Pathology of Debt

Henry C.K. Liu

Part I: Commercial Paper Market Seizure turns Banks into their own Vulture Investors

This article appeared in AToL on November 27, 2007

Vulture restructuring is a purging cure for a malignant debt cancer. The reckoning of systemic debt presents regulators with a choice of facing the cancer frontally and honestly by excising the invasive malignancy immediately or let it metastasize over the entire financial system over the painful course of several quarters or even years and decades by feeding it with more dilapidating debt.

But the strategy of being your own vulture started with Goldman Sachs, the star Wall Street firm known for its prowess in alternative asset management, producing spectacular profits by manipulating debt coming and going amid unfathomable market anomalies and contradictions during years of liquidity boom. The alternative asset management industry deals with active, dynamic investments in derivative asset classes other than standard equity or fixed income products. Alternative investments can include hedge funds, private equity, special purpose vehicles, managed futures, currency arbitrage and other structured finance products. Counterbalancing opposite risks in mutually canceling paired speculative positions to achieve gains from neutralized risk exposure is the basic logic for hedged fund investments.

Hedge Funds

The wide spread in return on investment between hedge funds and mutual funds is primarily due to differences in trading strategies. One fundamental difference is that hedge funds deploy dynamic trading strategies to profit from arbitraging price anomalies caused by market inefficiencies independent of market movements whereas mutual funds employ a static buy-and-hold strategy to profit from economic growth.  An important operational difference is the use of leverage. Hedge funds typically leverage their informed stakes by margining their positions and hedging their risk exposure through the use of short sales, or counter-positions in convergence or divergent pairs. In contrast, the use of leverage is often limited if not entirely restricted for mutual funds.

The classic model of hedge funds developed by Alfred Winslow Jones (1910-1989) takes long and short positions in equities simultaneously to limit exposures to volatility in the stock market. Jones, Australian-born, Harvard and Columbia educated sociologist turned financial journalist, came upon a key insight that one could combine two opposing investment positions: buying stocks and selling short paired stocks, each position by itself being risky and speculative, but when properly combined would result in a conservative portfolio that could yield market-neutral outsized gains with leverage. The realization that one could couple opposing speculative plays to achieve conservative ends was the most important step in the development of hedged funds.

The Credit Guns of August

Yet the credit guns of August 2007 did not spare Goldman’s high-flying hedge funds. Goldman, the biggest US investment bank by market value, saw its Global Equity Opportunities Fund suffer a 28% decline with assets dropping by $1.4 billion to $3.6 billion in the first week of August as the fund’s computerized quantitative investment strategies fumbled over sudden sharp declines in stock prices worldwide.

The Standard & Poor’s 500 Index, a measure of large-capitalization stocks, fell 44.4 points or 2.96% on August 9. On August 14, the S&P 500 fell another 26.38 points or 1.83%, followed by another fall of 19.84 points to 1,370.50 or 1.39% on August 15, totaling 9.4% from its record high reached on July 19, but still substantially higher than its low of 801 reached on March 11, 2003.

Goldman explained the setback in Global Equity Opportunities in a statement: “Across most sectors, there has been an increase in overlapping trades, a surge in volatility and an increase in correlations. These factors have combined to challenge many of the trading algorithms used in quantitative strategies. We believe the current values that the market is assigning to the assets underlying various funds represent a discount that is not supported by the fundamentals.” The statement is a conceptual stretch of the meaning of “fundamentals” which Goldman defines as value marked to model based on a liquidity boom rather than marked to market, even as the model has been rendered dysfunctional by the reality of a liquidity bust.

The market value in mid August of two other Goldman funds: Global Alpha and North American Equity Opportunities also suffered big losses. Global Alpha fell 27% in the year-to-date period, with half of the decline occurring in the first week of August. North American Equity Opportunities, which started the year with about $767 million in assets, was down more than 15% through July 27. The losses had been magnified by high leverage employed by the funds’ trading strategies. Goldman said both risk-taking and leverage in these two funds had since been reduced by 75% to cut future losses. Similarly, leverage employed by Global Equity Opportunities had been reduced to 3.5 times equity from 6 times. The three funds together normally managed about $10 billion of assets.

Feeding on One’s Own Death Flesh

Facing pending losses, Goldman Chairman Lloyd Blankfein was reported to have posed a question to his distraught fund managers: if a similar distress opportunity such as Goldman’s own Global Equity Opportunities presented itself in the open market outside of Goldman, would Goldman invest in it as a vulture deal. The answer was a resounding yes. Thus the strategy of feeding on one’s own dead flesh to survive, if not to profit, took form.

Goldman would moderate its pending losses by profiting as vulture investor in its own distressed funds. The loss from one pocket would flow into another pocket as gains that, with a bit of luck, could produce spectacular net profit in the long run if the abnormally high valuations could be manipulated to hold, or the staying power from new capital injection could allow the fund to ride out the temporary sharp fall in market value. It was the ultimate hedge: profiting from one’s own distress. The success of the strategy depends on whether the losses are in fact caused by temporary anomalies rather than fundamental adjustment. Otherwise, it would be throwing good money after bad.

The Fed Held Firm on Inflation Bias

The Fed, in its Tuesday, August 7 Fed Open Market Committee (FOMC) meeting, defied market expectation and decided against lowering interest rates with a bias against growth and focused instead on inflation threats. In response, the S&P 500 index, with profit margin at 9% against a historical average of 6%, fell 44.4 points or 2.96% to 1,427 on August 9. The Dow Jones Industrial Average (DJIA) dropped 387 points to 13,504 on the same day, even as the Federal Reserve pumped $62 billion of new liquidity into the banking system to help relieve seizure in the debt market.

On the following Monday, August 13, Goldman announced it would injected $2 billion of new equity from its own funds into its floundering Global Equity Opportunities fund, along with another $1 billion from big-ticket investors, including CV Starr & Co., controlled by former American International Group (AIG) chairman Maurice “Hank” Greenberg, California real estate developer Eli Broad who helped found SunAmerica and later sold it to AIG, and hedge fund Perry Capital LLC, which is run by Richard Perry, a former Goldman Sachs equity trader.

The new equity injection was intended to help shore up the long/short equity fund, which was down almost 30% in the previous week, to keep the fund from forced sales of assets at drastic discount long enough for markets to stabilize and for the fund to get out of the tricky leveraged bets it took before the credit markets went haywire in mid August.  Global Equity “suffered significantly” as global markets sold off on worries about debt defaults credit draught, dragging the perceived value of its assets down to $3.6 billion, from about $5 billion.

