Comment By Ektoras

A good friend whose opinion I respect wrote a comment that deserves space in the front page.

My only additional point is that he has been saying these EXACT same things for more than 6 months now...

Ektoras Wrote:

This is just the beginning. I believe US will get out of the recession much faster than Europe. This will take at least 3-5 years. Europe will face a longer but milder recession. Unfortunately the New Europe dream is under attack. The FDIs are going to die, Inflation will increase by at least 15% in most of these countries, growth won't be around for many years and people will keep living under panic. Major Banks are going to fail since the financial system is COMPLETELY OUT OF BUSINESS. More or less the same goes for Europe. The only -but vital- difference is that Europe has a strong social, politic and economic structure.
Banks are out of business. You don't have to be a nuclear scientist to get it...You buy high you sell low...what follows next? Bankruptcy.
The only reason people believe that the system won't collapse is because they cannot imagine what follows next. It is impossible for people to imagine a second great depression even though they have read about it in the past.
On the political grounds now, New Liberals should be punished. New Liberals would include the republicans in the US, the imposers of the "dead end" economic policies in Italy, the populist right representatives in Greece, the national social right politicians in Poland, the liberals in Germany and so many others.. They should not be punished for imposing their thoughts. They should be punished because they were arrogant.
On the financial grounds, humanity, initially, needs to see how to get over the crisis and then punish all the "useless, arrogant, short sighted and constantly conspiring" finance people. Everybody in the market knew what was about to follow BUT nobody was strong enough to admit it..Maybe this is because everybody would reveal the secret after the bonus payment.. How short sight policy..
Even the entry level employers were chosen under doubtful criteria. These are things that people should expect when the system blindly trusts "top university" alumnus. Alumnus who have never been tested for their global views and entrepreneurship mentality they ought to have. Introducing so many quant people in the system would lead to these results. The economy needs economists and people who are in position to explain what the F**k is "inflation", “growth” and “stagflation”.
The irony of the whole story is that moderate people, Keynes supporters and people who used to believe in the European fundamentals of social governments, workers rights, Unions, moderate monetary policies were criticized as inadequate..Now they are here to save the New Liberal politics.. “Socialism saves Capitalism”…what an irony

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The CDO unwind waiting to happen (Bloomberg)

The CDO unwind waiting to happen

Are the days of CDO carnage behind us?

Apparently not. Bloomberg reported on Wednesday:

Oct. 22 (Bloomberg) — Investors are taking losses of up to 90 percent in the $1.2 trillion market for collateralized debt obligations tied to corporate credit as the failures of Lehman Brothers Holdings Inc. and Icelandic banks send shockwaves through the global financial system.

The article is referring to synthetic CDOs: that is, CDOs which are not backed by tangible collateral (RMBS, CMBS, for example) but CDS contracts which reference some form of collateral.

In this case, CDS on corporations.

All of which may sound dreadfully esoteric. Until you ratchet up the numbers. On Friday last week, Barclays analyst Puneet Sharma put out a report on a possible synthetic CDO unwind, and what can be expected to happen to the market as we move through a recession in the coming months.

In graph form, here’s what would happen to the ratings on prime and high-grade tranches of the trillion dollar synthetic CDO market:

Huge, disastrous downgrades: exactly mirroring the structured finance downgrades from ABS CDOs which have brought the financial system to its knees already. Don’t forget, moreover, that these CDOs aren’t backed by dodgy subprime collateral, but are supposed to reference the investment grade corporate world. More proof that it’s not the collateral which is to blame, but the structuring. The medium is the message, and all that.

We guess the impact of this might make itself felt in three ways:

Firstly, there will likely be the mark-to-market losses on the CDO notes themselves. As the Bloomberg article noted, in some cases this is equivalent to a 90 per cent loss on capital. The question here then, is who is holding these notes? Hedge funds were certainly big buyers of synthetic CDOs. But guess what - banks are also holders too. And by and large, banks synthetic corporate CDO holdings haven’t been written down.

Secondly, trouble in the synthetic CDO market will - just as with ABS CDOs - have huge regulatory capital impacts for banks. Shama at Barclays produces another set of graphs to demonstrate:

Downgrades of synthetic CDOs, in other words, will have a devastating caustic effect on banks’ capital ratios - with the potential to completely offset government recapitalisation actions.

