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December 13, 2007



Sorry to start off topic, but... IBD has what I consider is an important and informative editorial: Beware Islamist Plants In Debates.

Patrick R. Sullivan

Short and sweet at the WaPo; Fed will offer cash to banks:

The Federal Reserve, in a move coordinated with central banks in Canada and Europe, announced a new set of steps to try to make banks more willing to lend their cash and help thaw the world's frozen financial system.

In a surprise announcement Wednesday, a day after cutting interest rates to stimulate the U.S. economy, the Fed said it would make $40 billion and perhaps more available to banks through new short-term loans, and would also provide at least $24 billion to European central banks coping with a dollar shortage.

Rick Ballard

"If lending between banks has slowed (and who can doubt it?), it is not because the specific collateral being offered is dubious, it is because of a loss of confidence in the borrower's ability to make timely repayment to all creditors."


Doesn't the "loss of confidence" relate to the lenders inability to discern the quality of the borrowers earnings? Your statement seems almost circular in the sense that analysis of "ability to repay" is rather difficult to detach from the perceived quality of underlying assets.


The Fed and the European banks have reason to be concerned. While there's lots of liquidity and lots of cash sloshing around (M3 is quite heatlhy), bank capital is dwindling as the banks write down their bad paper. The successive rate cuts have resulted in a positive yield curve, so the banks at least have a spread to work with. But this last rate cut was the proverbial pushing on a shoestring. Every bank is suspicious of every other bank's assets because the individial banks haven't gotten to the bottom of assessing the amount of shakey paper they own. And thus, LIBOR is at a huge premium to Treasuries.

The process of solving the problem will be different than past credit crises. Over the last ten years, credit has moved from the traditional banking system to the capital markets system. That's why you hear the cries of anguish from Wall Street and London and elsewhere.

So, are the central banks buying preferred stock in the world's banks?
Just a minor quibble, but while these central banks are not buying preferred stock in the world's banks, the UBS and Citibank capital infusions have been sovereign nations (Singapore, Abu Dhabi). According to the wsj (I think that's a pay link...)
Swiss banking giant UBS AG has joined a long list of Western financial firms that have received capital investments from state funds or banks in Asia and the Middle East this year, either because the firms were hobbled by exposure to subprime securities or for strategic reasons. Bear Stearns Cos., Barclays PLC and HSBC Holdings PLC have all tapped the massive funds built from exporting to the West.

UBS's agreement, under which it will sell as much as a 12.4% stake in the bank to two new investors, comes just a few weeks after Citigroup Inc., also hit by subprime markdowns, got a $7.5 billion investment from the Abu Dhabi Investment Authority. That Middle Eastern sovereign wealth fund will ultimately own a 4.9% stake in the New York-based bank.


Liquidity, Capital. What's the difference once you're broke ?

Ralph L

Why couldn't all these bankers see that housing prices were in a speculative bubble? Wheat is in one now; the price tripled in less than 2 years.


Well, Ralph, of course the bankers knew, they just didn't care. That is the moral hazard of securitization. Consider George Bailey, who was using his judgements about who was and was not a good risk in Bedford Falls, and rising and falling directly upon the strength of his judgement. Compare to a modern-day mortgage banker, whose mega-bank employer packages up the loans into securities which are sold to other banks, and buys other banks' loans. Completely disconnected from the rewards of taking risks on good loans, or the losses of bad risks, they have no incentive to care.

This is the price of risk amelioration. Things like diversification and securitization really do reduce risk, and create tremendous value in the process. Unfortunately, risk has its advantages -- the real possibility of catastrophe does tend to focus the mind admirably. Whether it's portfolio insurance or health insurance, the problem is the same...


"Wheat is in one now; the price tripled in less than 2 years."

How much of this is due to corn prices rising (ethanol production)?


The crisis in a nutshell is this. Mortagages used to be made and held. Loans were underwritten with strict ratios and if your total debts including the propsed mortgage were too high, or your income did not support the ability to service all that debt with a cushion for unforseeable events, you did not get the loan.