Goldman chief financial officer David Viniair on a conference call with analysts was emphatic that the move was not a rescue but to capture “a good opportunity”. After more than a week of panic over the disorderly state of global capital markets, Goldman Sachs pulled a kicking live rabbit magically out of its distressed asset hat.

On a conference call to discuss the additional equity investment in the $3.6 billion Global Equity Opportunities fund, Goldman executives insisted the move would not add to moral hazard (encouraging expectations that lead investors to take more risk than they otherwise might because they expect to be bailed out), but would merely reflect the firm’s belief that the value of the fund’s underlying assets was out of whack with “fundamentals” and that sooner or later the losses would be recouped when an orderly market returns.

“We believe the current values that the market is assigning to the assets underlying various funds represent a discount that is not supported by the fundamentals,” Goldman explained in a statement. A day later, on August 14, the S&P 500 fell another 26.38 points or 1.83%, followed by another fall of 19.84 points or 1.39% on August 15, notwithstanding that a chorus of respected voices were assuring the public that the sub-prime mortgage crisis had been contained and would not spread to the entire financial system.

But Goldman did not inject more equity into two of its other funds: Global Alpha and North American Equity Opportunities that had also suffered sharp losses. Goldman said it was reducing leverage in the funds, a process that was mostly complete, but added that it was not unwinding Global Alpha, down 27% this year through August 13, about half of that in the previous week alone. Unlike Global Equity Opportunities, Goldman did not bolster its Global Alpha quantitative fund. Investors had reportedly asked to withdraw $1.6 billion, leaving Global Alpha with about $6.8 billion in assets after forced liquidation to pay the withdrawals.

Ireland registered Global Alpha, originally seeded in 1995 with just $10 million and returned 140% in its first full year of operation, was started by Mark Carhart and Raymond Iwanowski, young students of finance professor Eugene Fama of the University of Chicago. Fama’s concept of efficient markets is based on his portfolio theory which states that rational investors will use diversification to optimize their portfolios based on precise pricing of risky assets.

Global Alpha soon became the Rolls Royce of a fleet of alternative investment vehicles that returned over 48% before fees annually. Hedge funds usually charge management fees of up to 2% of assets under management and 20% of investment gains as incentive fees. Global Alpha fees soared to $739 million in first quarter of 2006, from $131 million just a year earlier and boosted earnings rise at the blue-chip Goldman Sachs by 64% to $2.48 billion, the biggest 2006 first-quarter gain of any major Wall Street firm. Goldman is one of the world’s largest hedge fund managers, with $29.5 billion in assets under management in an industry that oversees $2.7 trillion globally.  Goldman reported in October 2006 that its asset management and securities services division produced $485 million, or 21% of its $2.36 billion in pretax profit for the fiscal third quarter.

For 2006, Global Alpha dropped 11.6% through the end of November and end up dropping 9% for the year yet still generating over $700 million in fees from earlier quarters. That was the first annual decline in seven years and followed an almost 40% gain for all of 2005. The fund took a hit misjudging the direction of global stock and currency markets, specifically that the Norwegian krone and Japanese yen would decline against the dollar. Global Alpha lost money partly on wrong-way bets that equities in Japan would rise, stocks in the rest of Asia and the US would fall and the dollar would strengthen. Before August 2007, the fund had lost almost 10% on wrong bet in global bond markets.

Goldman’s smaller $600 million North American Equity Opportunities fund had also hit rough waters, losing 15% this year. There was real danger of a rush of redemptions from nervous investors that would force the funds to sell securities in a market that had all but seized up, forcing down asset prices to fire sale levels.  Global Equity Opportunities investors were entitled to pull their money monthly with a 15-day warning, meaning notices for Aug. 31 were due on August 16. Global Alpha investors could redeem quarterly, and certain share classes also must notify the fund by the week of August 13.

Hedge funds are private, largely unregulated pools of capital whose managers command largely unrestricted authority to buy or sell any assets within the bounds of their disclosed strategies and participate in gains but not losses from investment. The industry has been growing over 20% annually due to its above-market performance. Still, Carhart and Iwanowski, both in their early forties, had not been able to take any of their 20% incentive fees since Global Alpha fell from its 2006 peak. They would have to make good about 60% of their previous incentive fees from profit, if any, in future quarters before they could resume taking a cut of the fund’s future gains.

The Fed Wavered

By August 16, the DJIA fell way below 13,000 to an intraday low of 12,445, losing 1,212 points from its 13,657 close on August 8.  The next day, August 17, the Fed while keeping the Fed Funds rate target unchanged at 5.25%, lowered the Discount Rate by 50 basis points to 5.75%, reducing the gap from the conventional 100 basis points by half to 50 basis points and changed the rules for access by banks to the Fed discount window.

In an accompanying statement, the Fed said: “To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility. The Board approved a 50 basis point reduction in the primary credit rate to 5-3/4 percent, to narrow the spread between the primary credit rate and the Federal Open Market Committee's target federal funds rate to 50 basis points. The Board is also announcing a change to the Reserve Banks’ usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower. These changes will remain in place until the Federal Reserve determines that market liquidity has improved materially. These changes are designed to provide depositories with greater assurance about the cost and availability of funding. The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets. Existing collateral margins will be maintained. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York and San Francisco.”

The Fed Panicked

A month later, on September 18, brushing aside a DJIA closing at a respectable 13,403 the day before even in the face of poor employment data for August, the Fed panicked over the unemployment data and lowered both the Fed Funds rate target and the Discount Rate each by 50 basis points to 4.75% and 5.25% respectively. The rate cuts gave the DJIA a continuous rally for 9 consecutive days that ended on October 1 at 14,087. Obviously, the Fed knew something ominous about the credit market that was not reflected in the DJIA index.

The Global Equity Opportunities fund, now with about $6.6 billion in asset value, was using six times leverage before the capital infusion. Like many other managers, Goldman was experiencing the same problems with its so-called quantitative funds. Quant funds use computerized models to make opportunistic investment decisions on minute statistic disparities in asset prices caused by market inefficiency. When the short-term credit market seized up, the quant models turned dysfunctional.

Funds caught with significant losses in credit and bond investments had to sell stock holdings to lower the risks profile of their overall portfolios, and the herd selling in the stock market magnified the price shift in a downward spiral. Stocks that were held long fell in price, and stocks that were held short rose, exacerbating losses.

Opacity Fueled Market Rumors

As required, quant fund managers have been disclosing losses to investors but they are not required to disclose to the market. The opacity fueled the rumor mill. Renaissance Technology’s $26 billion institutional equities fund was reportedly down 7% for the year. Some of the funds Applied Quantitative Research (AQR) managed were down as well, as were quant funds at Tykhe Capital, Highbridge Capital and D.E. Shaw (of which Lehman now owns 20%).

