Here There Be Monsters

The phrase “here there be monsters” was used by early European mapmakers to warn of dangerous beasts awaiting in unexplored locations of the Seas.

______________________________________________

The manufacture of CDOs and other such highly engineered financial products was similar to any other industrial process: raw material (loans) came in and were processed into an array of products (CDO tranches). After inspection by the quality assurance department (rating agencies), the merchandise was shipped out and sold to different customers, each according to his needs. The AAA tranches went to pension funds, insurance companies, mutual funds and other end-users, while the mezzanine tranches were bought by higher-risk entities such as hedge funds.

But what happened to the left-overs, the non-rated equity tranches that are first to absorb losses, known as "toxic waste"? These contain 100% concentrated risk, extracted from the raw-material loans when they were packaged into the more marketable tranches. Unlike industrial waste, this paper could not be dumped into the environment but had to be sold to speculators willing to bear the highly elevated risk, or be kept by the "manufacturer" bank which then retained the risk itself.

How much of this toxic paper was produced? According to SIFMA the global issuance of CDOs in 2004 - 1Q2007 totaled $1.17 trillion (click image to enlarge). The percentage of equity tranches varied between 2%-15% of face amount, depending on the assets, the structure, etc. Assuming an average 8.5%, it comes to $100 billion and in this credit-crunch environment it is pretty certain it has been totally wiped out.

CDO Issuance Data (SIFMA)

Next question is, who bought them and who is stuck with the losses? As we saw, only two major classes of holders existed for this toxic waste: issuing banks and speculators with a highly elevated appetite for risk. There is no way to know what the split is, so let's assume the holdings were equally split between banks and hedge funds, leaving each with $50 billion of losses.

Here comes the interesting part: so far, banks worldwide have written down slightly over $50 billion for their entire exposure linked to US mortgages and structured finance which is, of course, far greater than just the equity tranches. The conclusion is that there are significantly greater losses coming up for the financial sector in the very near future, since $50 billion covers only their estimated exposure to the equity tranches. Hedge funds are also on the hook for at least an equal amount of losses.

Trying to navigate through the terra incognita of structured finance holdings at banks (and hedge funds) is a near impossibility. They are so heavily annotated with Class II and Class III markings - plus unknown off-balance sheet exposures - as to be the equivalent of "Here There Be Monsters" in old maps. It is little wonder that the credit market has seized: mariners are unwilling to steer by such maps; the few that do, ask for pay commensurate to the risk. Yields on asset-backed commercial paper have moved back to the highs reached before the Fed cut rates for the first time, and risk spreads are the highest in at least seven years.

Discount rates on 30-day commercial paper (Charts:FRB)

Spread between A2/P2 and AA non-financial CP

In the era when ships sail loaded with GPS, radar and SATNAV why does anyone expect investors to jump into a ship captained by a bearded one-eyed pirate gulping rum and yelling: "C'mon ye stinkin' cowards!! Are ye afraid to die?"