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 Forecasting America's Destiny ... and the World's


Generational Dynamics Web Log for 1-Oct-07
International Monetary Fund (IMF) questions the globe's continuing financial stability

Web Log - October, 2007

International Monetary Fund (IMF) questions the globe's continuing financial stability

Saying that the "global financial system is enduring an important test," the IMF is warning that the global financial system has been getting increasingly unstable for at least several months, and that this trend is continuing.

Let's look at some excerpts from the executive summary of the International Monetary Fund's October, 2007, Global Financial Stability Report (GFSR):

"Since the April 2007 Global Financial Stability Report (GFSR), global financial stability has endured an important test. Credit and market risks have risen and markets have become more volatile. Markets are recognizing the extent to which credit discipline has deteriorated in recent years—most notably in the U.S. nonprime mortgage and leveraged loan markets, but also in other related credit markets. This has prompted a retrenchment from some risky assets and deleveraging, causing a widening of credit spreads in riskier asset classes and more volatile bond and equity markets. The absence of prices and secondary markets for some structured credit products, and concerns about the location and size of potential losses, has led to disruptions in some money markets and funding difficulties for a number of financial institutions, as some counterparties have been reluctant to extend credit to those thought to hold lower quality, illiquid assets. The resulting disruption has required extraordinary liquidity injections by a number of central banks to facilitate the orderly functioning of these markets."

This refers to the tremendous volatility and investor anxiety that occurred in August. The report indicates August events are a great threat to global financial stability, and most of the report is about what happened in August and how to keep it from happening again.

"The potential consequences of this episode should not be underestimated and the adjustment process is likely to be protracted. Credit conditions may not normalize soon, and some of the practices that have developed in the structured credit markets will have to change. At the same time, the global economy entered this turbulent period exhibiting solid growth, especially in emerging market countries."

The report does not predict a 1930s style Great Depression, as I do, but says that the problems will continue for a long time, and will get worse.

The report says that "some of the practices that have developed in the structured credit markets will have to change," but as we'll see, any significant change is unlikely.

"Systemically important financial institutions began this episode with adequate capital to manage the likely level of credit losses. So far, despite the significant ongoing correction in financial markets, global growth remains solid, though some slowdown could be expected. Downside risks have increased significantly and even if those risks fail to materialize, the implications of this period of turbulence will be significant and far reaching. Eventually, lessons for both the private sector and the regulatory and supervisory arenas will have to be drawn in order to strengthen the financial system against future strains."

"Systemically important financial institutions" refer to major financial institutions, such as large banks, insurance companies, and investment firms around the world. This makes the point that it's not just a few small town savings banks that are in trouble.

"The threat to financial stability increased as the uncertainty became manifest in the money markets that provide short-term financing (especially commercial paper markets). At the center of the turmoil is a funding mismatch whereby medium-term, illiquid, and hard-to-value assets, such as structured credit securities, were being funded by very short-term money market securities—often asset-backed commercial paper."

This "funding mismatch" is the problem that exploded. Here's an example of what can happen:

"The market illiquidity and the difficulty in valuing the complex, structured products held as assets has compounded the risks of the funding mismatch. Thus, while potentially helping protect the financial system from concentrations of credit risk in banks, the dispersal of structured credit products has substantially increased uncertainty about the extent of the risks and where they are ultimately held."

The creation of these "complex, structured products" is the most bizarre financial development of the modern age. Let's continue with the above example:

And so, returning now to the paragraph above from the IMF report, the phrase "market illiquidity" refers to the fact that there's rarely a market for these CDOs; "difficulty in valuing" refers to the computer models, and the difficulty in relating notional values to market values; and "increased uncertainty about the extent of the risks" refers to the fact that no one has the vaguest idea what's going to happen when these "marked to model" CDOs have to be re-valued, because they've been sold.

"This funding mismatch was undertaken by a significant number of conduits and special purpose vehicles that had assumed they could hold their illiquid assets to maturity. Many have been associated with regulated banks, and to a large extent their funding strategies were backed by contingent liquidity lines from those banks. When doubts about the quality of some of the underlying assets emerged and the high ratings were perceived as less reliable, prices of the assets fell, the rollover of associated asset-backed commercial paper became very difficult, and funding began to be squeezed. As a consequence, what had been contingent, off-balance sheet liabilities for regulated banks threatened to move "on balance sheet."