Vulture Opportunities in Distressed Funds

At Goldman, quant funds made up half of the $151 billion of alternative investments under management, and half of which was the sort of long-short equity quant funds that had been having trouble. But Goldman executives began to see opportunities in distressed funds. The highly respected AQR was raking in new funds to invest in distressed situations, as were other astute fund managers. AQR is an investment management firm employing a disciplined multi-asset, global research process, with investment products provided through a limited set of collective investment vehicles and separate accounts that deploy all or a subset of AQR's investment strategies. These investment products span from aggressive high volatility market-neutral hedge funds, to low volatility benchmark-driven traditional products. AQR’s founder is Clifford S. Asness, a Goldman alumni where he was Director of Quantitative Research for the Asset Management Division responsible for building quantitative models to add value in global equity, fixed income and currency markets. He was another of Fama’s students at the University of Chicago.

Goldman was putting its own money down alongside that of select outside investors, an expression of its faith in the fund’s ability to recoup. The situation differed from that of Bear Stearns which had to loan $1.6 billion to bail out one of two internal hedge funds that had big problems with exposure to mortgage-related securities.

The First Wave of Warnings

Goldman, one of the world’s premiere financial companies, had joined Bear Stearns and France’s BNP Paribas in revealing that its hedge funds had been hit by the credit market crisis. Bear Stearns earlier in the summer disclosed that two of its multibillion dollar hedge funds were wiped out because of wrong bets on mortgage-backed securities. BNP Paribas announced a few weeks later it would freeze three funds invested in US asset-backed securities.

The assets of the two troubled Bear Stearns hedge funds had been battered by turmoil in the credit market linked to sub-prime mortgage securities. On Jun 20, 2007, $850 million of the funds’ assets held as collateral was sold at greatly discounted prices by their creditor, Merrill Lynch & Co. The assets sold included mortgage-backed securities (MBS), collateralized debt obligations (CDO) and credit default swaps (CDS). JP Morgan, another Bear Stearns creditor, had also planned an auction for some of the collateralized assets of the Bear Stearns funds, but cancelled the auction to negotiate directly with the Bear Stearns funds to unwind positions via private transactions to avoid setting a market price occasioned by market seizure.

The two Bear Stearns funds: High-Grade Structured Credit Strategies Enhanced Leverage Fund and High-Grade Structured Credit Strategies Fund, run by mortgage veteran Ralph Cioffi, were facing shut-down as the rescue plans fell apart. The funds had slumped in the first four months of 2007 as the subprime mortgage market went against their positions and investors began asking for their money back.  The High-Grade Structured Credit Strategies Enhanced Leverage Fund sold roughly $4 billion of subprime mortgage-backed securities in mid June, selling its highest-rated and most heavily traded securities first to raise cash to meet redemption requests from investors and margin calls from creditors, leaving the riskier, lower-rated assets in its portfolio that had difficulty finding buyers.

Collateral Debt Obligation Crisis

CDOs are illiquid assets that normally trade only infrequently as institutional investor had not intended to trade such securities.  Demand for them is not strong even in normal times. In a credit crunch, demand became extremely weak. Sellers typically give investors one or two days to price the assets and bid in order to get the best price. Bid lists were now sent out for execution within roughly an hour, which was unusual and suggested that sellers were keen to sell the assets quickly at any price.

Bear Stearns’ High-Grade Structured Credit Strategies Enhanced Leverage Fund sold close to $4 billion worth of AAA and AA rated securities. The fund was started less than a year ago with $600 million in assets, but used leverage to expand its holdings to more than $6 billion. But subprime mortgage trades that went wrong left the fund down 23% in the first four months of 2007. The fund was selling its highest-rated and most tradable securities first to raise cash to meet expected redemption requests and margin calls. Buyers were found for the bonds but the fund still had to retain lower-rated subprime mortgage-based securities which had triggered its losses earlier in the year.

Bear Stearns was highly leveraged in an illiquid market and was faced with the prospect that its funds were going to start getting margin calls so it tried to sell ahead of being in the worst spot possible. Subprime mortgages were offered at low initial rates to home buyers with blemished credit ratings who could not carry the adjusted payments if and when rates rise. This was not a problem as long as prices for houses continued to rise, allowing the lenders to shift loan repayment assurance from the borrower’s income to the rising value of the collateral. Thus subprime mortgages lenders were not particularly concerned about borrower income for they were merely using home buyers as needed intermediaries to profit from the debt–driven housing boom. This strategy worked until the debt balloon burst. Rising delinquencies and defaults in this once-booming part of the mortgage market had triggered a credit crunch earlier in the year that left several lenders bankrupt. Many hedge funds had generated big gains for several years on this unstainable liquidity boom. The premature bears who shorted the market repeated lost money as the Fed continued to feed the debt balloon to sustain the unsustainable.

As delinquencies and foreclosures rose finally, losses first hit the riskiest tranches of subprime mortgage-backed securities (MBS). The losses were subsequently transmitted to collateralized debt obligations (CDOs) which invested in the higher-rated tranches of subprime MBS that did not have an active market since they were bought by institutions with the intention to hold until maturity. Such securities were super safe as long as their ratings remain high.

Hedge funds have become big credit-market players in recent years, and many firms trade the riskiest tranches of subprime MBS and higher-rated CDOs tranches to profit from the return spread. While some funds, such those managed by Cheyne Capital and Cambridge Place Investment Management, had suffered sudden losses, some hedge funds made handsome gains in February 2007 betting that a subprime mortgage crisis would hit.

As the number of market participants increased and the packaging of the CDO became more exoteric over the liquidity boom years, it became impossible to know who were holding the “toxic” tranches and how precisely the losses would spread, since the risk profile of each tranche would be affected by the default rates of other tranches. The difficulty in identifying the precise locations of risk exposure caused a sharp rise in perceived risk exposure system wide. This sudden risk aversion led to rating downgrades of the high-rated tranches, forcing their holders to sell into a market with few buyers.

The Federal Deposit Insurance Corporation, which monitors risk in the banking system, tracks bank holdings of MBS, but not specific tranches of CDOs. It has no information on which bank holds CDOs and how much, since such instruments are held by the finance subsidiaries of bank holding companies, off the balance sheets of banks.  Asian investors, particularly those in Japan, had been eager to seek off-shore assets yielding more than the near zero or even negative interest rates offered at home. Many Japanese as well as foreign investors participated in currency “carry trade” to arbitrage interest rate spreads between the Japanese yen and other higher interest rate currencies and assets denominated in dollars, fueling a liquidity boom in US markets. The US trade deficit fed the US capital account surplus as the surplus trade partners found that they could not convert the dollars they earned from export to the US into local currencies without suffering undesirable rise in money supply. The trade surplus dollars went into the US credit market.

