Citi had announced, on Nov 4, a record writedown (read: "money we have lost") of between $8bn to $11 bn, due to CDO losses. A CDO, or "collateralized debt obligations" the concept of putting a lot of loans into a basket, and selling pieces of that basket. Citi still owned a considerable amount of the basket, it turns out. The basket is usually divided into tranches - some part of the tranches are "junk" meaning recovery may not be possible (rated: BB or lower) , and the best tranche is marked "AAA".
Let's now look at the Subprime CDO market - this is marked by the ABX index, (Asset backed securities index). So an index named "ABX-HE-AAA 07-2" meaning the index for Home Equity loans, rated AAA, made in the second half of '07. That's since July 1, 2007.
The index reflects what people are willing to pay for a $100 of the underlying loan. so an index value of 95 means people are willing to pay $95 per $100 worth of loans (the $5 being the return on the risk they take etc.) So lower the value, higher the underlying risk. Most importantly, the CDO issuer probably paid $100, so every bit lower is a value that is a loss.
Now check this out:
Citi probably holds a lot of the 07-2 series (probably, because they wouldn't have been able to sell all of them yet). Now they announced on Nov 4 of their write downs. See what's happened since then - a fall greater than 10%. And this is the AAA tranche. Similar stuff has happened with teh AA, A, and BB/Junk rated ABX!
This will obviously be hitting Citi big time, and probably the rest of the financial world too. They want to take this stuff "off balance sheet" by creating Special Investment Vehicles (SIVs) to fund the purchase of such securities. JP Morgan and bank of America are in on the game. Effectively, they setup another company to buy these securities because no one else will buy them. And the "off balance sheet" means: we'll lose the money anyhow, but we won't tell you how much anymore.
If this gets worse, Citi will be seriously impacted and the entire credit markets will unwind. Heck, they are probably unwinding.
Why do I care? This is the filter through which nearly all the liquidity in the world flows.
And the Yen carry trade is the other big source of liquidity. The yen is at 109.25 to the dollar as I write this, the lowest in about 18 months. People borrow the yen (which is available at ridiculously low interest rates) convert to dollars, and deploy the money in other markets. They earn higher returns, and use the returns to pay high interest.
Example: I borrow 108,000 yen at 1% when $-yen is 120, giving me $900. I then put $100 of my own, and invest the $1000 in say Indian equities, or better still, Indian govt. bonds giving 6%. I make an income of $60. Now I gotta pay back the yen guy 1080 Yen. If the yen rate is constant, That is only $9 - the remaining $51 I can keep for myself - it's a fabulous 51% return on $100 investment!
Okay now what happens if the yen falls to 110? My payment increases by 10% - to about $10 in this example - and my profit comes down to $50.
The example I chose is simplistic because a) people borrow about 20x-50x their investment in yen (i chose 9x) and b) the interest rates depicted have wide spreads. So in reality a lot of guys have much closer spreads and high leverage, meaning that they get affected badly if the Yen appreciates 10%. Till now the Yen stayed above 110, and that seemed to be fine (the last time I heard this was an issue was at 114, but it was no big deal)
But at 110 and below I would see a lot of unwinding. And the Yen should appreciate on each leg of unwinding as people scramble to buy it back. Look at the graphs over the last few days, and you'll see some scrambling.
Who in India has big yen loans? Uhm: ICICI Bank. $1 billion last year and $1.5 billion this year.
The liquidity crunch, yen-carry trade, etc. are all global issues that affect us only in a supplementary manner...and the impact may not be huge. Still, it's worth watching out for.
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>I like the way you explain complicated things with simple examples :)
I live in US and can see it’s getting worse day by day. Today E*trade lost half of its market cap due to one analyst comment. I have friends working in this company and I’m now worried for their jobs.
11.13.07 at 2:02 AM
>It is really mind boggling that Big Banks around the world and Investment Banks could not assess the risks in these complicated CDOs(despite having best brains and super computers). Few months back even Fed Chairman Ben Bernanke said that subprime issue is contained.
Now as I read the situation the malaise has spread from sub-prime to CDOs, Commercial Real estate, Car loans, Credit Card Loans, SIVs…. etc etc.
Seems recession is US is imminent. What happens to India then?
Please suggest strategy to protect our capital in Indian context.
