The last revivion is made on the part of the second deviation from the idealized cycle in Section 3.
The deflation of the debt bubble is progressing steadily. The resulting liquidity squeeze is broadening its scope and is triggering increasing number of havocs in the financial market. The most vulnerable parties are naturally those holding toxic structured securities backed by risky mortgages, other assets and loans. The parties at risk, of course, do not want to reveal their identities, otherwise they will be shunned by the market and be driven into bankruptcy quickly. However, the lack of transparency about who hold those toxic structured securities is causing the financial market to seize-up. When financial institutions undertake lending activities or make deals, they need constantly suspect the exposure of their counter parties to those toxic structured securities. This kind of environment discourages financial institutions to lend actively. The phenomenon that the lending and deal-making phobia spread widely among financial institutions is called “Japan Syndrome” since Japan has encountered this phenomenon when it has lowered its interest rate to near zero level since the middle of 1995. Under the Japan Syndrome no matter how much liquidity the central bank may inject into the financial market, majority of the injected liquidity is simply parked in the safe treasuries instead of being lent out to reinvigorate the economy. Currently the Japan Syndrome is descending on the US financial market. The main purpose of this comment is to estimate how much various business groups are exposed to toxic structured securities by scrutinizing the quarterly Z1 report published by FED (the Federal Reserve Board); the Z1 report is based on comprehensive surveys of the US financial market. This kind of estimates is necessary for us to assess the effectiveness of actions taken by FED in fighting the Japan Syndrome and in preventing the collapse of the financial system. It will also help us in the analysis about the future actions FED and the US Government may take in dealing with the financial crisis and the slowing economy. Before going into the explicit scrutiny of the Z1 report a taste of those toxic structured securities of our concern is given by using mortgage backed securities as examples in the next section. The details about the inflation and the deflation of the mortgage and housing bubble, that is the most important component of the current debt bubble, are discussed in the third section. The bubble of risky mortgages and the structured toxic securities that are poisoning the financial market is covered in the fourth section. The last two sections are about the result of the analysis of the Z1 report and about the FED actions respectively.
The quarterly Z1 report from FED classifies mortgage backed securities into two categories. The simpler and less risky category is called “private mortgage pass-through securities”. The toxic strucutured securities of our concern are contained in the category of “private CMO and other structured MBS” The word “private” means that the underlying mortgages are not backed by government sponsored enterprises like Fannie Mae and Freddie Mac. CMO stands for “Collateralized Mortgage Obligations” and MBS stands for “Mortgage Backed Securities”. Let us start from the simpler one first by quoting an example. Suppose a bank initiates 1 billion dollar worth of mortgages and hand them over to a group of conduits called the “issuers” here. The issuers put the mortgages into a pool and issue 1 billion dollar worth of securities backed by the mortgage pool. The holders of the securities are entitled to all the proceeds from the mortgage payments generated from the pool less any fees involved. This kind of plain mortgage backed securities is called “private mortgage pass-through securities”. An example of more sophisticated “private CMO and other structured MBS” is as follows: Banks initiate 1 billion dollar worth of mortgages. After issuers put them into a pool, they issue two classes of securities backed by the mortgages in the pool with face value of 500 million dollars each. The conservative class receives a lower interest rate but is promised to be paid first out of the proceeds of the mortgage payments from the pool. The venturesome class receives a higher interest rate but is paid only after the conservative class is paid in full. The difference between the interest rates that two classes will receive is calculated from the assumed default rate of the mortgages in the pool. If the actual default rate exceeds the projected one, the payment to the venturesome class will dwindle. If the actual default rate of the mortgages in the pool reaches 50%, the venturesome class will receive nothing at all and the price of this class of security will tumble to zero. Of course, if the actual default rate exceeds 50%, even the payment to the conservative class will fall below the projection and the price of the security will decline accordingly. However, if the actual default rate is lower than the projected default rate, the venturesome class will receive higher payments than projected. Considering those features, the interest rate spread between two classes will become larger if the projected default rate is higher and vice versa. If fixed rate and fixed term prime mortgages with little default risk are converted to such kind of securities, the interest rate difference between two classes will be minuscule; there is no advantage to convert such low risk mortgages into CMO at all. On the other hand risky subprime and alternative-A mortgages are ideal ones to be converted into such speculative securities. Thus most of “private CMO and other structured MBS” in the home mortgage front are backed by subprime or alternative-A mortgages. In the actual cases the number of classes issued based on a mortgage pool can be any number as desired, not just two as in our example.
