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CDO Trouble

Fannie and Freddie Assets
Emerging Market Bond Spreads
Housing Starts

A week of dismal technology earnings led equity prices lower from the U.S. to Europe to Asia. Here at home, stocks outside the tech sector generally held their own. For the week, the Dow was marginally higher and the S&P500 fractionally lower. Economically sensitive issues continue to outperform, with the Transports and Morgan Stanley Cyclical indices adding 1%. The Morgan Stanley Consumer index jumped 3%, while the Utilities sank 3%. The broader market was relatively quiet, with the small cap Russell 2000 and the S&P400 Mid-Cap indices generally unchanged. The wildly volatile technology stocks came under selling pressure this week, with the NASDAQ100 and Morgan Stanley High Tech indices dropping 4%. The Semiconductors dipped 3%, the NASDAQ telecommunications index 4%, and The Street.com Internet index slipped 7%. Biotech stocks were generally unchanged. Financial stocks were unsettled, with the S&P Bank index gaining 1%, while the AMEX Security Broker/Dealer index was unchanged. With bullion gaining $2.60, the HUI gold index gained 3%.

Heightened financial stress, both at home and abroad, and hope of more Fed rate cuts supported the Treasury market. For the week, 2-year Treasury yields dropped 13 basis points to 3.94%, 5-year yields 10 basis points to 4.65%, and the benchmark 10-year Treasury yield dropped 9 basis points to 5.13%. The long-bond saw its yield decline 7 basis points to 5.54%. Mortgage-backs and agency securities performed strongly, with yields dropping 13 and 17 basis points respectively. Curiously, the benchmark 10-year dollar swap spread narrowed 6 to 81. Junk bond and financial sector debt spreads widened somewhat. The dollar suffered its worst week in months, dropping 2% against the euro. Analysts blamed faltering corporate profits, complaining exporters, and Greenspan comments for the weakness, but we tend to focus on what we see as increasing recognition of U.S. financial system fragility. Argentina continues its desperate efforts to stave off devaluation, and emerging markets continue to trade poorly worldwide.

From Gary Rosenberger's Marketnews International (www.marketnews.com) Reality Check column: US Compensation Execs Say Worker Costs on Rise: "Although the bloom is off the boom economy and layoffs are growing, employment costs surprisingly continue to rise, say compensation consultants. Anchoring that is an acceleration in the cost of health benefits, which one consultant termed 'faster than ever.' Wages are immune for now as companies jump hurdles to keep their top performers in place, consultants say…Buck Consultants recently surveyed website employers and found compensation is still rising an average of 6% in salary and 10% in total (salary and benefits), well above the national average." The article quoted an employment executive from Houston: "Things are crazy in health care costs," with expenses rising an average of 12.8% this past year.

Credit inflation continues to fuel the historic Bubble in real estate finance. It is worth noting that the acceleration in home building continues, with housing starts increasing to the strongest level since January. Annualized starts of 1.658 million units during June were six percent above year ago levels, and were actually the strongest June numbers in years. Starts were almost 11% above average June starts from the past six years. For the first half, starts are running slightly ahead of last year but remain below 1999's record. There is no mystery as to the source of the booming housing market; it's all about the availability of credit and asset Bubble dynamics. Greenspan touched upon this most critical issue in his testimony, although he certainly doesn't address the Bubble: "We have constructed a very sophisticated housing economy, and it's having a very significant effect on consumer spending and indeed the rest of the economy." That it is!

