The Wall Street Journal ran a front page lead article titled, "Wall Street Fears Bear Stearns Is Tip of an Iceberg."
Last week, in our column, "Hedge Funds Sell into Sucker's Rally", we pointed out the significance of the Bear Stearns hedge fund bailout.
If this is just the tip of the iceberg, as the Journal says, this could cause a major unraveling of subprime lending (including both mortgages and credit cards) and a return to high credit premiums, possibly snowballing into all highly-leveraged instruments, threatening financial stability
[Editor's Note:The Mother of All Financial Disasters]
We and our sister newsletter, Financial Intelligence Report, have warned repeatedly of the systemic risk resulting from excessive liquidity, derived mostly from the staggering leverage created when hedge funds invest in derivatives.
A world awash with cash has allowed credit spreads to become very compressed.
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Abundant liquidity caused asset prices to continue in an upward spiral. Cheap credit and compressed credit spreads fueled this credit spiral into a massive explosion in asset prices.
We pause for a moment, to give our readers some idea of the gigantic size of this threatening problem. We recommend you sit down before reading on!
According to the Economist, the total value of residential property in just the developed economies increased some $70 trillion (25 percent) over the past five years.
To put that staggering figure in perspective, the Economist went on to refer to this increase as, "equivalent to 100 percent of all those [developed] countries' combined GDP."
Of course, this massive figure means that, the potential credit problem in this area is beyond the means of all the major central banks to bail out!
That is why we referred, way back in April 2006, to another Economist article which warned our readers that, "This [housing bubble] dwarfs any previous house price boom-it's larger than the global stock bubble in the late 1920s. In other words, it looks like the biggest bubble in history."
Well, if you have not fainted already, you may rightly ask three key questions. First, where has all this money come from? Second, why was the SEC not been on top of it? Third, what happens if derivative credit comes unwound?
[Editor's note:Sir John Templeton first warned of market, housing crash – Read More Here]
Let us try to explain, briefly.
The answer to your first question is leverage — leverage to a degree you could hardly imagine. Let us give you an example.
As our readers know, hedge funds are largely unregulated. They have recently been in great favor and were able to leverage themselves highly. (Despite the fact that many of them are not "hedged" but are very "exposed.")
As we said on June 21, a hedge fund invests in a CDPO (Credit Derivative Product Company), which can leverage its capital by a staggering 30 times.
Say that CDPO, in turn, is invested in some CPDOs (Constant Proportion Debt Obligations), each of which can leverage its capital some 15 times. Soon you are talking real leverage.
By full use of leverage and investment in highly-leveraged credit derivatives, a hedge fund can, according to the Economist, leverage its capital by a staggering 54 times!
It does not take a rocket scientist to see that, a fall in the value of the underlying asset value, of a mere 2 percent, can wipe out the entire equity of the (un-hedged) hedge fund.
The lenders to the hedge fund can then trigger the "margin call" — restrictive covenants in the loans — requiring the manager of the hedge fund (Bear Stearns, for instance) to pump more equity into the hedge fund. This all assumes, of course, that normal market restrictive covenants were included in the loan documentation.
The problem is, as the Financial Times highlighted, (see last week's "Easy Credit Continues to Stoke the Liquidity Boom"), "Talk is that arrangers (investment bankers) are being told not to bother calling (private equity) sponsors for new mandates unless they are prepared to do 'cov-lite'," says S&P LDC.
In other words, there are a number of loans to hedge funds that have few restrictive covenants. Lenders flush with money, have agreed to lend on terms far more lax than industry norms would dictate. Worse still, they have lent for further investment in highly-leveraged derivatives.
No wonder Warren Buffet has called such derivatives, "financial weapons of mass destruction."
[Editor's Note:Buffett, Soros, Templeton, Rogers: Learn Their Money-Making Secrets]
Liquidity has been so great that Stephen Roach, former chief economist of Morgan Stanley, commented, "There is one word that permeates virtually every discussion I have with investors around the world — liquidity. It's really the only thing they want to talk about. …For my money the risks of a global fizzle are being taken too lightly."
Now for your second question as to why the SEC has not been on top of this boom in credit and liquidity?
The basic fact is that the SEC is there to protect normal investors, not accredited investors in private equity.
In addition, most of the subprime lending has been done by brokers and hedge fund managers that are largely unregulated by the banking authorities.
