“No worries. It’s contained,” most experts on Wall Street said of the implosion in the Subprime market that kicked off just 6 months ago in December 2006. New Century Financial’s woes were the obvious consequences of reckless new kids on the block who began to believe their own B.S., it was said. Then, early this months a quiet article in the WSJ raised a small red flag, although it all seemed innocent enough.
Yet over the past two weeks nothing short of a bomb exploded upstream of the lowly subprime dealers and their clients when not one, but two Bear Stearns hedge funds dealing in various forms of alchemy-debt (where high default risk debt is carved up into payment streams and repackaged as AAA rated debt) imploded. (How ironic that one of the funds goes by the name “High-Grade Structured Credit Strategies Enhanced Leverage Fund.”) The worst news hit the wires by Thursday of this past week when it appeared billions of dollars of the securities would be marked to market in a desperate bid for liquidity. $1.6 billion of funds controlled around $25 billion of Collateral Debt Obligations (CDOs), a leverage of about 15 to 1.
Said Bloomberg of such prospects on June 21:
“A sale would give banks, brokerages and investors the one thing they want to avoid: a real price on the bonds in the fund that could serve as a benchmark. The securities are known as collateralized debt obligations, which exceed $1 trillion and comprise the fastest-growing part of the bond market.
Because there is little trading in the securities, prices may not reflect the highest rate of mortgage delinquencies in 13 years. An auction that confirms concerns that CDOs are overvalued may spark a chain reaction of writedowns that causes billions of dollars in losses for everyone from hedge funds to pension funds to foreign banks. Bear Stearns, the second-biggest mortgage bond underwriter, also is the biggest broker to hedge funds.”
The quote puts into perspective exactly the instability associated with sub primes, the most recent bubble beneficiary of central bank enabled credit and money supply expansion to crash under its own, impossible weight.
Too biased and talking down the economy, you say?? Nouriel Roubini over at RGE summed it up this way:
…these highly illiquid securities have been priced so far based on unrealistic and distorted credit ratings as the rating industry has been complicit with the mispricing and misrating of these securities: most of these securities have not been re-rated in a way consistent with the rising default rates on subprime mortgages. That is why Wall Street is now in a panic about getting true market values – through an auction - of such securities. Losses for CDOs investors will be massive once these assets are correctly priced to market rather than kept on books based on valuation that do not make any sense as they were based on distorted and obsolete ratings.
Regular readers are all too familiar that this was coming down the pike in some form or another. That’s what happens when you transfer tremendous wealth out of the hands of those who back the dollars they spend with actual production as the byproduct of savings and effort, vs. those who gain purchasing power by sacrificing nothing and merely printing fresh currency out of thin air. The latter is the banking system, which transferred those freshly minted dollars — and the purchasing power they gained at the expense of those who contribute to the economy — and ginned them into the credit system and into the hands of those who couldn’t buy up enough of the securities that are now falling apart in front of our eyes.
And now mainstream journalists are catching up to the fact that this is very likely to spread to Main Street as more dominoes fall. It may well be that the markets actions last week are signaling, finally, that the mainstream is starting to question if all that smoke actually means there is a fire.
While the scramble is on to bail out what’s left (although Merrill came up well short of hopes on Thursday) of the two funds, the carnage is clear and spreading. MBIA is now being exposed as another mainstream casualty — a blow up at the major CDO insurer (billions of dollars of guarantees) will only send more ripples through the markets. Also on the hook as lenders are Goldman Sachs (GS), JP Morgan Chase (JPM), Bank of America (BAC), Citigroup (C), Lehman (LEH), and Barclays (BCS).
The dominoes are set for a few big players to burn their fingers. At that level of the game, you’re in the business of playing with others money — and often that which is minted from nothing. No doubt these banks will survive under any circumstance since it will always be argued that without them the U.S. economy will vaporize. As such, any hardship will merely contribute to the vast expansion of money supply flooding the markets.
At what point do the ripples turn into the credit bubble tsunami backlash that many have warned about for several decades? Let it suffice to say, a bloating money supply always results in mispriced assets of all sorts. Once that’s understood to be the real problem we’re dealing with, and not just in sub prime derivatives, well.. the cat’s out of the bag, and then look out!
