"The Complete Evaporation of Liquidity"

As I usually do, I wrote this today for posting tomorrow. Events are running ahead fast, however, and I think it is more timely to post it today.


On March 15 I posted what has turned out to be a prophetic entry titled "Well, What Do You Want It To Be?" , which followed the various stages in securitizing and derivativizing a simple home mortgage up to the fourth degree (CDO, CDS, hybrids, funded vs. unfunded, etc). By that stage the resulting structured instrument is completely unrecognizable vs. the original mortgage and is impossible to price without a long list of assumptions about future default rates, the shape of the yield curve, volatilities, etc. The various institutional owners, mutual funds among them, relied on daily, weekly or monthly indicative valuations from their broker-dealers who were more than happy to oblige by concocting essentially fictitious quotes, since no one was selling, anyway. But the real price is always revealed when you finally have to sell and then the firm quote you may get could be... -95, i.e. no bid - 95 offered. A completely worthless quote that cannot be used to price anything, let alone sell.

BNP-Paribas, the largest bank in France and one of the largest in the world, took the highly unusual and severe step of stopping the calculation of NAV's and suspending redemptions for three of its mutual funds that held such mortgage-related instruments because, and I quote: ``The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly regardless of their quality or credit rating''.

Let's translate, though it is quite straightforward for an official release:

a)The complete evaporation of liquidity = No one wants to buy, there are no bids.

b) Impossible to value = Brokers/dealers aren't even giving us official indications - too scared of their implied legal obligations.

c) Regardless of their quality or credit rating = Those AA or AAA ratings are on paper only. God knows what they really are.

There are also several highly disturbing facts:

1. These are plain vanilla mutual funds from a highly reputable bank, not some high-roller leveraged hedge fund. Supposedly ho-hum, safe and with daily pricing and redemption privileges. They are designed for the conservative middle-class investing public who are putting money away pour les enfants, or towards a house down-payment.
   
2. The amounts involved are quite large: as of July 27 the three portfolios together amounted to $2.8 billion.
3. The structured bonds in question are rated AA or better.

The myth of "containment" is now completely and utterly destroyed. If vanilla mutual funds are in such trouble, can you imagine what is happening to the balance sheets of hedge funds? For example, those that bought mezzanine CDO's on margin which now have NO BID? Or, how about those that wrote naked CDS's on those same CDO's?

Here's a question to ask the SEC, NASD and, of course, the OCC (Comptroller of the Currency: Ensuring a Safe and Sound National Banking System For All Americans): Do you have any idea whatsoever what the real exposure is to the hedge funds of the institutions you are charged with overseeing? Especially those large deposit-taking institutions (aka banks) that also act as prime brokers (soup to nuts package deal to hedge funds, from transaction services all the way to margin lending). Because if liquidity has evaporated, what's the collateral ultimately backing those savings and checking accounts worth?

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...and as I finished writing this the ECB had to intervene in the interbank euro money market to provide 90 billion euro at 4% (normal amts. are around 5 billion) because banks started to deny lending to one another, pushing O/N rates to 4.7% - if they could get any, that is. This being an area I know very well, I cannot emphasize enough how concerning this is. The ECB became the lender of last resort, a role that central banks hope to never have to play because it means the financial system has seized up. Likewise, dollar O/N LIBOR rates shot up to 6% from 5.37% yesterday and this is for the biggest, strongest banks like BofA and Barclays. The Fed just did a 14 day repo to add liquidity at 5.25% - no news on the amt. yet. (just in $15 billion).

If the banks are nervous about lending money O/N (just one day) to one another, what do you think they are doing with their hedge fund customers? Calling in margin loans (yen included)? Bigger haircuts on the collateral? Higher interest rates? Pressuring them to reduce debit balances by selling positions? All of the above?