The Rude Awakening
Krakow, Poland
Friday, July 6, 2007 ------------------------- - Following the trail of risky money…all the way back home,
- Investment banks bury toxic loans all along Wall Street,
- Homeless in Poland (and loving it!) and plenty more…
------------------------- Joel Bowman, checking in from somewhere along the Polish Slovakian border… Wandering though the labyrinthine backstreets of Krakow's Old Town is a treat this time of year. The temperature lingers in the twenty-somethings and the cool breeze from the nearby gardens brings with it the scent of summer flowers and the sounds of accordion players serenading the night. Cafes goers spill out onto the winding footpaths, interrupting for a moment the shuffle of nuns and the occasional passing bicyclist. Church bells sound out around the town but few stop to notice the time. Welcome to one of Europe's quaintest little big towns. Earlier this week your editor decided to splash a few zlotys and take his girlfriend out for a traditional Polish meal here in Old Town. We'd been traveling for a few days and granola bars can get a little bland after two or three boxes. Meandering through the streets we arrived at the doorstep of a warmly lit restaurant. The place seemed inviting enough so we took a table near the window and ordered a couple of aperitifs. A few moments later our waiter returned with a basket of fresh herb bread and our drinks. Outside the streets were coming alive with groups of well-dressed men and women, smoking cigarettes and laughing heartily. For starters we had a sumptuous array of meats, cheeses and fruits. If you have never tasted fresh pear with roquefort cheese, we highly recommend it. For our entrees we feasted on kielbasa, duck with apple puree, salmon in vodka sauce, potatoes in chives and butter and more steamed vegetables than we could manage. When washed down with a few glasses of sweet wine from neighboring Hungary, this meal is enough to tantalize even the most discerning of palates. What will a night like this cost you, here in Krakow's main square? About one hundred zlotys (including an unnecessary tip), or forty dollars, U.S. While it may seem difficult to imagine, this was the most expensive bill we were handed all week. Even our modest accommodations in the heart of town only set us back sixty zlotys, less than twenty-five dollars per night. It is a great time to be homeless. In the column below, Bullion Vault's Paul Tustain uncovers some unsettling news regarding the subprime lending farce - and Wall Street's desperate attempts to cover their behinds - that could inspire a few people to take a temporary vacation from the homeowning arena. Read on for Part One of this fascinating tale of toxic loans… ----------------------------------- Investment Landfill - How Professional Investors Dump Their
Toxic Waste On You
By Paul Tustain [Joel's Note: Paul Tustain appears courtesy of Bullion Vault. Click here for more: https://www.bullionvault.com/ The subprime mortgage collapse now hitting Bear Stearns may be just the start of something much bigger. Serious analysts from big investment firms are talking ominously about "the big one" - a major crisis that will roil the global financial markets. Our story begins with the humble mortgage. About six million people in the United States, who hold very little savings in reserve, have borrowed 100% of the value of their homes. These are the subprime borrowers. Every day that home prices continue to fall, their situation becomes more dire. The original lenders to these questionable borrowers have never worried too much about the risk of default, because these lenders simply rolled their subprime mortgages into bond-like securities called Mortgage-Backed Securities (MBS), which they then sold to various investors. But it is not always easy to sell a package of risky Mortgage-Backed Securities…unless you can convince the buyers that these risky things are not as risky as they seem. This is where it pays to get a bunch of smart investment bankers involved. The investment bankers slice the MBS into several "tranches". These are known as Collateralized Debt Obligations, or CDOs for short. The idea is to slice the MBS into a variety of CDOs that possess different risk profiles. These CDOs are categorized as equity (high risk), mezzanine (middle risk) and the much sought-after investment grade bonds (low risk). Higher risk equals higher returns, of course. So the equity tranche of the MBS will earn the highest profits if things go well. But if things start to go wrong, the equity loses first, and then the mezzanine. Even then, the investment-grade bonds could still get fully paid out. This persuades the credit-rating agencies like Moody's and S&P to give the lowest-risk tranche a high enough credit rating to qualify as investment grade, sometimes even AAA. In this way the investment bank has created a decent proportion of highly marketable bonds out of a package of low-quality mortgages. Fairly standard, for example, is to convert a large package of MBS into perhaps 80% investment-grade bonds, 10% mezzanine, and 10% equity. The original mortgage lender is in a hurry to get the whole MBS sold off, because this raises cash which can then go to fund fresh mortgage loans to new subprime borrowers. The investment bank is well motivated to slice up the MBS, because selling investment products is what it does best…and how it generates its fees. It won't want to keep much, if any, of the newly created CDO tranches, because investment banks earn their money primarily by deal-making and distribution, rather than by taking risks with borrowers. In the market for CDOs, the investment bank will find it relatively easy to sell the investment grade bonds. They go mostly to pension funds and other institutional investors. But the mezzanine, and particularly the equity tranches, can be trickier to dispose of. The effect of concentrating the risk, as well as the upside, in these tranches is to make them "hot" - so hot, in fact, that investment insiders