This describes the credit crisis that began in August. These CDOs were everywhere, and there was no institution really had any way of knowing how exposed it was, let alone how exposed other institutions are.

What's the total value of all the credit derivatives in the world?

The IMF's Global Financial Stability Report provides an answer.

Click on the "Statistical Appendix," and open the PDF file. Go to page 136, and look at the "TOTAL" line in table 4. Expand that single line into a table by itself, and you get the following:

    Table 4. Global Over-the-Counter Derivatives Markets: Notional
    Amounts and Gross Market Values of Outstanding Contracts

(In billions of U.S. dollars)

Date Notional amounts Gross Market Values ----------- ---------------- ------------------- 31-Dec-2004 257,894 9,377 30-Jun-2005 281,493 10,605 31-Dec-2005 297,670 9,749 30-Jun-2006 369,507 9,936 31-Dec-2006 415,183 9,695

FOOTNOTE: All figures are adjusted for double-counting. Notional amounts outstanding have been adjusted by halving positions vis-à-vis other reporting dealers. Gross market values have been calculated as the sum of the total gross positive market value of contracts and the absolute value of the gross negative market value of contracts with non-reporting counterparties.

According to this table, credit derivatives have been growing quickly since 2004. Today, the total notional values of credit derivatives is $415 trillion.

This $415 trillion of credit derivatives is built on top of only $9 trillion in contract market values. And the total GDP of the entire world is only $45 trillion.

Incidentally, Ron Insana on CNBC has lately been quoting an up to date figure of $750 trillion. This is considerably larger than the December figure quoted by the IMF report, but it wouldn't be a surprise, because the use of credit derivatives accelerated during 2007.

Whether it's $415 trillion or $750 trillion, we're talking about a bubble so huge that it almost can't be imagined. I've been talking for years about the whole world being a giant financial bubble, but as this $750 trillion sized bubble sinks in, it's shocking even to me, after all this time. The world is headed for a financial disaster of almost unimaginable proportions.

A web site reader has called my attention an article by Jon Markman about credit derivative expert Satyajit Das. The article describes how we got into the current situation, and what's going to happen next. Here are some excerpts:

"Das is pretty droll for a math whiz, but his message is dead serious. He thinks we're on the verge of a bear market of epic proportions.

The cause: Massive levels of debt underlying the world economy system are about to unwind in a profound and persistent way. ... [He] foresees hard times as an optimistic era of too much liquidity, too much leverage and too much financial engineering slowly and inevitably deflates. ...

[He] points a finger at three parties: regulators who stood by as U.S. banks developed ingenious but dangerous ways of shifting trillions of dollars of credit risk off their balance sheets and into the hands of unsophisticated foreign investors; hedge and pension fund managers who gorged on high-yield debt instruments they didn't understand; and financial engineers who built towers of "securitized" debt with math models that were fundamentally flawed.

"Defaulting middle-class U.S. homeowners are blamed, but they are merely a pawn in the game," he says. "Those loans were invented so that hedge funds would have high-yield debt to buy."

The liquidity factory

Das' view sounds cynical, but it makes sense if you stop thinking about mortgages as a way for people to finance houses and think about them instead as a way for lenders to generate cash flow and create collateral during an era of a flat interest-rate curve. Although subprime U.S. loans seem like small change in the context of the multitrillion-dollar debt market, it turns out these high-yield instruments were an important part of the machine that Das calls the global "liquidity factory." Just like a small amount of gasoline can power an entire truck given the right combination of spark plugs, pistons and transmission, subprime loans became the fuel that underlays derivative securities many, many times their size.

Here's how it worked: In olden days, like 10 years ago, banks wrote and funded their own loans. In the new game, Das points out, banks "originate" loans, "warehouse" them on their balance sheet for a brief time, then "distribute" them to investors by packaging them into derivatives called collateralized debt obligations, or CDOs, and similar instruments. In this scheme, banks don't need to tie up as much capital, so they can put more money out on loan.

