"It is a fully fledged solvency crisis that has arisen because two giant and interlinked bubbles burst simultaneously - one in property, one in credit - leaving banks and investors on the brink of bankruptcy, some hanging on by their fingertips."

Apologies to Robert for joining the mob.

You're forgetting the impact of mortgage foreclosures on CBO market and all the various instruments financially engineered (sic) over the last 20 years.  Most of the latter were leveraged meaning the downside is much worse than the money owed for the mortgages.

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

If the instrument is divided into four equal tranches, and you hold the 25% riskiest tranche a 10% default in the pool is a 40% loss for you ... a 20% default in the pool is an 80% loss. A 40% loss in the pool, which is certainly likely to be seen in many of the instruments that have concentrated the systematic risk of a downturn in the housing market, and the riskiest tranche is wiped out, and the second riskiest tranche has 60% of its backing in default ... and the remaining 40% is the absolute worst risk remaining in the pool.

And consider the higher quality tranches now ... someone bought the second best tranche for slightly better returns than the top tranche while still expecting, absent a meltdown in the housing market, low default risk and low pre-payment risk ... indeed, given that this was rated as an investment grade instrument, you were focusing on the pre-payment risk when deciding between the first and second tranche. But now you are, in effect, mostly holding the junk tranches of the mortgages still standing.

The top quality tranche, which is the best sheltered from default risk, was bought by an institution looking for a rock solid, steady stream of income for a number of decades, and all of a sudden is holding an asset with a clear pre-payment risk, when the returns available to pre-payments is lower than when the top quality tranche was originally lost.

Its lost value across the board ... sure, loss of value in the lowest quality tranches, loss in quality in the highest quality tranches, but still, lost value as financial assets.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

Then it's indeed a question of opinion as to what the inability means. But there is a conceptual difference between a temporary mismatch between resources and debts, and a long term inability to pay one's debts. The first kind can be solved by liquidity injection, the second cannot.

So, after the failure of the recent liquidity injections, one can infer that we are no longer in a temporary mismatch situation.

In the long run, we're all dead. John Maynard Keynes

In 1928 the US housing market started to lose value.  The market value of these homes did not return to pre-28 values until the 1950s.  Mr. Munchau is saying this downturn will be worse.

Munchau's little calculation is about UK housing market, not the US one.

The problem isn't the CMOs (note my correction to my original comment.)  The problem is what happens once derivatives are spun using the CMO as the underlying asset.  derivatives have come far from their original use and the risks to the financial system have grown alongside.  

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

This industry is set to crash and burn.  

WE don't KNOW that the banks are insolvent (though we think they are) because they will not let us see their books.  If we saw their books we THEN would know.  

But they are not fools:  There is no way they would let us see their books.  How bad is it?  Based on how rotten their own position is, they are not willing to other banks whose position is likely as bad.  

And is that not bad enough for you?  What more, really, do you need to know?  

If you were a rich foreigner holding dollars, why would you buy into these insolvent banks?  Well, your dollars are going to lose value no matter what you do.  By buying pieces of the financial system before the dollar loses value, you might--while taking the inevitable loss--acquire control.  

The Fates are kind.

So with a 1.5% interest rate, it can still get an 18% return on capital invested. Also, as a lender, you get first dips at being reimbursed so, as long as you don't lend the whole amount, you let the initial investor take the first hit (the whole thing about CDOs was to create more tranches between the traditional "debt" and "equity" tranches, to fine tune risk taking even better - exactly as ChrisCook suggests should be done).

But my point above is that the 5-10% default rate appears optimstic (see separate answer on that)
While the amount of capital at risk has not changed (ie the amount that can potentially be lost), the overall amount of money at risk (in a more diluted way, sure) has gone up.

In the long run, we're all dead. John Maynard Keynes

Now, you are correct in that there will be some tranches which hold onto a value better than keeping money in a pillowcase. In particular, loans sold a few years ago or more are pretty good. Not only were they sold in an above board manner to people who could qualify for loans in an above board manner, but the houses were valued at a value more realistic than today's and they were 80% loans.

The last few years the 100% loans and the illicit paper fixing to get someone fundable put a dent in the system. And if it were just taking a hit for those percent of foreclosures (suspected to hit more than 2 million additional to the standard in the next two years) perhaps your paper would return to value after the panic.

But the houses were valued too high to begin with, just because of the easy money bubble. The foreclosures are going to force the house value down in every neighborhood, the fact that job loses are going to accelerate will take buyers out of the system which will force house prices down, the fact that only the most pristine buyers will be looked at will take more people out of the system, driving the prices down.

Suddenly, even if you had the truanch based upon the best properties and were able to sit out the panic portion of this problem, the houses in your portfolio are not worth 60% of what they were loaned at. Or worse.

I had a house that I bought in the 80s - put 50K in paint and a new kitchen so that I had 425,000 in it. Market collapsed.  Value was at less than 300K for a long time and didn't get up to 425 for a decade. If I had to sell (to follow a job, for example) or if there were a medical disaster (I was self employed, no insurance), that house would have been on the market and someone would have gotten a deal in your long run.

And that is how I think that the best AAA tranche is short term, incalculable dust, and the worst are sand through the fingers...you just can't hold out that long for something that is going to stay undervalued for the length of time it would take to "normalize".

And yet, many American corporations have a lot of cash, and have the ability to tighten up at home and sell more abroad. It will be an interesting game. So, what you are saying rdf about the houses might actually be true about the stock market...some parts might be a disaster, but they are not the majority and there are some parts that are just going to grow fine...though there are a lot of presumptions even in that (like, at which point can they just not afford to keep us old folks alive anymore on the high priced medicines and care that it will  take to do so?

Never underestimate their intelligence, always underestimate their knowledge.

Frank Delaney ~ Ireland

(I can't believe I just wrote "a minor purchase of $100 billion dollars.")

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

I agree that some form of long term "intensive care" ward for banks is something likely to happen. What's interesting is that the problems do not quite come only from the banks:

Out of the shadows: How banking's secret system broke down

(...) while investors are scrutinising some of the industry's best-known names, a spectre will be silently haunting events: the state of the little-known, so-called "shadow" banking system.

A plethora of opaque institutions and vehicles have sprung up in American and European markets this decade, and they have come to play an important role in providing credit across the financial system. Until the summer, structured investment vehicles (SIVs) and collateralised debt obligations (CDOs) attracted little attention outside specialist financial circles. Though often affiliated to major banks, they were not always fully recognised on balance sheets. These institutions, moreover, have never been part of the "official" banking system: they are unable, for example, to participate in Monday's Fed auction.

But as the credit crisis enters its fifth month, it has become clear that one of the key causes of the turmoil is that parts of this hidden world are imploding. This in turn is creating huge instability for "real" banks - not least because regulators and bankers alike have been badly wrong-footed by the degree to which the two are entwined.

"What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending [that is] so hard to understand," Bill Gross, head of Pimco asset management group recently wrote. "Colleagues call it the `shadow banking system' because it has lain hidden for years, untouched by regulation yet free to magically and mystically create and then package subprime loans in [ways] that only Wall Street wizards could explain."

If Lehman fails who cares beside a bunch of speculators that trade in its paper?

All the corporates that get liquidity from Lehman's trades on the market and from direct investments.

Plus, the Fed provides normal liquidity as well, there were headlines just because of the unusual procedure this time - and, as it happened in the European timezone, US banks took advantage of the available offer right away too.

In the long run, we're all dead. John Maynard Keynes