Leveraged debt and the current debt crisis

Credit default market . NY Times.

Image from NY Times article, Arcane Market Is Next to Face Big Credit Test, an article which is getting huge circulation among financial blogs as it is makes public to the world at large what the financial blogs have been saying for months, that the coming debt crunch could make subprime seem small.

Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.

Sudden Debt has a clear explanation of this impending debt market crisis.

The investment bank factories synthesized a whole array of artificial goods, ultimately far removed from the income streams of the underlying assets:

1. CDOs and CLOs, i.e. tranched bonds made up of loan packages.
2. CDSs on the above bonds, i.e. credit insurance policies.
3. Hybrid and synthetic CDOs, i.e. bonds made up of the above CDSs.
4. SIVs that issued their own ABCP in order to buy and hold the above “goods”.
5. CPDOs that were structured to own CDS income streams.

… and more…

The alphabet soup seems thick and opaque, but don’t let the jargon confuse you. Here is the crucial point: almost all of these “securities” were unfunded debt, i.e. money equivalents created from thin air. All they did was to generate more and more “buying power” to boost asset prices higher, from houses in the Inland Empire of California to share prices in New York, London and Shanghai. In case it is still unclear: it was margin debt.

If you are familiar with buying stocks or commodities on margin, you can immediately appreciate what went on, and why all current attempts to avert a wider crisis will fail miserably for as long as the focus is on the symptoms, instead of the underlying illness. Margin debt cannot be “restructured” with falling asset prices. Period.

In other words, this entire pyramid of bizarre financial instruments was created and paid for with borrowed money. A hedge fund borrows ten million to create CDOs, which they then use as collateral to borrow more money to create even more debt instruments. Some hedge funds and investments can be leveraged 30 to 1 or more on this. That means they’ve bought $30 worth of securities on credit for every actual dollar they have. So, just a few mild breezes could easily knock such a house of cards down. Especially when some of what they bought is now worthless or selling for pennies on the dollar assuming a buyer could be found.

But with margin money, the clock is ticking. If the asset value drops below a predetermined level, the borrower is then forced to sell whatever they can to pay back all or part of the loans and can not hold in hopes of the price coming back.

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