11.13.07 at 3:30 AM
>I think you are worrying prematurely.
11.13.07 at 5:42 AM
>guy from sg: Thanks! Btw, ETrade lost not because of any analyst but because their own admission that they have MASSIVE losses on CDO holdings.
anon1: Oh the CDOs were predictable, but when you need to make your quarterly bonus you don’t do such things.
Protecting capital: for the short term, buy puts. In the longer term, go to cash. You can buy “defensive” picks but in a market meltdown defensive means losing less, which is not really protecting capital.
anon2: I admit, this is premature. Just noting stuff down though.
11.13.07 at 5:53 AM
>I believe there will be FII hammering and sensex will get a hit. There are good companies like TCS, HCL hovering around 52 weeks low. Does that make it a good pick from long term perspective. What is your view on good stock pick in current context ?
11.13.07 at 8:40 AM
>good thing… more smart pple will stay in India as the US is no longer a dream, but a nightmare. Heck, I can see people earning less in the US than in India after converting their salary to rupees!!
The bad thing – all these smart pple will go into ibanking in Bombay! Everybody wants to be a dealmaker now…
Another great blog to track the housing problem. Written by mortgage experts
http://calculatedrisk.blogspot.com/
USD-JPY is now at 110.06
http://www.bloomberg.com/markets/currencies/fxc.html
The sad thing is that AAA CDO’s are selling for 72 cents not because of lack of liquidity. But they will be worth only this much with 25% defaults. Imagine if half those loans default.
11.13.07 at 8:50 AM
>Interesting judgement:
Judge Christopher A. Boyko of the Eastern Ohio United States District Court, on October 31, 2007 dismissed 14 Deutsche Bank-filed foreclosures in a ruling based on lack of standing for not owning/holding the mortgage loan at the time the lawsuits were filed.
Judge Boyko issued an order requiring the Plaintiffs in a number of pending foreclosure cases to file a copy of the executed Assignment demonstrating Plaintiff (Deutsche Bank) was the holder and owner of the Note and Mortgage as of the date the Complaint was filed, or the court would enter a dismissal.
The Court’s amended General Order No. 2006-16 requires Plaintiff (Deutsche Bank) to submit an affidavit along with the complaint, which identifies Plaintiff as the original mortgage holder, or as an assignee, trustee or successor-interest.
Apparently Deutsche bank submitted several affidavits that claim that Deutsche was in fact the owner of the mortgage note, but none of these affidavits mention assignment or trust or successor interest.
Thus, the Judge ruled that in every instance, these submissions create a “conflict” and they “do not satisfy” the burden of demonstrating at the time of filing the complaint, that Deutsche Bank was in fact the “legal” note holder.
While the decision is great for homeowners in distress (due to providing a new escape hatch out of foreclosure), it is a big blow to the cause of sorting out the high-finance side of the mortgage mess.
Jacksonville Area Legal Aid Attorney, April Charney, broke this news to us via email and made these comments in regards to the Ohio Federal Court ruling (emphasis ours):
This court order is what I have been saying in my cases. This is rampant fraud on every court in America or nonjudicial foreclosure fraud where the securitized trusts are filing foreclosures when they never own/hold the mortgage loan at the commencement of the foreclosure.
That means that the loans are clearly in default at the time of any eventual transfer of the ownership of the mortgage loans to the trusts. This means that the loans are being held by the originating lenders after the alleged “sale” to the trust despite what it says per the pooling and servicing agreements and despite what the securities laws require.
This also means that many securitized trusts don’t really, legally own these bad loans.
In my cases, many of the trusts try to argue equitable assignment that predates the filing of the foreclosure, but a securitized trust cannot take an equitable assignment of a mortgage loan. It also means that the securitized trusts own nothing.
So with this decision, it appears confirmed that investors in the mortgage debacle may in fact own nothing—not even the bad loans they funded! It seems their right to the cash flow from the underlying properties does not extend to ownership of the properties themselves; thus clouding the recovery picture considerably.
Charney further remarked to us:
This opinion, once circulated and adopted by state and Federal courts across the country, will stop the progress of foreclosures, at first in judicial foreclosure states, across America, dead in their tracks.
