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Let's take a look at what happens when guarantors go bust through the eyes of CIBC, a large Canadian bank.

Canadian Imperial Bank of Commerce CIBC has a big skeleton in its vault.

CIBC's lightly guarded secret is the name of a "U.S. financial guarantor" that faces a possible downgrade on its A credit rating and is "not necessarily rated by both Moody's & S&P."

The company's identity matters because the bank said these hedged CDOs were worth just $1.76 billion at Oct. 31, down almost half from their face amount. If the guarantor goes poof, CIBC loses its hedge on these derivative contracts. And the Toronto-based bank would have to recognize the loss, which is growing. Should the masked insurer fail, CIBC would have to bring the CDOs' full face amounts onto its balance sheet and record losses for any declines in their fair value.

It's unclear why CIBC thought it made sense to have a small A-rated insurer guarantee a third of its AAA-rated "super senior" CDO holdings. This would be like paying your middle class friend to insure your 100-foot yacht. Perhaps it just wanted to say it was hedged, and didn't think about needing to file a claim someday.
What Happens If Guarantors Go Bust?

Perceptive minds will note that I am not really discussing CIBC here. Rather I am discussing what happens when guarantees are worthless. Does anyone even know who the guarantors really are?

This reminds me of a candid Email From Bernanke I received about a year ago. Following is a snip of that email from Bernanke.
Speaking on behalf of all the Fed members we thought it was time to honestly address the situation the country is facing. This is part of our new policy to be as candid and honest as possible. Quite frankly we are frightened by the rapid falloff in housing permits, the rise in jobless claims, the rise in inventories, and the slowdown in consumer spending. It now appears the landing is not going to be soft and it is also doubtful the financial markets are fully prepared for it.

This slowdown in jobs and wages could not have come at a worse time because consumers are cash strapped already. ... We are also frightened by the massive speculation in the financial markets with stock buybacks, mergers, leveraged buyouts, and trillions of dollars in derivatives floating around some of which we do not even know who the ultimate guarantor is. We are hoping but do not know that the ultimate guarantor of these derivatives is not Madame Merriweather's Mud Hut in Malaysia.
Yes, that was a spoof (Bernanke did not really Email me!) but please read it and see how much has played out.

Restoring Market Liquidity in a Financial Crisis

With the above in mind, let's tune into a Fed speech today at The Second New York Fed — Princeton Liquidity Conference. Here are a few key snips:
As market participants have adjusted to what has been a very acute change in expectations about economic and credit risk, they have become more cautious in how they use their liquidity and capital. ... The danger this poses is the risk of an adverse, self-reinforcing dynamic in which concerns about overall liquidity magnify concerns about credit problems. ... Central banks have been employing a range of different tools to help reduce the incentive for an excessive level of liquidity hoarding by banks that might impede an efficient flow of liquidity among banks.

The Term Auction Facility gives us a tool that lies somewhere between our open market operations and our primary credit program. It provides a mechanism for expanding the range of collateral against which we provide funds to the market—in effect to change the composition of our balance sheet—in ways we cannot do through traditional open market operations.

....The auction facility and other measures we have taken to address market liquidity problems do not directly address the balance sheet or capital constraints facing financial institutions. Nor can they be expected directly to reduce the perceived risk in exposure to other financial counterparties.
Self-reinforcing Liquidity Hoarding

That speech is rather interesting. Combining two distinct ideas into a single sound bite, the theme that stuck most out in my mind was about "self-reinforcing liquidity hoarding".

That is what the Fed is facing and it seems like they know it. However, they do not seem sure what to do about it. They do not want to use all their interest rate cuts before they even admit we are in a recession. Don't let GDP fool you. We are in a recession now. However denial runs deep as do speculative habits of market participants.

Even though the stock market is in a bubble (yes it really is based on forward earning estimates that are going to crash), the only tool the Fed has is cutting interest rates to encourage still more reckless speculation. Recall that the housing bubble we are in is a direct result of the Fed trying to smooth over the last recession.

The end of the line comes when consumers are unwilling or unable to borrow or banks are unwilling or unable to lend. No matter which comes first, the reversal once started soon becomes a "self-reinforcing" trend.

Why is This?
  • Consumer psychology changes. Consumers are unwilling to chase housing prices higher.
  • Foreclosures rise.
  • In the face of massive writeoffs, banks restrict lending.
  • In the face of falling demand, corporations start laying people off.
  • In the face of layoffs, consumers hold off on purchases.
  • In the face of all of the above prices of goods and services drop.
  • Credit is hoarded.
  • Banks do not trust each other.
We are only in the initial phases of this economic downturn cycle, led by housing. However, this is not about subprime lending or even housing in general. Nor is this a mid-cycle correction.

This is the tip top peak of a secular spending spree fueled by housing, LBOs, commercial real estate, unsound stock buyback programs, and expansion of credit on sillier and sillier terms. The expansion continues until the patient dies of exhaustion, which is where we are now.

Note the Fed's admission that they can "not directly address the balance sheet or capital constraints facing financial institutions" nor can they "directly reduce the perceived risk in exposure to other financial counterparties". Those are arguably the only candid statements of fact the Fed has made in years, but ironically enough, they are the only Fed statements that everyone refuses to believe.

Source: What Happens if Guarantors Go Bust?