K
Kickin' Ass and Takin' Names
Guest
March 31 (Bloomberg) -- Be it ever so devalued, $1 trillion is a lot
of dough.
That's roughly on a par with the Russian economy. More than double the
market value of Exxon Mobil Corp. About nine times the combined wealth
of Warren Buffett and Bill Gates.
Yet $1 trillion is the amount of defaults and writedowns Americans
will likely witness before they emerge at the far side of the bursting
credit bubble, estimates Charles R. Morris in his shrewd primer, ``The
Trillion Dollar Meltdown.'' That calculation assumes an orderly
unwinding, which he doesn't expect.
``The sad truth,'' he writes, ``is that subprime is just the first big
boulder in an avalanche of asset writedowns that will rattle on
through much of 2008.''
Expect the landslide to cascade through high-yield bonds, commercial
mortgages, leveraged loans, credit cards and -- the big unknown --
credit-default swaps, Morris says. The notional value for those swaps,
which are meant to insure bondholders against default, covered about
$45 trillion in portfolios as of mid-2007, up from some $1 trillion in
2001, he writes.
Morris can't be dismissed as a crank. A lawyer, former banker and
author of 10 other books, he knows a thing or two about the complex
instruments that have spread toxic debt throughout the credit system.
He once ran a company that made software for creating and analyzing
securitized asset pools. Yet he writes with tight clarity and
blistering pace.
The financial innovations of the past 25 years have done some good,
Morris notes. Collateralized mortgage obligations, invented in 1983,
saved homeowners $17 billion a year by the mid-1990s, according to one
study.
Slicing and Dicing
CMOs transformed the business by slicing pools of mortgages into
different bonds for different risk appetites. Top-tier bonds had the
first claim on all cash flows and paid commensurately low yields. The
bottom tier was the first to absorb all the losses; it paid yields
resembling those on junk bonds.
What began as a good thing, though, soon spawned a bewildering array
of new asset classes that spread throughout the financial system,
marbling balance sheets with what Morris calls inflated valuations,
hidden debt and ``phony triple-A ratings.'' The more the quants fine-
tuned the upper tranches of CMOs and other collateralized debt
obligations, the more dangerous the bottom slices grew. Bankers began
calling it ``toxic waste.''
Guess where the toxins wound up? That's right: Credit hedge funds are
now the weakest link in the chain, Morris says. Their equity stands at
some $750 billion and is so massively leveraged that ``most funds
could not survive even a 1 percent to 2 percent payoff demand on their
default swap guarantees,'' he writes.
`Utter Thrombosis'
Morris sketches a scenario in which hedge fund counterparty defaults
would ripple through default swap markets, triggering writedowns of
insured portfolios, demands for collateral, and a rush to grab cash
from defaulting guarantors. The credit system would suffer ``an utter
thrombosis,'' he says, making the subprime crisis ``look like a walk
in the park.''
As bankers and regulators try to prop up the ``Yertle the Turtle-like
unstable tower of debt,'' Morris points to two previous episodes of
lost market confidence.
The first was the 1970s inflationary trauma that prompted investors to
suck money out of the stocks and bonds that finance business.
Confidence returned only after Fed chief Paul Volcker slew runaway
inflation by ratcheting up interest rates.
The other precedent is the popped 1980s Japanese asset bubble. In that
case, politicians and finance executives tried to paper over their
troubles. Two decades later, Japan still hasn't recovered, Morris
writes.
We should be as bold as Volcker, he suggests: Face the scale of the
mess, take a $1 trillion writedown and shore up regulatory measures.
His recommendations include forcing loan originators to retain the
first losses; requiring prime brokers to stop lending to hedge funds
that don't disclose their balance sheets; and bringing the trading of
credit derivatives onto exchanges.
What he fears is that the U.S. will instead follow the Japanese
precedent, seeking to ``downplay and to conceal. Continuing on that
course will be a path to disaster.''