The discussion in the previous paragraph may give an impression that low risk fixed term and fixed interest rate prime mortgages are only fit to become low risk “private mortgage pass-through securities”. However, such notion vastly underestimates the inventive power of the financial market. Even such low risk mortgages can actually be turned into high risk speculative securities. The principal-only and interest-only securities as will be discussed below is a good example. Suppose a bank initiates 1 billion dollar worth of 30 year fixed rate prime mortgages with an interest rate of 6%, and turns the mortgages over to the issuers to form a pool. Based on the pool issuers issue two classes of securities. The principal-only class receives all the proceeds from the pay-down of the mortgage principals, and the interest-only class receives all the proceeds from the interest payments. Though the mortgages in the pool can last for 30 years, many of them will terminate in less than 30 years due to refinancing or the outright sale of the houses. A computer program based on the current economic parameters, many guesses and estimates will project the average life span of the mortgages in the pool. Suppose the computer says that the projected average life of the mortgages in the pool is 10 years, and further says that the fair division if the projection holds is to put face values of two classes at 500 million dollars each. The projected payments received by the principal-only class will be minimal in the first few years, only rise rapidly close to the 10-th year and a few years beyond as rate of refinancing and the outright sale of houses picks up, and then starts to decline and become zero at the 31st year. When 1 billion dollar of principals are all paid back, the principal-only class will have a 100% capital gain with the major part of the gain projected to come in around the 10-th year. The return of the interest-only class will be 12% in the first year, but will drop gradually due to the refinancing and the outright sales of the houses in the pool. The drop of the payments to the interest-only class will accelerate after the 10-th year and will become zero by the 31st year. Those securities become speculative if the actual average life-span of the mortgages in the pool differs from the projected one. Suppose at the third year the market mortgage rate drops suddenly to 4% and all the mortgages in the pool refinance and leave the pool. The principal-only class will reap 100% capital gain in just 3 years instead of the projected 10 years so becomes the big winner, whereas the interest-only class lose 74% of its initial value in 3 years since this class only receive 12% return for 3 years and then nothing from the 4-th year on. On the other hand if the opposite extreme condition becomes the reality, the fortunes of two classes will be reversed. For example, if the market mortgage rate jumps to 8% in the second year and stay there for the remaining 28 years, the interest-only class will enjoy a near 12% return for 30 years and becomes the big winner, whereas the principal-only class will receive the major part of the 100% gain near the 30-th year instead around the 10-th year as projected so becomes the big loser. Similar techniques used to convert home mortgages into speculative securities can be applied equally to other types of loans. If applied to commercial mortgages, auto loans, home equity loans, credit card debts, loans used for private equity firms to buy out publicly traded companies and so on, each type has its own fancy name and abbreviation. The speculative securities backed by assets other than home mortgages is not as risky as the “private CMO and other structured MBS” yet, but are shunned as well by the financial market as too risky to touch.
The US economy is currently experiencing the deflation of a giant debt bubble. This debt bubble has started to inflate from 2003, reached its pinnacle in 2006, and has been deflating since 2006. The August (2007) financial market panic is a violent turbulence on this background that has awakened the ignorant people to the painful process of the deflating debt bubble. The home mortgage bubble is a very important component of this debt bubble. In this section we will study the creation and the demise of this home mortgage bubble. Before going into the major topic of this section, let us look at the actual data to understand the scope of this debt bubble and the size of the home mortgage bubble within this larger debt bubble. From the fourth quarter of 2002 to the fourth quarter of 2006, nominal GDP had grown from 10.59 trillion dollars to 13.30 trillion dollars, a 26% rise. During the same period the outstanding amount of debt incurred by domestic non-financial sector had grown by 40%, from 20.63 trillion dollars to 28.80 trillion dollars, whereas the home mortgages had grown by 62%, from 6.44 trillion dollars to 10.44 trillion dollars.
An ideal cycle that creates the mortgage bubble is considered first; the conformation of this ideal cycle to the real world will be discussed later. The mortgage originators like commercial banks, saving institutions, mortgage companies and so on are collectively called as the “banks” here. There are various buyers of the originated mortgages like US Government sponsored Fannie Mae and Freddie Mac, insurance companies, pension funds, various mutual funds and so on. Those buyers of home mortgages are simply called the “buyers”. The developers that construct new houses, real estate agents that sell those houses and other supporting entities are all grouped under the term, the “developers” in this discussion. To start the cycle we assume that the “banks” have the capacity to originate 1 billion dollar worth of home mortgages, and the “buyers” have 1 billion dollar seed money in their coffers. The ideal cycle can be described by the following 4 steps:
Step 1 - The “banks” originate 1 billion dollar home mortgages and put those mortgages on their books.
Step 2 - The “banks” sell 1 billion dollar new mortgages to the “buyers”. After the “banks” receive 1 billion dollars from the sale, they remove the original 1 billion dollar home mortgages from their books since they do not own those mortgages anymore. With the clean slate the “banks” are ready to originate another 1 billion dollar worth new home mortgages.
Step 3 - The original 1 billion dollars paid out by the “banks” as mortgage loans flow through mortgage borrowers and go into the coffers of the “developers”. The “developers” disburse this 1 billion dollars into the society in general as they spend the money accordingly.
Step 4 - In this idealized cycle we assume that the disbursed 1 billion dollars eventually all flow back to the coffers of the “buyers”. Some may be surprised by this assumption and wonder how this is possible. For example, US Government sponsored Fannie Mae and Freddie Mac issue bonds to borrow money from the society. When people buy insurances or shares of mutual funds, money flows into those entities respectively. Other than the “buyers”, the only place that the disbursed money can flow into is the “banks” themselves, but we will discuss such deviation from our idealized cycle later. From here the cycle jumps back to Step 1 and repeats itself.