The more loans that were sold, the more they could use as collateral for more loans, so credit standards were lowered to get more paper out the door -- a task that was accelerated in recent years via fly-by-night brokers now accused of predatory lending practices.

Buyers of these credit risks in CDO form were insurance companies, pension funds and hedge-fund managers from Bonn to Beijing. Because money was readily available at low interest rates in Japan and the United States, these managers leveraged up their bets by buying the CDOs with borrowed funds.

So if you follow the bouncing ball, borrowed money bought borrowed money. And then because they had the blessing of credit-ratings agencies relying on mathematical models suggesting that they would rarely default, these CDOs were in turn used as collateral to do more borrowing.

In this way, Das points out, credit risk moved from banks, where it was regulated and observable, to places where it was less regulated and difficult to identify.

Turning $1 into $20

The liquidity factory was self-perpetuating and seemingly unstoppable. As assets bought with borrowed money rose in value, players could borrow more money against them, and it thus seemed logical to borrow even more to increase returns. Bankers figured out how to strip money out of existing assets to do so, much as a homeowner might strip equity from his house to buy another house.

These triple-borrowed assets were then in turn increasingly used as collateral for commercial paper -- the short-term borrowings of banks and corporations -- which was purchased by supposedly low-risk money market funds.

According to Das' figures, up to 53% of the $2.2 trillion commercial paper in the U.S. market is now asset-backed, with about 50% of that in mortgages.

When you add it all up, according to Das' research, a single dollar of "real" capital supports $20 to $30 of loans. This spiral of borrowing on an increasingly thin base of real assets, writ large and in nearly infinite variety, ultimately created a world in which derivatives outstanding earlier this year stood at $485 trillion -- or eight times total global gross domestic product of $60 trillion.

Without a central governmental authority keeping tabs on these cross-border flows and ensuring a standard of record-keeping and quality, investors increasingly didn't know what they were buying or what any given security was really worth.

A painful unwinding

Now here is where the U.S. mortgage holder shows up again. As subprime loan default rates doubled, in contravention of what the models forecast, the CDOs those mortgages backed began to collapse. Because they were so hard to value, banks and funds started looking at all CDOs and other paper backed by mortgages with suspicion, and refused to accept them as collateral for the sort of short-term borrowing that underpins today's money markets.

Through late last month, according to Das, as much as $300 billion in leveraged finance loans had been "orphaned," which means that they can't be sold off or used as collateral.

One of the wonders of leverage is that it amplifies losses on the way down just as it amplifies gains on the way up. The more an asset that is bought with borrowed money falls in value, the more you have to sell other stuff to fulfill the loan-to-value covenants. It's a vicious cycle. In this context, banks' objective was to prevent customers from selling their derivates at a discount because they would then have to mark down the value of all the other assets in the debt chain, an event that would lead to the need to make margin calls on customers already thin on cash.

Now it may seem hard to believe, but much of the past few years' advance in the stock market was underwritten by CDO-type instruments which go under the heading of "structured finance." I'm talking about private-equity takeovers, leveraged buyouts and corporate stock buybacks -- the works.

So to the extent that the structured finance market is coming undone, not only will those pillars of strength for equities be knocked away, but many recent deals that were predicated on the easy availability of money will likely also go bust, Das says.

That is why he considers the current market volatility much more profound than a simple "correction" in prices. He sees it as a gigantic liquidity bubble unwinding -- a process that can take a long, long time."

That's a pretty good description of what's been going on and what's coming, and says the same thing that I've been saying for a long time.

When Satyajit Das was asked, using a baseball analogy, which "inning" the credit crisis was in, he said that we're only just starting to play the national anthem. In other words, we're barely at the beginning of a crisis that will go on for many, many years.

As I'm writing this on Sunday evening, Zurich-based banking giant UBS AG is expected on Monday to announce its first quarterly loss since 2002. The loss is expected to amount to $516 million. But more than that, they're forced to revalue their fixed-income assets from "notional value" to something closer to "market value," as described earlier. The result: A $2.5 billion loss of value. (1-Oct correction)

This kind of thing is going to keep on happening to one institution after another, until that $750 trillion bubble is fully deflated. It will not be pretty. (1-Oct-07) Permanent Link
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