``The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great
Credit Crash'' is from PublicAffairs (194 pages, $22.95).
of dough.
That's roughly on a par with the Russian economy. More than double the
market value of Exxon Mobil Corp. About nine times the combined wealth
of Warren Buffett and Bill Gates.
Yet $1 trillion is the amount of defaults and writedowns Americans
will likely witness before they emerge at the far side of the bursting
credit bubble, estimates Charles R. Morris in his shrewd primer, ``The
Trillion Dollar Meltdown.'' That calculation assumes an orderly
unwinding, which he doesn't expect.
``The sad truth,'' he writes, ``is that subprime is just the first big
boulder in an avalanche of asset writedowns that will rattle on
through much of 2008.''
Expect the landslide to cascade through high-yield bonds, commercial
mortgages, leveraged loans, credit cards and -- the big unknown --
credit-default swaps, Morris says. The notional value for those swaps,
which are meant to insure bondholders against default, covered about
$45 trillion in portfolios as of mid-2007, up from some $1 trillion in
2001, he writes.
Morris can't be dismissed as a crank. A lawyer, former banker and
author of 10 other books, he knows a thing or two about the complex
instruments that have spread toxic debt throughout the credit system.
He once ran a company that made software for creating and analyzing
securitized asset pools. Yet he writes with tight clarity and
blistering pace.
The financial innovations of the past 25 years have done some good,
Morris notes. Collateralized mortgage obligations, invented in 1983,
saved homeowners $17 billion a year by the mid-1990s, according to one
study.
Slicing and Dicing
CMOs transformed the business by slicing pools of mortgages into
different bonds for different risk appetites. Top-tier bonds had the
first claim on all cash flows and paid commensurately low yields. The
bottom tier was the first to absorb all the losses; it paid yields
resembling those on junk bonds.
What began as a good thing, though, soon spawned a bewildering array
of new asset classes that spread throughout the financial system,
marbling balance sheets with what Morris calls inflated valuations,
hidden debt and ``phony triple-A ratings.'' The more the quants fine-
tuned the upper tranches of CMOs and other collateralized debt
obligations, the more dangerous the bottom slices grew. Bankers began
calling it ``toxic waste.''
Guess where the toxins wound up? That's right: Credit hedge funds are
now the weakest link in the chain, Morris says. Their equity stands at
some $750 billion and is so massively leveraged that ``most funds
could not survive even a 1 percent to 2 percent payoff demand on their
default swap guarantees,'' he writes.
`Utter Thrombosis'
Morris sketches a scenario in which hedge fund counterparty defaults
would ripple through default swap markets, triggering writedowns of
insured portfolios, demands for collateral, and a rush to grab cash
from defaulting guarantors. The credit system would suffer ``an utter
thrombosis,'' he says, making the subprime crisis ``look like a walk
in the park.''
As bankers and regulators try to prop up the ``Yertle the Turtle-like
unstable tower of debt,'' Morris points to two previous episodes of
lost market confidence.
The first was the 1970s inflationary trauma that prompted investors to
suck money out of the stocks and bonds that finance business.
Confidence returned only after Fed chief Paul Volcker slew runaway
inflation by ratcheting up interest rates.
The other precedent is the popped 1980s Japanese asset bubble. In that
case, politicians and finance executives tried to paper over their
troubles. Two decades later, Japan still hasn't recovered, Morris
writes.
We should be as bold as Volcker, he suggests: Face the scale of the
mess, take a $1 trillion writedown and shore up regulatory measures.
His recommendations include forcing loan originators to retain the
first losses; requiring prime brokers to stop lending to hedge funds
that don't disclose their balance sheets; and bringing the trading of
credit derivatives onto exchanges.
What he fears is that the U.S. will instead follow the Japanese
precedent, seeking to ``downplay and to conceal. Continuing on that
course will be a path to disaster.''
``The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great
Credit Crash'' is from PublicAffairs (194 pages, $22.95).