The idealized cycle of 4 steps is driven by the profit motives and the generated benefits. The beneficiaries want the cycle to turn over as fast as it can. The “banks” profit from the fees for originating the mortgages and selling them to the “buyers”. The “buyers” profit from the difference between the proceeds of mortgage payments less the fees and the interests or returns that they must pay out as they gather the disbursed 1 billion dollars back into their coffers. The “developers” profit from building new houses and selling them to mortgage borrowers. The society in general benefits as the disbursed 1 billion dollars flow through the system. Also the cycle induces many people to become home owners. Thus all the players and the society itself want the cycle to turn over as fast as it can to maximize the profits and benefits generated within a year. However, there are bottlenecks in the cycle that will dictate how fast the cycle can turn over in a year. It takes the “developers” time to build new houses and to sell them to mortgage borrowers. It also takes time for the “banks” to issue mortgages to borrowers and then sell mortgages to the “buyers”. Certainly the “buyers” too cannot gather the disbursed money back into their coffers instantly. As the maximum number of turn-over of the cycle in one year is limited, the profits and benefits can be generated by the cycle in one year is also limited. If the cycle can only turn over five times a year, it can only generate profits and benefits from 5 billion dollar flow and so on. The only way to get more profits and benefits from the cycle within a year as all the players and the society itself want is to expand the scale of the cycle by increasing the original seed money in the coffers of the “buyers”. Where does the seed money come from? It has been pointed out in article 10 that the seed money for the larger debt bubble comes from the runaway US trade deficit. The seed money for the cycle of mortgage lending also comes from the same source. Let us review quickly the process here. When the US runs trade deficit, US dollars flow into the hands of foreign manufacturers that export to the US. Those foreign manufacturers must change the US dollars into their own local currencies in order to continue their operations. The trade deficit related dollars eventually flow into the hands of large foreign financial institutions or foreign central governments as they buy dollars in order to keep their own currencies undervalued against US Dollar. When those foreign financial institutions and foreign central governments bring those US dollars at hand back to the US financial market to invest, say in US treasury instruments, they will displace same amount of the domestic capital previously in US treasuries. Thus some of displaced domestic capital can flow into the coffers of the “buyers” to serve as the seed money. Of course, some of the returning trade-deficit related dollars will be directly invested with the “buyers”, too. Thus the whole society and all the players not only tolerate the runaway US trade deficit but also secretly wish the trade deficit to expand more to enrich every parties involved including the society itself more. The cry of blue color workers that lose their jobs due to the mounting trade deficits are naturally ignored. It also explains why the self claimed free market promoters like the Wall Street and US businesses become so upset about the intents to punish foreign governments that are artificially holding down their own currencies vs. US Dollar, since such actions will depress the value of US Dollar and reduce US trade deficit. It is also why US Government refuses to label currency-market manipulating foreign governments as “currency manipulators” from the fear that such actions will reduce US trade deficit and cut short the mad party based on the bubbles that derive their seed money from the runaway US trade deficit.
So far we have only considered the idealized cycle. However, there are two places that the idealized cycle needs to be modified. The first is the assumption that new mortgages are only for buying new houses. If a new mortgage is for buying an existing house, the seller of the existing house should be treated as a part of the “developers” since the seller will be disbursing the difference between the new mortgage plus the buyer's down payment and the old mortgage into the society in general just as the “developers” do. The second deviation is the assumption that the money disbursed by the “developers” will all flow back to the coffers of the “buyers”. As mentioned before, in reality a portion of the money disbursed into the society by the “developers” will flow back to the hands of the “banks”. Suppose 100 million dollars out of the disbursed 1 billion dollars flow back to the “banks”. This means that the “buyers” can only buy 900 million dollar mortgages from the “banks” in the second turn over of the cycle. The “banks” will be forced to keep 100 million dollar mortgages in their books, but by combining this 100 million dollar flow back with the 900 million dollar proceeds from the sell of the mortgages to the "buyers", the "banks" can still make the next 1 billion dollar new mortgages so that the cycle can process impeded. However, when a "bank" keeps a mortgage in its book, it needs to keep some reserve against the mortgage. The reserve comes out of the capital of the "bank" so that with a final amount of capital the "bank" can only keep a limited amount of mortgages in its book. Suppose the "banks" can only keep 100 billion dollar worth of mortgages in their books due to the constraints of their capitals, and let us further assume that the 100 millon dollar leakage occurs in every turn over of the cycle. To accumulate the maximum number of mortgages, that is, 100 billion dollars, in the books of the "banks" the cycle can turn over 1,000 times. The 1,000 turn overs of the cycle will generate 1 trillion dollars of mortgages in total. In the old days without this cycle, the "banks" must keep every mortgage they generate in their books so that only 100 billion dollar worth mortgages can be originated in total. Here we see how the cycle pushed by the runaway US trade deficit has ballooned the mortgage and the housing bubble 10 times.
As the US trade deficit runs wild, US Dollar will be subject to increasing pressures as more and more US dollars flood into the hands of reluctant foreign private holders. US Dollar will start to fall sharply against the currencies of its major trading partners in spite of persistent efforts of foreign governments to keep US Dollar artificially high. The falling Dollar, with some time delay of several years, will eventually curb the runaway US trade deficit. Thus the seed money for the mad cycle of mortgage lending will be reduced, the bubble starts to deflate, and the day of reckoning arrives for those over leveraged “banks”.
The proliferation of mortgages through the cycle discussed in the previous section creates shortage of qualified mortgage borrowers soon. The traditional fixed rate 30 or 15 year prime mortgages carry stringent conditions. The borrower must have an excellent credit rating, the ability to put in at least 10% of the price of the house as the down payment with no second mortgage to cover the down payment allowed, and has a verifiable income statement to show the ability to cover the mortgage payment in the future. At the time of the runaway US trade deficit that has allowed US consumers to save little, not many are qualified for such old fashion mortgages. The lending standard on the prime mortgages are steadily lowered to make more and more people qualified to borrow mortgages. When even this kind of lowering of lending standard of the prime mortgages are not sufficient to satisfy the voracious appetite of the cycle, risky alternative-A and subprime mortgages start to proliferate. Alternative-A mortgages are for borrowers with good credit ratings but lack some conditions demanded by the prime mortgages. Most often borrowers lack the verifiable income statements to show that the mortgage payments can be sustained. The alternative-A mortgages require low down payments, and often are adjustable rate mortgages carrying a fixed low interest rate period for the first several years. This fixed low interest rate period of the first several years is called the teaser rate period. When the teaser rate period expires, the interest rate on the mortgage will be adjusted up by a substantial amount. The subprime mortgages are for the borrowers with poor credit ratings. The subprime mortgages mostly require no down payment, with no verifiable income statement, and most of them are adjustable rate mortgages same as the case for alternative-A mortgages. The “banks” are lending alternative-A and subprime mortgages essentially only based on the current housing prices and nothing else. As has been pointed out in Comment 18 once mortgage lenders consider only the current housing price as the lending standard, it is very easy to boost the housing price to stratosphere. Indeed when subprime and alternative-A mortgages has taken hold, US housing price shoots up rapidly. This exploding housing price then gave a false sense of security and induced more to borrow such risky mortgages. The borrowers thought that before the teaser rate period expired they could easily cash in with a huge profit by selling the house outright or would have no problem to refinance into a lower fixed rate mortgage since they would have accumulated a substantial amount of home owner's equity by the time teaser rate period expired. By the end of 2007, the outstanding amount of subprime and alternative-A mortgages is estimated to top 2 trillion dollars, and most of them are believed to have originated between 2003 and the second quarter of 2007. During the same period total amount of new home mortgages originated is about 4.4 trillion dollars. From those numbers we can see the degree of proliferation of subprime and alternative-A mortgages.
