Thursday, November 8, 2007

The AAA Trap

Things are snowballing in the (nominally) AAA residential mortgage-backed securities land. As I pointed out two weeks ago and then again just a week ago, the weakness in those tranches is more a matter of structure and time delay, than anything else.

Lo and behold, the AAAs are now getting some serious selling attention, as investors and speculators alike wake up to the ultimate effects of cascaded tranches. (I should point out that ABX indeces are NOT direct bond prices, as some think. They follow credit default swap prices for CDOs; the lower the index, the more expensive the CDS and thus the higher the presumed risk of default.)

Here is the set of all AAA ABX tranches...

Real money investors (e.g. pension funds) who bought into this AAA sub-prime trap are now in a bind. They thought they were buying gold-plated bonds but are now stuck with securities whose value is melting away with no bid underneath. Turns out, you can't make silk purses out of sows' ears, after all.

Where does this leave the Fed? After yesterday's plunge in stocks the air is full once more with calls for them to cut, cut, cut. Two decades of regular pilgrimages to the temple of Fed The Saviour has resulted in financial invalids, rogues, mountebacks, conjurers and snake oil merchants expecting that their Lourdes is located at 33 Liberty Street in Manhattan.

But what if the Fed's own juju majik, even if supplied in copious quantity, fails to miraculously grow new limbs for the credit amputees? Will they pitifully gather outside the massive faux Renaissance palazzo, begging for miracles and alms? Some have already been unceremoniously defenestrated (e.g. Merrill and Citi CEOs), though their golden parachutes made the decent rather comfy.

The trip down will not be as painless for plain shareholders and creditors.

P.S. The ABX/CMBX situation is now quite well understood - if not by the populace at large, at least by the more informed. But the CDX, iTraxx and LCDX indeces tracking corporate bonds and high-yield loans are not yet discussed as much. I believe the market is still underestimating the extent of the trouble in the corporate sector.


  1. "Some have already been unceremoniously defenestrated"

    [heart goes pitterpat] What a way to put it!

    How distorted is life inside the bubble that it's taken this long for people to realize this is just going to keep spilling over?

  2. It looks like we are close to 500 billion USD loss of capital from global financial system.

    Although this tremendous loss may be still manageable do you think the dynamic effects will destablise the system?

    heterogenous distribution of risk,
    counterparty risk, JPYcarry trade unwinding and finally negative multiplier effects to the global economy etc

    I think you are one of the few who could adress this problems competently. As i am living in the country poor Cassandra used to live.

    I have a feeling even Prof Roubini will be proven as too optimistic.


  3. I was reading Sanyajit Das' book "Traders Guns and Money" and it eerily echoed what you were saying ...

  4. I'm a tad perplexed about the use of the word 'loss' in relation to the current financial/credit mess. Loss implies that I had something in my possession but now I do not - for example, I lost my wallet with all my cash in it. Is the 'loss' being referred to the lower value being assigned to some class of a virtual (paper) asset, or has actual cash been given out and nothing of equivalent value exchanged?

    Brian Woods.

  5. Definition of loss.

    When you lose your wallet with cash in it the economy overall loses nothing, presuming that someone else finds it and keeps your cash.

    In financial markets (eg stocks) the losses are much more damaging because they wipe out total wealth. For example, if XYZ stock goes down by 10% this means that ALL holders of XYZ now have 10% less wealth.


  6. Hi hellasious,

    Where can I get all the charts of indexes which you posted up here?

  7. The invisible hand, reaching into my pocket for my wallet!

  8. Thanks for your reply.

    I understand that wealth (in the economic and financial sense) is something real, a hard, solid asset; ie. property, gold, a commodity, something which could be bartered or exchanged. Now Virtual Wealth is a different matter altogether. This is NOT real - but is conjured into existence and is given the substance of reality. This is my understanding of financial instruments. Hence my understanding of financial loss is that I may bought a financial instrument with my cash and now this instrument is mysteriously valued at less than I paid for it. However, if I start by 'creating' the Virtual Wealth financial instrument, and get some dopes to pay me cash for it!! Now I can see where THEIR loss might occur. So whose 'cash' have the financial instituitions 'lost', their own or Other People's? And if the loss is actually cash, where has it all gone to?

    Brian Woods.

  9. But it has nothing to do with "communism"; rather it has everything to do with Thermodynamics, specifically the Second Law.

    Trust me, I can spot a commie/socialist from 100 miles away, because I grew up with them in our government. They are very intelligent and pursuasive people, and identify the problems correctly. It is only when they propose solutions, they create a bigger mess - always, without failing.

    There is no peak oil...rubbish. Petrolium did not replace oil from whales, because the world ran out of whales. It is just that supply/demand went out of balance, and people innovated solution. Another much bigger example - humans did not move from hunting (depleting asset) to agriculture, because all forests ran out of animals.

    Think along those lines, and you will realize that you are chasing a chimera. If you are still not convinced, you may need to pick up your engineering hat for few years, and come back to the real world. Innovations are going on at very rapid pace, and humans will find solutions.

    But irrespective of that, oil, wheat, copper, gold - all prices are going up synchronously not because of 'peak commodities', but due to falling dollar. Have you plotted CRB Commodities index in Euro? It has been flat for a year now. How could the europeans not run out of any commodity and we managed to deplete each of them?

  10. BTW, I do not want to mean you are a bad person or anything by using that 'commie' word. It is far from that. Commies are usually good people, usually in the beginning. They deeply think about some problem that affects large mass of people, and come up with a solution (which typically always involves some method of conservation). Then they go out and try to convince others that the solution they thought of is the best one. That is ok so far. However, many people do not want to follow the socialist leader. This is where the problem starts and goes out of hand. Commies/socialists are often as deeply committed to their solution as the problem they want to solve. So, they have a tendency to push the medicine into the throats of those who are unwilling. And that is when the outsiders start to learn about the 'socialist movement'. Now, would you blame them for being so negative on the world-improvers?


  11. Fascists are usually good people too. They make the trains run on time, rid the populace of undesirables, and really boost flag production. But, the next thing you know, they're burning down the Reichstag, torturing people, and building internment camps.

    Labeling people who care about the planet with a term you find repugnant is childish. The world is a sphere, finite, has limits. What part of that is so hard to understand? The part that says less trips to the Scunchborough mall in your Suburban might be a good thing? Just think how much blubber you'll shed.

  12. "There is no peak oil...rubbish. Petrolium did not replace oil from whales, because the world ran out of whales."

    That's not what Peak Oil suggests.

    Peak oil refers to the reduction of the rate of production--NOT whether oil will "run out".

    Wikipedia:"peak oil is the point or timeframe at which the maximum global petroleum production rate is reached. After this timeframe, the rate of production will enter terminal decline." (...)

    It's an important distinction.

    Also production rate numbers are measured in oil produced--NOT in currency/price, so it's irrelevant to talk about Peak Oil being relative to a particular currency.

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