Availability of credit in the US

The New York Federal Reserve Board released earlier this week it's Empire State Manufacturing Survey:

Most respondents cited little or no difficulty obtaining financing for either long-term commitments (capital investment) or short-term needs (operating expenses). Moreover, fewer than 10 percent of those surveyed indicated that problems obtaining credit had adversely affected their production or sales.

So credit is available to businesses that can demonstrate a capacity to repay...

Roubini on emerging world capital flows

Reversal of Capital Flows in the Emerging World

RGE Lead Analysts | Mar 18, 2009

"The reversal of capital inflows due to deleveraging or losses in financial markets has been one of the most significant effects of the financial crisis on emerging and frontier economies. After a period in 2007 and 2008 when many emerging markets faced the problem of dealing with extensive capital inflows, now capital flows have reversed. Private capital flows in 2009 are expected to be less than half of their 2007 levels, posing pressure on emerging market currencies, asset markets and economies. Countries that relied on readily available capital to finance their current account deficits are particularly vulnerable. Furthermore, capital outflows pose the risk that governments may react with some type of capital controls or barriers to the exit of foreign investments."

Another unsettling analysis from Brad Setser

A bit more to worry about; foreign demand for long-term Treasuries has faded

He states "I wanted to highlight one trend that I glossed over on Monday, namely that foreign demand for long-term Treasuries has disappeared over the last few months." Then he adds this chart:
If the US Treasury is going to sell a lot of long term debt, it is going to have to find some new buyers(other than the US Fed).

US bankruptcies in 2008

Bankruptcies of 2008 (as reported by Bankrupctydata.com):
AIG (insurance)
Aloha Airlines (airline)
American Color Graphics (newspaper)
Ascendia Brands (retail)
ATA (airline)
Bear Stearns (banking)
Bill Heard Enterprises (auto)
Bluepoint RE (insurance)
Blue Water Holdings (auto)
Boscov’s (retail)
Brooke Corporation (insurance)
Buffets Holdings (restaurants)
Ciena Capital (real estate)
Comfort Co. (bedding)
Dynamic Leisure (travel)
Education Resource Institute (insurance)
Empire Land (real estate)
Eos Airlines (airline)
Fashion House Holdings (retail)
Fortunoff (retail)
Friedman’s Jewelers (retail)
Fred Leighton Holdings (retail)
Fremont General (banking)
Frontier Airlines (airline)
Gainey Corporation (trucking)
Gemini Air Cargo (air delivery/freight)
Goody’s (retail)
Greatwide Logistics (trucking)
Greektown Holdings (casino)
Hospital Partners of America (healthcare)
HRP Myrtle Beach Holdings (entertainment)
Indymac (banking)
Integra Hospital Plano, LLC (healthcare)
Integrity Bancshares, Inc. (banking)
JHT Holdings (trucking/transportation)
Laketown Wharf (real estate)
Land Resource, LLC (real estate)
Landsource (real estate)
Legends Gaming (casino)
Lehman Brothers (banking)
Lillian Vernon (retail)
Linens n’ Things (retail)
Luminent Mortgage Capital (banking)
Kimball Hill (real estate)
Landsource Community Development (real estate)
Matrix Development Corporation (real estate)
Mervyn’s (retail)
Mortgages Ltd. (banking)
Motorcoach Industries International (transportation)
MPF Corp. (transportation)
Mrs. Fields Famous Brands (food services)
Pierre Foods (food services)
Pope & Talbot, Inc. (pulp/wood products)
PRC LLC (business services consulting)
Propext (textiles)
Quebecor World (USA), Inc. (office services/printing)
Red Envelope (retail)
Sharper Image (retail)
Silverjet Airlines (airline)
Sirva (moving services)
Skybus (airline)
STA Restaurants - Bennigan’s (restaurants)
Steakhouse Partners (restaurants)
Steve and Barry’s (retail)
Syntax-Brillian - Olevia (electronics)
Taro Properties (real estate)
Tropicana (casinos)
Vail Plaza Development (real estate)
Value City Department Stores (retail)
VeraSun Energy (alternative energy)
Vicorp (restaurants)
Washington Mutual (banking)
WCI (real estate)
Whitehall Jewelers (jewelry)
Wickes Furniture (retail)
Woodside Group (real estate)
WorldSpace, Inc. (satellite broadcasting)
Ziff Davis (media)

Lifted from Bankruptcies Revisited at a blog by Robert Salomon...