Before the proliferation of subprime and alternative-A mortgages, the process of selling mortgages to buyers was rather simple. Large buyers that have the capacity to service mortgages by themselves prefer to buy a pool of mortgages directly. To cater for smaller buyers that do not have the ability to service the mortgages by themselves, there exist a conduit called the “issuers”. The “issuers” buy a pool of mortgages from the “banks”, issue securities backed by the pool and sell them piecemeal to smaller “buyers”. The mortgages used by this way are prime mortgages and the securities issued are the conservative “private mortgage pass-through securities” discussed in Section 2. The speculative principal-only and interest-only securities based on prime mortgages (please see Section 2 for details) are very dangerous for the “issuers” and the “banks” so not many were issued. When such speculative securities are issued, buyers usually flocks to one class of the securities according to the prevailing market expectation about the future course of interest rates. If the market expects the rising interest rate in the future, buyers will flock to buy interest-only class and leave the “issuers” and the “banks” holding a large amount of the principal-only class and vice versa.
Subprime and alternative-A mortgages cannot be sold so easily as prime mortgages since they are far riskier products. Many “buyers” do not want to touch them. The solution is to issue structured securities backed by those risky mortgages. The “issuers” plays a big role in the cycle to promote subprime and alternative-A mortgages. After buying those mortgages from the “banks” and put them into a pool, the “issuers” issue CMO (Collateralized Mortgage Obligations) as discussed in Section 2. The rating agencies gave the conservative class of CMO AAA ratings since this class is protected by the venturesome class when defaults spread. Thus conservative “buyers” will buy the conservative class for better yields than genuine high grade mortgage backed securities like the ones backed by Fannie Mae and Freddie Mac, and the speculators will buy venturesome classes. As mentioned in the previous section the unsold CMO still accumulate in the books of the “banks”. In order to reduce their inventories of those toxic structured securities, the “banks” sponsor the establishment of speculative investment pools. Those investment pools issue a large amount of commercial papers compared to their own capitals, and use the proceeds from the sale of commercial papers to buy the inventory of those toxic CMO from the “banks”. There also emerge another class of “buyers” that buy the commercial papers from the speculative investment pools. Those commercial paper “buyers” are indirectly exposed to the toxic CMO. With all the players in place the cycle of subprime and alternative-A mortgages turns just as the general mortgage-lending cycle as discussed in the previous section to spurn out more and more of such risky mortgages and toxic structured securities backed by subprime and alternative-A mortgages.
When the US trade deficit wanes, the seed money to the cycle of subprime and alternative-A mortgages is naturally affected, too. As the origination of those risky mortgages slow down, the housing prices stagnates and then fall. Many borrowers of subprime and alternative-A mortgages are trapped within the teaser rate period since once they sell the houses they will incur losses that they can ill afford. As the teaser rate period expires and the mortgage interest rates adjusted substantially higher many of them default on the mortgages, and the houses are foreclosed. The rising foreclosure rate depresses housing prices further, and that in turn induces more default and foreclosures. The bust of the subprime and alternative-A mortgage bubble naturally hit the CMO based on such mortgages hard. Even the most conservative classes rated as AAA quickly tumble down to near the junk status, and those CMO become toxic structured securities of our concern. As stated in the introductory section, the lack of transparency about who are exposed to those toxic structured securities is grinding the financial market to a halt. In the next section we will use FED's quarterly Z1 report to estimate which business groups are exposed to those toxic structured securities.
Up to this point we have concentrated our attention on an important component of the overall debt bubble, that is, the mortgage and housing bubble, and have considered “private CMO and other structured MBS” as the toxic element among the securities backed by home mortgages. There are other toxic elements backed by various different assets other than home mortgages in the balance sheets of various business groups. For example, CDO (Collateralized Debt Obligations) is such a security. All those toxic securities are classified as “corporate bonds” in the Z1 report. Since Z1 report does not break corporate bonds down to detailed components for business groups other than the US chartered commercial banks and saving institutions, we do not need to worry about how much CMO and how much CDO each business group is exposed to but just estimate the exposure to poisonous stuff that includes both CMO and CDO. Another note that should be given before we go into the detailed analysis is about the way that Z1 report describes the acquisition of financial assets, especially short maturity debt instruments like commercial paper. Let us consider the following example to illustrate this point. Suppose an entity bought 1 billion dollar commercial papers with one year maturity in year 2005. In year 2006 the entity let the 1 billion dollar commercial papers purchased in 2005 rolled over for another year. In addition the entity purchased another 1 billion dollar commercial papers with one year maturity. In year 2007 the entity let all 2 billion dollar commercial papers to mature without rolling over any of them. Z1 report considers the entity had a net 1 billion dollar purchase of commercial papers in year 2005. In year 2006 the expiration of the original 1 billion dollar commercial papers is recorded as a negative 1 billion dollar purchase and the roll-over as a positive 1 billion dollar purchase so that these two cancel out each other. The new additional 1 billion dollar purchase is considered as a positive 1 billion dollar purchase. Thus the net commercial paper purchase in 2006 is 1 billion dollars. In year 2007 2 billion dollar worth of commercial papers had expired without any roll-over, so the net purchase of commercial papers becomes negative 2 billion dollars.