The growth of CDOs has been explosive during the past decade. In 1995, there were hardly any. By 2006, more than $500 billion worth was issued. About 40% of CDO collateral was residential MBS, with three quarters in subprime and home-equity loans, and the rest in high-rated prime home loans. CDOs became an important part of the mortgage market because their issuers also bought the riskier tranches of MBS that others investors shunned. The high-rated tranches of MBS were sold easily to pension funds and insurers. But the ultra-high rated tranches paid such low returns because of their perceived safety that few buyers were interested, forcing the banks which structured them to hold them themselves. The issuers often hold the more riskier tranches to sell at later dates for profit when the value of the collateral rose with rising home prices. But when the riskier tranches could not be sold as home prices fell and mortgage default rose, the higher rating tranches suffered rating drops and institutional buyers were prevented by regulation to hold the ones they had bought and from buying new ones.  When the ultra safe tranches held by banks are downgraded, banks are forced to writedown their value. With CDOs withdrawing from the residential MBS market, mortgage lenders were unable to sell the loans they had originated for new funds to finance new mortgages.

The chain of derivative structures that turns home loans into CDOs begins when a mortgage is packaged together with other mortgages into an MBS. The MBS is then sliced up into different CDO tranches that pay on a range of interest rates tied to risk levels. Mortgage payments go first to the highest-rated tranches with the lowest interest rates. The remaining funds then flows down to the next risky tranches until all are paid. The riskiest CDO tranches get paid last, but they offer the highest interest rates to attract investor with strong risk appetite.

In theory, all trenches have the same risk/return ratio. As the liquidity boom has gone on for years with the help of the Fed, historical data would suggest that risks of default should be minimal. Yet when losses actually occurred from unanticipated mortgage defaults and foreclosures, the riskiest tranches were hit first, while the top-rated tranches were hit last. But until losses occurred, the riskier tranches got the higher returns. Over the years, the riskier tranches generated big profit for hedge funds when the risks did not materialize to overwhelm the high returns. The problem was that the profitability drove new issues of MBS at a faster pace than maturing MBS, with the number and amount of outstanding securities getting bigger with each passing year, exposing investors to aggregate risk higher than the accumulated gains.  Because of the complexity and opacity of the CDO market, institutional investors were not alerted by rating agencies of the fact that their individual safety actually caused a sharp rise in systemic risk. They felt comfortable as long as assets they acquired were rated AAA and deemed bankruptcy-remote, not realizing the system might seize up some Wednesday morning. That Wednesday came on August 15, 2007.

CDOs, a cross between an investment fund and an asset-backed security (ABS), perform this slicing process of risk/reward unbundling repeatedly to keep money recycling and money supply growing in the mortgage market. While CDOs lubricate the credit market to make more home financing affordable to more home buyers, it raises the price of home and its financing cost beyond the carrying capability of almost all home buyers when the bursting of the debt bubble resets interest rates to normal levels, making a rising default rate inevitable.

Hedge funds are attracted by the high returns offered by the lowest-rated tranches of subprime MBS undbubled by CDOs, the so-called equity tranches which sink underwater as home prices fall. Many hedge funds arbitrage the wide return spread with low-cost funds borrowed in the commercial paper market and magnify the return with high leverage through bank loans. They often hedge against risk by holding derivatives that are expected to rise in value when housing prices fall, such as interest rate swaps. They also hedge against defaults with credit default swaps. These hedges failed when risk was re-priced by the market at rollover time for short-term securities which could be every 30 days.

CDOs and Commercial Paper

Much of the money used to buy CDOs come form the commercial paper market. Commercial paper consists of short-term, unsecured promissary notes issued primarily by financial and non-financial corporations. Maturities range up to 270 days but average about 30 days. Many companies use commercial paper to raise cash needed for current transactions, and many find it to be a lower-cost alternative to bank loans. Financial companies use high-rated CDO tranches as collateral to back their commercial paper issues.

Because commercial paper maturities do not exceed nine months and proceeds typically are used only for current transactions, the notes are exempt from registration as securities with the United States Securities and Exchange Commission.

Large institutions have long managed their short-term cash needs by buying and selling securities in the money market since the early 1970's. Today, a broad array of domestic and foreign investors uses these versatile, short-term securities to help to make the money market the largest, most efficient credit market in the world driving assets from $4 billion in 1975 to more than $1.8 trillion today. This money market is a fixed income market, similar to the bond market. The major difference being that the money market specializes in very short term debt securities.

The money market is a securities market dealing in short-term debt and monetary instruments. Money market instruments are forms of debt that mature in less than one year and are very liquid but traded only high denominations. The easiest way for individual investor to gain access is through money market mutual funds, or sometimes through a money market bank account. These accounts and funds pool together the assets of thousands of investors and buy the money market securities on their behalf.

Borrowing short-term money from banks is often a labored and uneasy situation for many corporations. Their desire to avoid banks as much as they can has led to the popularity of commercial paper. For the most part, commercial paper is a very safe investment because the financial situation of a large company can easily be predicted over a few months. Furthermore, typically only companies with high credit ratings and credit worthiness issue commercial paper and over the past 35 years there have only been a handful of cases where corporations defaulted on their commercial paper repayment.

ABCP Conduits

Asset backed commercial paper (ABCP) is a device used by banks to get operating assets, such as trade receivables, funded by the issuance of securities. Traditionally, banks devised ABCP conduits as a device to put their current asset credits off their balance sheets and yet provide liquidity support to their clients. Conduits raise money by selling short-term debt and using the proceeds to invest in assets with longer maturities, like mortgage-backed bonds. Conduits typically have guarantees from banks, which promise to lend them money up to the amount of the SIVs the banks structure.

A bank with a client whose working capital needs are funded by the bank can release the regulatory capital that is locked in this credit asset by setting up a conduit, essentially a special purpose vehicle (SPV) that issues commercial paper, such as the ones used by Enron that led to its downfall. The conduit will buy the receivables of the client and get the same funded by issuance of commercial paper. The bank will be required to provide some liquidity support to the conduit, as it is practically impossible to match the maturities of the commercial paper to the realization of trade receivables. Thus, the credit asset is moved off the balance sheet giving the bank a regulatory relief. Depending upon whether the bank provides full or partial liquidity support to the conduit, ABCP can be either fully supported or partly supported.