And while it may in fact be "sophisticated,' the critical characteristic of the U.S. real estate finance Superstructure is rather simple: the brute force of aggressive lending. The Mortgage Bankers Association has estimated second quarter total mortgage originations at an incredible $477 billion. We see that Fannie Mae's "business volume" (mortgage purchases) hit an all-time record of $58.6 billion during June, with outstanding mortgage-backed securities (sold in the marketplace) increasing at a 28% annualized rate. For the entire quarter, Fannie's total "book of business" (mortgages held and securities sold) increased $70.4 billion (22% annualized) to $1.437 trillion. The company increased its total assets by $36 billion to $737 billion (a 22% growth rate), with assets jumping $129 billion (21%) over the past 12 months. Outstanding Fannie Mae mortgage-backs (not held in Fannie's portfolio) increased $48 billion during the quarter, a 29% rate. Total second quarter "business volume" of $165.7 billion compares to the first quarter's $105.6 billion, and $62 billion during last year's second quarter. During the past three years, total Fannie Mae assets have increased $308 billion, or just over 70%.

I could only chuckle with a Wall Street analyst's comment, "Freddie Mac continues to benefit from a healthy mortgage market. Anyway, "Highlights" of Freddie Mac's quarter include "record new business purchase volume of $126 billion, up 180% from $45 billion for second quarter 2000. Record mortgage portfolio growth of $54 billion, representing 22% annualized growth." Total outstanding Freddie Mac mortgage-backs increased to $1.048 trillion, supported by $14 billion of shareholder's equity. Total assets increased $40 billion during the quarter, a stunning 32% growth rate, and are up 30% year over year. Curiously, non-mortgage "investments" increased $14 billion (112% annualized growth rate) during the quarter to $63 billion. Is Freddie financing other's holdings of some of these mortgage backs the GSEs are selling? Over the past three years, total assets have increased $308 billion (134%) to $538 billion, while shareholder's equity has increased $5.6 billion.

It is also interesting to note that Freddie Mac financed much of its second quarter balance sheet growth with short-term liabilities. Current liabilities increased $28 billion to $224 billion, and ended the quarter at 42% of total assets. Financing long-term mortgages in such a fashion is "playing with fire." Apparently they have "hedged" much of this risk in the derivatives market, so there are counterparties vulnerable to getting burnt. It is important to recognize that derivative players today must be in the process of reevaluating risk. With huge losses in telecom debt, venture capital, Argentina and emerging market debt, and general U.S. and global credit problems, one would expect much less appetite for interest rate, currency, and other risk going forward.

For the past year or so, we have watched with considerable consternation as the bursting of the historic technology bubble only worked to incite additional aggressive lending and speculation in other sectors, most notably consumer and real estate finance. Amazingly, such a precarious circumstance occurred with the full support of the Federal Reserve. We have nonetheless viewed this period as the "terminal stage" of the consumer Bubble, parallel to what had previously transpired in the technology sector, but of even greater significance. It now appears the Great Credit Bubble is increasingly vulnerable, with momentous ramifications for the U.S. economy, financial system and dollar.

Credit Bubble analysis very much takes an "institutionalist" perspective. What does that mean? Well, simplistically it implies that the institutions (particularly financial), having come to enjoy incredible financial rewards and great power, play a dominant role in determining the nature, dynamics and dimensions of the Bubble. This is precisely the motivation behind our weekly focus on the myriad of lenders and financial players. As we have witnessed, the U.S. financial sector has gone to great links to sustain the Bubble, acting aggressively to maintain their dominant positions. While not surprising, this is nonetheless a very dangerous game with tremendous ramifications for financial fragility. Credit Bubble analysis holds that systemic risk expands exponentially during the "terminal stage of credit excess." Clearly, the American consumer, the U.S. financial sector and economy would be in a much less precarious position today had it retrenched after the bursting of the tech bubble. Instead, even greater excesses were perpetrated.

And, as history has proven time and again, lenders do have a propensity to respond to initial credit problems with even more aggressive lending - in rarely successful efforts to grow their way out of trouble. When the Savings and Loans found themselves in dire straits in the late 70's early 80's, many (with the government's blessing) made a fateful assault on commercial and real estate lending, as well as other escapades that ended (not surprisingly) in financial disaster. In the process, however, they did help fuel one heck of a real estate boom during the late 1980's. The consequence was an exponential rise in the cost of the S&L bailout, along with other bank problems and an impaired financial system. The most important lesson not learned from the S&L debacle was that it is better to recognize and mitigate credit problems early.

