by Jerome a Paris
Wed Oct 17th, 2007 at 09:10:18 AM EST
This article by Lee Adler is required reading to understand what's been happening in the markets in the past few weeks. It explains why stock market prices have gone up despite the crisis and other unexpected phenomena.
Its basic contention is that the ABCP (Asset Backed Commercial Paper) market was a giant Ponzi scheme, and that it is now unravelling. ABCP is very short term debt (typically, 3 months) which is backed by other financial assets - i.e., if the borrower does not pay back, the lender can grab the asset and sell it.
Suddenly, there is huge doubt in the market that the underlying assets (thinks like mortgages and an amazing variety of debt obligations or other instruments sliced and diced and repackaged) are really worth what they are, banks and other investors have suddenly stopped providing new Commercial Paper, and asking for repayment of existing lines. Thus the total notional size of the market shrank from $1,170 billion to $917 billion between early August and last week, a $255 billion decrease (or more than 20%).
What that article asserts is two things:
- one is that that big chunk of money was moved out of ABCP into US Treasuries and stocks, thus explaining the drop in interest rates and the paradoxical increase in stock markets in recent weeks. This is now comoing to an end, however;
- the second thing is that these $250 billion is, in all likelihood, the only value that could be extracted from the whole pile of ABCP, and that the rest is essentially worthless. Nobody wants to invest in ABCP right now, so the remaining outstandings are those that investors are forced to roll over (i.e. extend) because they are not getting paid - i.e. lending new ABCP to repay the existing ABCP in order to avoid an actual non-payment
Banks can hold on that fictitiously valuable paper for a while longer (including via the "Superfund" that has just been put in place), but many others, like hedge funds, cannot extend these lines indefinitely and will need cash. when they do, they will need to sell the paper, or the underlying assets, and this is likely to happen only at deep discounts, thus materialising real losses, and dragging the whole market down by providing an actual value for the paper.
In other terms, everybody is still trying to pretend that these assets are worth something, because everybody would be hit by the revelation of their real price, but that pretense has a cost, i.e. immobilising money, which is likely to become increasingly hard to bear. But once the floodgates open, well the whole sorry mess will become visible.