sometimes call them "toxic waste." How can these toxic bonds be sold off? There are several ways. Method One: Create a hedge fund The investment bank might choose to set up a hedge fund, possibly even using some of its own money to get the fund started. The hedge fund's objective is to trade in the high-risk equity and mezzanine CDO instruments. Let's imagine that the investment bank puts up the first $10 million. The hedge fund then buys the equity tranche of the CDO from the investment bank. In effect, the investment bank is actually buying the equity from itself. With a bit of luck - and this is what happened over recent years - the housing market then goes up. Now the CDO equity is floating higher in the water, because there's a cushion of higher house prices preventing those original subprime borrowers from defaulting. This rather obscure equity instrument, which is not traded on any open market, and so is not a liquid asset that can readily be bought and sold, should now be worth more than it was at issue. It gets marked up in value, and it gets marked up much faster than the underlying house prices, because all the price volatility is concentrated in this thin slice of CDO equity. The hedge fund is now a star performer! And that means it will be rewarded by further investment from outside. So what started as a vehicle with a little investment bank cash can grow the funds it manages under its own steam. Next, and this is what hedge funds are all about, it will leverage its risk, too. The hedge fund goes out to an unrelated lending bank, holding its high-performing, but illiquid, toxic waste in hand, and asks to borrow money, using the waste as collateral. The lending bank has access to cheap money, and so it has the prospect of lending for spectacular profits. Now the MBS wheel is fully in motion. With a little co-operation from the investment bank, to which it is closely related, the hedge fund loses no time in marking up the value of its equity CDOs, mostly on the basis of rising house prices. There is an overwhelming pressure to mark up CDO values, not least because the hedge fund managers are rewarded on performance. Alas, in the absence of a genuine open market, it is too easy to manipulate the CDO's price up to an unrealistic value. The lending bank can see its collateral floating higher and higher, and so it lends ever more cash to the hedge fund. Naturally, as with all collateral, the bank claims the right to sell the bonds if the underlying debt gets into trouble. But it doesn't look like a real danger at this stage. So the money lent by the bank against the CDO equity goes back to the hedge fund, which buys more CDOs from the investment bank, which buys more MBS from the mortgage lender, which provides more money to subprime borrowers, who then buy more houses, pushing real-estate prices higher again. This vituous cycle only gets into trouble when house price turn sharply down, as has been occurring for more than a year. When home prices fall, the lending banks become less eager to lend, or worse, ask for their money back from the hedge funds. But the hedge funds haven't got it. They exchanged all of their borrowed money for illiquid CDO tranches. So the collateral needs to be sold. No problem, surely. It's on the books at a few billion dollars after all. But with its concentration of risk in a falling market, the equity slice has been haemorrhaging value, without ever being bought or sold in an open exchange. It's incredibly painful for the investment banker to mark down a "paper price" in these circumstances. First, he doesn't actually know for sure that the price is falling, any more than he knew it was rising when he marked the price up. But he does know that marking the price down will immediately be bad for him, his team, his bank, his customer and everyone else. He doesn't have to be totally evil to put off marking down the price until tomorrow - or maybe the next day. In the current stressed environment for subprime CDOs, everyone around these instruments has a pretty good idea that they are not worth anything close to what everyone pretends they are worth. But no one is in any hurry to determine their fair value. Something like the scenario above is what happened to Bear Stearns' hedge funds. Its two funds were leveraged 5 times and 15 times respectively. That's the number of times they went round the financing wheel of leverage. The smaller, more cautious fund had 5 times as much money invested in CDOs as it had received from its hedge fund investors in cash. This means that its balance sheet may have looked like this: Assets $5bn CDOs Liabilities $1bn hedge fund investment
$4bn bank loans Whereas the bigger fund was 15 times leveraged. So its balance sheet could have looked like this: Assets $15bn CDOs Liabilities $1bn hedge fund investment
$14bn bank loans
So far, only the smaller hedge fund has been rescued and we await developments on the larger one. The picture that is emerging is that the providers of the bank loans became increasingly nervous as US house prices turned down, and they wanted their money. Clearly, there were no cash assets in the hedge funds. So the banks took hold of the CDOs - their collateral - and went to sell them. The first out of the door, rumoured to be Merrill Lynch, mostly got the collateral it was owed, but it exhausted the CDO market of buyers. The rest found no bids and quickly stopped trying to sell for fear of advertising the rock-bottom prices of something which currently sits in many portfolios at funds all over the world. Worse still, we are advised that the Bear Stearns funds were not actually invested in the toxic waste. They had bought the investment grade bonds. That clearly means the toxic waste and the mezzanine bonds have no value. We do not know who owns these. Check in next week for Part II of the CDO Saga… Joel's Note: Who owns these wastebaskets and when they will keel over is anyone's guess. One thing is almost certain, however: The little guy at the end of the line is likely to get hit the hardest. Mike Shedlock has been monitoring the trembling housing market for a while now and has prepared a Housing Survival Report for homeowners who wish to know how they can escape the deluge. If you're a homeowner, prime or subprime alike, you'd do well to give this report a quick peruse. You'll find it here: Why Your House Could Be Worth 43% Less by 2011 ------------------------------------- Joel's Endnote: We'll be back tomorrow with your weekly wrap up. Until then we've got a train to catch and Addison and Ian are working on you five. Look out for it soon. Cheers, Joel P.S. If you'd like to send along an email for consideration for the Monday Mailbag, please address it to aussiejoel@the-rude-awakening.com . | 
