Monday, March 31, 2008

A $1 Trillion Write-Down Lurks

Be it ever so devalued, $1 trillion is a lot of dough.

That's roughly on a par with the Russian economy. More than double the market value of Exxon Mobil Corp. About nine times the combined wealth of Warren Buffett and Bill Gates.

Yet $1 trillion is the amount of defaults and write-downs Americans will likely witness before they emerge at the far side of the bursting credit bubble, estimates Charles R Morris in his shrewd primer, “The Trillion Dollar Meltdown.” That calculation assumes an orderly unwinding, which he doesn't expect.

“The sad truth,” he writes, “is that sub-prime is just the first big boulder in an avalanche of asset write-downs that will rattle on through much of 2008.”

Expect the landslide to cascade through high-yield bonds, commercial mortgages, leveraged loans, credit cards and -- the big unknown -- credit-default swaps, Morris says. The notional value for those swaps, which are meant to insure bondholders against default, covered about $45 trillion in portfolios as of mid-2007, up from some $1 trillion in 2001, he writes.

Morris can't be dismissed as a crank. A lawyer, former banker and author of 10 other books, he knows a thing or two about the complex instruments that have spread toxic debt throughout the credit system. He once ran a company that made software for creating and analyzing securitized asset pools. Yet he writes with tight clarity and blistering pace.

The financial innovations of the past 25 years have done some good, Morris notes. Collateralized mortgage obligations, invented in 1983, saved homeowners $17 billion a year by the mid-1990s, according to one study.

Slicing and Dicing

CMOs transformed the business by slicing pools of mortgages into different bonds for different risk appetites. Top-tier bonds had the first claim on all cash flows and paid commensurately low yields. The bottom tier was the first to absorb all the losses; it paid yields resembling those on junk bonds.

What began as a good thing, though, soon spawned a bewildering array of new asset classes that spread throughout the financial system, marbling balance sheets with what Morris calls inflated valuations, hidden debt and “phony triple-A ratings.” The more the quants fine-tuned the upper tranches of CMOs and other collateralized debt obligations, the more dangerous the bottom slices grew. Bankers began calling it “toxic waste.”

Guess where the toxins wound up? That's right: Credit hedge funds are now the weakest link in the chain, Morris says. Their equity stands at some $750 billion and is so massively leveraged that “most funds could not survive even a 1 percent to 2 percent payoff demand on their default swap guarantees,” he writes.

Utter Thrombosis

Morris sketches a scenario in which hedge fund counter-party defaults would ripple through default swap markets, triggering write-downs of insured portfolios, demands for collateral, and a rush to grab cash from defaulting guarantors. The credit system would suffer “an utter thrombosis,” he says, making the sub-prime crisis“ look like a walk in the park.”

As bankers and regulators try to prop up an unstable “Yertle-the-Turtle-like tower of debt” Morris points to two previous episodes of lost market confidence.

The first was the 1970s inflationary trauma that prompted investors to suck money out of the stocks and bonds that finance business. Confidence returned only after Fed chief Paul Volcker slew runaway inflation by ratcheting up interest rates.

The other precedent is the popped 1980s Japanese asset bubble. In that case, politicians and finance executives tried to paper over their troubles. Two decades later, Japan still hasn't recovered, Morris writes.

We should be as bold as Volcker, he suggests: Face the scale of the mess, take a $1 trillion write-down and shore up regulatory measures. His recommendations include forcing loan originators to retain the first losses; requiring prime brokers to stop lending to hedge funds that don't disclose their balance sheets; and bringing the trading of credit derivatives onto exchanges.

What he fears is that the US will instead follow the Japanese precedent, seeking to “downplay and to conceal. Continuing on that course will be a path to disaster.”


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