What Are They Talking About?

Today's Journal contains an article (Lehman's Demise Triggered Cash Crunch Around Globe). Many in the press and the finance community blame Credit Default Swaps (CDS) for the current travails of capital markets. The article reports that Fed (FRB) has been pushing Wall Street for month to establish a clearinghouse for CDS. This means that unlike the current situation, all such contracts will have to pass through a central body that will record them. This will enable the Fed to, first, have a general picture of what is happening in this field and, second, allow it to regulate it.
Recall: CDS are in essence insurance contracts. Like all insurance types they make sense only when the risk is non-systemic. To understand this, consider home insurance. The insuring company will be able to honor it when the risk is non-systemic. But if a giant hurricane is going to hit the whole U.S. at once (systemic disaster) all insurance companies will fail to honor their obligations. The same holds true for credit insurance. In normal times when a few companies default on their loans in a random manner, credit swaps on such companies will be honored. But what happens if the economy hits a bump and thousands of companies default on their loans? So, I really don't understand how regulation could have prevented the current crisis.
The only way top remove the risk of systemic failure of the CDS market is to ban this type of contract altogether.

Covertible bonds

I recommend you read yesterday's WSJ article "Short-Sale Ban Wallops Convertible-Bond Market" It might serve you in both my forthcoming exam (it falls under the Bond Classification subject) and the derivatives class.
Make sure you understand the claim regarding who issues such bonds and the statement that 75% of convertible bondholders also go short on the stock of the bond-issuing company. Obviously, without knowing what a short sale is, this article will make no sense to you. So if you are a bit hazy about this sale, look it up on the Internet.

Debt Market Distress Spreads

An article in today's Wall Street Journal provides a description of the commercial paper market and its recent upheavals. Read it!!!

Toxic Mortgage Pools

You probably heard a description of the recently proposed $700 billion rescue plan as cash for trash. This plan calls for the Treasury to purchase from financial institution mortgage backed security that are completely illiquid; nobody want to buy them. You may want to ask why is that that these securities are untouchable. The answer lies in the uncertainty surrounding the cash that will ultimately will flow from them. As more borrowers whose mortgages are part of the pool default, the less is the payoff from the securities backing the pool. This is not a problem for conventional (or prime) loan whose cash flows are now guaranteed by the U.S. Treasury. Subprime loans that were securitized by private banks are at risk; they are not protected from borrowers defaulting.
Yesterday's New York Times had an EXCELLENT description of the toxicity of one mortgage pool. Please read this article titled "Plan’s Mystery: What’s All This Stuff Worth?" Make sure to examine carefully the multimedia table in this article.
Once you read this article, you will be able to understand why (in my opinion) the $700 billion rescue plan will reap off the tax payers. Suppose a bank is currently holding securities from two different pools:a high quality Pool I and a low quality Pool II. The bank cannot get rid of either one of them because buyers believe that the bank will try and get rid of the bad pool first. George Akerloff was awarded a noble prize (2001) for this idea (he titled his article "The Market for Lemons"). Enter the cash for trash program: the banks can now sell to the Treasury either the Pool I or the Pool II security. Which one do you think the Treasury is going to end up owning?

Is The Crsis Winding Down?

The DJ Industrials average closed today some 400 points up. Do market believe that the worse is over?
many commentators argue that there is at times a dichotomy between the bond and the stock markets. The bond market "predicted" the current crisis by demanding historically high risk premiums on LIBOR and on junk borrowings. It is my view that the bond market is more "rational" because fewer small investors play this market. I would wait to see if the other shoe (commercial real estate, Credit card ABS) drops before passing judgement.
At any rate, my suggested reading for today is Steven Levitt's blog in the New Your Times titled "Diamond and Kashyap on the Recent Financial Upheavals"

The AIG Crisis

9/17/08
These are momentous times. Current events in the fixed income area may paralyze the world’s economy and push it eventually into a deep recession. This is not a forecast but rather one of several potential scenarios.
I could elaborate in person on current events. Fortunately, because of the centrality of fixed income securities in the current crisis, better persons than me comment on the situation and it is my pleasure to refer you to several excellent sources:
1. In today’s New York Time read “Fed Agrees to Lend A.I.G. $85 Billion to Head Off Crisis” In particular, examine the Multimedia chart in this article titled “AIG Troubles and Why They matter”. You should review the concept of Credit-Default Swaps that I discussed in an earlier posting.
2. The front page from today’s WSJ (print!). The article titled “U.S. to Take Over AIG in $85 Billion Bailout; Central Banks Inject Cash as Credit Dries Up” mentions the fact that even money market funds are no longer safe. This means that for the first time in two decades, investors who park their cash in a MM funds can actually collect less than 100% of what they deposited. In short: their buck may break.
3. You should also listen to an excellent interview conducted today with Professor Michael Greenberg, (a U. of Maryland law professor) on Fresh Air – an NPR podcast. It takes 38 minutes to listen but it’s worth it.

To me the most worrisome development is that banks stopped lending to each other. This may have happened either because banks don’t have excess reserves or because they don’t trust each other.

Last: it is easy to forget but the FNMA-Freddie Mac dominated the news only a week ago. Are you sure you can describe the nature of the business conducted by those two institutions?

The Financial Markets Crisis

In my most recent posting, I elaborated on the murkiness of the default-credit swap market and pointed out the risks involved. In page 8 of today's Section C (The WSJ)there is an excellent article making the same point: "Credit-Swap Players Puzzle Over Fan-Fred Fallout" I suggest you read all parts of the newspaper today. In a way this crisis can be a positive development. Lehman Brothers is sunk because it revealed that its mortgage security holdings are worth only 39% of their face value. Many other institutions will have to take a similar bath now (marking their investments to market). This will encourage investors to step in knowing that 39.000 is probably a fair price. Reality may however refute this optimistic view.
Life has never been so interesting in the fixed income securities area.