In this respect, we note the Democrat Congress has now started to "pin" Fed Chairman Bernanke as an easy "scapegoat". Poor Bernanke does not only have to deal with a spendthrift government and a dollar in free fall, but is now facing attacks from outside his difficult dual mandate.
So there you have it, this massive problem has built up below the radar of Federal regulators, to a size that it is now beyond their pooled resources to correct if things should go wrong.
So, on to your third question, what if it unwinds?
Bear Stearns appears to be a classic example.
Apparently they had funds that raised massive amounts of leverage on "cov-lite" documentation (including an absence of margin call rights for the lenders) to invest in high-yielding, but highly-leveraged subprime mortgage credit derivatives.
As these derivatives trade, "by appointment", they are held on the books at their cost price. In addition, Bear Stearns made few friends among the Wall Street "club", when they failed to step to the plate and participate in the ($3.6 billion) rescue package to bail out Long Term Capital a few years ago.
Recently, the number of defaults on subprime credits has mushroomed, threatening the equity base of some (we believe many) hedge funds.
When lenders, such as Merrill Lynch realized their "cov-lite" loans to Bear Stearns hedge funds offered them no rights to margin calls, they seized the underlying collateral bonds and offered them for auction.
According to a CNBC report last Friday, some of the market bids were as low as ten cents on the dollar. The devastating result of such a "free market" bid is that the remaining tranches of loans to the same borrower must be marked to market, showing a loss of some 90 percent!
It is not difficult to see that a fall of 90 percent in asset values can do devastating damage in a highly-leveraged situation.
[Editor's Note:Buffett: The best book ever written on investing.]
Today, we note a report in the New York Times that Bear Stearns "pledged up to $3.2 billion in loans," to bail out just one of their hedge funds.
That figure is almost equal to the total rescue package for Long Term Capital and is for only one of Bear Stearns's un-hedged, but highly-leveraged, hedge funds!
So what will this do for the credit rating of Bear Stearns and even for other lenders, perceived by the rating agencies as "associated" with the great risks that the fund managers took with other peoples' money in the name of greed?
If credit ratings of borrowers are lowered, certain holders of their debt may be legally prohibited from holding it at the lower rating.
Very soon, you have what are known as "Buyer's Sales."
Seeing this, credit spreads start to increase, towards and then above premiums, considered normal. This magnifies still further the funding problems of any borrower, perceived to be in "trouble".
On the bright side, a "normal" flight to capital is likely to be largely towards Treasuries, resulting in a drop in yields of some Treasuries. However, for reasons we have long mentioned to our readers, these are not "normal" days for U.S. Treasuries.
As if this were not bad enough, there appears to be an increasing chance of an increase in interest rates.
We believe that the probability of a Fed rate hike has increased substantially due to the sharp fall off (some 99 percent last month) in the net foreign purchases of Treasuries.
This most serious fact, may act as a force majeur on the Fed - overwhelming the counter arguments of economic recession, a housing bust, and government politics - to "force" a rate increase.
A rise in the Fed rate at this time would be very bad news for any highly-leveraged situation, which was experiencing a loss of credit rating.
As we reported in the May issue of FIR, Yale economist Robert Shiller recently told Money magazine that he still sees disaster looming for the U.S. housing market.
In the same issue of FIR, we referred to Christopher Ruddy's interview with Sir John Templeton in February 2005, which contained the legendary investor's warning that U.S. investors could expect housing prices to fall by as much as 50 percent, when the bubble burst.
[Editor's Note:a href='/jump/suggestions/fir41.htm'>Will the Liquidity Crisis Sink Your Stocks? 12 Ways to Profit.]
Today, the liquidity bubble affecting most of the Wall Street infrastructure is even more dangerous than it was more than two years ago.
We have long been concerned and have advised our more risk-averse readers to be ultra cautious. This may have cost some of them certain opportunity costs as frothy markets raged.
But our readers still have their money, relatively safe and yielding more than 5 percent in cash and gold!
© NewsMax 2007. All rights reserved.
Editor's note:
Sir John Templeton first warned of market, housing crash – Read More Here
Will the Liquidity Crisis Sink Your Stocks? 12 Ways to Profit.
Buffett, Soros, Templeton, Rogers: Learn Their Money-Making Secrets
Buffett: The best book ever written on investing.
The Mother of All Financial Disasters