There are few businesses that offer the growth potential of lending to risky credits. Such borrowers are always a captive audience, quick with an enthusiastic response to newfound credit availability. They are not "price sensitive," more than willing to pay high rates to attain previously unavailable financing. Besides, they often meet debt service costs through additional borrowings anyway. For lenders, the opportunity to rapidly increase the volume of high-margin loans is just too good to pass up. This is especially the case in a stock market Bubble with investors willing to pay mightily for "earnings growth," while at the same time indifferent to the quality of earnings. Despite all the "New Era" talk of wonderful advanced technologies, the great impetus behind the "Communications Arms Race" was the incredible investment banking fees and lending margins. After all, the high yielding loans created for risky credits are the valuable fodder for "sophisticated" Wall Street "structured finance." It was truly investment bankers' paradise. Paradise, that is, as long as new finance was readily available to keep these borrowers afloat. But massive over lending and speculative excess sowed (as it always does) the seeds of its own destruction. Most unfortunately, after the collapse of this spectacular Bubble the powerful cadre of investment bankers and aggressive lenders simply shifted their attention to the last bastion of risky credits - the American consumer.

Perhaps investors have been so enamored with Internet and technology stocks over the past few years that they have forgotten how the consumer finance Game is played. And while it seems like we've been to this movie before, from the popularity of the consumer lender stocks over the past year it is quite apparent that this is one more lesson forgotten (or somehow never learned). Granted, (just like the telecom sector) as long as new finance is forthcoming everything looks just wonderful and borrowers remain anxious to maintain their status as sound credits. Stock market investors, generally shaken and having lost their bearings, are quick to take the "opportunity"; happy to rid themselves of the dismal prospect of owning shares of companies struggling to profitably produce real products, preferring instead a sector with "Earnings Mo" that is now consistently "Beating Street Estimates." Right on cue, rising stock prices are met with lenders and analysts trumpeting new technologies and sophisticated systems that have created a better mousetrap for risky lending. Huge stock option packages ensure that company management plays along (lend in sufficient quantities to meet/beat analyst's inflated earnings estimates). Meanwhile, investment bankers salivate at the mountain of asset-backed securities created. Some will be sold to investors and speculators, while leaving plenty of high-yield "fodder" for "structured products" after the telecom debt collapse.

During the current lending Bubble, loan volumes are exceptional, accounting earnings growth impressive, and credit problems appearing well under control. But there are several important things to keep in mind: First, aggressive receivable growth masks underlying credit deterioration (delinquency and charge-off ratios are distorted by the rapid growth of new loans that are not yet "seasoned"), while also providing the basis for overstating earnings by taking insufficient provisions for future credit losses. Second, as soon as lending growth slows, loss ratios rise rapidly as defaults from previous aggressive lending "play catch up." Earnings suffer immediately on the back of increased loss provisions and likely charges for "unexpected" credit problems. And third, as credit losses rise and profits falter, investors retreat from the sector (stocks and, more importantly, the asset-backed securities), creating a problematic reduction in credit availability. Then, as witnessed in telecom, faltering liquidity brings the seductive game of "Ponzi Finance" to an abrupt conclusion, ushering in a period of escalating credit losses and financial difficulties. We certainly believe we are at the peak of the consumer debt Bubble, with this earnings season a critical juncture with respect to the perception of underlying fundamentals.

We see that JP Morgan took another billion-dollar write-down of its "private equity" portfolio during the quarter, as non-performing commercial loans increased 28% to $2 billion. At the same time, Morgan has increased credit card lending by 15% over the past year (while charge-offs have jumped 22%). Mortgage loans have jumped 21%. Wells Fargo wrote down the value of its private equity portfolio by $1.16 billion, while record mortgage lending fueled a 10% increase in total loans. Non-interest income jumped by 18%. At Bank of America, the company struggles with $6.2 billion of non-performing loans (up 60% y-o-y), while increasing investment banking revenues by 22% and "trading income" by 14%. Declining commercial loans were made up for with a 13% annualized increase in consumer loans.

