The Real Cause of the Credit Freeze?

[audreyh1]

Banks are hoarding cash in expectation of pay-outs on up to $400bn of defaulted credit derivatives linked to Lehman Brothers and other institutions, according to analysts and -dealers.

FT.com / Home UK / UK - Banks prepare for CDS pay-outs

So is that why there has been so much cash hoarding by banks and refusal to lend to creditworthy customers for normal business operations?

The big Lehman CDS auction is tomorrow. That might explain this week of vicious stock selloffs and the super negative market futures right now.
The Big Picture | $400 Billion Lehman CDS Unwind?

Comments? I'm out of my depth on this stuff.

Audrey

P.S. 9/15/08 is the day Lehman went bankrupt. Less that two weeks after that was when Bernanke and Paulson went to Congress and said "Oh $h!t" when two or so weeks before they had said "we're fine".

 

[socca]

The uncertainty regarding the ultimate extent of CDS liability, and how these liabilities will be bourne by the existing financial system, are undoubtedly contributing to the market turmoil.

It looks to me like we need to build a new, parallel financial system from the ground up - a financial system free of derivatives liability. Institutions could perform their usual transactions in the new financial system using their normal transaction risk estimates; i.e., risk estimates free of derivatives liability concerns.

However, gov't bureaucrats are notorious for their lack of imagination, and the current crop of leaders who are trying to 'fix' the existing financial system appear to be no different. They are trying to mutate the existing bad-derivates burdened financial system into a new one free of such burdens. It's not at all clear that this is even possible, though. I detest the thought of American taxpayers taking on trillions of dollars in new debt to perform such a mutation.

A problem with my proposal is how to operate the two financial systems side-by-side during the transition period, and what happens (ultimately) to the old one? These are some interesting questions for economists to ponder.

I'm surprised that world leaders aren't calling for the creation of a new country- and region-independent worldwide reserve currency, since we Americans have demonstrated conclusively that we aren't capable of managing the dollar for the benefit of all. Such a worldwide reserve currency would need a world bank to manage it. I don't even want to think about the political wrangling that would go on behind the scenes to create and manage such a world bank.

We live in interesting times. I wish they were less interesting.

 

[al_bundy]

after they fix the CDS system it's here to stay, much better than the insurance company system

 

[socca]

The latest brilliant plan is for taxpayers to purchase equity in selected banks to recapitalize them. This is a non-starter, and illustrates that the Treasury and Fed haven't performed even an elementary root cause analysis of the current situation. Taking part ownership in a business with unknown - and potentially enormous - liabilities is just plain stupid. Executives will inevitably come back and ask the business owners (investors) for more capital down the road to help cover their losses. We've already seen this with AIG.

Does having the taxpayer as part owner of a business suddenly make that business a good credit risk? Only if there is an implicit understanding that the taxpayer will do whatever is necessary to keep the business afloat. It is unacceptable for taxpayers to be required to cover trillions of dollars of Wall Street gambling debts. What is more frightening, it may simply be impossible for taxpayers to do this if the liability numbers are as large as some people fear. The worldwide market selloffs may reflect this fear.

The Fed and Treasury shouldn't be proposing solutions to a problem the extent of which they have not yet fully grasped. When the problem is completely understood, it may be obvious that creating a new, parallel financial system would far easier and far more just than trying to patch the old one. Furthermore, speaking as an engineer, building a new financial system would be a lot more fun.

 

[al_bundy]

a lot of respected economists are saying to do this or we face a total collapse of the banking system

at this point the only way to fix things is to nationalize the banks, take the bad debts off the books, throw moral hazzard out the window for now

 

[Frugality_of_Apathy]

A lot of economists are also saying the economy will be far worse with this plan.
http://faculty.chicagogsb.edu/john.cochrane/research/Papers/mortgage_protest.htm

If a bank is privately owned and goes bankrupt it is bad the owners and investors of that bank. You think it will be better if the entire country is saddled with the mistakes of poorly run banks rather than just those that ran and invested in them?

A Bank can go bankrupt and close it's doors if it fails then open a new bank some other time. The United States cannot close up shop and start a new country if it fails.

 

[al_bundy]

the current credit seize is because everyone thought lehman was too big to fail after bear stearns. now that lehman failed along with it's $400 - $600 billion in bonds no one wants to lend to anyone and this worsens the situation due to the risk of cascading failures.

governments can take over banks, chop them up and sell the pieces and make sure the debt will still be paid off or sell the debt along with the pieces. this will put confidence back that if you lend joe's bank money you won't lose it and interbank lending will resume.