ABCP conduits are virtual subsets of the parent bank. If the bank provides full liquidity support to the conduit, for regulatory purposes, the liquidity support given by the bank may be treated as a direct credit substitute in which case the assets held by the conduit are aggregated with those of the bank. ABCP conduits are also set up large issuers that are not banks.

The key weakness in the entire credit superstructure lies in the practice by intermediaries of credit to borrow short term to finance long term. This term carry is magical in an expanding economy when the gap between short term and long term credit is narrower than gains from long term asset appreciation.  But in a contracting economy, it can be a fatal scenario, particularly if falls in short term rates raise the credit rating requirement of the short term borrower, putting previously qualified loans in technical default. Securities that face difficulty in rolling over at maturity are known as “toxic” in the trade.

Lethal Derivatives

The credit default swap market is a microcosm of investor confidence. Credit default swaps are insurance for bad debt. Insured creditors are compensated by the seller of the insurance if a debtor defaults on a loan. When the threat of default rises in the market, the insurance premium rises, just as Katrina boosted hurricane insurance premium. This is known in the business as re-pricing of risk. The cost of credit default swaps written on investment banks such as Bear Stearns and Goldman Sachs and on commercial banks such as Citibank have soared in the past few months amid worries that troubles in the subprime-mortgage market and the leveraged-buyout market could leave them with massive loan defaults. The financial industry tracks mortgage-linked securities via the ABX index, which calculates the prices of a basket of assets backed by subprime loans.

The ongoing crisis in the US housing market has pushed the ABX, a key mortgage-linked derivatives index, to new lows, threatening to unleash a further bout of credit market upheaval.  Price swing in the ABX can reduce the value of ultra-safe credit instruments that carried high credit ratings, forcing banks and other regulated investors to make further large write-downs on their credit market holdings, on top of the huge losses several major US and foreign banks suffered from credit turmoil that began in August.

As the US mortgages market deteriorates, financial sector losses will accumulate. Secondary market price movements indicate that losses on mortgage inventory are likely to be larger in coming quarters. Before July, the part of the ABX index that tracks AAA debt was trading almost at face value. However, in the last three weeks in October, it has fallen sharply due to downgrades by credit rating agencies and continuing bad data from the housing sector.

As a result, the so-called ABX 07-1 index – which tracks AAA mortgage bonds originated in the first half of this year – fell to a record low close of 79 on October 30, meaning that traders reckon these bonds are worth only 79 cents on the dollar. The ABX "BBB" 07-1 index measures the performance of loans made during the second half of 2006, when many home purchase loans were made to buyers with shaky credit standings. The index traded around 44, or 44 cents on a dollar, nearly its weakest level ever.

The swing is creating real pain for investors, since in recent years numerous firms have created trading strategies which have loaded large debt levels onto these “safe” securities, precisely because these instruments were not expected to fluctuate in price.  Investors normally hold such “safe” securities to maturity thus there is no demand for a ready market for them. But as the credit rating of these securities falls, investor cannot find buyer for them at any reasonable price. The last week in October saw the worst falls in the ABX market this year, especially higher up the capital structure with highly rated debt.

Pension funds and insurance companies hold the less risky, senior CDO tranches because regulatory rules restrict them from investing in lower-rated securities. When the low-rated tranches default in large numbers, the high-rated tranches lose rating and these regulated institutions are forced to sell their non-conforming holdings into a market with few buyers.

Pension funds, insurance companies and university endowment funds have also invested in hedge funds that hold the riskier CDO tranches to get higher returns.  In recent years, CDO issuance has exploded and many hedge funds have been buying the riskiest tranches of MBS that are backed by subprime loans. Mortgages closed by 4 pm New York time were sent electronically to back-office locations in India to be packaged into CDO tranches and resent electronically to New York at 9:30 am the next day to be sold in the credit market, generating huge fees and profits for Wall Street firms every day.

Rating Agencies Under Pressure

Moody’s Investors Services, an influential rating agency, warned in late July that defaults and downgrades of subprime MBS could have “severe” consequences for CDOs that invested heavily in the sector. CDOs that Moody’s rated from 2003 to 2006 had 45% exposure to subprime MBS on average. But that varied widely from almost zero to 90% with recent CDOs having the high concentrations of such collateral, the potential downgrade for which could be 10 or more notches in rating. The secondary market for CDOs responded to these heightened risks, pushing prices down and widening spreads - the difference between interest rates on riskier debt and measures of short-term borrowing costs such as the London Interbank Offered Rate (LIBOR) or commercial paper rates. Spreads on BBB-rated asset-backed securities (ABS) CDOs over LIBOR have widened by roughly 125 basis points to 657 basis points since the end of 2006.

Structured investment vehicles (SIVs)

Although the first structured investment vehicles (SIVs) appeared in the structured finance world some 15 years ago, and the growth of SIVs had been somewhat limited, (there are fewer than 20 vehicles globally), there is no doubt that these sophisticated bankruptcy-remote structures have strongly influenced other funding vehicles and asset management businesses. Since 2002, there has been renewed interest by different types of financial institutions in starting up SIVs or SIV-like structures with evolved capital structures embracing new classes of financial instruments.

The first SIVs were founded in the mid-1980s as bankruptcy-remote entities and were sponsored by large banks or investment managers for the purpose of generating leveraged returns by exploiting the differences in yields between the longer-dated assets managed and the short-term liabilities issued. The balance sheet of a structured investment vehicle typically contains assets such as asset-backed securities (ABS) and other high-grade securities that are funded through issued liabilities in the form of commercial paper (CP) and medium-term note (MTN) and subordinate capital notes. SIVs typically hedge out all interest and currency risks using swaps and other derivative instruments.

Overall, CP and MTN issuance shot up dramatically in 2004, up US$25.7 billion to US$133.1 billion at year-end, with capital investments at an all-time high. In general, advances in capital structures and asset portfolio management have invigorated interest from investors and prospective sponsors.

SIVs, Conduits and Asset-Backed Commercial Paper (ABCP)

SIVs are typically funded in the low interest short-term asset-backed commercial paper (ABCP) market to invest in high-return long-term securities for profit. The viability of the stratagem depends on the ability to roll over the short-term commercial paper when they mature in typically less than 120 days. To keep the liquidity risk at a minimum, issuers stagger the maturity so that only a small portion of the loan needs to be refunded in any one week. The credit market crisis in mid 2007 created a break in short-term debt rollovers to cause a funding mismatch in long-term assets positions because investors have stopped buying new ABCP issued by some SIVs and conduits.