In our estimates, only the direct positions in those toxic securities are considered. Any derivatives that
theoretically will reduce the exposure of the owner of those toxic securities are not taken into account since Z1
report does not deal with such derivatives. The business groups that possess substantial amount of corporate
bonds but do not show abnormal behavior in the acquisition of corporate bonds before and after the financial
panic of August (2007) are not reported here since we do not know how much they are exposed to the toxic stuff
from the Z1 report alone. A good example is the group of life insurance companies that has 1.9 trillion dollars of
“corporate and foreign bonds” outstanding at the end of 2007. In the third quarter of 2007, this group had an
abnormally large acquisition of those bonds. Since this group is not an insider group of the cycle considered
earlier, there is no reason for this group to come in to buy up those toxic securities after the financial panic
to support its price. Furthermore, the sudden surge of the acquisition in the third quarter of 2007 coincides
with the sudden surge of annuity buying by their clients. Thus we conclude that there is no evidence from Z1
report of the meaningful exposure of this group to the toxic securities of our concern. If we are allowed to
guess why the sudden surge of the annuity buying, we will say that is due to the view of many that life insurance
companies are safer than banks after the August panic. Of course, our inability to detect the evidence to the
exposure of this group do not exclude the possibility of indirect exposure to those toxic securities like through
the “credit risk swap” type derivatives. Similar situations apply to the property-casualty insurance group and
the private pension fund group. The estimates of the exposures of various business groups to toxic corporate
bonds shunned by the financial market are listed below:
(1) US chartered commercial banks and saving institutions
For those two groups Z1 report has information to break their net purchase of corporate and foreign bonds to three categories, “private CMO and other structured MBS”, “private mortgage pass-through securities” and “other”. The amount of not risky “private mortgage pass-through securities” is very small compared to other two components so can be ignored. Poisonous CDO type securities are supposedly buried in the category of “other”. The commercial banks had 222 billion dollar “private CMO and other structured MBS” outstanding at the end of 2007. This business group acquired 16 billion dollar and 47 billion dollar of such securities in the third and the fourth quarters of 2007 respectively. The amounts of those two purchases are substantially above its normal purchase pattern, so they are apparently designed to support the collapsing price of those securities after the August (2007) financial panic. The US chartered commercial banks had 301 billion dollar “other corporate and foreign bonds” outstanding at the end of 2007. This group acquired an abnormally large amount, 42 billion dollars, of such bonds in the third quarter of 2007, and then sold off 39 billion dollars in the fourth quarter of 2007. In the aftermath of the August (2007) financial panic, the structured securities backed by the assets other than subprime and alternative-A mortgages were also shunned by the market, so commercial banks came in to buy them up in order to prevent the wholesale collapse of the markets for such securities. However, not like subprime and alternative-A mortgages the default rate on those underling assets had not increased noticeably yet, so the market for those securities had settled down in the fourth quarter of 2007 and the commercial banks were able to sell off most of their acquisitions made in the third quarter of 2007. At the end of 2007 there were still 300 billion dollar of “other corporate and foreign bonds” outstanding for this group. The financial details of the group of “issuers of Asset Backed Securities” shows that the ratio of home-mortgage backed securities to other-asset backed securities is about 3 to 2. Assuming the same ratio for the holdings of commercial banks and using the outstanding amount of “private CMO and other structured MBS” at the end of 2007, that is, about 222 billion dollars, we estimate that about 150 billion dollar “other corporate and foreign bonds” are the structured securities backed by assets other than home mortgages like, commercial mortgages, consumer credit card debts, auto-loans and so on. As has been pointed out in our earlier discussion about the cycle, the attraction of structured securities is in their speculative nature, so this 150 billion dollar “other bonds” are also potentially toxic stuff and can easily be shunned by the financial market. In conclusion commercial banks as a group are exposed to 370 billion dollars of toxic or potentially toxic structured securities.
