The Sixth Day
Monday, February 18, 2008
  Rising Risk - Installment Two
Fourth, the downgrade in ratings of the three primary bond insurance companies (Two have already been downgraded) will lead to additional losses in mortgage-backed securities and other asset-backed securities. Those losses put some money market mutual funds at risk of having their net asset values drop below $1.00 per share because they invested in these securities. Some of those funds were guaranteed by banks or other financial institutions. They will be weakened further by having to make the losses to keep the NAV's at $1.00. Taken together, the shaken confidence in the financial system can cause another drop in equity prices beyond what has already been experienced.

Fifth, the commercial real estate loan market will contract in a similar way to the subprime residential loan market. In a contracting economy in which home builders are struggling or already bankrupt, loans to build offices, shopping centers, and apartment communities will be priced higher if available at all.

Sixth, the failure of a large regional or national bank is possible because of losses on a combination of residential mortgages, commercial mortgages, and construction loans. The Federal Reserve will have to affirm again its "too big to fail" doctrine. This will damage the bank insurance fund, reduce confidence in the banking system and add to the credit crunch.

Seventh, bank loans for leveraged buy outs are now worth only about 90 cents on the dollar on average, and cannot be sold into the secondary market as they were during the credit expansion. (A leveraged buy out, or LBO, is an arrangement whereby a company whose stock is publicly traded is bought up by a few private individuals with borrowed money with the expectation that they can cut costs and increase profitability enough to pay the loans until they can re-sell the company, either to a larger company or through a new stock offering.) Many large banks are stuck with LBO loans that are under water and cannot be sold. Some of these LBO companies will go bankrupt during the recession increasing the losses to the banks.

Eighth, defaults on corporate debt generally will rise significantly. The yearly average default rate from 1971 to 2007 was 3.8% per year. In a typical recession it rises to 10% per year. In 2006 and 2007 it was only .6% per year because of extraordinary liquidity and easy financing terms that allowed debt that otherwise would have defaulted to be refinanced on generous terms. The easy terms are gone, the recession is here, and defaults will rise.

Many financial institutions protected themselves (so they thought) with credit default swaps or CDS's. (A CDS is an arrangement whereby a lender trades default risk with a counterparty for some part of the risk of financial loss on a particular loan. It sounds a lot like insurance but it not because there are no reserves. While it does spread the risk around, the systemic risk to our financial system is not reduced. It may actually be increased by the illusion of safety.)

There are an estimated $50 Trillion (yes, that is Trillion with a T) in CDS's out there. As credit defaults rise, there will be massive transfer of wealth from those who sold such protection to those who bought such protection. That transfer will probably bankrupt at least one hedge fund or large stock brokerage firm. Credit default swaps are largely unregulated, private contracts that will add stress to the financial system because counterparty risk is difficult to quantify.

Once again, this is a summary of Twelve Steps to Financial Disaster by Professor Nouriel Roubini. More information is available at http://www.rgemonitor.com/
 
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I grew up in Kansas in the 1950's - 60's. I attended Kansas State (B.S. in Soc. Science) and Washburn Law School (J.D.). My wife and I have been married for over thirty years and are the parents of three grown sons.

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