The Trillion Dollar Meltdown

This book traces the key events in the US political and economy history that have supposedly led to the current crisis. Books such as these attempt to try to make a good narrative of the events around us. As they say , connecting dots backwards is easy ..and so this book in that sense does a better job.

Usually crisis is associated with a specific asset class. Junk bonds, CMO’s, Real estate, etc. However the current financial crisis is a different one . It is a credit crisis which permeates across all asset classes. It is like poisoning air and there is no respite for any living being in the environment. Credit crisis permeates across all assets as it is the lifeblood of finance and that makes this crisis VERY dangerous. The asset classes which are going to get impacted are not just the dodgy mortgages but Commercial Mortgages, Credit Card debts, High yield bonds, Leverage Loans, Complex bond structures, all in total, according to the author’s estimate is ONE TRILLION DOLLARS!!! That’s equivalent to the GDP of India!! scary to think of it.
LTCM was just 100 billion in positions and 10 million assets at risk. This time , the numbers are scary and bailout means unbelievable sum of money.

Liberalism to Monetarism

The author starts off discussing the era of 1970s , an era characterized by a change of philosophy at the center. Nixon was a liberal who believed in the top down approach. 1970s were bad times for US economy and Nixon tried using the top down approach of price controls, import tax, etc. But by 1980s US was struggling to compete. It has huge inflation , high unemployment .Enter the Keynesian Monetarism. Ronald Reagon was an out and out Monetarist who believed that inflation is always a monetary phenomenon. If the money supply is controlled with respect to economic growth, inflation is always in reins. With this philosophy in mind, US started seeing a new regime , the regime of Monetarism.

**Paul Volcker and Inflation
**

Nixon appointed Paul Volcker as a fed chairman in 1979 and he was a thorough monetarist. With the help of money supply instruments, he successfully brought down the inflation levels . Even though the growth rate became negative, slowly over a period , growth was established and wall street was sold the idea that monetarism is an effective instrument to control the economy. However there were 2 crisis that were a part of 1980s. First being the LBO boom and bust, second being Savings and Loans bubble. Both these incidents illustrate the fragility of free markets.

1990’s is called the Goldilocks economy , a new term which I learned today. An economy which is neither hot, i.e not plagued by inflation nor cold, i.e not plagued by unemployment is called Goldilocks economy. So 90s as such was a happy happy :) period for everyone. With monetarists in control , credit was pushed in to economy and US economy was on a roll.

**Not all hunky-dory
**

It was not that there were no crisis in the markets. There were three significant ones . First was CMO bubble which is a bubble created by tranching a pool of loans and then selling off different pieces to different investors. It was a genuine instrument, until the time when greed took over . 125 tranches became a common place and that was the end of it. CMO market collapsed . Big firms like Kidder Peabody shut their operations. The next crisis worth mentioning are Portfolio insurance crash in 1987 and LTCM debacle in 1998. In all the three stories, there was a common thread. Financial markets were becoming more unregulated, agency problem was becoming more dangerous and the concept of everything can be mathematicized was taking prominence.

Think about it : CMO crisis should have taught us something and subprime crisis could have been averted. Well, there were other forces that were shaping US financial industry. HEDGE Funds and INVESTMENT Banks were transforming the financial markets.

**Instruments Galore

**From 2000 to mid 2005, US witnessed the biggest housing boom in its history. An increasing housing activity led banks to start issuing instruments to hedge default risk. What started as a hedging exercise resulted in something completely new. Commercial Mortgage securitization was a bit difficult. Hence banks started involving rating agencies. Once rating agencies gave some rating, investors were sold on it. With the rise of hedge funds, credit derivative swaps, the credit market saw a huge increase in notional as well as the type of instruments being traded. 125 tranches for the securitized assets was being done, synthetic CDOs, CDO squares, etc..you name it…all that was needed was a computational power, a few math geeks , greedy investors and the game was set..A bubble was on and it was only a matter of time that party would come to a stop and it did…Housing market slow down blew away a couple of hedge funds AND it was a sign of things to come.

Unwinding Effect

With the easy credit available, the CDO’s made a comeback. Why ? Well there was always a problem to sell the bottom tranche of the structured security. However with hedge funds in play more SIVs were being formed as there were good enough hedge funds to buy the crap. Hedge funds , as of 2007 deployed 2T of capital , and economic capital 5 times the size in to US economy. Usually a credit hedge fund investor is leveraged 100:1 . How is that ? Well 5:1 is the leverage provided by prime broker, and the investment like a CDO typically provides another 20:1 leverage . Thus credit hedge funds are highly leverage plays which provide liquidity to the market. The other players are Ibanks. Thus with I banks and hedge funds providing 50% of credit to the market, there was a huge built of portfolio with dicey assets.

The highlight of this book is a table which the author provides. This table gives author’s estimate of the total unwinding that is due in the US markets. Table is really scary as it says that the mess has just started. Whole lot of asset classes are going to take a hit like credit card industry , high yield corporate bonds, monoline insurers etc. Here is the table. It would be worthwhile to keep a watch on this table and see whether this this is a 1 Trillion mess. The numbers before the brackets denote the outstanding and numbers in brackets denote the estimated loss. There are some asset classes where these numbers are not provided. May be the crap is too exotic to put a number on
_
All numbers in $Billion_

• Residential Mortgages
  • Subprime - 1500 (150)
  • CDO Bonds - 1200 (300)
• Corporate Debt
  • High Yield bond defaults - 1000(50)
  • High Yield bond writedowns - 900(180)
  • CLO Defaults - 500(25)
  • CLO writedowns - 450(90)
• CMBS Defaults - 800(40)
• CMBS writedowns - 720 (108)
• Credit Cards - 900(67)
• Monoline – ??
• Credit Default Swap defaults – ??
• CDS Writedowns - ??
• Leverage Loans - ??

The total mess is about 1Trillion, a conservative estimate.

WOW!! Is this the place to stay and make a career ? Well, looking at the leverage that has been built up, it would take atleast 2-3 years before things return to normalcy…what would quants do till then ? What will other players in the fin industry do ? The other day , one of my friend’s friend, a trader from morgan stanley was asked not to trade for few hours as the situation was hopeless and nobody knew where the market is going. No one knew where is bottom ? US has become , as you would have seen a highly leveraged nation. Consumer spending will remain flat and go down atleast in the coming years. So, where are the opportunities ? Emerging countries are also going to take a hit. This is the best time to start a firm and put some time and effort in building a valuable asset. Any ways, there will not be any earth shattering work in the economy. Hence this is the time to start and work on building an asset. Recession / Depression always gives rise to some spectacular companies. We will see some of them in the years to come.Who are building them ? Well , atleast a few of the brilliant folks from wallstreet who have been hit by the crisis will take the brave step of getting out of the usual rut and work towards building a great asset / value in the coming years.

What’s the prescription ?

The prescription offered by the author should not come as a surprise. Financial regulation and more direct control of the government rather than believing completely in the markets. 1970s and 80s flourished because of free markets . The current crisis is the demonish side of free markets and may be there is a case for going back to liberalism , more govt controlled measures etc. May be. The next president will have a tough job to do . Will the markets which have been given free rein be controlled. it is easy to give away control but very difficult to put controls.

This book certainly makes a very crucial point. US is leverage to hilt and this meltdown will hit all the asset classes and it will take atleast 2-3 years before things return to normal!!