a sensible tax base. A global empire cannot be run on absurd trickle-down economics.

    I view the explosive emergence of credit derivatives as the last act in the debt "play". They permitted that last move down in effective interest rates, allowing even the absolute bottom-credit dwellers to borrow. Who's left to borrow? Prison inmates?

    I think we have finally run out of bubbles.


  5. Yep, I am sure Spain is making mistakes as well. We have some of them here in Finland, to my regret.

    And in Finland people are also fleeing the cities to the imaginary safety of the countryside. I do not see why, but they seem to consider cities unsafe, contrary to all statistics.

    Yes, waiting for the crash to come to Finland as well. In anticipation, I moved over to work for the Finland Post, which being a state company and monopoly, is not that eager to lay employees off.

  6. Dear Hellasious,

    I couldn't agree with you more on the foolhardiness and long-term financial destructiveness of the government and federal reserve adopting the drastic fiscal and monetary policies I described in my previous post. Nevertheless, as an investor who has to determine the appropriate allocation of financial resources, it is important to make an informed judgment re: the likelihood that such policies will be implemented given the pending crisis in the housing and mortgage markets and what the implications will be for the financial markets.

    Right now I am exclusively invested in treasuries all along the yield curve as I believe an inverted yield curve will ultimately result in a recession with substantial deflationary rather than inflationary consequences. Nevertheless I do fear that somehow the federal govt and federal reserve may decide to pull out all the stops to prevent a deflationary spiral in light of the experience of Japan and land us in an environment of stagflation, which obviously would be brutal for my investment strategy.

    They have been successful in doing so over the last several years and nothing has led me to believe that they will not resort to even more drastic policy measures to prevent deflation. I agree that the long term result of such policies would be the further hollowing out of the US economic base but feel there is still significant production capacity left to be hollowed out and I don’t agree that the only people left to lend money to are prisoners. As long as the US govt. can issue foreign debt in its own currency, the govt.’s ability to borrow or loan money is virtually limitless.

    Also should the US govt find a suitable pretext to escalate its military involvement to include Iran that would add further additional inflationary pressures on the US economy.

    With respect to the Euro being an alternative currency, and without even getting into the Euro countries' own debt and financial fragility (i.e. Spain, French housing bubbles), I think we all know that Europe simply does not have the requisite military might to back a reserve currency. As I am sure you are aware, the strength of a fiat reserve currency is ultimately dependent upon the military prowess of the issuing country, i.e. the issuing country's ability to control the access and flow of natural resources throughout the global economy.

    That is clearly the reason the Iraq war was fought. As long as the US govt can dictate that oil-producing countries must accept dollars in exchange for oil, dollar hegemony will remain intact. It is the world's biggest protection racket.

    Along this same line of thinking, I think it is interesting to note that second and third most activist military powers, the British and Israeli govts are not part of the Euro.

    However, above and beyond this underlying geopolitical reality, the fact is that the more that the economies of China, Japan and other export driven economies become dependent upon export to the US to grow their GDP, the more those countries must accomodate US hegemonic financial power. At this juncture, there is no real alternative for them but to continue accommodating US fiscal and monetary policy. There is no policy route available to the govt decision makers in these export-based counties that would not cause severe financial dislocation, economic destruction and accompanying social upheaval.

    Despite the understandable unwillingness of the American public to accept the reality that the "ownership society" is based on a vast imperial army, that is the reality. Until American military might is truly challenged in a significant way, I don't see how the advantageous economic position of the US vis a vis the rest of the world will change.

    Another factor militating against the possibility of a preemptive wholesale bale out of the mortgage industry is the political background. It seems to me that it is in the political interests of the Democratic Party to allow the economic fallout from the current mortgage fiasco to transpire in the last couple of years of an already unpopular Republican president.

    While the democrats will come under increasing pressure to legislate a solution to the mortgage crisis, it does not seem like it would be in there interest to do so until there has been significant damage done. In other words, in addition to charges of massive govt corruption, it would a great platform for a democratic presidential or congressional candidate to run on for the 2008 presidential election cycle against the republicans.

  7. You've got a helluva blog, hellasious. Thanks for educating the rest of us.

    Here's a question for you concerning derivatives. A recent essay at contraryinvestor emphasized, as you have done, the explosive growth in derivatives. It noted JP Morgan had a derivatives exposure amounting to an incredible $62.6 trillion on total assets of $1.17 trillion; that Bank of America had a derivatives exposure of $25.5 trillion on total assets of 1.19 trillion, and that Citi had a derivatives exposure of 24.4 trillion on total assets of .816 trillion. For JPM, the "percentage of total exposure to risked based capital" was 806.7%, for BofA, 268%, and for Citi 430%.

