The Rude Awakening
Laguna Beach, California
Tuesday, July 10, 2007 ------------------------- - Tidal waves in a giant global liquidity pool,
- The unknown, untested threat to your money,
- And why sometimes it's better to leave the party early…
------------------------- Eric Fry, resisting the urge to dance, reports… "We're still dancing," beams Chuck Prince, the CEO ofCitigroup, in reference to the big bank's lendingactivities. The problems in the sub-prime mortgage marketare not large enough to cause a problem for Citigroup, hesays, much less for the financial markets as a whole. "The depth of the pools of liquidity is so much larger thanit used to be," Prince explains to the Financial Times,"that a disruptive event now needs to be much moredisruptive than it used to be." Hmmm…seems like a reasonable assessment. On the otherhand, a bigger pool makes a bigger splash. In the contextof today's gargantuan derivatives markets, for example, theLTCM debacle of the late 1990s seems like a storm in ateacup. The next storm, if and when it arrives, will likelyproduce ripples of much larger magnitude and much greaterdestructive force. Back in the days when the Nobel prize winners at LTCM weredevising news ways of losing billions of dollars, creditderivatives were little more than gleams in the eyes ofinvestment bankers. The problems at LTCM, therefore, failedto trigger any enduring knock-on effect. But the financialmarkets of today feature an unprecedented quantity andvariety of illiquid financial oddities that have neverwitnessed a financial crisis, nor even a garden-varietybear market. What will happen, therefore, if the unexpected were to occur? No one knows. What we do know is that the notional value of creditderivatives outstanding has doubled five years in a row andnow exceeds the value of the entire American GDP. 
"At some point," Citigroup's Prince admits, "the disruptiveevent will be so significant that instead of liquidityfilling in, the liquidity will go the other way…When themusic stops, in terms of liquidity, things will becomplicated. But as long as the music is playing, you'vegot to get up and dance." …unless you don't mind leaving the party a little early. ----- The Survival Report ----- Why Your House Could be Worth 43% Less by 2011 Thought you were "done" with the property bust? Think again-- then get ready as a whole "second wave" of fallingprices sparks the worst property-led recession of the last76 years! The following triple-edged "housing hedge" strategy couldshelter both you and your money, IF you let me rush it toyou FREE as soon as possible… Grab Your Copy Right Here: The Survival Report -------------------------------- Investment Landfill, Part II
By Paul Tustain [Joel's Note: Paul Tustain appears courtesy of BullionVault. Click here for more: https://www.bullionvault.com/ Do you remember Lloyds of London? It used to be theworld's biggest insurance underwriter. The way it workedwas that rich individuals were allowed to keep all theirmoney invested in their favourite stocks and shares, butthey could also earn a second income from those assets bypledging that same wealth to underwrite commercialinsurance risks, which were sliced and diced by syndicateson behalf of their members. Unfortunately, when a series of vicious insurance losseshit the world's insurance market through the early '90s,many Lloyds members lost absolutely everything - houses,furniture and indeed their lives. Many of today'sprofessional money managers engage in a similar practicewhen they sell credit default swaps (CDS). CDSs, CDOs and all the other credit derivatives thatpopulate the global financial markets present a new anduncertain risk for investors. Let's dig a little deeper… CDOs, as we explained in last Friday's edition of the RudeAwakening, are new-fangled credit derivatives - i.e. theyare bond-like instruments that are derived from pools ofloans, usually mortgages. Through the wizardry of modernfinancial engineering, a pool of sub-prime mortgages, forexample, can become an array of CDOs, some rated as high asAAA, others rated much lower. Industry insiders sometimesrefer to the lower-rated CDOs as "toxic waste." "Who owns the toxic waste?" we wondered. A knowledgeable financial professional informed us that at least some of itgoes into tame, largely unsuspecting, and almost always"institutional" portfolios - the type of investment fundwhich looks after your money and lazily signs an indemnityto confirm to its brokers and banks its own professionalismand awareness of risk. The same source smiles wryly when asked how these"investment landfills" get their daily value for the un-marketable sludge. They phone their investment bankers,and dutifully record in their bond valuation package thenumbers they receive back, he explains. They have nomotivation to ask follow-up questions. This cosy arrangement means that thousands of fund managersare habitually mis-pricing billions of dollars worth ofcredit derivatives. No one really knows what these thingsare worth, but they've got a pretty good idea they are notworth what many professional investors pretend they areworth. And yet, institutional investors have been gobbling upthese high-yielding - but very risky - CDOs because theyare able to buy default insurance - otherwise known as acredit default swap (CDS). For example, the buyer of a particular CDO couldsimultaneously buy a CDS to protect against a default. Theinvestor would, effectively, pay an insurance premium toanother investment institution for underwriting the risk ofthe underlying home-loans defaulting. Apart from a bit oflegal drafting, that's all there is to a Credit DefaultSwap. In return for a cash payment, you swap the risk ofdefault. These insurance premiums, paid to the underwriter of theCDS, appear to the receiver as income - just like theinsurance premiums that any insurance company wouldreceive. You are being paid for accepting risk, not forlending money. So you see, the investment bankers have been very clever. They have said there are two components in a bond-interestpayment: a fee for the use of your money, and a fee for therisk of default. The CDS simply separates out the elementfor the risk of default.