Faulty premise at the heart of credit derivative mathematical model

"In 1997, nobody knew how to calculate default correlations with any precision. Mr. Li's solution drew inspiration from a concept in actuarial science known as the "broken heart": People tend to die faster after the death of a beloved spouse. Some of his colleagues from academia were working on a way to predict this death correlation, something quite useful to companies that sell life insurance and joint annuities."Suddenly I thought that the problem I was trying to solve was exactly like the problem these guys were trying to solve," says Mr. Li. "Default is like the death of a company, so we should model this the same way we model human life."

There are serious problems with this approach. First, the existence of a meaningful analogy between the relationship of a married couple and connections between complex legal/financial structures seems unlikely.

A related post: This is No Longer Funny...by Paul Wilmott.

No Bid

With respect to CDOs, naked capitalism describes them as “so arcane, so complex, and so highly differentiated on so many axes that one is likely to need to have a large number of CDOs trading to capture enough permutations to allow for realistic pricing.” For example, “underlying assets (they can contain any tranche of asset backed securities, other CDOs or even CDOs of CDOs, whole loans, mortgages), degree of credit enhancement (whether via overcollateralization or the use of guarantees), leverage, use of synthetics. As a result, the maturity of the deals vary, and the structures used to achieve the desired credit ratings are all over the map.”

In addition, NC says that “you can't get the deal documents.” Here’s his backup for that assertion: In "Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions," by Joshua Rosner and Joseph Mason (pages 83-4) the authors state that “At present, even financial regulators are hampered by the opacity of over-the-counter CDO and MBS markets, where only “qualified investors” may peruse the deal documents and performance reports. Currently none of the bank regulatory agencies (OCC, Federal Reserve, or FDIC) are deemed “qualified investors.” Even after that designation, however, those regulators must receive permission from each issuer to view their deal performance data and prospectus in order to monitor the sector.”

That is an absurd state of affairs. NC’s logical conclusion is that “if regulators can't get the description of the securities, market participants certainly won't.” No wonder there is little to no bid for these securities. Adding to the confusion is the fact that “many CDOs are "active" or "managed" CDOs, meaning blind pools…That means the investors pony up money before the fund…is formed, and the manager gets to trade it over its three to five year life. No CDO manager is going to disclose his holdings (it would put him at a competitive disadvantage) but how can you value it otherwise?” So many of these CDO’s are essentially opaque mutual funds, not all that different from the garden variety scam where a promoter offers great returns on your money on something like diamond mines in Argentina but you can’t ask what they’re actually doing with your money.

So now that the values of assets making up some CDOs have collapsed, investors want to know what’s in all the other ones they’ve bought into and are discovering how opaque these things really are. So no one wants to buy unless they can see what they’re buying, and if CDO managers aren’t giving in on the disclosure issue no one is going to be making any offers. It would be like buying a used car just from an ad in the newspaper without going to inspect the vehicle at the lot. Now that this has all come to light, situations like the one described at Florida Schools Hit by Fund Freeze are going to appear everywhere. Managers of public funds aren't going to be going anywhere near this type of investment.

A different kind of credit cycle

Back in June, the following comment(slightly edited by me) was posted to a thread at Calculated Risk:

“A tougher market for LBO bonds/CLO's means less bank capacity(investment or commercial?) for additional lending, which means less deals. All this should remind us why this cycle is so different: the marginal dollar of credit is coming from levered lenders with concentrated portfolios and unstable sources of funding, or from "non-natural" buyers such as the hand-over-fist Chinese buying of Agencies. The nature of these creditors is that their provision of credit is a) correlated with one another and b) highly variable.

And yet we continue to compare this cycle to 2001, 1998, 1991, and 1981.

