I’ve been writing a bit over the last few months about the financial mess we’re about to fall into and an event I’ve been expecting for a while came to pass late last week – a foreign bank wrote down all of their U.S. CDOs to $0.10 on the dollar.
This event, the long dreaded "mark to market" for CDOs, has implications for all bonds, both commercial and municipal, due to the exposure monoline bond insurers have. This matters for stocks as commercial bonds are often the offerings of publicly traded companies, it matters for the pensions that will have to fire sale all bonds that stop having a AAA rating if the monoline insurers implode, and it’s happening against the backdrop of the first of what promise to be somewhere between 900 and 2,200 bank failures that will result in an FDIC bailout to match the recent Fannie Mae/Freddie Mac bailout.
Grab a bottle of scotch and your teddy bear, ‘cause you’re gonna need both before this is done.
A CDO is a collateralized debt obligation. All those ‘for sale’ signs on your street? The mortgages of those foreclosed houses are part of a CDO somewhere. The repossessed car that belonged to the people that lived there? That loan was part of a CDO. The credit cards they defaulted on? Part of a CDO. Starting to see how this works?
A CDO has a credit rating – the underlying issuing entity pays a monoline insurer an insurance premium for which they receive a "AAA" or investment grade rating on the instrument. The monoline insurers used to be the most boring sort of business in the world, taking a little slice of each bond issue and loaning out their AAA rating in exchange. The risks were well known, they scored consistent, unexciting profits, and life was good. They got seduced by the dark side, began insuring make believe financial instruments, are now on the hook for CDO performance, and now the two in New York, AMBAC and MBIA, are under intense scrutiny from the New York insurance commission and will certainly fail.
This stuff is all like a pile of discarded California Christmas trees on February 1st. One little spark and the whole business will go whoooosh in a puff of flame. Bank of America purchasing Countrywide? Totally and completely about not having to fess up to what their mortgage bundles were worth; it would have taken down both companies and the rest of our economy along with it. J.P. Morgan buying Bear Stearns? More concealment in action with the hand of the U.S. Treasury guiding the event.
Pension plans have rules – they can’t own crap. They own a lot of CDOs which are crap in their own right and they also own lots of other bonds which will become crap due to the loss of their AAA rating when a run on the monoline insurers begins. They'll have to sell, sell quickly, and that means prices for all of these sorts of securities will tumble.
The triggering event for the run on the monoline bond insurers could not come from within the United States; the Federal Reserve, the U.S. Treasury, the Congress, and the White House have all shown a willingness to do whatever was necessary to head off this day of reckoning. It was always obvious the trigger for the meltdown would come from a "mark to market" occurring outside the control of these entities.
National Australia Bank’s decision to value the CDOs it holds at 10% of their face value (this is what got me started on this diary) may very well be the event that will trigger the destruction of the monoline insurers, the revaluing of CDOs from their "mark to model" to "mark to market". If you prefer to be more direct you can call it "mark to meltdown".
These synthetic securities or derivatives (Just call ‘em funny money) were valued via computer models that purported to express the percentage of debtors who’d fail to pay. No one actually sold these things in the open market, they just bought and held them, taking the payments that came and trusting the investment banks that were bundling up and selling these things. Financial innovation, they called it. This was true until two Bear Stearns funds imploded fifty four weeks ago.
Bankers were terrified that this would trigger an overall "mark to market" event.
- Dan Denning, Australia’s Daily Reckoning.
Well, the bonds just aren't worth what most people are carrying them on their balance sheet for. If Merrill sells, it's admitting whole huge chunks of mortgage-backed assets should be revalued to reflect market pricing. "No one in the subprime business wants to ask the question of whether they need to re-mark all the assets. That would open the floodgates," says Janet Tavakoli in the Journal article. "Everyone is trying to stop the problem, but they should face up to it. The assets may all be mispriced."
Consider just what this means. Municipalities are already under stress due to declining property tax revenues and that source of funding is about to get reset bigtime due to declining home values. Corporations are under stress due to declining consumer confidence and the recession we’ve already entered which threatens to turn to depression in the third quarter of 2008 and will certainly be there by fourth quarter(!)
Many of the CDO issuers are mortgage making banks. I’ve written here and here regarding the coming storm in the banking business. Executive summary? One eighth to one quarter of our banks will die very shortly. The FDIC has $51 billion in assets and a failure of any one of the top eighteen deposit holders alone will exceed that amount. Wachovia is widely seen as being marked for death and their insured deposits are ... $392 billion. Bank of America is on the list, too, and their deposits are $600 billion.
You heard it here first, folks. The treasury bailed out Bear Stearns, they bailed out Freddie Mac, and they bailed out Fannie Mae. The first one showed Wall Street a failing investment bank would get the keys to the treasury and the two Government Sponsored Entities, Fannie and Freddie, had already been put to work as collecting points for toxic mortgage securities, transferring private troubles to you and I. Call it Welfare for Wall Street. The FDIC bailout will be next and right after that, I fear, we’ll see a terrible need for addition funds for the Pension Benefit Guaranty Corporation, with the failure of Chrysler, GM, and Ford being one of the driving factors.
So where does all of this bailing get us? Nowhere. Fast. When a single institution or a region of the country has trouble we spread the losses around and pull them out of it. When every institution and every region has trouble there isn’t anywhere to bail to. What we face now is a systemic crash tied to the deflation that has been in motion since the Bear Stearns funds collapsed last year. The Federal Reserve "printing money" isn't going to help in the face of a systemic problem; a doubling of dollars would just cut the value of all of them in half.
If I sound like I know what I’m talking about it’s only because I’ve been religiously reading the work of Kossack Stoneleigh regarding the credit crunch. Stoneleigh and Ilargi broke away from The Oil Drum:Canada a while back to run their own thing - The Automatic Earth which is a daily, in depth read for me.
Good sources for bad news? These are the ones I use:
and I really like this new one of which I was just informed ... a time line for the whole mess.