SallieMae (USA Education Inc.), the largest acquirer of guaranteed student loans, increased its holdings of student loans at a 13% annualized rate during the quarter. Year over year, total assets are up 30% to $51.2 billion. The company CEO stated, "momentum is strong. I expect our growth to accelerate in subsequent quarters." Company insiders have sold $155 million of stock over the past six months.

During the quarter, aggressive credit card lender Capital One increased its managed loans at a 47% annualized rate to $35.3 billion. With mass mailings and attractive "teaser rates," total loans have increased 61% year over year. The company added 1.7 million new accounts during the quarter bringing its total to an astonishing 38 million. The company has added 11 million new customers the past year. Delinquencies on its managed loan portfolio rose modestly to 4.92% from 4.72%. Of course, management and Wall Street trumpet the relatively low delinquency and charge-off rates, but don't let them fool you. Losses will rise rapidly as soon as growth slows. Company management has sold $280 million of stock in the last six months, a truly unbelievable transfer of wealth.

Subprime credit card lender Providian saw total managed loans increase 39% to $30.5 billion. The loss rate jumped this quarter to a troubling 10.29%, from last quarter's 9.34%. Write-offs of $754.2 million compare to last year's $419.5 million. This company now runs a significant risk of having credit losses spin out of control, a particularly alarming situation considering the size of its portfolio. Providian now has 17.7 million customers (an increase of 27% this year) and is expected to add three million new accounts this year. Subprime lender Metris Companies, with its 4.6 million customers, saw its managed receivables expand 29% year over year to $10.1 billion. Its charge-off rate increased 30 basis points to 10.9%. Clearly, these credit card companies have already pushed the envelope for receivable growth.

While it did not garner much attention, I am of the view that American Express's announcement of an $826 million write-down of its high-yield investment portfolio is a very significant Credit Bubble development. We have, of course, written often of our expectation of considerable problems in the area of "structured finance." And with $500 billion outstanding ($411 billion issued during the past three years!), we have mentioned collateralized debt obligations (CDOs) as an area of acute vulnerability. While they are rather lengthy, I am including remarks from American Express management that address some very critical issues and signals what we view as a likely sea-change in the marketplace for risk and sophisticated Wall Street "structured" products.

"AEFA (American Express Financial Advisors) has invested in high-yield securities for about 15 years. In the 1997/1998 time frame, AEFA began investing in structured investments such as collateralized debt obligations (CDOs) and structured loan trusts (SLTs) and increased their holdings in high-yield securities as a percent of their overall investment portfolio to between 10 and 12%. Now the structured investments represent ownership interest in an underlying pool of high-yield bonds and loans. AEFA's holdings of these include products they manufactured and sold to institutional investors - however it also includes products we had purchased from third parties. At the end of the first quarter of this year, the total high-yield portfolio amounted to approximately $3.5 billion, or 11% of total investments. It included approximately $90 million of CDO residuals, $400 million of low-grade CDOs, and $3 billion of directly owned bonds. In addition, the AEFA portfolio also included approximately $900 million of high-grade CDOs and $745 million of investment grade structured loan trusts.

It has now become clear that in 1997 when we began to significantly increase our holdings of high-yield investments - mostly through structured instruments - we took on securities that did not have the appropriate balance for us between risk and reward. So why were these investments made? Well, most of the structured investments were purchased as long-term investments in 1988 when the default rates were at historically low levels. AEFA entered into these structured investments at a time of a bull market and, as you know, a very robust economy. Given the favorable loss experience we had in high yield investments in prior years and the positive spread versus investment grade securities, this type of investment seemed to make sense. Also, many of AEFA's structured investments were in investment grade, so they thought they had a reasonable level of protection against loss.