Underwriting standard get lax and people start loaning more than 100% of the collateral, less than 20% down and even using interest only payments to qualify folks. This happens partially because of what I am about to describe next.

The wiseguys on Wall St.showed up. They started packaging up loans in packages and selling securities not whole loans. Creates some new buyers but otherwise not that big a thing EXCEPT for what it also leads to ( see above and what I am about to describe ). Soon enough, the wiseguys decided that they could strip the loans into pieces and get more than 100% of the value they had as whole loans. First they stripped on interest and principal. An IO ( interest only ) strip and a PO ( principal only ) strip were created and voila! 2 + 2 now equalled 5. A true miracle which lead to $50 million dollar bonuses on Wall St and a huge appetite to do ever so much moreso ( apologies to Dr. Suess).

Onward we march and ever so esoteric we go. At some point the strips are on risk and multiple strips are happening on the same basket of loans. It gets pretty complicated but 2 + 2 is still 5 or even 6 so keep the music playing.

I likening this stripping process to making cookies. When you use cookie cutters and roll out dough, you ultimate get a certain number of cookies out of it and you are left with something left over ( with lots of holes in it from where the cookies were cut out.) That in the business is called a "residual". ( Didn't I tell you these Wall St. guys were smart, think of it! What brilliance to come up with that name!)

Now the residual is real hard to value but everyone did it anyway. GAAP demanded a value and everyone got out their Cray computers and made a whole bunch of assumptions about how the underlying loans whould perform over long periods and ran iteration after iteration until they got one they liked. No one bought residuals so they layed over in the corner and began piling up on the balance sheet of lots of players.

Up to this point its all good at lenders and investment banking houses. Unfortunately Bear Stearns took a stroll down Wall Street buck naked and it was no longer fashionable to say that the Emperor was wearing fine garments. In a semi-panic everyone started looking at the residuals and scratching their heads. Soon enough the loans that were in the pipeline cant be sold and therefore warehouse lines of credit are full and cant be used to make the next loan.

And now you are up to date. Part of the plan is to push some of these mortgages off on FNMA and FHLMC and part of the plan is loaning lenders on some less than liquid assets as collateral. The rest is basically praying that nothing shocking happens in the meantime.


GMax--Wow!! What a heck of an explanation of what is known as the mortgage mess. That is definitely a keeper.
Regarding wheat as in a price "bubble" that is something the experts cannot figure out. I'm in a third generation wheat growing family and you can be sure that the joy and love is at an all time high.
Australia has been through some major droughts. Russia isn't exporting. The once poorer countries now can buy. Wheat has been a fall back grain commodity but it sure has found its place in the sun--for now.


I'd add one more thing, which is an unintended consequence of removing the tax deduction for loan interest other than mortgage interest. This created an entire industry focused on getting people to have all of their debt be transferred to their mortgages. So in the old days people would just leave their home equity alone and take out a 5-year car loan with deductible interest every 5 years. But since the car loans are no longer deductible they refinanced their house every 5 years, paying closing costs, and financing those cars at 30-year terms, and putting them at risk of foreclosure if they got into a rough spot. Whereas under the previous system if they got into trouble they would have sold the car and maybe had to borrow a few thousand (with a consumer loan with tax-deductible interest) to cover the gap between the car value and the loan balance, now they are tens of thousands in the hole with nowhere near enough that they could sell to raise the difference.

Kent schmidt

The Fed hasn't injected liquidity-they do that by repos. They have lowered the cost od borrowing between banks and from the Fed. That's all.

Kent schmidt

The Fed hasn't injected liquidity-they do that by repos. They have lowered the cost od borrowing between banks and from the Fed. That's all.


""Wheat is in one now; the price tripled in less than 2 years."

How much of this is due to corn prices rising (ethanol production)?"

It's all related to high oil prices and the decline of the $$$.

I'd be interested in discussing Ethanol with some non Ag folks. My email addy works.

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