They are as different from today as chalk and cheese. It’s not about assets, it’s about how they are funded. We should prepare to see a different type of credit cycle, perhaps more similar to the "Golden Age" late 1800's downturns we experienced before the advent of regulated financial institutions.” David Pearson | 06.27.07 - 1:44 pm | #

I agree with Pearson’s conclusion that this credit cycle will be different than any in the US since the establishment of the Federal Reserve system. None of the crises that Pearson mentions were brought about by asset overvaluations based on issuance of CDOs. According to the July 2007 issue of Bloomberg magazine, “Worldwide sales of CDOs—which are packages of securities backed by bonds, mortgages and other loans—have soared since 2003, reaching $503 billion last year, a fivefold increase in four years..” One aspect of CDO issuance is that these securities were designed so that illiquidity and low transparency were selling points; i.e. the risk due to those two factors implied that yields would naturally be higher than traditional asset classes. Given that in the post dot com bust recovery most asset classes were providing relatively low yields, the popularity of CDOs is not surprising. Of course, very few were paying much attention to what might happen should these investments run into trouble. People were ignoring the risk side of the risk-return equation.

Pearson comments a couple of days later at Calculated Risk along these lines…

”I believe the opacity is very much by design, and that these securities are a direct analog to Enron's opaque "Special-Purpose Entities". The hedgies need securities which they can "mark to model" (again like Enron) so as to support claims of huge short-term profits from which to take their 20% cut.”

I don’t think there is any question that hedge funds have been a primary target market for securitizers. However, I believe that just about every type of investment vehicle out there has purchased some type of CDO during this boom.

To elaborate on Pearson’s comment above that this credit cycle will be similar to those that occurred pre-Federal Reserve, there is no regulatory agency in the US with the specific ability to manage debt securitization activity. One of the Fed’s purposes was to reduce the volatility of business cycles by regulating the creation of credit. Now that a major portion of credit creation has been occurring outside the control of the Fed, we have seen a massive explosion of credit and are likely to now see a massive implosion of credit.

Commercial real estate appears to be in same quagmire as residential

Calculated Risk has several good posts on this, but today CR pointed out a Bloomberg piece with the following quote:

U.S. commercial real estate prices may fall as much as 15 percent over the next year in the broadest decline since the 2001 recession as rising borrowing costs force property owners to accept less or postpone sales. ``People aren't willing to do deals right now,'' said Howard Michaels, the New York-based chairman of Carlton Advisory Services Inc., ... ``The expectation is that prices will come down.'' Investors in July bought the fewest commercial properties since August 2006 and apartment building acquisitions were down 50 percent from June, data compiled by industry consultants at New York-based Real Capital Analytics Inc. show. ...``There are so many deals falling apart,'' said David Lichtenstein, chief executive officer of Lakewood, New Jersey- based Lightstone Group, an owner of more than 20,000 apartments and 30 million square feet of office and retail space. ``People who can get out are getting out.''

I added some bold highlights...it appears to me that the loosening of lending standards took place in CRE as well as in residential; not a big surprise there. So it makes sense that CRE would be grossly overvalued now that credit is tight. It seems a bit surprising that apartment acquisitions would be down as there are a lot of people who are going to be foreclosed out of or forced to sell their homes and therefore will be looking for rentals.

Asset backed commercial paper and lock-up of market for same

Bloomberg has a story today headlined Banks Have $891 Billion at Risk in CP, Fitch Says in which the authors state that "Some companies that use commercial paper to buy asset-backed securities or collateralized debt obligations backed by subprime mortgages are having trouble finding investors." That shouldn't be a surprise. Given that the valuations of no ABS's or CDO's related to mortgages can be trusted right now, why would anyone want even the shortest term CP related to these as there could be insta-default loans hidden in said CP.

Clearly the issuers of ABS CP do so as a sort of bridge financing while they find long term buyers of the ABS. Personally, I think that the seize-up of the market for this sort of CP is healthy as it will force issuers of ABS to demonstrate plainly that the mortgages they are selling warrant the ratings they receive.

A Genuine Financial Crisis

This has been a bizarre, yet fascinating week. We have seen (so far):

-a genuine run on a bank...Worried about the stability of mortgage giant Countrywide Financial, depositors crowd branches.

Anxious customers jammed the phone lines and website of Countrywide Bank and crowded its branch offices to pull out their savings because of concerns about the financial problems of the mortgage lender that owns the bank.
...
At Countrywide Bank offices, in a scene rare since the U.S. savings-and-loan crisis ended in the early '90s, so many people showed up to take out some or all of their money that in some cases they had to leave their names.