It is also now apparent that our analysis of the portfolio at the end of the first quarter did not fully comprehend the risk underlying these structured investments during a period of persistently high default rates. You might ask why not. Well in 2000 we saw an increase in default rates and recorded $123 million of losses related to our high yield investments, primarily in the fourth quarter of last year. Performance deteriorated further. In the first quarter of this year, and as a result, we recognized a related charge of $182 million at AEFA. At that time, we believed there would not be any further significant losses this year. Subsequent events proved us wrong. During the second quarter we saw a sharp increase in defaults to historically high levels throughout the high yield sector. For purposes of evaluating our portfolio this quarter, we are now assuming current high levels of default will continue for the remainder of 2001 and through the end of next year. As a result of these increased defaults, we recognized a small amount of additional losses on the directly owned high yield bonds in our portfolio.

However, more impactful was the deterioration within our holdings of CDOs which was higher than we had anticipated. As defaults of the high-yield market continued to rise, the cash flows available in CDO structures diminished significantly. As a result, there is a lower likelihood of receiving expected payments on many of our CDO residuals and below investment grade CDOs. However, because the overall deterioration in the market was more severe than we expected, we also saw erosion in the investment grade CDO tranches that we hold.

The bulk of the deterioration that took place in AEFA's investment portfolio during the second quarter fell within these structured investment categories. Because expected proceeds from the underlying portfolios are becoming insufficient to pay holders of the residual and more junior tranches, the risk exposure in our mid-range rated, or mezzanine tranches, has increased dramatically. In many cases we are now the original position of the CDO residual holders, first in line to absorb any further losses from the underlying pool of investments. Based on our revised assumptions for future default rates, our estimates now indicate that we will not receive full payment of interest and principle on some of these investments, although the more highly rated - or senior tranches - of our CDO holdings have continued to perform well. As a result of the unexpectedly high default rates, and their apparent impact on the risk profile of our structured investments, we initiated a comprehensive review of these investments during the quarter. In addition to looking at individual credits, we ran computer simulations on the structured investments. These reviews helped to determine possible future losses on different economic and market conditions. Following the recent completion of this review, we concluded that structured investments that had been relatively high quality now carry a much greater level of risk and the current risk/reward balance in our portfolio we believe is inappropriate for us.

Accordingly, we are making a significant change in our investment portfolio to rebalance it toward higher quality, less volatile holdings. Our analysis indicates that the economic benefit of continuing to own some of the high yield investments in our portfolio is not sufficient to compensate for their underlying risk during difficult market cycles. And we are taking a substantial charge to recognize in the second quarter the impact of our higher default assumptions on rated structured investments. As I said earlier, we now believe the high level of defaults will continue through next year. This action represents approximately $403 million of the charge. And to further lower our risk profile by selling lower rated securities, to reduce the level of our high-yield portfolio and to make additional sales within the remaining high-yield portfolio, to allocate investments toward stronger credits and to reduce the concentration of exposure to individual companies or industry sectors, these actions represent approximately $344 million of the charge. And also, we want to write down the value of certain other investments to recognize losses incurred during the second quarter. This action represents approximately $79 million of the charge…we will no longer purchase CDOs from third parties for our portfolio."

American Express management now admits to "not fully comprehending the risk of complex securities." In this regard, we suspect they have much company. Considering this development, I would like to delve further into the some of the "structure" of "structured finance." First, let's look at a couple definitions. From JPMorgan: A CDO (collateralized debt obligation) is "a securitization of corporate bonds, bank loans, ABS (asset-backed securities), RMBS (residential mortgage-backed securities), CMBS (commercial mortgage-backed securities), or almost any non-consumer obligation. Refers to the special purpose vehicle (SPV) that holds the asset portfolio and issues liabilities…" From Bloomberg: A CDO is "a structured debt security backed by a portfolio consisting of the following: secured or unsecured senior or junior bonds issued by a variety of corporate or sovereign obligors. Secured or unsecured loans made to a variety of corporate commercial and industrial loan customers of one or more lending banks." These vehicles also purchase emerging market debt, various derivative products (especially credit instruments), credit-linked notes, and even other CDO securities.