What separates a SIV from other investment vehicles is the nature of its ongoing relationship with rating agencies – from the originating qualification process to the continuous monitoring of its asset diversification, risk management and funding practices. These guidelines include frequent reporting of operating parameters such as portfolio credit quality, portfolio diversification, asset and liability maturity, market risk limitations, leverage and capital adequacy requirements, and liquidity requirements.

The rigorous monitoring allows SIVs to be highly capital efficient, enabling them to be leveraged on an average of 12 times the capital base, with exceptions. Unlike related traditional asset backed commercial paper (ABCP) conduits, SIVs do not require 100% liquidity support and credit enhancement.

Many SIVs faced trouble in the summer of 2007 as they were hit by both sharp falls in the value of their investments, mainly financial debt and asset-backed bonds, and a lack of access to new refinancing as investors shunned short-term commercial paper debt linked to asset-backed securities (ABCP).

Most CDOs are cash flow transactions not directly sensitive to the market value of their underlying assets as long as the cash flow is undisturbed. But if a CDO manager needs to sell an asset quickly even at a loss because of ratings agency downgrade, the CDO manager will be forced to carry the remaining assets at a lower value, upsetting both collateral for the agreed cash flow and the balance sheet of the participants.

While some hedge funds have profited from the sublime mortgage meltdown, other funds have been hit hard, resulting in a deteriorating financial sector as asset values plummeted faster than potential gains by vultures.

Other big lenders that raised warning flags earlier about bad-performing debt portfolios included Washington Mutual, New Century Financial and Marshall & IIsley Corporation. Foreclosures jumped 35% in December 2006 versus a year earlier. For the fifth straight month, more than 100,000 properties entered foreclosure because the owner couldn't keep up with their loan payments. In January 2007, Washington Mutual disclosed that its mortgage business lost $122 million in the fourth quarter, highlighting the weak sub-prime market.

New York Attorney General Sues Appraisal Company

New York Attorney General Andrew Cuomo, a potential Democrat gubernatorial candidate for New York, has filed suit against eAppraiseIT (EA), a real estate appraisal management subsidiary of First American Corporation, for having “caved to pressure from Washington Mutual” to inflate property values of homes. Washington Mutual allegedly complained to EA that “its appraisals weren't high enough.” Cuomo said in a statement that “consumers are harmed because they are misled as to the value of their homes, increasing the risk of foreclosure and hindering their ability to make sound economic decisions. Investors are hurt by such fraud because it skews the value and risk of loans that are sold in financial markets.” The bank is also facing a number of class action suits from irate borrowers.

Shares of government sponsored mortgage lenders Fannie Mae and Freddie Mac tumbled after receiving subpoenas seeking information on loans they bought from Washington Mutual and other banks. Cuomo said he uncovered a “pattern of collusion” between lenders and appraisers, and is seeking documents that may prove the lenders inflated appraisal values. The subpoenas also seek information on Fannie and Freddie's due diligence practices. If decided that they own or guarantee mortgages with inflated appraisals, company policy dictates that the lenders buy back the loans. “In order to fulfill their duty to consumers and investors, Fannie Mae and Freddie Mac must ensure that Washington Mutual’s mortgages have not been corrupted by inflated appraisals,” Cuomo said.  In 2007, WaMu is Fannie Mae’s third-largest loan provider, selling it $24.7 billion and Freddie Mac’s fourteenth largest at $7.8 billion. Washingtom Mutual share fell 17% after it announced it would set aside $1.3 billion fourth quarter 2007 for credit losses, up from $967 million in the third quarter.

Mortgage Lenders Fell Like Flies

The handwriting had been clearly on the wall. Back on February 6, New Century Financial  shares plunged 29%  after the mortgage services provider slashed its forecast for loan production for 2007 because early-payment defaults and loan repurchases had led to tighter underwriting guidelines. A week later, Pasadena, Calif.-based IndyMac Bancorp Inc. which sold Alt-A mortgages for borrowers who were not required to submit conforming income and financial documents necessary to quality for conventional conforming mortgages, warned that its quarterly earnings would come in well short of analyst expectations because of increased loan losses and delinquencies. Other lenders were also squeezed by deteriorating credit. Marshall & IIsley reported a jump in non-performing assets in the quarter, while Bank of the Ozarks reported a 69% increase in problem loans. US Bancorp predicted an increase in retail loan charge-offs and commercial loan losses in coming quarters. Wells Fargo warned it expected net credit losses from wholesale banking to increase in 2007.

Britain’s Barclays PLC, in the midst of an unsuccessful takeover battle for ABN Amro, was reported as among the banks that were having trouble with bad loans and its hedge funds. Barclays Global Investors was one of the world's biggest fund managers, with some $2 trillion in assets under management.

The Case of Countrywide Financial

mortgages securities packaged by Countrywide Financial  needed to be sold in the private, secondary market to alternative investors, instead of the agency market. On August 3, 2007, this secondary market collapsed and essentially stopped the sales of most non-conforming securities. Alt-A mortgages (loans given to self-declared creditworthy borrowers without supporting documentation) completely stopped trading and the seizure extended to even AAA-rated mortgage-backed securities. Only securities with conforming mortgages were trading. Unfazed, Countrywide Financial issued a reassuring statement that its mortgage business had access to a nearly $50 billion funding cushion.

In reality, the sub-prime mortgage meltdown put Countrywide Financial, along with many other mortgage lenders, in a crisis situation of holding drastically devalued loan portfolios that could not be sold at any price. Amid rising defaults, investors have fled from mortgage-related investments, drying up market demand. The ongoing credit crunch threatened Countrywide’s normal access to cash.

After the collapse of American Home Mortgage on August 6, the market’s attention returned to Countrywide Financial which at the time had issued about 17% of all mortgages in the United States. Days later, Countrywide Financial disclosed to the SEC that disruptions in the secondary mortgage markets could adversely affect it financially. The news raised speculation that Countrywide was a potential bankruptcy risk. On August 10, a run on the Countrywide Bank began as the secondary mortgage market shutdown, curtailing new mortgage funding.

The perceived risk of Countrywide bonds rose sharply. Credit ratings agencies downgraded Countrywide to near junk status. The cost of insuring its bonds rose 22% overnight. This development limited Countrywide access to the short-term commercial paper debt market which normally provides cheaper money than bank loans. Institutional investors were trying desperately to unload outstanding Countrywide paper held in their portfolios. Some 50 other mortgage lenders had already filed for Chapter 11 bankruptcy, and Countrywide Financial was cited as a possible bankruptcy risk by Merrill Lynch and others on August 15. This combined with news that its ability to issue new commercial paper might be severely hampered put severe pressure on the stock. Countrywide shares fell $3.17 to $21.29, which was its biggest fall in a single day since the crash of 1987 when the shares fell 50% for the year. The 52-week low to date was $12.07 per share.