-a liquidity crisis in short term money markets that prompted central banks around the world to take emergency action... ECB Injects €94.8 Billion To Ease Jittery Markets... Bank of Canada Says It Will `Provide Liquidity' to Aid Markets...Fed Enters Market To Tamp Down Rate...

-whipsaw volatility in global stock markets resulting primarily in major declines...

-mortgage lenders going bankrupt...Aegis Mortgage files for Chapter 11 bankruptcy...

"Aegis has described itself as one of the 30 largest U.S. mortgage lenders. It made "prime" and "Alt-A" wholesale loans, and "subprime" retail and wholesale loans to residential borrowers who couldn't qualify for the best rates.

In court papers, Aegis listed more than $100 million of assets, and estimated it owes more than $600 million to creditors. The latter included $178 million of unsecured debt owed to Madeleine LLC, a Cerberus affiliate that has an 80.9 percent equity stake, the papers show"...

-exchange rates move radically...the yen has strengthened quite a bit against the dollar...this suggests that many investors are exiting the "carry trade"...

Ignoring risk and the credit bubble

The linked article is titled "Robert Rodriguez On the 'Absence of Fear'" and describes Mr. Rodriguez's "concept of RISK since there appears to be little concern about risk in the financial markets currently." Per the link, "Rodriguez is CEO of First Pacific Advisors, an $11-billion investment management company located in Los Angeles."

Rodriguez says that

"Two years ago, we noticed a problem developing in our bond portfolios involving Alt-A securities. Despite having average FICO scores of 718 on the underlying loans, these securities experienced rapidly escalating delinquencies and defaults after just nine months. We sold them since we did not want to wait around to find out the reason why this was happening."

Doubtless, his firm had little trouble selling the bonds at the time. He follows up by stating that

"Our worst fears were recently confirmed in a study by First American Financial entitled, "First American Real Estate Solutions Report, Alt-A Credit: The Other Shoe Drops" This report shows the following changes in underwriting standards between 1998 and 2006, with the major changes occurring in the last two or three years:

* ARM % of originations rose from 0.7% to 69.5%
* Negative Amortization rose from 0% to 42.2%
* Interest Only rose from 0.1% to 35.6%
* Silent Seconds rose from 0.1% to 38.7%
* Low Documentation rose from 57% to 79.8%
* FICO scores were essentially unchanged at an average of 706.

What is interesting is that the origination volumes for the last two years, when the most egregious deterioration in underwriting standards occurred, total more than the previous seven years of originations combined. "

There is much more in the linked post...well worth your time. To me, this data just confirms the emerging picture that financially sound homeowners got caught up in the tide of buying larger houses than they could afford, or sucked out all of their equity to spend.

Recent global market activity

I found an interesting quote in a Bloomberg piece this evening regarding Asian markets:

``There are indiscriminate sell orders from panicked investors,'' said Liu Juming, a fund manager at Ta Chong Investment Trust Corp., which manages $1.1 billion of assets. ``The old saying in the investment world that `cash is king' came about because of days like today.''

Referring to US markets, Marketwatch says

"Stocks got crushed Thursday, plunging right out of the gate; and every attempt to buy on the day's dips was met with even stronger waves of selling pressure. Renewed fears about credit risk, this time from across the pond, prompted investors to take a deeper look at the severity of the ongoing subprime problem and the difficulties that diminishing liquidity is having on banks and brokers to accurately value assets...The news out of Europe prompted a 50-basis point jump in Libor (London Interbank Offered Rate) to its highest level in six years and prompted the ECB to inject nearly 95 bln euros ($130 bln) into money markets. The Fed also chimed in by adding $24 bln in banking reserves. Such attempts to temporarily ease the pain of a possible credit crunch, however, were viewed with a glass half empty and merely exacerbated the worst of liquidity fears."

I made a few comments regarding asset valuation at my Hedge Fund Failometer page, specifically in regard to the BNP Paribas events.

The liquidity moves by the ECB and the Fed are intended simply to prevent panicky actions by banks; the extra funds availability will likely be very short-term. Today's situation is precisely what central banks are set up to handle. The extra funding will be pulled back by the central banks once their member banks get a handle on what their true market positions are. With the volatility that we've seen, I see it as humanly impossible for financial institutions to keep up with the market fluctuations. The central bank actions reassure their member banks that funds will be available, so the banks can review their positions without feeling the need to take rash actions.