As mentioned above, there have been almost one half trillion dollars of CDO issued, 80% coming into existence over the past three years. Issuance averaged $137 billion annually between 1998 and 2000, with 1996 the first year when issuance surpassed $4 billion. Year-to-date, about $45 billion have been issued, with high-yield bonds and loans comprising 49% of collateral, investment grade bonds and loans 32%, and ABS/MBS/CMBS 18%. CDOs pool various types of collateral, and then issue multiple classes of debt and equity that are "tranched" by the degree of protection ("seniority") the structure provides in respect to the pool's underlying cash flows. "Lower" (subordinated) tranches protect the "higher" (senior) tranches against pool credit losses.

It may be helpful to look at a recent CDO deal. Bank of America was lead underwriter for a $410 million deal named Landmark CLO (collateralized Loan Obligation) managed by Aladdin Capital Managers. This vehicle is structured with 5 tranches, the senior "A" through subordinated "D" and "Equity." The "A" tranch is the largest, comprised of $314 million of debt securities rated triple-A by Moody's. The "A" tranch is protected by the $20 million "B" tranch, the $26 million "C", $19 million "D" and the $31 million "Equity" tranch. Underlying pool credit losses are first absorbed by the "Equity" tranch, and then move up the food chain as necessary. This deal was priced with the "A" tranch yielding 46 basis points over LIBOR. The "D" tranch, protected only by the $31 million "Equity" tranch, provided speculative yields 625 basis points over LIBOR.

These types of structures have been extremely popular for several reasons. For one, they are structured to provide the "Equity" tranch the potential for huge returns as long as losses come in as expected. Many lenders and asset managers have created CDO structures specifically to speculate for these leveraged returns. Imagine a $100 million pool of risky credits yielding 10%. For our example, a CDO is structured with three tranches, a $60 million "triple-A-rated" "A" tranch yielding 8%, a $30 million below investment grade "B" tranch yielding 12%, and a $10 million "Equity" residual tranch. If there are no defaults, the $10 million pool cash inflow received by the CDO ($100 million of assets yielding 10%) will first pay interest of $8.4 million ($4.8 million to "A"- $60 million at 8%; and $3.6 million to "B" - $30 million at 12%), with the "Equity" tranch enjoying the residual $1.6 million (16% return on $10 million "equity"). Obviously, the "Equity" and below investment grade tranch returns look extremely appealing during the halcyon days of a bull market. But now lets assume the bursting tech Bubble ushers in a rash of defaults. If 10% of pool assets default the first year (a very reasonable assumption in this environment), only $600,000 ($9 million of interest received less $8.4 million interest paid) is available to the "Equity" tranch. Then, if another 10% default the next year, the $8 million pool cash inflow becomes insufficient to cover interest payments to the "B" subordinated tranch. The "Equity" tranch is destroyed, the "B" tranch becomes severely impaired, and the highly rated "A" tranch suddenly becomes vulnerable to continued defaults. Hopefully this example illuminates how volatile the underlying subordinated tranches become to rising default rates. As American Express has admitted, there have been enormous and worsening losses in these structures and a wholesale reduction in the quality of CDO assets.

Last week's Bulletin discussed how derivatives have played a major role in increasing the availability of credit to risky borrowers, a paramount issue for the U.S. Bubble economy and financial system. The same analysis applies generally for the entire area of "structured finance." Investment bankers absolutely adore CDO vehicles, as they have been major buyers of risky loans and securities over the past few years. As my above example illustrates, $100 million of risky loans are "transformed" through financial alchemy into $60 million of easily sold "safe" securities and $40 million of enticing product for those seeking high yields. But are such untested structures viable in less hospitable environments? We don't think so. Certainly, American Express management has admitted to being blindsided by the risks involved, no longer wanting to play. Increasingly, we expect many residual/"Equity" and subordinated tranches to take on the characteristics of "toxic waste," with perhaps even investment grade tranches under closer scrutiny. Many institutions will certainly now avoid such vehicles. And, importantly, with the demand for new subordinated and equity tranches disappearing, we would expect the ability to sell new CDO structures will be substantially diminished. If this proves to be the case, this will have a major impact on credit availability for risky borrowers, something that is clearly already well underway throughout the telecom and commercial loan area. This could as well prove a major development for the marketability of risky consumer loans going forward.

