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The end of the Ponzi scheme

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.


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The ever continuing saga of financiers purchasing a 12 gauge shotgun, loading it, aiming it at their "valuables," and then pulling the trigger all the while proclaiming, "Things are different now" is starting to get boring.

What did these Bozos think would happen, eventually, if they continuously sold long and borrowed short?

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Wed Oct 17th, 2007 at 11:21:59 AM EST
The boom will go on for ever, so long as the coyote does not look down.

It is like the Northern Rock executives appearing before the House of Commons Treasury Committee yesterday. They were quite unable to see (or at least admit in public) that there might have been something wrong in the way they ran the bank.

They considered the recent run on the bank was all the fault of the Bank of England, for not extending 31 billion pounds of credit when asked so the bank could be sold, and of the BBC for pointing out what was going on. If taxpayers money bailed them out, without the general public knowing about it, then all would have been well.

by Gary J on Wed Oct 17th, 2007 at 11:42:20 AM EST
[ Parent ]
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.

I believe what happened in August was that hedge funds, instead of selling illiquid asset-backed securities at a large loss, chose instead to sell other very liquid assets to get cash. This had an opportunity cost as they were actually selling stuff they thought they could hold for a profit. Also, because everyone was essentially betting a few strategies many hedge funds had similar holdings and the market impact of some hedge funds carrying out a massive unwinding of their positions was to force other hedge funds who were not esposed to the "commercial paper" to sell more liquid assets to meet margin calls.

We have met the enemy, and it is us — Pogo

by Migeru (migeru at eurotrib dot com) on Wed Oct 17th, 2007 at 11:40:20 AM EST
Anyone willing to bet when the sh!t will hit the fan ?

As for the behaviour of the market ? What are the odds of all those clever, clever, smart-suited, multi-home-ed, porche-driving, mega-bonus "earners" being held financially to account for their misdeeds. Nick Leeson served time, I think this lot should lose their gonads.

keep to the Fen Causeway

by Helen (lareinagal at yahoo dot co dot uk) on Wed Oct 17th, 2007 at 02:05:29 PM EST
Interesting things are happening right now. For example, Morgan Stanley Sells Entire New York Times Stake. But this impulsion may written off as woes of the printed press in the digital age.

What about this? IMF says dollar `overvalued'. Is that IMF?!

And now recall that one of the big pillars of this global financial regime is Asian banks stocking dollar-based assets, allowing America to build all possible instabilities and bubbles, but reluctant to invest into their own economies because of inflation "menace".

Japan and China lead flight from the dollar

Japan and China led a record withdrawl of foreign funds from the United States in August, heightening fears of a fresh slide in the dollar and a spike in US bond yields.

Data from the US Treasury showed outflows of $163bn (£80bn) from all forms of US investments. "These numbers are absolutely stunning," said Marc Ostwald, an economist at Insinger de Beaufort.

Asian investors dumped $52bn worth of US Treasury bonds alone, led by Japan ($23bn), China ($14.2bn) and Taiwan ($5bn). It is the first time since 1998 that foreigners have, on balance, sold Treasuries.

[The US] requires $70bn a month in capital inflows to cover its current account deficit, but the key sources of finance are drying up one by one.

BNP Paribas said America has relied on "hot money" from abroad to cover 25pc to 30pc of the US short-term credit and commercial paper market over the last two years.

This flow is now in danger after the seizure in parts of the market over the summer and after the Federal Reserve's half point rate cut, which has shaved the US yield advantage over other countries.

Ian Stannard, a Paribas currency analyst, said the data was "extremely negative" for the dollar. "It exceeds the worst fears. It is not just foreigners who are selling US assets. Americans are turning their back as well," he said.

Central banks in Singapore, Korea, Taiwan, and Vietnam have all begun to cut purchases of US bonds, or signalled an intent to do so. In effect, they are giving up trying to hold down their currencies because the policy is starting to set off inflation.

The Treasury data would have been even worse if it had not been for $60bn of inflows from hedge funds based in Britain and the Caymans, which needed to cover US positions at the height of the credit crunch.

This looks pretty scary, for all we know. (Even if the opinion comes from BNP Paribas.)

Apocalypse about now?

by das monde on Thu Oct 18th, 2007 at 12:10:27 AM EST
[ Parent ]
I think that to talk about "fictitious" value is slightly misleading in that while some of it is based upon crap like unsecured credit card debt there is asset backing in the form of real estate for a lot of it.

However, the point is that the actual value underpinning the loans, which is that of a stream of land and property rentals, is nowhere near sufficient to meet the present, never mind the future, obligations to repay principal and interest that exist.

I believe that the solution to the current problem lies in what is effectively a debt/equity swap by creating quasi REIT vehicles ("Land/Property Rental Pools") which will acquire the properties and then rent them out, probably to the existing - defaulting - borrowers.

Why should this work?

(a) there is no capital repayment, since this is "equity" based on ownership of land, not debt secured against it;

(b) the "Rental" payment may be set at a reasonable (affordable) level, say 3 to 4% but then index-linked.

So the property Occupier/ Co-owner will probably be paying less in cash terms than he was under the original loan.

The property occupier may then acquire equity simply by paying more rental than is due, and thereby acquire "Equity shares" or units in what will essentially be a "pool" of land and property rentals.

While the banks now have a security perfect for pension investment which they can sell on.

I really don't see why such a Debt/Equity approach should not work. After all, buying productive assets with borrowed money, and then packaging them up in funds and flogging them to pension funds, is how people like Macquarie make all their money.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Wed Oct 17th, 2007 at 04:33:24 PM EST
Well, I think you're right, it probably would work.
But are they likely to undertake that course of action?
I'm not optimistic.
by Metatone (metatone [a|t] gmail (dot) com) on Wed Oct 17th, 2007 at 06:19:56 PM EST
[ Parent ]
As Keynes had it.


Worldly wisdom teaches that it is better to fail conventionally than to succeed unconventionally


"The future is already here -- it's just not very evenly distributed" William Gibson
by ChrisCook (cojockathotmaildotcom) on Wed Oct 17th, 2007 at 06:40:31 PM EST
[ Parent ]
The fact that the assets are worth a little does not really make the nominal evaluations less fictitious.

The evil of compound interest is becoming evident: you can't beat mathematical exponential growth in the real world for long.

Of course, borrowers and lenders can make deals, disposing mathematical principles. The situation of lenders getting all assets they don't need, against busted without basic necessities, is not how the market is supposed to work. Unless the lenders would like enjoy the power differential more than just making money.

by das monde on Thu Oct 18th, 2007 at 12:21:43 AM EST
[ Parent ]
Are the ABCPs the same thing as repos (repurchase argeements)?

Henry Liu writes about repos in similar way: as asset-based short term loans that could be used (for example) to cover other loans, possibly of the same sort.

Meanwhile, the Calculated Risk blog is paying much attention to a big drop in ABX indices, which apparently shows worthiness of mortgage securities. Does it mean that the value of suprime CDOs is gonna vanish? The ARM resetting season is going just to start at around Christmas.

by das monde on Thu Oct 18th, 2007 at 12:56:33 AM EST


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