On Thursday, August 16, having expressed concerns over liquidity because of the decline of the secondary market for securitized mortgage obligations, Countrywide also announced its intention to draw on the entire $11.5 billion credit line from a group of 40 banks. On Friday August 17, many depositors sought to withdraw their bank accounts from Countrywide.  It also planned to make 90% of its loans conforming. By this point stock shares had lost about 75% of their peak value and speculation of bankruptcy broadened.

The Fed Discount Window Accepts Toxic Collateral from Banks

At the same time the Federal Reserve lowered the discount rate 50 basis points in a last-minute, early morning conference call. The Fed also accepted $17.2 billion in repurchase agreements for mortgage backed securities to provide liquidity in the credit market. This helped calm the stock market and investors promptly responded positively with the Dow posting temporary gains.

Additionally, Countrywide was forced to restate income it had claimed from accrued but unpaid interest on “exotic” mortgages in which the initial pay rate was less than the amortization rate. By mid 2007, it became apparent much of this accrued interest had become uncollectible. In a letter dated August 20, Federal Reserve agreed to waive banking regulations at the request of Citigroup and Bank of America to exempt both banks from rules that limited the amount that federally-insured banks can lend to related brokerage companies to 10% of bank capital, by increasing the limit to 30%.  Until then, banking regulations restricted banks with federally insured deposits from putting themselves at risk by brokerage subsidiaries’ activities.  On August 23, Citibank and Bank of America said that they and two other banks accessed $500 million in 30-day financing at the Fed’s discount window at the new low rate of 5.25%.

On the next day, Countrywide Financial obtained $2 billion of new capital from Bank of America Corp, the banking holding parent. In exchange, the Bank of America brokerage arm would get convertible preferred stock yielding 7.3%, a profitable spread over its Fed discount rate of 5.25% and the Fed funds rate of 4.75%. The preferred stocks can be converted into common stock at $18 per share (trading around $12 on October 25).  This gave the distressed mortgage lender a much-needed cash infusion amid a crippling credit crunch. Countrywide shares soared 20.01%, or $4.37, to $26.19 after hours on the news. Bank of America shares rose 1.9%, or 98 cents, to $52.63 (trading around $46.75 on October 25 after announcing third quarter earning dropping 32%).

SEC to Scrutinize Security Valuation

The Securities and Exchange Commission (SEC) is reportedly looking into the accounting and securities valuation practices at Wall Street investment banks to ensure consistency and clarity for investors. Meanwhile, major financial institutions were lining up to announce write-downs on their sub-prime mortgage exposures. Merrill Lynch wrote down $5.5 billion which was later revised to $8 billion; Citigroup $3.3 billion which was later revised to $11 billion; Goldman Sachs $1.7 billion, Lehman Brothers $1 billion, Morgan Stanley $0.9 billion and Bear Sterns $0.7 billion. Many in the market expect further write downs in coming quarters. Already Merrill Lynch write down is widely put at more than $14 billion and few believe that Citigroup’s loss could be kept to $11 billion in coming quarters. The heads of Merrill, UBS and Citigroup all resigned.

Wachovia, the fourth-largest US bank by assets, estimated on Friday, November 9 that the value of its subprime mortgage-related securities had fallen $1.1 billion in October. It said loan-loss provisions would be increased by as much as $600 million in the fourth quarter due to “dramatic declines” in home values. The announcement came three weeks after Wachovia reported writedowns of $1.3 billion in the third quarter and posted its first earnings drop in six years.

Morgan Stanley, the second-biggest U.S. securities firm, said on November 7 its subprime mortgages and related securities lost $3.7 billion in the past two months, after prices sank further than the firm’s traders anticipated. The decline may cut fourth-quarter earnings by $2.5 billion. Colm Kelleher, Morgan Stanley chief financial officer to the Financial Times in an interview: “You need to see some of these long positions reduced, you need to see buyers coming in, you need to see an easing of liquidity in the market.” Kelleher said credit markets would take three or four quarters to recover, instead of the one or two he estimated when the firm reported third-quarter results on September 19.

Concerns about potential writedowns at Morgan Stanley have pushed the stock lower this week, bringing the year-to-date decline to 24 percent. The stock fell $3.32, or 6.9%, to $51.19 in New York Stock Exchange composite trading on November 8.  Analysts estimate the firm would lose about $4 billion on asset- backed securities and collateralized debt obligations and expected the remaining losses to be booked on residual mortgage interest and on credit lines to structured investment vehicles.

Being Right Can lead to Losses through Aggressive Hedging

Part of the losses Morgan Stanley incurred stemmed from derivative contracts the firm’s proprietary trading unit wrote earlier in the year. The traders anticipated correctly a decline in the value of subprime securities and took up short positions and the contracts made money for the firm in the second quarter. But the contracts started losing money when prices fell below the level the traders had anticipated. As markets continued to decline, the firm’s risk exposure swung from short, to flat to long because the structure of the book had big negative convexity.  For any given bond, a graph of the relationship between price and yield is a convex curve rather than a linear straight-line. As a bond’s price goes up, its yield goes down, and vice versa. The degree to which the graph is curved shows how much a bond’s yield changes in response to a change in price. Negative convexity gives the investor a greater loss in the event of a 50 basis points drop  in yields than his gain in the event of a 50 basis points rise in yields. For any given move in interest rates, the downside is bigger than the upside to give a built-in loss for a short position with negative convexity. Sophisticated traders can create instruments which have so much negative convexity that the price might start off moving in one direction as yields start moving, and then eventually start moving in the opposite direction beyond a given range. The hedge then begins to cannibalize profitability.For any given move in interest rates, the downside is bigger than the upside to give a built-in loss for a short position with negative convexity, thus producing losses. For positive convexity, the upside is bigger than the down side, thus giving short positions an advantage.  Morgan Stanley’s short positions allegedly turned against them by negative convexity; at least that was how they explained the loss. Some analysts think there must be more than meets the eye, assuming Morgan management itself even know. The people who put on the bad trades were fired and not there to answer questions.

It is one thing to lose money, but it is quite another to lose money without knowing why and how. Morgan Stanley, Citibank, and the rest still have difficulty figuring out how they lost money last quarter and how much loss is waiting in future quarters. They only know the numbers came in very bad.

SEC Concern over Accuracy of Writedowns

US market regulators have been working with investment banks and accounting firms over the past few months to keep tabs on how they are dealing with changes to the accounting treatment of securities that were introduced this year by the US Financial Accounting Standards Board (FASB). The SEC has been particularly concerned during the third quarter earnings season, which resulted in billions of dollars in write-downs at investment banks after problems in the sub-prime mortgage markets that triggered a wider credit crisis. At issue is whether these write-downs accurately reflect the total financial impact of the credit crisis on the banks and their investors.