I don't have a link for a quote, but I recall seeing a comment on a discussion thread suggesting that the spike in LIBOR rates could mean that banks didn't have confidence in their own balance sheets and thus were looking to get capital quickly, which would of course drive up the rates. This clearly prompted the central bank actions. Today would seem to be a red letter day in that we have seen an actual short term credit crunch. It doesn't happen that often.

I just spotted a great quote over at Calculated Risk:

"So, today the monetary base in the North Atlantic economies is 7% higher than it was yesterday--an annualized growth rate of 2100% per year.This is indeed a significant liquidity event...Professor DeLong, August 9, 2007 "

The calculation provided by Dr. DeLong is eye-popping; however as I said previously the extra liquidity will be out there for a short time period only. Clearly the central banks aren't going to add funds every day at the same rate that they did today.

I would definitely check out Calculated Risk's postings today; the posts as a whole pretty much sum up the global economic situation as it stands today.

Here are the NASDAQ charts for the last 5 days and the last 3 months:

As you can see the 5 day chart starts and ends at about the same position, with wild swings in between. This is what I would expect to see when investors realize that their assumptions may be without merit, and so you see a variety of reactions from market participants leading to volatility. I see volatility as indicating that investors as a group have diverse opinions on the direction of the securities making up the market. However, a big chunk of the trading volume is due to algorithm driven computer trades, as Calculated Risk notes in a discussion of how investors using this trading method are faring.

To sum up, we are seeing an inflection point in global markets. Investors of all sizes and outlooks are rethinking their strategies and are experiencing the pain of leverage.

Influence of rating agencies on international debt markets

In "The Global Credit Channel and Monetary Policy" Claus Vistesen raises the issue of the importance of credit rating agencies with respect to the effect of global financial liberalisation on the global economy.

With respect to the rating agencies, I think one of the major problems has been that investors, whether institutional or retail, have been accepting the ratings assigned to securities at face value without really digging into the guts of the ratings reports or doing much independent analysis. In the case of portfolio managers for institutions, this is really a kind of failure to perform their job.

I am sure that a conversation between a investment bank rep and an institutional buyer like the following hypothetical has happened many times:

Banker: I have X billion of automaker Y bonds available; they're going fast!

Institution: Moody's says these bonds are BAA; no problem..I'll take $100 million as fast as you can get them to me. I need the yield...

So I agree that the ratings agencies have been incentivized to shade their ratings to the optimistic side, but as always the rule of "buyer beware" applies. Buyers of issues rated by the three major raters used the reputation of the raters to cover their butts in case of default: "Well, Moody's said it was BAA!"...

With respect to the ratings agencies and sovereign debts, I am not all that sympathetic to the agencies. Both the buy-side and the investment banks wanted the agencies in place to help justify pricing of issues, and governments frequently have touted their ratings. All four groups of entities have had a stake in the system as it currently exists. If the raters downgrade a country's debt, instead of complaining about the raters, it's up to that country's policymakers to convince the market that the rating is incorrect by providing information or policy changes that demonstrate that the country's issues warrant the desired pricing.

The LBO market appears to have seized up

Headlines in the financial press today and recently:

-KKR Banks Fail to Sell $10 Billion of Boots Loans..."Kohlberg Kravis Roberts & Co.'s banks, led by Deutsche Bank AG, failed to sell 5 billion pounds ($10 billion) of senior loans to fund the leveraged buyout of Alliance Boots Plc, two people with direct knowledge of the deal said"...

-Chrysler, Facing Resistance, Abandons Loan Sale Plan..."Chrysler abandoned plans to sell $12 billion of loans to complete its purchase by Cerberus Capital Management LP after investors balked at purchasing the high-yield, high-risk debt, according to investors who were briefed on the decision...Banks led by JPMorgan Chase & Co. will assume $10 billion of that debt"...

-KKR, Blackstone Find `Tide Is Going Out,' Gross Says..."The cheap financing that fueled the leveraged buyout boom is over, according to Bill Gross, manager of the world's largest bond fund"...

