Who's Holding The Bag?

Mike "Mish" Shedlock
Jul 5, 2007

There is an interesting article in the Financial Times article about Liquidity Threats and who is holding the toxic tranches. Following is a snip.

"After getting bids of a mere 85-90 per cent of face value for about a quarter of the securities, the [Bear Stearns] auction was called off: better to let the Bear flounder than reveal just what a low value the Street puts on even the A-rated paper.

A bunch of hedge funds may have problems, but that is the tip of the iceberg for "Titanic" Wall Street. Who holds the toxic tranches? Answer: the originating banks and syndicating investment banks for the most part.

As these lower-rated tranches retain the bulk of the credit risk in the mortgages, their retention by such banks means the much-trumpeted shifting of credit risk off balance sheets was less than met the eye. If the higher-rated stuff is worth 85-90 per cent of face value at best, what is the value of the $750bn of mortgage-backed securities said to be held in US commercial banks' balance sheets?

The toxic tranches have been valued in recent days at prices as low as 60 per cent of face value.

Wait a second. Didn't the originating and syndicating investment banks hedge their bets via credit defaults swaps (CDSs) in situations where they could not securitize, sanitize, or offload the junk to hedge funds, pension plans, or foreign investors?

Of course they did, at least in part. But exactly what is the credit worthiness of those on the other end of the hedge? And what happens when trillions of dollars worth of hedges or pure bets are made on assets worth far less? Does anyone really think this can possibly work out in the end?

But before we continue with that line of thought, let's back up for a moment and talk about what a Credit Default Swap is.

Credit Default Swaps (CDS)

A Credit Default Swap is a bet between two parties on whether or not a company will default on its bonds. A CDS investor is therefore making essentially the bet as the corporate bond investor. The difference being the counterparty is not a company issuing bonds but a third party willing to speculate on the outcome.

Credit Default Swaps are often used in lieu of corporate bonds when a fund manager can not find enough bonds of the right duration for a company in which they want to invest. In that case, if a hedge fund or other party wants to make a bet as to whether or not a particular company will default, all it has to do is find a suitable counterparty such as another hedge fund, a broker/dealer, or an insurance company, etc. to take the other side of the trade. In a typical CDS, the parties agree to swap cash flows so that one party gets a large payoff if the company defaults within a set period of time, while the counterparty gets periodic payments as long as the company does not default.

In theory, CDSs should trade in tandem with corporate bonds. Then again, there is theory and there is practice. One reason they may not trade in tandem is due to the fact that CDS trades are party-to-party deals that are by their very nature extremely illiquid. There is also a huge anomaly because these derivatives are not marked to market as a general rule. Book value can dramatically overstate open market value.

How Big is the CDS Market?

Inquiring minds might be asking "Just how big is the CDS market?" Because of the over the counter nature of some of these derivatives, the lack of reporting guidelines, and the liquidity issues, no one really can say for sure, but the International Swaps and Derivatives Association (ISDA) does publish data annually. Following are the results of the ISDA 2006 Market Survey.

"Notional amounts of interest rate derivatives outstanding grew almost 14 percent to $285.7 trillion in the second half of 2006. For the full year, interest rate derivatives notional amounts rose 34 percent over 2005, which is above the annual growth rate of recent years.

The notional amount outstanding of credit default swaps (CDS) grew 32 percent in the second half of 2006, rising from $26.0 trillion at June 30, 2006 to $34.4 trillion at December 31, 2006. This compares with 52 percent growth during the first half of 2006. CDS notional growth for the whole of 2006 was 101 percent, compared with 103 percent during 2005. The survey monitors credit default swaps on single-names, baskets and portfolios of credits and index trades.

Notional equity derivatives amounts outstanding grew 12 percent from $6.4 trillion to $7.2 trillion in the 2006 second half. Annual growth was 29 percent, compared with 34 percent during 2005.

The above notional amounts, which total $327.3 trillion across asset classes, are an approximate measure of derivatives activity, and reflect both new transactions and those from previous periods. The amounts do not, however, represent the risks associated with the activity; in order to determine risk, it is necessary to estimate net replacement cost, which ISDA does not collect.

Just to give you an example of how carried away everyone has gotten with CDSs, GM has close to $1 trillion in derivatives betting on its financial outcome even though its current market cap is only $21.5 billion.