Thirdly - crisis for synthetic CDOs will suck money out of the banking system in other ways. Synthetics are “unfunded”. In a normal asset-backed CDO, the cash raised from selling bonds is used to buy assets, but in a synthetic CDO, the cash raised from selling bonds is not used up front: as a protection seller, the CDO collects premiums on CDS contracts which only cost it money in the event of a default (when the CDO must make good on its protection). Of course, depending on what is happening to the spread on the various CDS contracts a synthetic CDO might hold, the CDO might also need to make margin calls. Here is a quick diagram of the generic structure:

The point here is that the “collateral” account of synthetic CDOs usually takes one of two forms: a bank deposit, or a similar cash-equivalent holding: a money market deposit, for example. As spreads widen, and collateral posting (the red line in this diagram) comes into force, synthetic CDO SPVs will be drawing money out of banks and money market funds to meet their obligations. Given that there are quite a few synthetic CDOs out there, the effect shouldn’t be too insignificant.
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There’s one other point too: synthetic CDOs almost always have a super senior swap written on them. You can see it in the above diagram, technically sitting “outside” - above - the structure. The swap effectively offers the arranging bank protection against its position. The question is, who writes these swaps? LSS conduits, for one (another layer of SPV fun - backed by CP), insurers do (monolines and AIG, for example) and other banks do.

Complicated all the above might be. The long and the short of it is that the synthetic CDO market has used derivative technology to build a huge amount of leverage. With recession now biting, the whole house of cards is dangerously close to collapse.

The CDS markets should feel the impact when it does. One way synthetic CDO managers can offset losses- or rather, crystalise them at acceptable levels - would be to buy protection in the market to sterilise their portfolios.

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Quote of the day

Quote of the day

Oct 23 14:12
by Stacy-Marie Ishmael

Jim Reid, Deutsche Bank:

It’s a depressing world when the only safe haven at the moment is a country that has recently nationalised its two largest mortgage companies, bailed out the world’s largest insurance company, More…

Jim Reid, Deutsche Bank:

It’s a depressing world when the only safe haven at the moment is a country that has recently nationalised its two largest mortgage companies, bailed out the world’s largest insurance company, is spending $700bn buying toxic assets, is injecting $250m into its largest banks after high profile failures and is about to go on a fiscal expansion the likes it has never before seen in its history.

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It can get worse (FT Alphaville)

It can get worse

Granted, this was written by UBS’s Jeffrey Palma on Oct. 21, and things have deteriorated since then.

Year to date, global equities are down 36.2%, on a total return basis, the worst year ever since MSCI World began in 1970. Before that, 1974 was the worst returning year, when equities fell 24.5%.

At today’s prices the MSCI World is back to its September 2003 levels, erasing 61 months of gains so far. This is more than the gains erased at any other time since the 1970s. In 1990 the index erased 24 months of gains, and then a further 15 months of gains in 1992. Between 2000-2003 the index erased its prior 53 months of gains.

Peak to trough things have been worse in the past. From their October 2007 peak, global equities are now down 43% in price terms compared to 48% between 2000 and 2003.

On the plus side, that means equities are trading on an average price/earnings ratio of 11.1 — the cheapest PE since 1982, according to UBS. FT Alphaville notes, however, that might not be so good when you consider the stocks are at their lowest level since before 1970 (as above).

On the other hand, over 50 per cent of companies are now offering dividend yields above 3 per cent — greater than the long-term average of 2.8 per cent since 1974, UBS says.

Opportunity to buy then? Not quite.

There’s still the coming recession.

In previous earnings cycles, global earnings have fallen 30-40% from their peak. So far EPS is down around 15%, suggesting earnings weakness is likely to persist well in to next year.

What’s worse is that while analysts are just starting to revise their earnings estimates for 2008 (almost over anyway) downwards, 2009 and 2010 still have a long way to go.

… while 2008 numbers have come down significantly, 2009 and 2010 estimates still look too lofty. As a result, forecasts for growth in these years will need to fall sharply.

What’s an investor to do then? Palma has the answer:

Stay defensive. Against an uncertain landscape we retain our defensive sector allocation, as investors continue to manage cyclical risk. Our largest overweights are in Consumer Staples and Telecoms as we encourage investors to search for yield and companies with stable earnings and less relative downgrade risk. These sectors are trading at a premium to the market because of these characteristics, but we don’t expect a reversal while uncertainty prevails.

Not surprising then that UBS have Campbell’s Soup on their preferred stock list.

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