Undoubtedly everyone has heard of the Subprime crisis and the credit
market issues that have developed in late July and early August. Let’s look at
the events that unfolded and discuss where we go from here.
Reports surface that two Bears Stearns hedge funds are in trouble and
may face liquidation.
The hedge funds file for bankruptcy protection on July 31st
in the
BNP Paribas announces profits that beat expectations and said their
exposure to the Subprime market was minimal. As the owner of BancWest, it said its total portfolio exposure to Subprime
was 2%.
BNP Paribas announces two funds with an asset base of €2.35 billion ($3.23 billion) are frozen from redemption because of
the CDO crises.
The European Central Bank (ECB) responds with an injection of €95 billion ($1.31 billion) into the banking system
to ease liquidity concerns. This is the largest injection in the ECB’s history,
surpassing even the €69 Billion after September
11. This was to ensure credit markets functioned properly as the sharp rise the
rate banks charged each other to lend overnight increased.
The credit spillover hits US markets which promptly sell off. The DJIA
is down almost 400 points on this news and the fear of the unknown in the CDO
credit market. No one wants to buy CDO’s. No one wants to buy any commercial
paper. Treasuries become the de facto choice as investors clamor for safety.
Two Treasuries fall 22 basis points to yield 4.44 percent.
The Federal Funds rate still trades at about 6.5 percent, well above the
target of 5.25 percent. Banks are very hesitant to lend to one another for fear
of unknown value of underlying collateral creating a liquidity crises and essentially
freezing the credit markets.
ECB injects another €61
billion ($83.5 billion) to continue to add liquidity to the system.
ECB injects another €47.5
billion ($65 billion).
Fed cuts the discount rate from 6.25% to 5.75% to ward off the credit
squeeze taking place. It left the Fed funds rate unchanged at 5.25%. It also
announced it would allow a broader range of collateral and allow borrowing for
longer than traditional periods. This way banks could access the emergency cash
they need from the discount window.
All of these items were started by the subprime investments. Let’s take
a careful look at the all of this.
Wall Street was awash was money from the credit creation over the past
six years and also from the carry trade where many borrowed in
With all these subprime loans – Wall Street needed a way to sell these
loans. They came up with the CDO (Collateralized Debt Obligations) – Take those
risky subprime mortgages and place just enough of them into a pool of
hi-quality mortgages to keep an A rating by independent rating agencies. Give
investors the feeling that they are buying safe debt instruments based on these
independent ratings so that ultra conservative pension funds and other
retirement assets were able to invest in them. Everyone is happy – the borrower
is getting a loan he wouldn’t be otherwise able to get, the Wall Street lender
is packaging those loans and earning money selling them as CDO’s and adding
derivates so they can make even more money, and the funds that are buying these
CDO’s are getting higher yields in what they think is a safe bet.
But then, the housing market changed – investors could not sell their
units, borrowers started defaulting. Suddenly all of these defaults caused
these CDO’s to lose a large percentage of their value. And these funds that
held them were forced to declare their losses. Some funds were leveraged with
borrowed funds and found themselves with no cash after the losses. If a fund
had $100 million in assets but leveraged to buy $300 million in these CDO’s and
now the value of the CDO dropped 50%, the loss to the fund was $150 million –
meaning that the original fund not only lost the original investment, but an
additional $50 million.
With the fear of the unknown, no buyers stepped in to buy these CDO’s in
early August and threatened to bring down our financial system. To keep liquid,
many funds needed to sell assets. They ended up selling their most liquid
assets such as high quality stocks and high quality Treasuries. Corporate,
agency, and municipal bonds were much less attractive, with investors demanding
higher yields for the increased risks. However,
investors stopped trading many debt instruments as they were unsure how to
price them. This spillover effectively froze the credit markets for several
days. Countrywide was not able to sell their portfolio of jumbo mortgages and
suffered a liquidity crisis (as did other jumbo lenders) and rates for jumbo
rose significantly.
Most recently the credit markets have started trade more normally and
the fear on Wall Street has been replaced by gentle optimism that the world
economy is strong and will assist the
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