Greenspan on Financial Stability

What should have everyone worried right now is this Greenspan flashback from May 5th 2005 when he spoke about Risk Transfer and Financial Stability

"Perhaps the clearest evidence of the perceived benefits that derivatives have provided is their continued spectacular growth. The use of a growing array of derivatives and the related application of more-sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions, which was so evident during the credit cycle of 2001-02 and which seems to have persisted. Derivatives have permitted the unbundling of financial risks. Because risks can be unbundled, individual financial instruments now can be analyzed in terms of their common underlying risk factors, and risks can be managed on a portfolio basis. Partly because of the proposed Basel II capital requirements, the sophisticated risk-management approaches that derivatives have facilitated are being employed more widely and systematically in the banking and financial services industries.

As is generally acknowledged, the development of credit derivatives has contributed to the stability of the banking system by allowing banks, especially the largest, systemically important banks, to measure and manage their credit risks more effectively. In particular, the largest banks have found single-name credit default swaps a highly attractive mechanism for reducing exposure concentrations in their loan books while allowing them to meet the needs of their largest corporate customers.

Greenspan: "Perhaps the clearest evidence of the perceived benefits that derivatives have provided is their continued spectacular growth." That is simply amazing logic for anyone, but especially a former Fed Chairman.

By the same token we had evidence of the perceived worth of dotcom companies in 2000 and the perceived value of Florida condos in the summer of 2005 when everyone was camping out overnight hoping to be "lucky" enough to buy one.

To be fair, Greenspan did say perceived benefits. If he stopped right there and explained the reality it would be one thing. But instead he went on falling in love with his perception by stating the "development of credit derivatives has contributed to the stability of the banking system by allowing banks, especially the largest, systemically important banks, to measure and manage their credit risks more effectively."

Warren Buffett vs. Greenspan

For comparison purposes please read Buffett warns on investment 'time bomb'.

"The rapidly growing trade in derivatives poses a "mega-catastrophic risk" for the economy legendary investor Warren Buffett has warned.

In his letter Mr Buffett compares the derivatives business to "hell... easy to enter and almost impossible to exit".

Some derivatives contracts, Mr Buffett says, appear to have been devised by "madmen".

The profits and losses from derivative deals are booked straight away, even though no actual money changes hand. In many cases the real costs hit companies only many years later.

This can result in nasty accounting errors. Some of them spring from "honest" optimism. But others are the result of "huge-scale fraud", and Mr Buffett points to the US energy market, which relied for most of its deals on derivatives trading and resulted in the collapse of Enron.

One can believe Greenspan or one can believe Buffett. It's your choice. Clearly Buffett was early in his warning, and that is the general nature of all such warnings. But look at the eventual accuracy of his statements vs. Greenspan. Huge fraud in mortgage lending was made possible by "offloading" the risk to third parties (Greenspan earlier bragged about offloading risk). And one almost has to laugh at the amazingly accurate comparison of derivatives to hell by Buffett when he said: "easy to enter and almost impossible to exit". Bear Stearns is in derivatives hell right now.

Containment

So far everyone from Greenspan to Bear Stearns to the rating companies (Fitch, S&P, Moody's), to Fannie Mae and Freddie Mac are saying the mess is contained to subprime. The statements are ridiculous of course given that debt offerings of all kinds are being pulled because there simply is no bid, and next to nothing has been market to market by anyone including the ratings companies.

In addition there is a lot of debt masquerading as investment grade "A" that is in reality junk. The theory that allowed this to happen was that pools of junk would be packaged together and sliced up and even if some of the junk blew up the package itself would not. Let's watch what happens when some of this "A" rated stuff start blowing sky high.

Talk of containment is in reality nothing but psychological ploy by those doing the talking. For further discussion of the psychology of debt, please take a look at Sea of Change on this blog and/or Sea Change in Debt-Funded Buyouts? on SeekingAlpha.

Recent Blowups

The latest subprime blowups include Caliber Global and Brookstreet Securities.

"Caliber Global Investment Ltd., a London-listed fund that controlled almost $1 billion of mortgage assets, said on Thursday that it's shutting down after turmoil in the subprime market cut demand for its shares.

Caliber is the latest casualty of rising delinquencies in the subprime mortgage market, which caters to poorer borrowers with blemished credit records. Bear Stearns is trying to salvage two of its hedge funds that focus on the space, while another run by UBS AG shut down earlier this year.

On June 30th, the OC Register reported on the demise of Brookstreet Securities.

"Agents with the U.S. Securities and Exchange Commission spent Friday monitoring the last day of business at the Irvine offices of Brookstreet Securities, which closed to retail customers this month after failing to meet margin calls on complex mortgage-based investments.

Brooks said his company had $17 million in cash on hand at the end of May. But by June 20, after the clearing firm that handled Brookstreet's accounts demanded cash to meet margin calls, Brookstreet was left with debts of $14 million.