-RLPC-Maxeda...The 1.075 billion-euro loan backing the buyout of Dutch retailer Maxeda DIY has been pulled from syndication after failing to clear a European loan market in the throes of a correction, banking sources said on Monday. The deal is Europe's first leveraged loan to be put on ice in the current market correction and was withdrawn from syndication on Friday after concessions failed to generate additional momentum, arrangers ABN AMRO and Citibank told Reuters Loan Pricing Corporation"...

-Bloomberg reports:...

"At least 20 companies have canceled or postponed debt offerings since June 26 as credit markets grow tighter.

The extra yield investors demand to own high-risk, high- yield, or junk-rated corporate bonds has jumped 0.85 percentage points to 3.37 percentage points since the day before Expedia announced its share buyback, according to Merrill Lynch & Co. index data"...

The eminent Bill Gross of PIMCO agrees with me:

"That growing lack of confidence – more so than the defaults of two Bear Stearns hedge funds and the threat of more to come – has frozen future lending and backed up the market for high yield new issues such that it resembles a constipated owl: absolutely nothing is moving."

July 22nd-housing earthquake

Thanks to Seattle Bubble for pointing out that

"New guidelines making it tougher to qualify under interest only mortgage terms begins on July 22nd...In summary: “any mortgage containing an interest-only feature be underwritten at the highest possible interest rate or subsequent amortizing payment, and that any mortgage containing a negative-amortizing feature be underwritten at the highest possible balance and interest-rate adjustment”"

It may take a while for the effects of this to filter through the market, depending on ARM reset dates, but it will surely put severe pressure on home prices nationwide.

US national debt shrank during the first half of 2007

According to a Bloomberg report today,

"the Treasury Department sold less securities from January through June than matured, the first time that has happened since 2000...the fiscal outlook is so good that investors and strategists are beginning to handicap which maturities the government may stop selling or even buy back for the first time in five years."

This is in spite of continued military spending in Iraq. The Bloomberg piece also noted that

"The government has reduced the sizes of its auctions of two-, five- and 10-year notes to avoid letting cash pile up for the past two years. Ten-year notes were cut to $21 billion from $23 billion a quarter in 2005. Five-year notes, sold monthly, were reduced to $13 billion from $15 billion. Quarterly three- year note sales were suspended in May."

Also, "The deficit as a percentage of gross domestic product narrowed to 1.9 percent in 2006 from 3.5 percent in 2004"...

Conveniently, "The drop in supply comes just as international investors, owners of more than half of all Treasuries, slow their purchases. They bought a net $16.2 billion a month on average in the first four months of this year, compared with $28.2 billion a month in 2005."

It would appear that the US economy is experiencing a virtuous cycle. The fact that the US is needing to borrow less at the same time that foreign investors have decided that they wish to loan the US less is striking. Should the US reduce its spending in Iraq over the next year, as it appears likely to do, there should be even more improvement in the budget deficit.

A quick look at who could lose big due to CDO problems

Jim Jubak of MSN wrote Deepening Debt Crisis providing an estimate of who is at risk(my highlights):

"First, the investors who elected to buy the equity tranche (which are the riskiest debts), attracted by the possibility of an equitylike return on a fixed-income investment, get killed...

Hedge funds bought about 10% of equity tranches in 2006, according to Bear Stearns. But pension funds bought more -- 18%. Insurance companies bought even more -- 19%. And asset managers bought even more -- 22%. When pension funds take big losses, parent companies have to make up the loss or workers have to take smaller pensions. When insurance companies take the loss, insurance rates go up. When asset managers take the loss, well, we all cry when we open our monthly mutual-fund statements.

It's hard to get a complete list of who owns equity-tranche CDOs. But some names that come up include the California Public Employees' Retirement System ($140 million), the Teachers Retirement System of Texas ($63 million), French financial giant AXA and the New Mexico State Investment Council ($223 million)"...

CDO and CMO problems: a simple explanation

CDO's and CMO's are in essence nothing more than loans; there's complicated paperwork involved, but at the core there is what I'll call the primary lender and a borrower. Well, the problem these days is that the primary lenders borrowed money to make loans to the end borrowers. The lenders had to put some of their own money in, but most of the cash came from funds borrowed from what I'll call secondary lenders. So far, not all that different from how your neighborhood bank operates. However, these primary loans don't just sit on the primary lenders' books; they trade in similar fashion to stocks and regular bonds. So the value of the loan can go up and down.