 

[audreyh1]

I definitely think there is a direct causal link between the credit freeze and the Lehman bankruptcy.

There was a significant improvement in the overnight Libor rate today, so that is a good sign for credit easing.

Lets see after the end of the Lehman auction today (2 p.m. eastern time) if things settle down a lot more. One big unknown (how much banks are on the hook) will be known. That usually goes a long way to helping calm things down.

Audrey

 

[REWahoo]

Lets see after the end of the Lehman auction today (2 p.m. eastern time) if things settle down a lot more. One big unknown (how much banks are on the hook) will be known. That usually goes a long way to helping calm things down.

Lehman auction implies holders to get 10 cents on dollar

LONDON (MarketWatch) -- Initial results from the Lehman Brothers credit-default swap auction indicate a midpoint of 9.75 -- implying the recovery rate on Lehman's senior debt is about 10 cents on the dollar.

 

[audreyh1]

Yeah - I got that news already. But they don't know the final answer until 2 p.m.

Audrey

 

[BarbaraAnne]

This video by Jim Jubak really helped me understand what is going on.
("Is This The End of the Financial World")

America in financial crisis - MSN Money Video

 

[audreyh1]

OK - the price was 8.625 cents on the dollar - lower than expected.

So any financial institution who sold credit default protection against Lehman Brothers will have to pay out 91.375 cents on the dollar in CASH.

This is the biggest payout ever. That has been part of the big selloff - due to the credit freeze financial institutions without access to borrow directly from the Fed (such as hedge funds or mutual funds) have not been able to borrow money to cover the commitment, so they've had to sell assets like crazy to raise cash.

Reference: http://www.bloomberg.com/apps/news?pid=20601087&sid=aLkOZnNcDmSQ&refer=home

Audrey

 

[ziggy29]

I'm getting ready for the Vaseline in about 27 minutes.

 

[Marquette]

I'm getting ready for the Vaseline in about 27 minutes.

I'm predicting S&P market close at 750... wait, 780, I don't want to scare myself too much.

edit: I've been refreshing for fun and it just doesn't want to break that 850

 

[ziggy29]

I'm predicting S&P market close at 750... wait, 780, I don't want to scare myself too much.

edit: I've been refreshing for fun and it just doesn't want to break that 850

It's not the last hour yet.

Last hour + Friday + long weekend = grab your ankles and kiss your assets goodbye.

 

[Gone4Good]

It looks to me like we need to build a new, parallel financial system from the ground up - a financial system free of derivatives liability.

A financial system without derivatives, hmmmm.

Calls are derivatives. So are callable bonds. So are forward commodity contracts. As are interest rate swaps. And . . .

 

[2B]

I called the bottom today before the open. I don't want anyone to forget that unless I'm wrong and then I'll call for Monday to be the bottom.

I'm going one day at a time. We were only down around 1%. Based on recent history that's a major rally.

 

[audreyh1]

Hey, NASDAQ closed positive! AAPL was up $8!!

Audrey

 

[Independent]

OK - the price was 8.625 cents on the dollar - lower than expected.

So any financial institution who sold credit default protection against Lehman Brothers will have to pay out 91.375 cents on the dollar in CASH.

This is the biggest payout ever. That has been part of the big selloff - due to the credit freeze financial institutions without access to borrow directly from the Fed (such as hedge funds or mutual funds) have not been able to borrow money to cover the commitment, so they've had to sell assets like crazy to raise cash.

Reference: Bloomberg.com: Worldwide

Audrey

I'm trying to catch up here. If the sellers have to pay cash, then the buyers get the cash. We go from a situation where the sellers were selling assets to get cash to one where the buyers have cash that needs to be invested somewhere.

So it seems to me that the auction is a "good thing" in terms of clearing the air and letting people get on with business. Is that right?

 

[audreyh1]

Hey!!!! Imagine that! I think you might be on to something there!

Audrey

 

[socca]

A financial system without derivatives, hmmmm. Calls are derivatives. So are callable bonds. So are forward commodity contracts. As are interest rate swaps. And . . .

OK, to be more exact, without the type of unregulated derivatives that got us into this mess. The details of what to permit/exclude and how to regulate what is permitted can be left to the experts.

The bailout/rescue mental model looks hopeless to me until the Fed/Treasury can (1) accurately quantify total taxpayer liability for the 'toxic assets', and (2) convince investors that we can and should actually bear this liability.

The dual financial system mental model (one 'clean', one 'dirty') appears far superior to me. How would it work, and how would the 'clean' financial system relate to the 'dirty' financial system? Don't ask me - another thing for the experts. Too bad I'm not an economist - it would be a fun project to work on.