    So the grand question is: how much of this derivatives exposure, in your estimation, is of the "naked put" sort that you have described in various posts? It has been obvious for some time that a price would have to paid for the ludicrous abandonment of normal credit standards in the mortgage business, but the thing that has always stumped me is who was actually bearing the risk. Who, in other words, is selling all those naked puts? I guess we've found out recently that the subprime mortage lenders were not able to lay off all their risk, but undoubtedly they laid off some of it. So where is the next shoe to drop? The private mortgage insurers? The banks? Various and sundry hedge funds? All of the above?

    Thanks again for your lucid explanation of these crazy derivatives. It's very helpful to those of us trying to understand what's going on.


  8. Dear dividedmind,

    Who's bearing the risk? That's the $64,000 question. There is really no way of knowing accurately, but we have indications.

    1) The rise of the hedge fund industry, now estimated to have ~$1.3-1.5 trillion under management, came at the same time as the increase in risk appetite (i.e. lowering of risk premiums). Those two events are surely related, because hedge funds are by definition seekers of higher returns via higher risk.

    2) The same must be said of the private equity funds, though they operate through a slightly different mechanism.

    3) The rise of retail-oriented "structured products", which almost always encompass derivatives, means that individual investors are also bearing a large portion of the risk, though they may not realize it.

    We must also be careful to distinguish notional derivative amounts from market values. Some derivatives, like options, have very high notional values vs. their underlying market value. The actual risk carried in (or off) balance sheets is smaller than those tens of trillions mentioned.

    At the bottom-bottom line, it comes to this: until recently we had a double whammy of record low interest rates plus record loose lending standards, world-wide. This resulted in extremely low default rates - for a while - and allowed even the least credit-worthy to borrow at relatively low rates.

    But all this has started to reverse now and the process will be with us for quite a while, I think.


  9. Dear anonymous,

    I certainly agree on the hegemonic role of military power to maintain the oil/resource routes and thus the value of the dollar. But things change..I'll explain.

    Investors and policy makers, particularly very large ones, look to the future. The EU has made a clear decision that its energy future does not lie in petroleum, concentrating instead on renewables and nuclear. The aim is to disentangle the EU from the grip of the Middle East/Russian producers and the hegemony of the US and the dollar. If they can make it fly, the euro won't need a huge military machine to back it up.

    It won't be easy, of course - but they will try very, very hard. I strongly believe they will succeed. Let's not forget that climate change is also a huge issue.

    I think the US is woefully behind the curve in this, choosing instead to fight fossil fuel resource wars instead of investing the wasted trillions in altering its energy/social regime. In this, as always, one must seek the vested interests behind the policy: in this case enormous US oil/gas companies and defense contractors.

    As far as mortgages are concerned, I think there will be no direct govt. bailout for borrowers, unless it becomes a huge social problem. Politicians will ask the lenders to bear the costs created by whichever policy they come up with to help the home-owners. There was a recent Bloomberg TV interview with Hillary Clinton and that's exactly what she said.

    On other matters.. look at what China is trying to do: it is clearly attempting to disentangle its economy from the export model, concentrating instead at creating a domestic market. It is raising interest rates and bank reserve requirements fast, passing environmental, tax and property regulations - all in an effort to slow the "bubble" mentality of export-driven over-investment. They are warning everyone: we do not like the boom-bust cycle and if need be we will push VERY hard on the brakes. They are still quite capable of authoritarianism, you know. For them "free markets" are a tool, not an ideological truth.

    And last, Japan. They are finally on the mend, certainly helped by the Chinese juggernaut next door, but also by the "natural" upswing of the business cycle after more than a decade of constant pain. Their domestic consumers are getting ready to spend again, so exports will be less important to them - on the margin, of course.

    The only smart policy choice for the US is this: become the #1 producer of technology and capital investment expertise in re-shaping the global energy/resource/social regime.

    For now, the US is choosing to base its hegemony on yesterday's paradigm. That's short-sighted, because the paradigm is changing rapidly and the longer it fights the change the more marginalized it will ultimately become.


  10. I won't comment the great content. Just have no time for it.

    Will just say: "Just go on". The content choice is right on spot.

    With all those big property bubbles (US, UK, Spain, Ireland), medium bubbles (France, Italy ...) and others popping out, the situation is clear.

    THIS IS ALL ABOUT CREDT ABUSE and by the way, currency abuse, in a lot of countries.

    What are you personnaly betting on as an output? Inflating their way out debts or a series brutal deflationary market crashes.

    Fran├žois from Paris, France

  11. Dear Francois,

    Thank you very much for your supportive comments. Yes, debt seems to have engulfed the whols of the "West", from the US and the UK to Spain (see my latest post with the picture of Carboneras) and even Greece. Everyone is borrowing to the maximum and beyond as if they will always be able to just squeeze another asset bubble into the future to make things right.

    I am predicting a credit-crunch driven asset deflation.