The
financial crisis took another giant leap this past
week. Credit insurer ("financial guarantor") Ambac
lost its AAA rating (from Fitch), in what will
mark the onset of a devastating run of downgrades
for the likes of Ambac, MBIA and the entire
industry.
The "monoline" insurance
business, as we've known it, is done and the value
of the insurance they're written is evaporating by
the day. The market is now desperate to determine
which financial institutions (and there are many)
have purchased large amounts of (now suspect)
insurance for hedging purposes, as well as other
financial companies that have in one way or
another participated
in the
credit reinsurance market.
Virtually all
the major financial players are embroiled in this
systemic credit fiasco. Importantly, the
mind-blowing demise of the financial guarantors is
fomenting a crisis of confidence in credit
insurance in all its various forms (certainly
including the credit default swap - CDS- and
mortgage-backed securities - MBS- guarantee
markets). According to Bloomberg news, $2.4
trillion of securities are at risk to the
financial guarantor industry downgrades.
I'm assuming that our policymakers will
attempt to throw together some type of industry
recapitalization strategy, although the complexity
of the issue leaves one perplexed as to how any
bailout plan would be structured. I suspect that
our federal government will eventually be forced
to enter the financial guarantee business, at
least to the point of assuming the obligations of
municipal bond (from the monolines) and
mortgage-backed security (from the
government-sponsored enterprises such as mortgage
lenders Fannie Mae and Freddie Mac) insurance.
The credit system is today an incredible
mess. Literally trillions of securities,
previously valued in the marketplace based upon
confidence in the underlying financial guarantees,
are now suspect. This has severely impacted
marketplace liquidity. And perhaps tens of
trillions of credit and other derivative contracts
are now subject to very serious counterparty
issues. Many players throughout the credit market
are now severely impaired and have lost the
capacity to hedge against/mitigate further losses.
To be sure, discontinuous and illiquid
markets have wreaked bloody havoc on "dynamic"
trading strategies used commonly to hedge various
risks. I don't believe it is hyperbole to suggest
that dynamic hedging (in particular shorting
credit instruments to provide the necessary
cashflows to pay on Credit derivative contracts
written) became the critical linchpin of
contemporary Wall Street risk intermediation. Yet
today the models behind so many strategies that
have come to permeate "contemporary finance" have
completely broken down; the strategies of
thousands of financial institutions - big and
small - have turned infeasible.
From a
macro perspective, Wall Street risk intermediation
has essentially crashed and the risk markets
essentially seized up. Almost across the board,
the major risk operators are moving aggressively
to rein in risk-taking. The leveraged speculating
community is in turmoil. The "quants" are in a
quandary. Basically, the entire market today
desires, at least to some extent, to
reduce/mitigate/transfer credit and market risk.
Inevitably, however, when the market is keen to
hedge there’ll be no one with the necessary
wherewithal to take the other side of the trade. I
have so many fears I don’t even know where to
begin, although I will say that I am less than
comfortable these days discussing individual
companies. Tonight the (brief) analysis will be in
generalities.
There are scores of
financial players - from small hedge funds to the
major money-center banks - with complex books of
derivative trades that now have a very serious
problem. These hedged books contain various
supposedly offsetting risk exposures that, in
there entirety, were to have created (through
financial alchemy) a reasonable and manageable
portfolio risk profile. But the breakdown in Wall
Street finance has transformed these too often
highly leveraged books into essentially
unmanageable toxic waste and financial land mines.
First, correlations between various
instruments have broken down (ie junk bond spreads
widen while dollar swap spreads narrow). Second,
the liquidity profile (hence pricing) of various
sectors has diverged radically (ie agency MBS vs.
private-label MBS/ABS - or asset-backed
securities) - with the Treasury market melt-up
causing further destabilization. Third, with the
breakdown in Wall Street's private-label MBS
market and the collapse in confidence in the
monoline credit insurers, liquidity has all but
evaporated throughout huge cross-sections of the
debt securities and related derivatives markets.
This dynamic is fomenting dangerous
counter-party risks and uncertainties. The
capacity of a rapidly rising number of market
participants to fulfill their obligations in
various types of derivative and insurance
contracts is in question.
Imagine you have
a hedged book of securities and derivatives - for
example a portfolio of CDOs (collateralized debt
obligations) hedged with credit default swaps
(CDS) from one of the monoline financial
guarantors. Today, the value of your CDO portfolio
is declining while the "value" of your offsetting
CDS hedge is impaired by the increasing likelihood
of a default by the monoline (who provided the CDO
default "insurance").