Well, the value of a lot of these loans have gone down(because end borrowers are defaulting). The money that the primary lenders borrowed from the secondary lenders to make the primary loans is now a greater amount than the value of the primary loans, whereas when the primary loan was first made it was the same dollar value as the secondary loan.

If the primary loan defaults, then the primary lender doesn't have enough cash to pay back the secondary lender. Then the primary lender has two choices: cough up their own cash, or default themselves. If the primary lender wants to stay in business, they've got to find another secondary lender, or get the first secondary lender to essentially refinance them. If the first secondary lender doesn't think the primary lender is willing or able to come up with the cash and that the primary loans have actually defaulted, they take the collateral (which is the primary loans that were made) away from the primary lender and absorb a loss of the difference between what they loaned to the primary lender and what the end borrower can actually pay back. The primary lender, of course, loses all of its cash that it put into the primary loans.

So in the end, all of the hoo-ha in the financial press is nothing more than a debate about who is going to end up eating the cash losses.

There are deeper issues regarding whether the borrowers and lenders at every level were honest about their financial condition and creditworthiness, and also about self-dealing and graft in the whole process; but those are entirely different matters.

Unwinding of mortgage backed securities positions

Bloomberg is reporting in "Bear Stearns's Attempt to Save Hedge Funds May Falter" this morning that "creditor Merrill Lynch & Co. decided to seize and sell $800 million of bonds held as collateral for loans to the funds"...referring to a couple of funds in trouble due to bad mortage loans...the bigger issue is as Greg Newton describes it here that "what happens when the whole world reprices its CDO and RMBS (residential mortgage-backed securities) [on the] basis [of] forced liquidation"...other commenters raise the same issue, specifically in the Bloomberg article of this morning as follows:

"The real fear has to do with just how many other funds and warehouses could be in trouble,'' said Jeremy Shor, who oversees about $3 billion in asset-backed bonds as a portfolio manager at Brown Brothers Harriman & Co. in New York", and " Asset sales could force the banks to reduce the value of their own investments and loans they made to other funds, said Josh Rosner, managing director at New York-based investment- research firm Graham Fisher & Co."...

The Bloomberg piece also states that

"As defaults rise, bondholders stand to lose as much as $75 billion subprime-mortgage securities, according to an April estimate from Pacific Investment Management Co., manager of the world's largest bond fund. Investors in all mortgage bonds will probably take about $100 billion in losses, according to a March report from Citigroup Inc. bond analysts"...

Also referenced is the bailout "of Long-Term Capital Management LP, which lost $4.6 billion, in 1998, he said. At the time, lenders met and agreed to slowly liquidate the fund's assets to limit the impact of its collapse"...a quick unwinding at any time would likely result in greater repricing to the downside than a more measured, gradual recognition that the mortgage-backed securities and associated derivatives are worth far less than what the owners have them valued on their books currently. Recognizing the $100 billion in losses mentioned above in a short time period would likely cause a lot of fear-driven market activity that might be avoided by the more measured workout.

China and US debt

According to Bloomberg,

"Chinese investors sold more U.S. Treasury securities in April than any time in at least seven years...China sold a net $5.8 billion of Treasuries, the first drop in holdings since October 2005...the nation held $414 billion of the $4.4 trillion of marketable Treasuries in April, according to today's report."

So China holds a little under 10% of marketable Treasuries...I don't see that as being a worrisome fact. As the Bloomberg report notes, "Chinese officials have said they have no intention of doing anything that would devalue their holdings." In fact, as an owner of so much of the float, the Chinese government would have a difficult time getting rid of a major portion of their holdings without pushing prices down significantly. So really you could look at China as an ally of the US Treasury.

The political implications of this are important to consider; in spite of occasional saber-rattling, China and the US need each other to succeed. China is a nation with no history of democratic rule, and until recently primarily negative experience with Western capitalism. The twentieth century was a period of extreme political and economic instability for China, to say the least. So Chinese leaders and the country's people as a group are learning as they go along in managing a capitalist economy. It seems that ideally China would make a political transition like that of South Korea, which has shifted from dictatorship to an electoral democracy.

From the US perspective, China is at least moving toward a more open economic system; unlike Russia, which seems to be reverting to a kleptocratic oligarchy. Given that the US has developed deep economic ties to China, the US has a strong interest in improving its political relations with China.