The investment bank can have still more fun with this. Just like the boring mortgage streams that we started with,these CDS streams can be aggregated into a pool…thendivided into tranches with different riskprofiles…producing the magic of higher credit ratings forlower-risk tranches…plus concentrated risk in new toxicwaste. If you can get a credit rating agency to assess thetranches you have created, then you have something thatlooks like a CDO - and smells like a CDO - but which is notnow based on cash flows deriving from borrowed money. Instead, it is based on cash flows deriving exclusivelyfrom insurance premiums that are paid to cover the risk ofmortgage default. That's how CDSs get packaged into what is known as a"synthetic CDO," and the investment banks can sell them forwhat appear to be fantastic yields. It's a really neatdeal…for the investment banks, which are selling to thehighest bidder the right to receive their mortgage defaultinsurance premiums in exchange for assuming the risks ofdefault - so the buyer is just another "investmentlandfill". He ends up with what's called a "contingent liability." Why would any investment fund possibly fall for thisscheme? The modern fund manager has a powerful short-termincentive to get a strong performance out of your investedsavings. If he gets 2% more than the next guy he is agenius, and he will get more money under his management andmuch larger performance fees. As long as defaults occurrarely, synthetic CDOs can provide a pretty neat deal forthe investors. They earn a steady income stream, simply bypromising to stump up if there's a default. So you can see now how through the use of synthetic CDOs,fund managers can underwrite credit default risk andincrease their income accordingly, without outlaying anyfund capital. Importantly, however, they are placing theirfund capital at risk. Your fund manager is a genius whilethere are no claims. But if it goes wrong, your fund getshammered. But the CDO story does not end here… It was not long before the investment banking industry hada "eureka" moment. They realised that by offering CDSs andsynthetic CDOs based on the worst possible companies, theycould make fantastic profits. So they started insuringagainst the default of securities they didn't even own! It's like noticing your friend is looking a bit ragged andtaking out insurance on his life for your benefit, withouthim having anything to do with it. And as long as there isdemand for "easy income," there's no limit to how many ofthem may have been created. When Delphi Corp, a large motor parts spin-off from GeneralMotors, got into serious trouble last year, its bonds fellinto default. Incredibly, more than 10 times the nominalvalue of its bonds were then claimed from investmentinstitution underwriters, by bankers who had insuredagainst the default of bonds they didn't own by issuingDelphi CDSs. This isolated incident suggests that the mushrooming growthof credit-derivative issuance imparts an unknown anduntested threat to the global financial system. Check in tomorrow, as we offer a few guesses about whatmight happen next… Joel's Note: It may seem as though the playing field isunfairly titled to the advantage of those who are employedto sit around all day and invent creative, complex ways ofpawning off risk to the next unwitting participant in themarkets…But that person doesn't have to be you. Mike Shedlock has been untangling all these fancy acronymsto assess how any ripple is likely to effect yourinvestments. The outlook may seem bleak, but thankfullyMike's identified a few ways you can protect yourself. Hisreport on the wavering housing market provides a perfectexample. Read on here for the Survival Report: The Bad News About Housing (And What You Can Do About It) -------------------------------------- Rude Endnote: If you have some insights you would like toshare with us regarding CDOs, CDSs or any other acronym youperceive as a threat to the average investor, write to usand let your fellow Rude readers know. You can do so byaddressing your investigative email to us here at aussiejoel@the-rude-awakening.com . Until then, look out for your 5, arriving from Baltimore H.Q. shortly. Cheers, Joel | 
