The Coming Capital Flood
Excesses in the financial sector have spilled into all sectors of the economy and are spelling global recession. The worst, most say, is yet to come, as the manufacturing, retail, housing and other sectors reel from the fallout, with more layoffs, generally rising unemployment, curtailed consumer and business spending, slashing asset values and so on—all on a global scale.
Nor have the financial sector causes of these real economy consequences ended: there remain trillions of dollars of financial instruments, created in the period 2004-06, outstanding, whose settlement upon maturity or other triggering events will have additional consequences.
Those consequences may either continue to add to the economic crisis or just possibly resolve it, not only by providing capital to the financial sector but possibly by reversing the consequences infecting the real economy.
This is the interesting analysis offered by Australian financial columnist, Alan Kohler, in Business Spectator, entitled A Tsunami of Hope or Terror?
As background, causes of the financial sector crisis include collateralized debt obligations and credit default swaps. The former have origins in asset-backed deals, trusts that issue debt securities to be repaid by cash flows on underlying assets, like credit cards and student loans, the trust owns. Credit default swaps are bets between two parties on whether one or more third parties will pay their obligations or not.
The two devices were combined by creating trusts to facilitate bets. A bank creates a trust in which people buy securities, funding the trust with large amounts of money, say $500 million to $1 billion or more. Investors are to be repaid principal and interest over time, with interest generated by the trust investing the principal plus payments by the bank of say 2% of the principal invested.
The risk investors face is based on bets the bank makes with the trust on whether designated borrowers default on their debt or not. A common payoff matrix provides that if, say, 7 of 100 named debtors default, the trust releases 1/3 of the invested principal to the bank; if 8/100 default, the trust releases 2/3 of that principal to the bank; and if 10/100 default, the trust releases all principal to the bank.
In most deals done during 2004-06, which remain outstanding, designated borrowers included: Bear Stearns, Lehman Brothers, Countrywide Financial, three leading Icelandic banks, Freddie Mac, Fannie Mae, American Insurance Group, plus General Motors, Ford and Toll Brothers.
In effect, banks sold insurance against these borrowers defaulting, essentially betting that there was risk that these borrowers were excessively leveraged. Investors, on the other side, wrote the insurance, betting that these were sturdy enterprises boasting strong debt repayment capacity.
So far, some 6 of the borrowers routinely designated in the bets have defaulted: Countrywide, Bear, Lehman and three Icelandic Banks and 3 others may be in partial default: AIG because it is under the indirect care of the US government and Freddie Mac and Fannie Mae because they are in US government conservatorship. Depending on how one counts (under the express contractual terms of the bets), that totals 6, maybe 7.5, or possibly 9 designated borrowers in default. If others—say GM, Ford or Toll Brothers—follow, that would trigger provisions requiring the trust to release additional principal to sponsoring banks.
How much and on exactly what terms is not publicly known because none of these devices is subject to regulation or disclosure by any US regulatory authority. But supposing such defaults reach the trigger number, massive infusions of capital—well into the trillions—from the trusts to the banks would ensue. That kind of capital dwarfs the $700 billion the US Congress authorized the US Treasury Department to use to flood the financial system with capital.
That massive capital infusion could end the credit crisis. It could even begin to reverse the process of convulsion world economies are going through. Yet economic consequences are “unpredictable but definitely huge,” Mr. Kohler observes. Betting on the effects may be more risky than buying into the marriage of collateralized debt obligations and credit default swaps was in 2004.