At the end of 2007 the group of “Savings Institutions” had a 105 billion dollar exposure to “private CMO and other structured MBS”. The outstanding amount of “other corporate bonds” at the end of 2003 was 56 billion dollars but had dropped to 27 billion dollars by the end of 2007, indicating that it is unlikely those are toxic structured products. Combining “US Chartered Commercial Banks” and “Savings Institutions” together, their estimated exposure to toxic structured securities is about 470 billion dollars.(2) Security Brokers and Dealers
This group includes Wall Street firms. Some of them are heavily involved in creating CDO (Collateralized Debt Obligations) backed by junk bonds used for private equity firms to take over public corporations. We will not be surprise to see that this group owns more toxic CDO than toxic CMO. Since there is no detailed break down of this group's holding of “Corporate and foreign bonds” that include both CMO and CDO, we must look at the purchase pattern of “Corporate and foreign bonds” by this group to estimate its exposure to the toxic CMO and CDO. From the end of 2002 to the end of the second quarter of 2007 this group purchased in net 284 billion dollar “Corporate and foreign bonds”, and than sold off 1.5 billion dollars and 35.1 billion dollars of such bonds in the third and the fourth quarters of 2007 respectively. This kind of sudden change from heavy buying to selling indicates that this group is indeed exposed to the toxic structured securities shunned by the market after the August (2007) financial panic. The major part of toxic CDO are issued in 2005 and 2006. From the purchasing patterns of corporate bonds before 2005 we estimate that the group's exposure at the end of 2007 was in the range of 150 to 200 billion dollars.(3) Bank holding companies
Bank holding companies are parent companies of banks. From 2003 to the second quarter of 2007 this group only purchased 0.6 billion dollar “Corporate and foreign bonds” in net, but it acquired 22 billion dollar worth of such bonds in the second half of 2007. We assume that this 22 billion dollar bonds are all the toxic structured securities, and the sudden spur of the purchase was intended to support the collapsing prices of such toxic securities.(4) Foreign bank offices in US
This group acquired only 0.2 billion dollar US corporate bonds in 2003, but 22 billion dollars in 2004, 81 billion dollars in 2005, 30 billion dollars in 2006 and 56 billion dollars in the first half of 2007 respectively. In the third quarter of 2007, the net purchase by this group drops to only 4.1 billion dollars, and in the fourth quarter this group purchased in net 17 billion dollars of such bonds. From this purchase pattern we put this group's exposure to toxic structured securities at 150 to 180 billion dollars. The exposure of this group will become the exposure of their parent foreign banks, but is treated separately from other foreign entities called “Rest of the world” as will be discussed later.(5) Money market mutual funds
This group purchased negligible amounts of “Corporate and foreign bonds” in 2003 and 2004. In 2006 the net purchase suddenly jumped to 105 billion dollars, and in the first half of 2007 this group added another 54 billion dollars of such bonds in its coffer. In the second half of 2007 this group abruptly sold off 45 billion dollars of “Corporate and foreign bonds”. One easy route is to consider this group as late comer to the game of toxic structured securities. In that case the group's exposure needs to be put at the level of 150 billion dollars. However, we have doubts about this explanation. This group must keep the majority of its holdings in short maturity instruments since investors in money market mutual funds can withdraw their investment in a moment's notice. It is rather difficult to think of any short-maturity toxic structured securities. The corporate bond purchasing pattern of this group can also be explained by the movements of short-term interest rates. In 2003 and 2004, the short-term interest rates were very low and there was no advantage to own short-maturity corporate bonds. We should note that corporations usually do not issue short-term bonds; bonds are instruments with long maturities. However, when a long-term bond is near its maturity, it becomes a short-maturity bonds since its yield will be tied to the short-term interest rates prevailing in the financial market. In 2005 the short-term interest rates rose sharply. Money market mutual funds rush to buy commercial papers in order to digest large amount of new investments pouring into their funds attracted by the high short-term interest rates. In 2006 and the first half of 2007 this influx of money into money market mutual funds intensified further. The funds started to experience difficulty to find enough commercial papers to buy to digest the torrent of new money pouring into their coffers so started to use short-maturity corporate bonds as substitutes. After the financial panic of August (2007) short-term interest rates came down and the advantage of owning short-maturity corporate bonds had diminished. Money market mutual funds let those short-maturity corporate bonds to mature so the group's net purchase suddenly dropped. We rather prefer the latter explanation. Thus we put the group's direct exposure to the toxic structured securities as negligible. Nevertheless, as discussed in section 3 about the cycle, money market mutual funds are designated as the buyer of commercial papers issued by the entities that hold a large amount of mortgages, including toxic structured securities backed by subprime and alternative-A mortgages. In that sense money market mutual funds are exposed indirectly to the toxic structured securities. Such indirect exposures will be covered later under a sub-title of “Commercial papers”(6) Government sponsored enterprises
The entity includes Fannie Mae and Freddie Mac. This group bought 50.3 billion dollar worth of “Corporate and foreign bonds” in 2003, 137.4 billion dollar in 2004, 50.9 billion dollar in 2005, 17.1 billion dollar in 2006, and 18.5 billion dollar in the first half of 2007 respectively. The diminishing purchase since the peak of 2004 is probably the result of the regulatory constraints put on Fannie Mae and Freddie Mac to prevent them to become over leveraged. In the second half of 2007 this group sold 36.4 billion dollar worth of “Corporate and foreign bonds”. The selling after the August (2007) financial panic implies that the portfolios of this group probably are infested by those toxic structured securities. However, with the purchase pattern influenced by the external regulatory force it is difficult to estimate the extent of exposure of this group.(7) Funding corporations
