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October 26, 2007

When Crumbling Credit Meets Deadly Leverage
by Richard Benson

If our country's debt problems in the private sector were simply limited to the $1.5 trillion of subprime mortgages that needed to be repaid, restructured or foreclosed, the situation might be manageable. But they're not, and it isn't. It's widely understood now that this mess was caused by a Federal Reserve that pumped up home ownership (for everyone in America) and then proceeded to cut interest rates too low for too long, and by credit market participants who threw common sense and basic loan underwriting to the wind.

In looking back at this era of easy lending, the orgy was effectively facilitated by Wall Street's ability to irresponsibly underwrite loans and then look the other way. Risky mortgage securities were packaged and sold in the secondary market to suckers who bought into the theory that the housing market would only go up.

As equity extraction becomes a thing of the past, a recession seems inevitable. I predict there will be continued credit surprises - mostly on the downside - as employment weakens, jobs are lost, and bills go unpaid. As a consumer-led recession unfolds, personal income and corporate revenues won't cover many debts, and the game of always being able to refinance has ended. So, for many borrowers the game is already over; they just don't know it yet.

The credit cycle has clearly turned. Financial institutions, such as banks, have only begun to add to the massive loan loss reserves they'll need to shelter from the storm of at least $2 trillion of consumer, commercial real estate, corporate, and single family mortgage loans, that could easily roll over into default. And that's not all. Loan loss reserves are also being set aside as banks brace for the stress that has begun to appear in commercial mortgages and mortgage securities. See the chart below:

Note: These are loans we can see, so the magnitude of the risk is known as the debts above have actually been recorded on individual and corporate balance sheets. The scary part is the magnitude of the derivative loans we haven't seen yet.

In the world of easy money and the exponential increase of artificial liquidity and credit, there is also the "shadow world" of derivatives.

A derivative allows a market participant to make money or hedge a position as if they owned a financial instrument, yet they're not required to put the asset on-balance sheet (or post the capital) the same way they would have to if the asset were on-balance sheet.

Why is this important? As Hank Paulson, Secretary of the Treasury, runs around trying to bail out the Structured Investment Vehicles ("SIVs"), it's become pretty obvious. These SIVs provided a way for huge banks, like Citibank, to hold another $400 billion of assets but conveniently keep them off-balance sheet. Up until a few weeks ago, the financial press hadn't even heard of a SIV. Now, suddenly, they're threatening the core of the financial system because the loans might have to go back on-balance sheet and tie up precious equity capital!

The big players love derivatives because they allow massive off-balance sheet leverage. However, the hedge funds and mortgage companies that have all blown up recently (along with some Wall Street firms and Bear Stearns) have learned a hard lesson: mixing massive credit losses with high leverage is a formula for quick and definitive financial death. While leverage may be positive to the bottom line on the upside, it can quickly kill on the downside.

While SIVs are continuing to rock the system, they are a mere rounding error compared to Credit Default Swaps ("CDSs") and other major derivatives. (CDSs are the most widely traded credit product.) See the Table below:

$28 trillion of CDSs is a staggering number! It's more than double the U.S. GDP, and is more than four times the total of all outstanding corporate debt. The off-balance sheet "shadow world" of credit actually dwarfs the on-balance sheet visible world.

As the Music Man says, "There is a lot of gamboling going on here in River City".

In real speak this means the financial players reap all of the benefits on the upside, while the investors assume most of the risk on the downside. The "gamboling" going on is off-balance sheet and, therefore, hidden from the investor's view.

In July and August we all learned how cruel the markets can be. When the market value (gain to one party, and loss to the other) of mortgages and mortgage derivatives spiked in value very quickly, quite a number of firms, and funds, simply failed. It was very sudden. Derivatives are by design extraordinarily leveraged, so small changes in the financial markets can affect their value in a big way. A sizable wave in the financial markets can easily be magnified and turned into a tsunami of market losses. With the current level of credit derivatives all sitting off-balance sheet (and unnoticed like the SIV's recently were), unsuspecting investors could wake up to discover more alarming losses amounting to a few trillion dollars that were neither anticipated nor welcome.

Finally, the financial institutions that have exposure to on-balance sheet credit risk are the Who's Who of major hedge funds, major banks, and Wall Street investment banks. Guess who the major counterparties are in the derivatives market? Why, they're the same major players! So, while Bear Stearns has become the poster boy for all that's wrong with subprime mortgages, don't worry. Other firms like JP Morgan Chase, Morgan Stanley, Citibank, Merrill Lynch, and even Goldman Sachs, may have their pictures posted alongside Bear Stearns' in the "Hall of Shame" when corporate credits turn down. Crumbling credit combined with deadly leverage can prove fatal to portfolios invested in financial stocks.

Richard Benson
Benson's Economic & Market Trends
Specialty Finance Group, LLC

Prior to founding the Specialty Finance Group in 1989, Mr. Benson acted as a trading desk economist for Chase Manhattan Bank in the early 1980's and started in the securitization business in 1983 at Bear Stearns, and helped build the early securitization businesses at Citibank and E.F. Hutton.

Mr. Benson graduated from the University of Wisconsin in 1970 in the Honors Program in Math, and did his doctoral work in Economics at Harvard University. Mr. Benson is a member of the Harvard Club of New York and Palm Beach.

The Specialty Finance Group, LLC is a Florida Limited Liability Company and is registered with the NASD/SIPC as a Broker/Dealer.

Copyright © 2004-2009 Richard Benson

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