Tuesday, September 4, 2007

Loose Loans Sink More Than Homes

The current unraveling of the structured finance market is said to be caused by, and contained within, the sub-prime mortgage market, i.e. financing for homes purchased by people with sub-standard credit. I strongly disagree; I view global credit markets as a continuum, a series of dominoes placed to form intricate shapes and effects, like one of those championship domino events we see on TV.

The sub-prime domino was the first to fall and, tellingly, it immediately knocked down the LBO domino, one that was seemingly completely unrelated to real estate. Then the ABCP domino fell, causing the money market fund domino to drop. In the meantime, the stockmarket domino also fell, causing the yen borrowing block to drop in a loop pattern that fed back and reinforced the thrust and speed of all domino moves.

The main thread running between all those dominoes is risk. As interest rates came crashing down during 2001-2004 to protect the US economy from a deflationary spiral, they ignited a massive borrowing boom directed to all manner of assets from suburban homes to emerging market shares. When conventional finance was exhausted, financial engineers started creating "innovative" products that had absolutely no connection to the real economy. Such credit exotics as hybrid CDOs, CPDOs, yield steepeners, etc. were manufactured bets and nothing more. Their creators maintained their raison d'ĂȘtre was that they spread risk around and thus provided a valuable service to the overall economy, which could now assume even more risk. I submit that reasoning to the court of common sense which, though common, is in apparent scarcity amongst the particular financier class.

In the end, borrowing had no other purpose than to place highly leveraged bets on other financial bets: risk piled on more risk. A simple example: an American hedge fund borrowing in yen to buy on margin a hybrid CDO made up of European CDSs. How many degrees of risk do you count right there? It is not surprising that the market simply stopped functioning, instead of just declining: complexity created one more overwhelming level of risk and everyone just froze. It is one of those profound "And now what?" moments, when everyone involved suddenly wakes up to the mess they created and is at a loss about what to do.

In the past a quick nudge of monetary policy would eventually do the trick. The cost of borrowing would be brought at or below the economic return of assets (rents, business IRR's, etc.) and the ball would start rolling again. But this is clearly not going to work this time around because what must be reduced is exposure to total risk itself, not the cost of borrowing to assume even more risk.

The market is not dumb: it realizes the dominoes have started falling and this is precisely why lenders, investors, speculators have all gone on a strike against anything that carries even a whiff of obscure risk that cannot be rationally calculated. They simply do not wish to be sitting on top of a domino.

At this point there is only one way to reduce risk relatively quickly and that is to lower or eliminate leverage used to place pure financial bets. Again, the market has realized this and is withdrawing ABCP financing just as quickly as it comes due. This is no mere coincidence; ABCP is a near cash-equivalent product that can be liquidated by simply not rolling it over, i.e. there isn't the pain involved in selling exotic bonds at a huge discount and writing losses in the books. Putting it another way, in a crisis you first sell what you can sell.

Of course the removal of ABCP is going to force down the whole ABS market, which in turn will remove cheap financing from all assets... and the dominoes will keep falling until the pattern of The Debt Bubble runs its course and risk is once again at a level that can be covered from the excess returns of assets, i.e. where the current reward of holding a risky asset clearly and conclusively exceeds the risk.

In closing, a note on the post's title. "Loose lips sink ships" was the warning given to WWII soldiers about inadvertently disclosing sensitive information to the enemy.

My version is a bit more inclusive, unfortunately.


  1. A VERY incisive comment on the gathering financial storm and why rate cuts cannot bail the system out.

    I would add though that considering the dollar's precarious position and still strong inflationary pressure on many of life's necessities deep rate cutes simply are not an option as was the case during 2000-2002.

  2. The ABCP market is collapsing because it became a holding ground for all sorts of toxic loans.

    AHM alone had $1.62B of ALT-A loans parked in its conduits waiting for securitization. It's little wonder they couldn't find anybody willing to roll over their ABCP.

    Some of these conduits were created for no other reason than to profit from the spread of money market rates versus the long term securities they were holding. Short term liabilities against long term assets are the classic formula for a run on the bank. A run that the Fed can't prevent because the ABCP market is outside the traditional banking system.

    In the US, these conduits are sponsored by banks that are there as a "fall back" in case the conduit can't roll over its loans in the ABCP market. The banks could then dump this paper on the Fed through the discount window.

    At least that is what's supposed to happen. When AHM's conduits were unable to fund the loans, they extended them to 270 days (the max under law) and are scheduled to do a fire sale of their holdings.

    If this becomes the pattern for banks we'll see accelerating asset sales. This could create losses in money market funds which would create a rush out of money market funds. With less money to lend, more conduits will fail to roll over paper, which will force more fire sales and the cycle could repeat.