In the Z1 report this group is defined as “Funding subsidiaries, nonbank holding companies, and custodial accounts for reinvested collateral lending operations”. Many large banks and Wall Street firms have their own funding corporations that handle various financial transactions that their parent companies do not undertake directly from various reasons. This group acquired in net only 2.8 billion dollar “Corporate and foreign bonds” from 2003 to the second quarter of 2007, but suddenly acquired 126 billion dollar of such bonds in the third quarter of 2007. Apparently the over whelming majority of this 126 billion dollar purchase is about the coordinated effort to support the collapsing prices of CMO and CDO after the August (2007) financial panic. It is safe to assume that those funding corporations buying CMO and CDO are the subsidiaries of commercial banks that were buying those CMO and CDO after the panic to support the collapsing prices of those toxic structured securities as discussed in category (1). Therefore, the exposure of about 120 billion dollar toxic structured securities incurred by the funding companies are actually the exposure of the banks.(8) Rest of the world
This group include all the foreign entities except the foreign bank offices in US that is already covered in category (4). We should note that besides the genuine foreign entities the speculative investment pools set up to borrow heavily and use the borrowed money to buy toxic structured securities are mostly registered in oversea tax heavens or in London so they are included in this group. “Rest of the world” is a large holder of US corporate bonds. At the end of 2007 there are 2.58 trillion dollar corporate bonds in the possession of this group. From 2003 to the second quarter of 2007 this group had bought 1.48 trillion dollar corporate bonds. In the third quarter of 2007 the purchase suddenly dropped to only 0.5 billion dollars. It is a clear sign that this group is exposed to toxic structured securities. From the buying pattern of corporate bonds before the boom of toxic structured securities, we estimate the exposure of this group at 500 billion dollar or more. It is reported that the aggregated assets of London registered SIV (please see Comment 49 about SIV), designed to hold large amounts of those toxic structured securities, reach 300 billion dollars. From this we can see that the exposure of genuine foreign entities other than those special investment pools sponsored by mortgage generating banks should be 200 billion dollars or more. Foreign entities are far less transparent about their balance sheets so it is difficult to pin down their exposures. We are only aware of one estimate from the Taipei office of a global accounting firm. The estimate puts the exposure of the whole Taiwan to the mess of subprime mortgages at 30 billion dollars. If that estimate is true, the exposure of genuine foreign entities may far exceed the 200 billion dollar estimate made here.(9) Issuers of asset backed securities (ABS)
This group issues securities backed by various assets. In early sections we have called them as the “issuers”. The assets that they use for secularization are home mortgages, commercial mortgages, consumer credits and a small amount of others like multifamily residence mortgages and trade credits. Secularizations of junk bonds used by private equity firms to buy out public companies are done by Wall Street firms that belong to the group of “security brokers and dealers”. At the end of the second quarter of 2007 the group of “issuers of ABS” owns 3.74 trillion dollar assets used for secularization. The break down of this 3.74 billion dollar assets are, home mortgage (60%), commercial mortgage (16%), consumer credit (18%), and others (6%). This group also own treasuries, agency and GSA-backed securities, and loans and advances to third parties. Those assets not used for secularization amount to 535 billion dollars at the end of the second quarter of 2007. This group has only two kinds of liabilities listed in the Z1 report, commercial paper and corporate bonds. Corporate bonds are exactly the asset backed securities issued by this group. At the end of the second quarter of 2007 there was 3.39 trillion dollar corporate bonds issued by this group outstanding. The amount of outstanding commercial paper issued by this group at the end of the second quarter of 2007 was 890 billion dollars. From those figures we can see that the difference between the borrowing from commercial paper issuance and the assets not used for secularization, that is, about 350 billion dollars at the end of the second quarter of 2007, were used to carry the inventory of assets used for secularization that was not used up as the asset backed securities. In other words this group has no self capital to speak of. The default risks of the underlying assets are all carried by the buyers of the securities issued by this group. This group is vulnerable to the adverse conditions in the commercial market since it is using short-term borrowing like commercial paper to finance its inventory of assets used for secularization. Those assets in its inventory must be heavily populated by subprime and alternative-A mortgages, since as the August (2007) financial panic hit the commercial paper issued by this group were shunned by the market and the outstanding amount of commercial paper issued by this group decreased by about 250 billion dollars in the second half of 2007. What did this group do to cope with the financial crisis? It secularized about 200 billion dollar worth of home mortgages into securities and sold to someone. Who are the buyers of those securities after the panic when everyone else was trying to get rid of them? As already been pointed out those were the “banks” and their associated entities like “bank holding companies” and “funding corporations”. From this we may guess that the “issuers of ABS” are mostly just conduit of the “banks”.
“Commercial paper”, of course, is not a business group. However, commercial paper has played an important role in the discussion of the subprime and alternative-A mortgage lending cycles of Section 4, so it is worth to pay special attention here. Commercial paper is included in the category of “Open market paper” in the Z1 report, but about 99.7% of “Open market paper” is commercial paper; the remaining 0.03% is “banker's acceptance”. At the end of the second quarter of 2007 there were 2.11 trillion dollars of commercial paper outstanding, but by the end of 2007 the outstanding amount had declined to 1.79 trillion dollars, a 320 billion dollar reduction in the second half of 2007. Looking into the decline in detail in the second half of 2007, following results show up: Domestic non-financial corporate business had reduced the issuance of commercial paper by 32 billion dollars during the period. Foreign financial issues declined by 79 billion dollars. Domestic commercial banking had increased the issuance of commercial paper by 26 billion dollars in the second half of 2007. As already discussed in category (9) , “issuers of asset backed securities” saw their commercial paper issuance declined by 253 billion dollars during the last two quarters of 2007.
