A financial planner sent me a Fitch Ratings report yesterday on a Lehman Brothers synthetic CDO investment he had personally put $1 million into. It’s a bit late now, and it looks like the money is all gone, but he wondered if I could understand the blood
A financial planner sent me a Fitch Ratings report yesterday on a Lehman Brothers synthetic CDO investment he had personally put $1 million into. It’s a bit late now, and it looks like the money is all gone, but he wondered if I could understand the bloody thing.
I read it three times and still found it utterly incomprehensible. I couldn’t even figure out what it was, let alone what it might be worth. But reading it did help me understand something else; why yesterday’s concerted action by the world’s central banks won’t work for long.
The US Fed organised a coalition of the willing to roughly quadruple the amount of US dollars central banks could auction to $US247 billion, in an effort to keep the system afloat. This immediately led to an easing of money market conditions and a relief rally on Wall Street last night.
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But while this latest central bank cash hose brought relief to the short end of the money markets, longer-term credit remains frozen. Interbank confidence has collapsed after a mind-boggling two weeks.
The major events are well known – the collapse of Lehman Brothers, the nationalisation of AIG, the sale of Merrill Lynch, the distress of Washington Mutual, the Fed’s refusal to cut interest rates. As a result, credit default swap spreads blew out, the TED spread (the key indicator of stress in the interbank money market) shot up, the three-month US treasury bill traded at 0.02% and may have gone into negative territory, the US dollar fell and gold soared by nearly $US70 an ounce.
In a column in the Financial Times yesterday, the former chief economist of the IMF, Kenneth Rogoff, suggested that the United States will need to be baled out to the tune of $US1 trillion to $US2 trillion, although he is not sure how such a mega-baleout will evolve.
Part of the problem, it seems to me, is that the actions of the US authorities – the Fed and the Treasury – seem incoherent and contradictory, and therefore not providing any sound basis for confidence.
That’s because they are determined to separate liquidity actions from monetary policy. At the same time as it shovels cash into the system to prevent a meltdown, the Fed is leaving interest rates on hold because, it says, “the inflation outlook remains highly uncertain”.
And as Anatole Kaletsky pointed out in The Times yesterday, Treasury Secretary Hank Paulson has been wiping out investors who have been prepared to bet on a recovery, while rewarding short sellers who have been betting on the opposite.
“Consider the event that triggered the market attacks on Lehman Brothers, AIG and HBOS. They all followed Mr Paulson’s punitive decision on September 7 essentially to expropriate the $20 billion of capital injected into Fannie Mae and Freddie Mac by shareholders over the previous 12 months,” Kaletsky wrote.
“Long-term shareholders made these investments, with the encouragement of the US Government, to stabilise Fannie and Freddie. Meanwhile, a host of short-term speculators were selling these same securities, convinced that the two companies would be driven into bankruptcy.”
Paulson thus sent a clear message to financial markets; any investors who put money into a US financial institution that might, in future, run short of capital, risks having it expropriated by the Government. Meanwhile any investor who sells the same institutions so they do run short of capital will be richly rewarded.
Any hope of a quick end to this crisis has been dispelled by the ramshackle response to it from the authorities, but the situation is probably beyond them anyway.
That was exemplified by the ratings report that my distressed financial planner friend sent yesterday.
It was a Fitch report on something called the Zircon Finance Ltd: Series 2007-1 (Coolangatta), Managed Synthetic CDO.
Zircon is “a bankruptcy remote special-purpose vehicle incorporated in the Cayman Islands”. The transaction, known as Coolangatta, is a synthetic securitisation of a portfolio of 150 geographically and industrially diverse, predominantly investment-grade corporate obligations.
“Credit exposure on the reference portfolio of 150 corporate obligations is obtained through a credit default swap entered into with Lehman Brothers Special Financing Inc. The portfolio is managed by Lion Capital Investment of Singapore,” the report said.
“Each class of notes will have a rating cushion, meaning an attachment point above the credit enhancement level determined using Fitch’s VECTOR default model (VECTOR) for the corresponding rating of the notes.”
And: “The issuer will apply the proceeds of the placed notes to acquire collateral securities. The initial collateral will be floating-rate notes issued by GE Capital Australia Funding Pty Ltd, guaranteed by General Electric Capital Corporation.”
Now this financial planner and I have both been kicking around investment markets for about 70 years between us, but this might as well have been Swahili. You invest in a Cayman Islands vehicle that enters a credit default swap with Lehman, buys collateral from General Electric and then has a portfolio of something or other managed by Lion Capital in Singapore.
Apart from anything else, how can there be anything left after those three scooped out their fees?
My friend is just one Australian investing a million bucks. Synthetic CDOs like this have been sprinkled around Australia, and the world, like financial anthrax. They are owned by individuals, municipal funds, charities and pension funds. Bank conduits own them. And the shadow banking system described recently in SmartCompany owns them in vast numbers.
No one understands them and no one knows what they are worth. It’s probably zero.
But the owners of them, including commercial banks and large investment funds as well as the unfortunate individuals who have lost $1 million, have now lost all confidence in the industry that devised and sold them.
And so profound is that loss of confidence that it’s probably permanent. No amount of cash-hosing by central banks will get it back.
This article first appeared in Business Spectator