30 Brookstreet CMOs reviewed by the Register were more complex than most CMOs. Their structures expose investors to losing or gaining money following tiny fluctuations in interest rates. As such, they are difficult to value.

Brooks said the accounts collapsed because the clearing firm, a subsidiary of Fidelity Investments, used what are called "notional values" to price the CMOs. Those values plummeted as confidence plunged in mortgage-backed securities to subprime home loans.

"We never had a performance issue," Brooks said of the CMOs. "We had a notional pricing disparity."

Here is the latest in creative excuse making: "We never had a performance issue. We had a notional pricing disparity."

What's on the Books?

Question: How much of that $285.7 trillion in derivatives is marked to market?
Answer: No one knows for sure but you can bet its far lower than is reported on the books.

Please consider Federal Court Freezes Assets of Hedge Fund in Chicago.

"A federal court froze the assets of Lake Shore Asset Management, a hedge fund firm run by a former chairman of the Chicago Mercantile Exchange, after regulators said it overstated its holdings.

Lake Shore, based in Chicago, said that it managed $1 billion for investors and traded in United States commodity futures contracts, according to the Commodity Futures Trading Commission. A review showed that the fund had about $466 million. Lake Shore barred regulators from inspecting its accounts on June 14, which is a violation of the Commodity Exchange Act, according to the commission's complaint.

Who's Holding The Bag?

Jim Jubak writing about the Deepening Debt Crisis sees it this way.

"First, the investors who elected to buy the equity tranche [Mish note: the riskiest tranches], attracted by the possibility of an equitylike return on a fixed-income investment, get killed. And unfortunately, those big losses won't be limited to Wall Street or to the sophisticated investors in hedge funds.

Hedge funds bought about 10% of equity tranches in 2006, according to Bear Stearns. But pension funds bought more -- 18%. Insurance companies bought even more -- 19%. And asset managers bought even more -- 22%. When pension funds take big losses, parent companies have to make up the loss or workers have to take smaller pensions. When insurance companies take the loss, insurance rates go up. When asset managers take the loss, well, we all cry when we open our monthly mutual-fund statements.

It's hard to get a complete list of who owns equity-tranche CDOs. But some names that come up include the California Public Employees' Retirement System ($140 million), the Teachers Retirement System of Texas ($63 million), French financial giant AXA (AXA, news, msgs) and the New Mexico State Investment Council ($223 million).

That's a nice start and the percentages reflect where some of the major concerns lie, but still it's just a start. In a more general sense let's start from the top and work our way through who was and will be affected by this mess and in what ways.

Obviously anyone investing in the Bear Stearns hedge funds, New Century Financial, Caliber Global, Brookstreet, or Lake Shore Asset Management is a bagholder. So is anyone who was working for any of over 60 companies that have now blown up or gone out of business. Many lost their jobs, their hopes and their dreams.

Investors, pension funds, hedge funds, etc buying these toxic tranches are also bagholders. But not so obvious are the tens of thousands of people that bought houses at inflated prices because the "miracle of offloading debt" permitted it. And when "A" rated paper starts to default, the bagholders will become even more numerous and the amounts involved much bigger.

Those that think they have protection via credit default swaps may find they too are bagholders. Take Brookstreet for instance. If Brookstreet was holding the wrong end of a credit default swap, and some other hedge fund or larger backer was counting on payment from that as a hedge.... oops. With $34.4 trillion worth of swaps floating around we are talking about the possibility of a major waterfall in CDSs. And that is just the CDS market. The total derivatives market as of year end 2006 is $285.7 trillion.

But the bagholders go far beyond the obvious. Everyone that owns a house and has seen property taxes skyrocket is a bagholder of sorts. That is close to 70% of the population. Don't own a house? How much did energy and commodity prices rise because of the world's most insane experiment with liquidity to date?

What about cities and municipalities foolishly banking on forever rising real estate prices and budgeting for exactly that by investing in a bunch of wasteful projects with money already down the drain? Expect to see some major cutbacks in services (canceled projects and job losses) as a result. But that money already raised via bonds has to be paid back somehow, doesn't it? Who's holding the bag there? Taxpayers of course.

In short, bagholders are everywhere you look. The big winners (in short supply) are those banking the fees , commissions, and profits rolling the dice with OPM (other people's money). Smaller winners will include anyone smart enough (or lucky enough) playing the greater fool's game to perfection then cashing out before the "time bomb" that Buffett described goes off. Everyone else is (or will be) left holding the bag.

Jul 4, 2007
Mike Shedlock / Mish
email: Mish
blog: http://globaleconomicanalysis.blogspot.com/

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