The reality is that
the hedged position has broken down and risk now
rises by the day. And, unfortunately, your options
are decidedly limited - there is little if any
liquidity to sell the underlying CDO. One could go
into the market and attempt to buy additional
protection, although in many cases the cost would
be prohibitive. Besides, there’s today little
assurance that counter-party risks wouldn’t emerge
in the second hedge as well.
The Wall
Street firms and many of the more sophisticated
hedge funds run very complex books of securities
and derivatives. The dilemma they face today is
commensurate with the complexity of their
strategies. Recent developments - in particular
heightened marketplace illiquidity, rising
probabilities of monoline defaults, dislocation in
the CDS markets, and a breakdown in typical
correlations between instruments/sectors/markets -
makes the job of effectively comprehending,
quantifying, analyzing and managing risk
impossible. Do the managers, then, attempt the
highly problematic task of recalibrating hedges
based on current conditions (ie spiking hedging
costs, likely counterparty defaults, and recent
market correlations) and risk compounding the
problem if market conditions begin to normalize?
Is it feasible for these players to recalibrate
hedges, knowing full well that our
well-intentioned policymakers are destined to
intervene clumsily in the marketplace?
It
is difficult for me to believe the leveraged
speculating community is not in serious jeopardy.
It became all too commonplace to leverage illiquid
(and difficult to price) securities, while even
the previously liquid markets today barely trade.
Few speculative bubbles in history were as
vulnerable to a run. None were remotely as
gigantic or global in scope. This community today
creates a systemic weak link on several fronts,
certainly including the vulnerability to outsized
losses and resulting redemptions instigating panic
dynamics. Today, market illiquidity increases the
likelihood that many funds will be forced to halt
redemptions. This dynamic has commenced and it
holds the potential to batter industry trust and
confidence.
The leveraged speculators
create various systemic risks. Their desire to
hedge risk exposures - as well as seek speculative
profits during market turbulence has certainly
exacerbated the credit crisis. During the cycle’s
upside, their affinity for leveraging securities
greatly amplified the liquidity bull run. Today,
their selling/deleveraging/hedging foments
liquidity crisis, fear and market dislocation.
Importantly, the speculators are today keen to
short stocks, sell futures, and purchase equity
put options. The hedge funds have, after all, sold
themselves as capable of minting money in any kind
of market environment. This could prove a major
systemic risk.
Leveraged speculator
dynamics in concert with a bursting credit bubble
now places enormous stains on the stock market.
Not only have faltering credit availability and
credit marketplace liquidity dramatically
diminished the prospects for companies, industries
and the general economy. Limited liquidity in the
credit market has also created a backdrop where
those seeking to hedge (or profit from) heightened
systemic risks have few places to go for
relatively liquid trading outside selling stocks
and equity index products. And sinking stock
prices further aggravates the unfolding corporate
credit crisis, fostering only greater systemic
stress and greater selling pressure.
Contemporary finance is being exposed as a
daisy-chain of interrelated weak underlying
structures, unrecognized risks and acute
fragilities.
WEEKLY WRAP Wow ...
For the week, the Dow dropped 4.0% (down 8.8%
y-t-d) and the S&P500 5.4% (down 9.8%). The
Transports dipped 0.2% (down 8.6%), and Morgan
Stanley Cyclicals dropped 3.9% (down 12.3%). The
Utilities were smacked for 7.5% (down 5.9%), and
the Morgan Stanley Consumer index fell 4.6% (down
7.7%). The small cap Russell 2000 was clipped for
4.5% (down 12.1%), and the S&P400 Mid-Caps
sank 5.0% (down 11.9%). The NASDAQ100 declined
3.6% (down 11.6%), and the Morgan Stanley High
Tech index lost 2.1% (down 12.1%). The
Semiconductors rallied 1.3% (down 12.2%). The
Street.com Internet Index fell 2.9% (down 11.5%),
and the NASDAQ Telecommunications index dropped
4.7% (down 12.8%). The Biotechs declined 2.6%
(unchanged). The Broker/Dealers sank 7.1% (down
14.2%) and the Banks 7.7% (down 12.4%). Although
Bullion was down only $10.50 to $885, the HUI Gold
index was hammered for 8.1% (up 6.7%)
Another week of trading, a further melt-up
in Treasuries... Three-month Treasury bill rates
sank 25.5 bps the past week to 2.845%. Two-year
government yields fell 21 bps to 2.345%. Five-year
T-Note yields fell 20 bps to 2.84%, and ten-year
yields fell 15.5 bps to 3.63%. Long-bond yields
were 9 bps lower to 4.28%. The 2yr/10yr spread
ended the week at 128 bps. The implied yield on
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