The black hole of (de) leveraging by Ektoras

As Krugman stated falling home prices lead to the feared phenomenon of “debt deflation.”
By common sense when businesses get into financial trouble, they sell assets and use the proceeds to pay their debt. Such selloffs are self-defeating when everyone does it: if everyone sell his assets at the same time, the resulting plunge in market prices undermines debtors’ financial positions faster than debt can be paid off. So we get into a vicious circle. The severe economic slump is some moments away. The same goes for the property market all over the world. Debt deflation at these moments is the real threat and unfortunately key financial players are highly leveraged.
The current U.S. financial crisis is similar to what happened to Japan back in the late ‘80s. Keep in mind that the Japanese crisis lasted almost a decade. The response to a Japan-type financial crisis was supposed to involve a very aggressive combination of interest-rate cuts and fiscal stimulus, designed to prevent spillover effects to the real economy.
What we currently face is aggressive rate cuts and push of funds into the private sector. Results show that the funds were not led to the right companies or at least it was not given the right way. There were no Tax reliefs at all.
In a few words, humanity is under heavy Deleveraging. The problem is not deleveraging itself. The problem is that nobody knows when this will end because nobody really knows the real leverage levels. It can be stated that the black hole of leverage will swallow everything before it disappears..
Overall, supporting the economy with government funds seems to be a good idea BUT governments should proceed to other actions in order to relief the corporate struggle. Just throwing money will not lead anywhere..the black hole will destroy everything. Central bank governors and Governments Should get the big picture. They just focus in specific aspects of the crisis and in the long run this may be the reason of the upcoming economic meltdown. Taking decision under panic is the worst thing that can happen. We should learn from the Japanese economic crisis and act in accordance. Of course there are differences but there are a lot of indications which show that we will be led there..

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The next day (or there will not be one?) by Ektoras

The market is crashing.. What did you expect? At this moment there are many reasons for the markets to collapse. May be we don’t want to realize it but it is just right in front of us. The real economy will suffer. The next thing that one should expect now is that debt coming from shipping companies will not be repaid and that banks that are heavily exposed to the emerging markets, and do not have a well established network, will face major loses.
The situation in the Shipping industry is really bad. One after the other, shipping companies shut down and things are about to get worse as the global economic slowdown really affects the world demand for commodities. The Inflows will diminish and the losses will increase dramatically. Hence, banks will not be paid for their shipping loans and will have to write them off or sell them with major loses.
On the emerging markets front now, unfortunately things are about to get even worse. The local currencies have declined against the US$ and the Euro, there is no liquidity in the market and on the top of that people are afraid of the banking system and they massively withdraw their savings. The funding gaps that will be created will be disastrous and the mother companies either will pay a high price to cover them or they will not cover them at all! The picture gets even more complicated if we add the fact that banks are not in position to borrow/lend money in the interbank market. Moreover the government intervention is not going to help, to this end, as it is not very likely that the governments will allow the banks to take risks and grow with its money.
We should realize that companies do not face losses.. they just try to survive under the destroy of capital. Finance returns to its roots and a new banking era starts.. In any case, in the long run banks will survive and will bring reality to their standards- not their standards to reality. After all, banking is the second ancient profession!

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F is also for Forex (FT Alphaville)

F is also for Forex

Oct 24 10:11
by Izabella Kaminska

The forex markets are seeing an unwind of epic proportions this morning,

Latest key rates include:
$£ 1.5516

$Y 93.35

$Y 93.35

The great British Krona’s decline is perhaps best reflected in chart form: More…

The forex markets are seeing an unwind of epic proportions this morning,

Latest key rates include:
$£ 1.5516

$Y 93.35

€$ 1.2798

The great British Krona’s decline is perhaps best reflected in chart form:

Regarding the carry trades that may have got us into this trouble in the first place Denis Gartman of the Gartman letter put it nicely yesterday:

Perhaps we have entered a new era of forex market volatility that shall be with us for a very long while, but we suspect we shall never, ever, EVER see the likes of this punishing unwinding of this hugely important cross position again in our lifetime. Certainly we hope never to see its likes again.

Adding to that we must not forget the ‘Great Emerging Market’ forex debacle featuring the Polish zloty, Hungarian forint and the South African rand all heading for their biggest weekley declines EVER. At the last count:

• The Zloty’s weekly decline is an impressive 16%

• The Hungarian forint’s decline is a slightly less impressive 14%

• And the “commodities trade” South African rand is down nearly 17% in the week

In Addendum - Wasn’t it the fall of the mighty denarius that actually brought down the Roman Empire?

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The rising default wave (FT Alphaville)

The rising default wave

Oct 24 09:10
by Sam Jones

From a Fitch report out Wednesday (emphasis ours):
Fitch believes that the toxic combination of economic and funding pressures has set in motion the beginning of the next cyclical peak in high yield corporate defaults. More…

From a Fitch report out Wednesday (emphasis ours):

Fitch believes that the toxic combination of economic and funding pressures has set in motion the beginning of the next cyclical peak in high yield corporate defaults. In fact, a surge in corporate defaults has already taken place. The par value of U.S. high yield bond defaults alone has increased to $25 billion year to date through September from $3.5 billion for all of 2007, and including bonds affected by Lehman Brothers Holdings Inc.’s bankruptcy filing and Washington Mutual Inc.’s collapse, pushes the par value of corporate bond defaults above $100 billion, a level comparable to 2002 defaults…

…already.

Fitch believes that recent events are among a number of worrisome factors that suggest that the coming high yield default wave may be the most severe on record.

A few other select snaps from the report:

Impaired credit access will remain an issue for speculative grade companies years beyond the current crisis.

Consumer retrenchment more problematic than telecommunication meltdown.

Defaults tend to spike roughly one year following a meaningful contraction in corporate profit growth.

Roll on 2009, year of the corporate default.

From a strictly old-world point of view, this is going to be painful: corporate defaults always hurt.

What will make it all the more so this time, however (as compared to during the 1990s) will be the effect this has on the CDS markets. The pricing models on which CDS markets trade have not been tested through a major recession. Synthetic structured finance, to boot, offers the possibility of a damaging positive feedback loop, with ructions in the CDS markets forcing further deleveraging from banks, causing further credit contraction, and more corporate defaults.

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Bernanke Bailouts Not Working, Banks Hoarding (the Financial Ninja)

Bernanke Bailouts Not Working, Banks Hoarding

Click on the chart to marvel at the carnage.

Bottom line, Bernanke pumps in liquidity and the banks continue to hoard it. The Bernanke bailouts are not working, yet...

I'm encouraged by some of the recent improvements in the credit markets, but it isn't enough.

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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.
______

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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