Monday, May 5, 2008

Credits of Mass Destruction

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

The New York Investing meetup has made a companion video to this blog entry. You can find it at:

In the week of February 14, 2008, the Auction-Rate Securities market collapsed with almost 1000 auctions failing. Auction-rate bonds were long-term debts that had their interest rates reset in a Dutch Auction every one to 35 days. The market had been created in 1984 and from that time until the end of 2007, only 44 auctions had failed. The market had grown to over $300 billion and was a favorite place to borrow for local governments, hospitals, museums, student-loan agencies and closed-end mutual funds. As long as the auctions worked the rates for these borrowers remained as low as 3%, but if they failed (something no one worried about since this almost never happened), the rates could be punitively high - as much as 20%. Wall Street raised money from some of its best clients to fund these auctions, with promises that these investments were 'as good as cash'. After 24 years without problems, the end came suddenly and without warning. The big banks and brokers withdrew their support and overnight their clients who had invested in these 'good as cash' investments couldn't get their money back. The borrowers suddenly found themselves paying junk bond rates.

At almost the same time, VIEs 0r variable interest entities (also known as conduits or special purpose vehicles) made the news. VIEs are off-balance sheet items for banks (contary to popular belief, the Enron scandal did not do away with off-balance sheet items) and their amounts were revealed to be around $800 billion. The first major news of off-balance sheet items for banks concerned SIVs (structured investment vehicles), which are a type of VIE. This news appeared in the fall of 2007. SIVs were estimated to have an original value of $400 billion and this amount was considered so great that the U.S. Treasury department attempted to arrange an SIV bailout. This effort never got anywhere and was abandoned by December. Only two-months later, the off-balance sheet problem was revealed to be twice as large as originally thought. Furthermore, it was estimated that the VIEs were worth only 27 cents on the dollar. In an SEC filing, Citibank indicated that it had $320 billion in VIEs, which would mean it might have lost approximately $240 billion off-balance sheet. It had only written off $22 billion in losses up to that time.

While problems with the auction-rate securities market and VIEs had not been predicted and appeared seemingly out of nowhere, warnings were being made about the Credit Default Swaps market (CDSs). These were derivatives that were a type of bond insurance and the functioning of this market was threatened on a number of fronts - particularly from bond insurers losing their top credit ratings or a failure of a major counter-party (any large bank or broker). The Fed would have to publicly bail out Bear Stearns in mid-March 2008 to prevent the collapse of this market. The CDS market was so huge at $62 trillion that it was four times the size of the U.S. economy and was effectively a financial nuclear weapon that could wipe out the entire system. If this happened, it would likely be sudden and without warning just like the collapse of the auction-rate security market (and Bear Stearns).

NEXT: Gold, Silver, and Oil - The Basics of Price Movements

Daryl Montgomery
Organizer, New York Investing meetup

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