Agora Financial’s Rude Awakening

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Laguna Beach, California

• Institutional dominos continue to roil Wall Street,
• Gold launches 9% as investors seek a debt-free safe haven,
• Lessons from LTCM, when CDSs turn ugly and much more…

Eric Fry, huddled in a bunker far from Wall Street, reports…

“This is as bad as it gets,” your editor sighed after the close of yesterday’s trading session.

“No,” his brother replied. “This is as bad as it has gotten…so far.”

“True,” your editor had to agree.

Even to a seasoned – and congenitally bearish – investor like your editor, the cataclysm rolling through the financial markets inspires both shock and awe. Yesterday’s trading action produced equal measures of both shock and awe, as the Dow plummeted 450 points and the gold price soared $85 an ounce. Financial stocks continued to grab the headlines…and to lead the stock market into a buyer-less abyss.

The CEOs of the wobbly financial firms blame the short-sellers for causing the recent crisis. We blame the CEOs. But finger-pointing never adds dollar bills to an investment account, foresight does.

Thus, for the second time this week, your Rude editors have decided to dust off a column from the Rude archives. In a three-part column from July of last year entitled, “Investment Landfill,” guest columnist, Paul Tustain, examined the murky world of credit default swaps (CDS). And after examining these high-tech derivatives, he explained why they might cause a big problem one day.

Tustain’s inelegant conclusion: Buy gold.

Given the fact that CDSs are crippling one financial institution after another, and the fact that gold jumped $85 yesterday, Tustain’s column may be more timely today than when it first appeared. So please enjoy the following excerpts from that column (along with the original introduction from yours truly)…

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Eric Fry, resisting the urge to dance, reports…

“We’re still dancing,” beams Chuck Prince, the CEO of Citigroup, in reference to the big bank’s lending activities. The problems in the sub-prime mortgage market are not large enough to cause a problem for Citigroup, he says, much less for the financial markets as a whole.

“The depth of the pools of liquidity is so much larger than it used to be,” Prince explains to the Financial Times,” that a disruptive event now needs to be much more disruptive than it used to be.”

Hmmm…seems like a reasonable assessment. On the other hand, a bigger pool makes a bigger splash. In the context of today’s gargantuan derivatives markets, for example, the LTCM debacle of the late 1990s seems like a storm in a teacup. The next storm, if and when it arrives, will likely produce ripples of much larger magnitude and much greater destructive
force.

Back in the days when the Nobel Prize winners at LTCM were devising new ways of losing billions of dollars, credit derivatives were little more than gleams in the eyes of investment bankers. The problems at LTCM, therefore, failed to trigger any enduring knock-on effect. But the financial markets of today feature an unprecedented quantity and variety of illiquid financial oddities that have never witnessed a financial crisis, nor even a garden-variety bear market.

What will happen, therefore, if the unexpected were to occur?

No one knows.

What we do know is that the notional value of credit derivatives outstanding has doubled five years in a row and now exceeds the value of the entire American GDP.

“At some point,” Citigroup’s Prince admits, “the disruptive event will be so significant that instead of liquidity filling in, the liquidity will go the other way…When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance.”

…unless you don’t mind leaving the party a little early.

[Ed. Note: If you want to read Part II of Paul’s Investment Landfill article, you can do so here.]

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Investment Landfill, Revisited
By Paul Tustain

Do you remember Lloyds of London?  It used to be the world’s biggest insurance underwriter. The way it worked was that rich individuals were allowed to keep all their money invested in their favorite stocks and shares, but they could also earn a second income from those assets by pledging that same wealth to underwrite commercial insurance risks, which were sliced and diced by syndicates on behalf of their members.

Unfortunately, when a series of vicious insurance losses hit the world’s insurance market through the early ’90s, many Lloyds members lost absolutely everything - houses, furniture and indeed their lives.  Many of today’s professional money managers engage in a similar practice when they sell credit default swaps (CDS).

CDSs, CDOs and all the other credit derivatives that populate the global financial markets present a new and uncertain risk for investors. Let’s dig a little deeper…

CDOs, as we explained in last Friday’s edition of the Rude Awakening, are new-fangled credit derivatives - i.e. they are bond-like instruments that are derived from pools of loans, usually mortgages. Through the wizardry of modern financial engineering, a pool of sub-prime mortgages, for example, can become an array of CDOs, some rated as high as AAA, others rated much lower. Industry insiders sometimes refer to the lower-rated CDOs as “toxic waste.”…

Institutional investors have been gobbling up these high-yielding - but very risky - CDOs because they are able to buy default insurance - otherwise known as a credit default swap (CDS).

For example, the buyer of a particular CDO could simultaneously buy a CDS to protect against a default. The investor would, effectively, pay an insurance premium to another investment institution for underwriting the risk of the underlying home-loans defaulting.  Apart from a bit of legal drafting, that’s all there is to a Credit Default Swap.  In return for a cash payment, you swap the risk of default.

These insurance premiums, paid to the underwriter of the CDS, appear to the receiver as income - just like the insurance premiums that any insurance company would receive. You are being paid for accepting risk, not for lending money.

So you see, the investment bankers have been very clever. They have said there are two components in a bond-interest payment: a fee for the use of your money, and a fee for the risk of default.  The CDS simply separates out the [fee] for the risk of default.