The SMELEC Super Fund Proposal

Citigroup, Bank of America and JP Morgan/Chase announced on Monday, October 15, plans for a super fund to buy mortgage-linked securities in an attempt to allay fears of a downward price-spiral that would hit the balance sheets of big banks. US banks collectively would put up credit guarantees up to $100 billion for the fund, named the Single-Master Liquidity Enhancement Conduit (SMLEC).

The concept of an SMLEC first emerged three weeks earlier when the US Treasury summoned leading bankers to discuss ways to revive the mortgage-linked securities market and to deal with the threat to the credit market posed by structured investment vehicles (SIVs) and conduits. The Treasury said it acted as a “neutral third party” in the discussions, but Henry Paulson, Treasury secretary, was reportedly strongly in support of the initiative.

Robert Steel, under-secretary for domestic finance, led the US Treasury side of the discussions, with the day-to-day work handled by Anthony Ryan, assistant secretary. The plan is an attempt to address concerns about SIVs and conduits, vehicles that are off-balance sheet but closely affiliated to banks.

Fears emerged that some SIVs might be pushed into forced sales of assets, prompting further declines in the market price of mortgage-linked securities as a class that could hurt the balance sheets of all lending institutions. SMLEC, designed as a superfund to preserve the theoretical value of the high-rated tranches by creating a ready buyer for them, is likely to be unpopular with some banks and non-bank institutions which have already started trading in distressed low-rated subprime securities at knockdown prices.

SMLEC as proposed is intended as a restructuring vehicle, repackaging credit securities to make them more transparent than existing SIV commercial paper and less risky to investors. It would only deal in “highly-rated” assets. Although it is envisaged that the scheme will initially focus on vehicles in the dollar market held by US banks, it is expected to extend to non-US banks as well, and may even be extended to the euro market. The US Treasury declined to provide official comment on the reported proposal.

In October, Citigroup Inc. posted a 57% slump in third-quarter net income at $2.38 billion, or 47 cents a share, from $5.51 billion, or $1.10 a share, a year earlier. The latest quarterly results included $1.35 billion of pretax write-down in the value of loans that helped finance the leveraged-buyout boom and $1.56 billion of pretax losses tied to loans and sub-prime mortgages. A couple of weeks after the SMLEC proposal, Citigroup announced a write down of $3.3 billion which was later revised to $11 billion and that its Chairman resigned after an emergency board meeting on the first Saturday of November.

SMLEC is in essence a big bet that a consortium of banking giants, at the prodding of the US Treasury, can persuade investors to pour new money into the troubled credit market to buy the assets of troubled SIVs to prevent the pending loss faced by the sponsoring institutions.

Alan Greenspan, former Fed chairman, immediately raised serious doubts over SMLEC, warning that it could prevent the market from establishing true clearing prices for asset-backed securities. “It is not clear to me that the benefits exceed the risks,” Greenspan told Emerging Markets, adding, “The experience I have had with that sort of intervention is very mixed.”  As the person most responsible for a macro liquidity boom that had prevented “the market from establishing true clearing prices for assets of all types”, Greenspan is critical of the effort of the Treasury to do the same thing on a micro level to save the banking system.

Greenspan explained: “What creates strong markets is a belief in the investment community that everybody has been scared out of the market, pressed prices too low and there are wildly attractive bargaining prices out there.” He added: “if you intervene in the system, the vultures stay away. The vultures are sometimes very useful.”  Goldman Sachs must have heard the message loud and clear and decided to act as its own home-grown vulture.

Greenspan’s remarks came amid growing speculation on Wall Street that the current Federal Reserve sees potential benefits in the SMLEC proposal in terms of preventing a possible fire sale of assets, and does not think it has been designed to allow financial institutions to avoid recognizing losses. But the Fed is concern that the superfund plan could exacerbate growing investor anxiety, and thinks markets might normalize faster if at least some troubled SIV assets were sold in the market to allow prices to find a floor. Fed officials have been officially silent on the superfund plan, leading to the impression that the Fed wants to keep its distance.  The Treasury regards the Fed’s silence as simply reflecting the separation of powers and responsibilities between the institutions. In reality, the Treasury leads the Fed on issues of national economic security, notwithstanding the Fed’s claim of independence.

Greenspan defended the 1998 Fed-sponsored rescue of Long-Term Capital Management (LTCM) by a group of creditor banks, saying it worked because it took a set of assets that would otherwise have been dumped at fire-sale prices off the market, allowing prices of the remaining assets to find a true equilibrium. But he said today “we are dealing with a much larger market.” To those who still have reliable memory, the justification for the Fed managed rescue of LTCM was to prevent the total collapse of the financial market because of the dominant size and high leverage of LTCM. Other distressed hedge funds would also have survived with a Fed managed bailout, but they did not qualify as being “too big to fail”.

Frederic Mishkin, a Federal Reserve governor, admitted to the Financial Times that although the central bank could use monetary policy to offset the macroeconomic risk arising from the credit squeeze, it was “powerless” to deal with “valuation risk” – the difficulty assessing the value of complex or opaque securities.

Robert J Shiller, Yale economist of “Irrational Exuberance” fame (2000), writing in the October 14 edition of the New York Times: Sniffles That Precede a Recession: “While it may seem as though these private banks could have met by themselves and agreed to create a fund without pressure from Treasury to do so, apparently there are times when the private sector cannot take care of itself and it needs the government to intervene and prod it in the right direction, at least that appears to be the attitude at Treasury (and I wonder if there will be government guarantees of any sort as part of the bargain, a situation that rules out the private sector doing it on its own, but also a situation that more explicitly recognizes the existence of market failure and the need for government intervention to overcome it). It would be refreshing to see this same attitude extended by the administration to other markets that cannot coordinate properly or that suffer from significant market failures of other types, markets that produce outcomes where, say, children are left without health coverage. But don't get your hopes up.”

Warren Buffett, the Pied Piper of other awed investors, told Fox Business Network that “pooling a bunch of mortgages, changing the ownership” would not change the viability of the mortgage instrument itself. “It would be better to have them on the balance sheets so everyone would know what’s going on.” Bill Gross, chief investment officer of Pimco, the giant bond fund manager, called the superfund idea “pretty lame”. Investors need to know what their portfolio is really worth at any moment in time, not merely constructed value if conditions should hold.

Next: The Commercial Paper Market and SIVs