Now let us turn our attention to the holders of commercial paper, and see how they changed their holdings in the second half of 2007. Household sector had reduced their holding of commercial paper by 38 billion dollars in the second half of 2007. Non-financial corporate business, and state and local governments reduced their holding by 24 and 13 billion dollars respectively. “Rest of the world” reduced their holding of commercial paper by 15 billion dollars only during the period, and life insurance companies reduced their exposure to commercial paper by 11 billion dollars. It is interesting to observe that money market mutual funds actually increased their positions in commercial paper by 47 billion dollars so the rumor that the financial panic of August (2007) was due to the refusal of money market mutual funds to let commercial papers tainted by toxic structured securities to be rolled over was not true. As discussed in category (5) money market mutual funds bought large amount of commercial papers in 2006 and the first half of 2007, so this group must hold reasonable amount of commercial papers issued by the entities heavily exposed to the toxic structured securities. The lack of reduction of the possission of commercial papers by this group in the second half of 2007 must mean that money market mutual funds as a group are still indirectly exposed to those tainted commercial papers. By far the major player in setting off the financial panic of August (2007) has been “funding corporations” since this group had reduced their exposure to commercial paper by a whopping 280 billion dollars in the second half of 2007. In category (7) when we discussed “funding corporations”, there was a subgroup of funding corporations most-likely associated with the “banks” that had bought 120 billion dollars of shunned securities after the August (2007) financial panic. Is the current subgroup of funding corporations that had caused the financial panic by reducing such a large amount of exposure in commercial paper the same subgroup as the one in category (7)? Is it a totoally different mysterious subgroup of "funding corporations" of trigger happy and experienced trader-like sense? At this moment we do not find any ground to speculate into either direction. However, we may say that this subgroup of "funding corporations" had been a major financial source for the structured securities backed by subprime and alternative-A mortgages before the August (2007) panic. One thing we can be sure is that by the end of 2007, this subgroup of funding corporations was not exposed to any commercial paper tainted by the toxic structured securities anymore.
The total amount of exposure to toxic structured securities as estimated in this section is about 1.47 trillion dollars. There are totally 2 trillion dollar subprime and alternative-A mortgages in existence. Assuming 70% of such mortgages are turned into “private CMO and other structured MBS”, there should be 1.4 trillion dollars of such securities around. Adding structured securities backed by other assets, probably about 2 trillion dollar worth of toxic structured securities should have been issued by the “issuers of Asset Backed Securities”. This is about 55% of all securities issued by this business group. Also there are Collateralized Debt Obligations mainly issued by Wall Street firms. We estimate the amount of CDO outstanding as 300 billion dollars. The total amount of outstanding toxic structured securities will be about 2.3 trillion dollars. Our estimate of exposure has caught about 65% of the toxic stuff floating around the global financial markets.
FED has lowered the target of the federal funds rate repeatedly and injected a large amount of liquidity into the financial market via the normal open market operations to reinvigorate the financial market but to no avail. Such failure is not surprising since once “Japan Syndrome” gets hold, it is very difficult to revitalize the market by just injecting liquidity as Japan has experienced. FED has drastically loosened the requirements of discount window borrowing, and has installed special term auctions to allow banks and Wall Street firms to swap their illiquid structured securities for US treasuries. If the need arises, certainly FED will loosen the conditions at the discount window and the special term auction further to allow all the toxic structured securities of our concern as collaterals. However, even the usage of those toxic structured securities as collaterals to borrow from FED may not be able to prevent a troubled financial entity from its ultimate demise. Let us consider the following example: Suppose the only asset of a financial entity is a block of private CMO backed by subprime mortgages with a face value of 2 billion dollars. Let us assume that the market price of this block of private CMO is only 1 billion dollars due to heavy default of the underlying subprime mortgages. This financial entity tenders this block of private CMO to FED and borrow 1 billion dollars to keep the firm alive. What happens if the price of such private CMO goes down another 50%, and the block now only worth 500 million dollars. What will FED do? If FED insists that it can only lend the entity 500 million dollars and wants to recall 500 million dollars from the firm, the financial entity will certainly go under. If that is FED's attitude, far before the price of such CMO drops by another 50%, the clients and counter parties of the entity will jump ship and push it into insolvency very quickly. If FED continues to lend the entity 1 billion dollars in spite of the sharp drop of the market value of the collateral, it is equivalent for FED to buy the block of private CMO at a vastly inflated price than the market price just to keep the financial entity alive. If FED is going to take the de facto buyout route, then it must be prepared to buy out all 2.3 trillion dollar worth of toxic structured securities at highly inflated prices. Even if FED decides a total buyout of such securities but at a realistic price, say 50% discount from the face value, the financial sector needs to take an immediate loss of 2.3/2 = 1.15 trillion dollars. Such a huge loss will trigger a financial fire storm that will destroy many large financial entities around the globe.
The plan considered by US Congress is to force holders of such private CMO adjust down by certain amount, readjust the subprime mortgage amounts owed by the borrowers down to the market value to forestall the default and foreclosures, and then US Government will guarantee the newly adjusted-down mortgages. The question is what is the “certain amount”. If the holders are forced to adjust down to the market value of those CMO, say 50% of their face value, the holders in aggregate will be forced to take an immediate loss of 1.15 trillion dollars just as for the case of the outright buyout by FED. If US Congress wants to avoid such a financial fire storm that very likely will sink the whole financial system considering the tightly interlocked modern finance by over 70 trillion dollars of various derivatives, and set the “certain amount” to a quite small number, say 150 billion dollars, then both the holders of CMO and the subprime borrowers will be bailed out by US Government. However, US Government will incur a loss of 1 trillion dollars. This is equivalent for US government to print 1 trillion dollars from the thin air and throw them into the market permanently. What is the effect of such a massive money-print operation? Most likely a hyper inflation will follow if the US economy is reinvigorated, FED will be forced to raise short-term interest rates substantially higher, and a worse economic slump will follow soon after.
The current plans floated by various politicians only amount to something like 50 billion dollar aids. This kind of small amounts certainly will not clean up the financial poisons spreading by the toxic structured securities. As the process of uncertainty continues and the US trade deficit continues to languish, more and more seed money will be deprived from the financial market, the liquidity squeeze will progress, the malaise will spread beyond subprime and alternative-A mortgages, and the amount of securities classified as toxic will increase further to make the clean up even more difficult. If some one wants to place the blame for this kind of deadlocked sorry situation, we suggest that he points his finger at the parties that have allowed the US trade deficit to run wild and unchecked under the name of “globalization”.