The investment bank can have still more fun with this. Just like the boring mortgage streams that we started with, these CDS streams can be aggregated into a pool…then divided into tranches with different risk profiles…producing the magic of higher credit ratings for lower-risk tranches…plus concentrated risk in new toxic waste.

If you can get a credit rating agency to assess the tranches you have created, then you have something that looks like a CDO - and smells like a CDO - but which is not now based on cash flows deriving from borrowed money. Instead, it is based on cash flows deriving exclusively from insurance premiums that are paid to cover the risk of mortgage default.

That’s how CDSs get packaged into what is known as a “synthetic CDO,” and the investment banks can sell them for what appear to be fantastic yields. It’s a really neat deal…for the investment banks, which are selling to the highest bidder the right to receive their mortgage default insurance premiums in exchange for assuming the risks of default - so the buyer is just another “investment landfill”.  He ends up with what’s called a “contingent liability.”

Why would any investment fund possibly fall for this scheme?  The modern fund manager has a powerful short-term incentive to get a strong performance out of your invested savings.  If he gets 2% more than the next guy he is a genius, and he will get more money under his management and much larger performance fees. As long as defaults occur rarely, synthetic CDOs can provide a pretty neat deal for the investors. They earn a steady income stream, simply by promising to stump up if there’s a default.

So you can see now how through the use of synthetic CDOs, fund managers can underwrite credit default risk and increase their income accordingly, without outlaying any fund capital.  Importantly, however, they are placing their fund capital at risk.  Your fund manager is a genius while there are no claims. But if it goes wrong, your fund gets hammered.

But the CDO story does not end here…

It was not long before the investment banking industry had a “Eureka” moment…They started insuring against the default of securities they didn’t even own! It’s like noticing your friend is looking a bit ragged and taking out insurance on his life for your benefit, without him having anything to do with it. And as long as there is demand for “easy income,” there’s no limit to how many of [CDS, the investment banks may create.]

When Delphi Corp, a large motor parts spin-off from General Motors, got into serious trouble last year, its bonds fell into default.  Incredibly, more than 10 times the nominal value of its bonds were then claimed from investment institution underwriters, by bankers who had insured against the default of bonds they didn’t own by issuing Delphi CDSs.

This isolated incident suggests that the mushrooming growth of credit-derivative issuance imparts an unknown and untested threat to the global financial system….

Long Term Capital Management failed in 1998.  It was the last truly serious financial collapse which threatened the U.S. financial system.  When LTCM went under, the bail-out fund required was $3.65 billion.  The [LTCM] fund itself was leveraged to about $125 billion of assets…

Back in 1998 LTCM was plowing a lonely furrow.  Its investment view was something to do with Russian bonds and the Japanese Yen.  It was off the main investment spectrum, and there were few copy-cats putting the same market view into action in the same way.

That is where things are very different this time…Many banks and funds are involved…This makes the size of the problem potentially much larger, and of much greater risk to the whole financial system.

How large?…Depending upon who’s counting, the world’s investors now hold somewhere around $1 trillion worth of credit derivatives, at market value. But since the notional value of these arcane financial instruments exceeds $25 trillion, no one really knows how large the potential losses could become during a panic.

Now you can see the difference in scale between LTCM and the subprime bust.  This may be 20 times worse than LTCM.  And it’s getting worse - daily.

At a time like this, we should not underestimate the skill of people like Ben Bernanke at the US Federal Reserve in underpinning the financial system.  They have been remarkably effective at organizing the lifeboats over many years and many crises….[But] Here at BullionVault we think the Bernankes of this world will one day fail.

The result will be a credit squeeze.  Bond issues will be pulled, bank loans recalled, and business activity will sharply decline for lack of funding.  The first two of these have certainly started - with a rash of failed issues at the end of June.  Will these risks be contained?  We don’t know…

Clearly we’re biased against excessive leverage, and against too much financial ingenuity, too. That’s why we’re in the physical gold bullion business.  We believe that real physical gold is a sensible insurance against today’s increasingly weird financial system.  It has been astonishingly reliable in that role in the past.

But this time, who knows?

[Rude Endnote: Gold bucked up $70 yesterday as investors sought the safety of the only real asset that represents nobody else’s liability. Unlike Treasuries, the world’s largest debtor does not issue gold, nor does mother earth possess a printing press to easily and quickly produce more of it.

If there was ever a time to be holding gold, now is that time.  To grab some yourself, check out BullionVault right here.

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Rude Endnote: Two quick but insightful thoughts to wrap up today’s proceedings; neither of them from us. One comes from a reader, the other from a writer.

The first is a must read article penned by Bloomberg’s Jonathan Weil on the red herring of short selling. Wanna know what’s got the wind up the skirts of financial CEOs these days? Read on here for an introduction to Marxism, Wall Street style.

Secondly, responding to some depressing math from Eric in yesterday’s issue, one reader observed, “Eric Fry's $283 loan figure [the amount each and every American taxpayer “lent” to AIG] got me thinking about the costs of the Freddie and Fannie bailout to Americans. 

“Assuming a cost of $200,000,000,000 - which seems to be the standard figure quoted - each of the approximately 300 million Americans is getting tapped for $666.6666666.  Aside from being a spooky number, this effectively obliterates the paltry tax refund our government doled out this summer.  And of course that tax gift was, in reality, just more debt tacked onto the mother of all credit cards, the federal deficit.  Isn’t math fun?”

Rude: It used to be…until the government started doing the additions for us.

Until tomorrow…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com