Year of Lending Dangerously

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The FT’s Gillian Tett writes up a blow-by-blow of the credit crisis; and the spread chart is a good reminder of how different things still are:

Interbank lending chart

On August 9 2007, the European Central Bank sent shock waves around world financial capitals when it injected €95bn ($150bn, £75bn) worth of funds into the money markets to prevent borrowing costs from spiralling sharply. The US Federal Reserve soon followed suit. But while the central banks had billed these moves as “pre-emptive” actions to quell incipient market tensions, they did not bring the panic to an end… A year later, there is still no sign of an end to these problems. Instead, the sense of pressure on western banks has risen so high that by some measures this is now the worst financial crisis seen in the west for 70 years.

There were a few people on the record as anticipating problems, and no easy way out – Hiroshi Nakaso, a senior official at the Bank of Japan; Jean-Claude Trichet, governor of the ECB; Timothy Geithner, president of the New York Federal Reserve – but it’s easy to data mine in retrospect. These are the drivers of the train, or at least in the engine cabin, and they just watched it crash.

Yet most investors, bankers and even regulators did not change their behaviour to any significant degree, owing to a widespread adherence to three big assumptions – or articles of faith – that have steathily underpinned 21st century finance in recent years.

The first of these was a belief that modern capital markets had become so much more advanced than their predecessors that banks would always be able to trade debt securities. This encouraged banks to keep lowering lending standards, since they assumed they could sell the risk on…

Second, many investors assumed that the credit rating agencies offered an easy and cost-effective compass with which to navigate this ever more complex world. Thus many continued to purchase complex securities throughout the first half of 2007 – even though most investors barely understood these products.

But third, and perhaps most crucially, there was a widespread assumption that the process of “slicing and dicing” debt had made the financial system more stable. Policymakers thought that because the pain of any potential credit defaults was spread among millions of investors, rather than concentrated in particular banks, it would be much easier for the system to absorb shocks than in the past…

Because the risk was systemic, there was no risk? A big mistake.

As a result, when high rates of subprime default emerged in late 2006, there was initially a widespread assumption that the system would absorb the pain relatively smoothly. After all, the system had easily weathered shocks earlier in the decade, such as the attacks of September 11 2001 or the collapse of the Amaranth hedge fund in 2006. Moreover, the US government initially estimated that subprime losses would be just $50bn-$100bn – a tiny fraction of the total capital of western banks or assets held by global investment funds… And as the surprise spread, the three pillars of faith that had supported the credit boom started to crumble… First, it became clear to investors that it was dangerous to use the ratings agencies as a guide for complex debt securities… [The end of that franchise.] Then, as bewildered investors lost faith in ratings, many stopped buying complex instruments altogether… As a result, western banks found themselves running out of capital in a way that no regulator or banker had ever foreseen… [Whocouldaknown?] Banks started hoarding cash and stopped lending to each other as financiers lost faith in their ability to judge the health of other institutions – or even their own… Then a vicious deleveraging spiral got under way… The IIF calculates that in the year to June, banks made $476bn in credit writedowns, as debt prices plunged in the panic (although tangible credit losses are hitherto just $50bn). However, they have also raised $354bn in capital…

It all seems so familiar somehow… but I cannot remember how the story ends. (Paul at Technology Investment Dot Info)

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4 comments

  1. doc holiday

    US CREDIT-Dealers may change some CDS contract terms
    http://www.reuters.com/article/marketsNews/idUSN2864411520080728

    Maybe OT, maybe not: In spite of these benefits, the challenges over changing
    the terms of the contracts could be significant.
    “I think it is a step forward in simplifying the entry and
    exit of positions but brings up as many problems as it solves,”
    said Tim Backshall, chief derivatives strategist at Credit
    Derivatives Research in Walnut Creek, California.
    Some dealers have floated the idea that the coupon for
    investment grade credits be based on the spread of benchmark
    credit derivative index, with prices then adjusted for a
    company being weaker or stronger than the index.
    However, as a new series of the index is introduced every
    six months, credit default swaps on a single company could have
    various coupons, and some may risk being less liquid than
    others.
    Also, spreads on individual companies can be wider, and
    more volatile than on the indexes.
    “The big difference is that the single-names can be
    considerably more volatile than the indexes and so upfronts can
    become very large and potentially negate any liquidity
    improvements,” Backshall said.
    Large upfront payments may make some protection buyers more
    hesitant to put on a trade than if they were only required to
    make quarterly coupon payments.
    “High yield investors are more likely to favor coupon
    payments because the spreads of high yield companies are so
    wide, though some investment grade investors may be worried
    about losing liquidity depending on standard coupon
    assumptions,” CreditSights’ Yelvington said.

  2. doc holiday

    Re: "Yet most investors, bankers and even regulators did not change their behaviour to any significant degree, owing to a widespread adherence to three big assumptions – or articles of faith – that have steathily underpinned 21st century finance in recent years.

    The first of these was a belief that modern capital markets had become so much more advanced than their predecessors that banks would always be able to trade debt securities. This encouraged banks to keep lowering lending standards, since they assumed they could sell the risk on…"

    >> Paul, this is a critical post from you and this story from FT's Gillian Tett should not be taken too lightly — because, as Paulson and his four banks prepare to play casino games with covered bonds, people should keep in focus the fact that covered bonds were a part of the global subprime problem, i.e, they were structures and entities that were used within the mechanics which pushed the global tsunami wave of super-liquidity which has resulted in this current systemic failure!

    I should go back and put that all in bold and flail wildly and repost it, but the system in place which generated this mess, is still in place, thus as Einstein implied: “We can’t solve problems by using the same kind of thinking we used when we created them.”

    Does anyone get this???

  3. Anonymous

    Wow. Basic materials names are getting clobbered, as evidenced by the vertical thrust of the ProShares UltraShort Basic Materials ETF (SMN), whose major inverse holdings include Monsanto (NYSE: MON), DuPont (NYSE: DD), FCX, and others. The ETF is now assaulting its declining 200 DMA at 37.80. Today’s close will be very important for the SMN. Above 38.00, and let’s expect upside continuation to 44.25/50 next.
    http://www.marketoracle.co.uk/Article5748.html

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