We agree with additional remarks Charney made pointing out that this decision has major adverse implications for the prospects of an amicable financial workout for the various investor contingents in mortgage-backed securities (MBSes). Doubt is cast on where the full write-downs will eventually land, and this uncertainty can only be expected to further harm the market value of MBS and MBS-based synthetic securities, already in shambles purely due to rising underlying delinquencies. Investors in these securities might have assumed—wrongly, it turns out—that they actually owned some “real estate” in these deals.
To paraphrase Jim Cramer, “They own nothing!”
SO THESE CDOS/SIVS VALUE IS ZERO
11.13.07 at 11:48 AM
>Useful/informative.Thanks
11.14.07 at 7:29 AM
>Very interesting discussion going on in this blog about positioning one’s investments for recession (if coming?). My experience is as below (I escaped the last tech meltdown);
Given that the steepest market plunges generally occur before a recession, my impression is that investors should at least be certain that they can tolerate the impact of a downturn without substantially deviating from their investment discipline. There is nothing wrong with a long-term buy-and-hold approach to stock market investing, provided investors recognize that the impulse to abandon that strategy can be extremely strong when the market has declined steeply and it seems that there is no end in sight.
I am a disciplined investor and would not like to deviate from carefully considered investment plans. But if a recession or a bear market would produce unacceptable losses or would force me to abandon my investment plan, it is best to begin altering my investment position immediately (even if not entirely at once) toward a position that I can maintain regardless of market outcomes. If my position is inappropriate, I will not wait for an “ideal” opportunity to change it. I will begin changing it immediately, and continue to change it in steps – larger steps when I get favorable prices, smaller steps when I have to do it at adverse prices. The important thing is to start immediately and decide in advance to move step-by-step over a reasonably limited period of time, until my position is appropriate.
Anytime I discover that I am taking too much risk, I would like to realise in advance that I will experience some level of regret as I correct it – if I sell my first portion and the market advances, I will regret having sold anything. If I sell my first portion and the market continues to decline, I will regret that I didn’t sell everything. The way to keep from being “paralyzed” in the financial markets is to realize in advance that gradually changing an investment position will always involve regret. It is better to “lock in” an acceptable level of regret than to risk an unacceptable loss.
In short I would carefully think about my risk exposures, and to make any needed changes in a step-wise fashion. The inability of some of my Indian friends in US to extract themselves from speculative positions destroyed the financial security of them during 2000-2002. I had got out of my postions from Feb-Apr. 2000 from 80% to 10%.
11.14.07 at 12:26 PM
>Anon: I think you have it down pat. That’s a fantastic approach – the last two days, as the index has shot up nearly 8%, I’ve felt pangs of regret for not having gotten out completely – and I’m learning to deal with it.
Also with a downturn the most difficult part to deal with are the bear market pullbacks – a rally can revive interest to buy (or to NOT sell) and is then followed by another slow grinding fall. It’s only the rare 1987 US event or the May 2004 India breakdown that is a steep one day fall – most other falls involve much slower recoveries.
They say the fall of 1929 was not the real bad thing – after all the index recovered 75% of its value by 1930. But between 1930 and 1932 it lost 90% – meaning that a person who didn’t sell in 1929 might have felt victorious in 1930 – but then would have lost viciously in the two years after that.
The problem then is: identifying a bear market versus a steep fall. The best thing, I think, is what you’ve said – take a call, work with the regret bit and do the job.
Another thing you may have to do is admit you were wrong (like in say, 1987) and reverse back to the original position, even if it was at a higher cost, once you realise that the negativity was temporary.
11.14.07 at 6:22 PM
>Taking a Call:
So finally for an individual it boils down to taking a call?
Which call should we take?
80% stocks/20 Bonds
70/30, 60/40, 50/50….?
or
10 years (5 years/3 years)expenses in Bonds remaing in Stocks?
This seems to be the crucial decision one has to make.
Some suggestions?
11.15.07 at 3:26 AM
>on what basis Indian real estate companies are trading at obscenely high PE multiples. How share prices of these companies are valued. What would happen if similar kind of slowdown happens at India. How land bank of these companies are added to its share price. What is the business model of these real estate companies. How their growth are sustainable. Could you write an article on this topic to enlighten our readers. I believe this is important topic since a slowdown in housing market couldn’t be ruled out.
11.20.07 at 12:27 PM