It is also critical to consider the ramifications of a faltering market in CDO and other structured products for the financial sector and "leveraged speculating community" generally. Clearly, huge losses have been suffered in technology stocks, telecom and junk debt, credit derivatives and now subordinated CDO tranches and other structured vehicles. U.S. branches of foreign banks are also major players in this market (as well as Cayman Island based institutions), so there are also likely associated issues with respect to currency swaps and potential dollar vulnerability. As with American Express, it is beginning to be recognized within the financial community that there are serious structural problems that are not going to be rectified anytime soon (despite the Fed!). Many will similarly seek to dump risky securities, reduce risk, and work to hunker down for difficult times. The illiquid CDO market is especially problematic, with most players having no alternative but to hold and hope. The insurmountable problem is that truly unprecedented risk has been created during the past few years of reckless lending that is not going to disappear, despite the certainty of rising individual and institutional risk aversion. This is why we are now on alert for derivative problems, contagion effects, and faltering system liquidity. As we have always stated, when the leveraged speculators move to reduce risk, there's going to be trouble. It appears that this process has commenced.

Last week I addressed the issue of derivatives with respect to the unfolding Argentine financial crisis. Many believe that Argentine problems are mainly a domestic debt issue, with limited ramifications for U.S. or global markets. I sense this view is much too complacent, with it actually bringing back memories of Wall Street dismissing Russian turmoil prior to the severe U.S. financial crisis in 1998. While the government grapples with its funding problems, Argentine companies are now struggling with $11.6 billion of debt coming due this year. Borrowing costs have exploded and liquidity has evaporated. Yesterday Fitch downgraded a group of mortgage-backed securities comprised of Argentine loans denominated in U.S. dollars (including BHN III Mortgage Trust, BACS Mortgage Trust). The subordinated tranches of these vehicles, in particular, are now acutely vulnerable to a currency devaluation and Argentina liquidity crisis. There are a myriad of structured products that will be impaired in the event of a currency devaluation, as well a long list of Latin American companies that would be instantly insolvent. And from news reports, we read that companies throughout the region are seeking hedging protection. While it is impossible to know with certainty, there are reasons to presume that there is enormous and growing derivative exposure, with significant financial ramifications in the event of Argentina peso devaluation. At the same time, with the Argentine economy now strangled for financing and increasingly vulnerable, it appears that the risk of devaluation and possible default is certainly not insignificant. This then today becomes a critical issue specifically because the major U.S.-based derivative players appear already increasingly impaired from domestic credit problems. There is little "wiggle room" to absorb losses.

The possibility of currency devaluation is particularly problematic for the derivative community (which rely on dynamic hedging programs), as it opens up the distinct possibility of a discontinuous market event - a significant and instantaneous market decline that does not afford the opportunity to put in place requisite hedges. With this distinct possibility, they would today quite reasonably be compelled to institute hedging programs that entail shorting securities to establish positions that would create the necessary cash flows in the event of devaluation. This, however, becomes destabilizing in itself, as this type of selling today only creates a self-feeding cycle of sinking security prices, problematic higher interest rates, additional hedging, faltering liquidity, and deepening financial and economic crisis. Despite talk to the contrary, at this point it does appear to have all the potential to develop into a financial "death spiral." Perhaps devaluation can be forestalled, but our sense is that the ramifications of such a crisis are not fully appreciated in the context of an acutely vulnerable U.S. financial sector. Stress within the U.S. and global financial system continues to gain momentum by the week, as does the vulnerability to a financial accident. I have argued in the past that "as goes 'structured finance', so goes the dollar." We may find out soon enough if such analysis has much validity.

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