Wednesday, August 22, 2007

The Chronicles of the Credit Crunch (almost sounds like an advertisement for cereal)

Below are excerpts are from a Market Watch article that gives an abbreviated history of the credit crunch of early August.

Let's review the series of seemingly inconsistent events . . . . during what was supposed to be a quiet stretch on the summer deck.

At the beginning of the summer, when "collateralized debt obligations" and "subprime mortgages" were first introduced into the mainstream vernacular, Treasury Secretary Hank Paulson was quick to assure us that the problems were "contained."

To be fair, Mr. Paulson wasn't alone. In fact, he was in very good company. San Francisco Fed President Janet Yellen, Federal Reserve Chairman Ben Bernanke, Dallas Fed President Richard Fisher and Federal Reserve Governor Fredric Mishkin were unanimous in their assuring voices that we had nothing to fear but fear itself.

Fast forward a few months. That's when things really started getting strange.
The Federal Open Market Committee, the Fed's rate-policy panel, announced on August 7 that while "markets were volatile" and "credit conditions tightened for some households and businesses," the economy "seemed likely to expand at a moderate pace in coming quarters, paced by solid growth in unemployment and incomes and a robust global economy." . . . .

Two days after the FOMC meeting, BNP Paribas, France's largest bank, halted withdrawals from three funds because it couldn't fairly value holdings tied to the stateside subprime mess.

IKB Deutsche Bundesbank confirmed that it was holding special meetings to discuss its "financial situation."

The U.K. issued a statement that its subprime crisis might be worse than the one in the U.S.

Those concerns, on the margin, were disconcerting. But as actions speak louder than words, the sequence of events that followed offered a more telling view that strange things were afoot at the Circle-K.

The European Central Bank, in an "unprecedented response to a sudden demand for cash," injected $130 billion into the financial machination.

The U.S., Japan and Australia also stepped up to the plate with piles of dough, upping the ante to more than $300 billion.

Even Canada -- Canada! -- chimed in to "assure financial-market participants that it will provide liquidity to support the stability of the Canadian financial system and the continued functioning of the financial markets."

The next day, Countrywide Financial, the biggest U.S mortgage lender, said it faced "unprecedented disruptions" in the operations. If investors were waiting for another shoe to drop, was that it?

On Aug. 14, as the price action in the financials continued to falter, UBS, Europe's largest bank, professed that "turbulent markets may cut into profits for the rest of the year."
Santander, the large Spanish bank, offered that it had upward of $3 billion of exposure to high-risk loans in the U.S.

Australian mortgage lender Rams Home Loans Group,
citing "unprecedented disruptions in credit markets," promptly took a 20% overnight haircut.

The ECB and the U.S. continued to pump liquidity into the marketplace as concerns continued to mount.

David Walker, the U.S. comptroller general, proclaimed that the U.S government was on a "burning platform of unsustainable policies with fiscal deficits, chronic health-care underfunding" and "chilling long-term stimulations" as he mapped the parallels between modern-day society and the fall of the Roman Empire.

These are not my words. They come from a nonpartisan figure in charge of the Government Accountability Office, which is often described as the investigative arm of the U.S. Congress.

"I'm trying to sound an alarm and issue a wakeup call," he said in the midst of his 15-year term, which began during the Clinton administration. "The U.S is on a path toward an explosion of debt."

The next session, as fate would have it, was Redemption Day for funds with a 45-day advance-notice redemption window. As the smartest money on the Street, including Goldman Sachs's mighty Alpha fund, took it on the chin, investors were given a chance to leave the dance.

That dynamic, so it's said, will continue to play out in the coming month as the clock ticks and outgoing mail begins to sail.

The next day, Bill Poole, the (soon-to-be-ex-) president of the St. Louis Fed, amazingly offered that the FOMC wouldn't issue a surprise rate cut absent a "financial calamity."
As Countrywide Credit tapped its entire $11.5 billion credit line, forced liquidations found their way across a spectrum of sectors and the mainstay averages approached a 10% correction from the highs, Mr. Poole seemingly tied a bow across the box the Fed now found itself in.

True to the path of maximum frustration, and amid a 300-point decline in the Dow Jones Industrial Average, the market reversed sharply higher and closed near the flat line, catching late-to-the-game pressers leaning the wrong way. Still, the overnight session was an absolute mess, with global markets getting pummeled and tensions rising into options expiration.

And that's when the FOMC, fully aware that the structural machination of August expiration would worsen volatility, pulled the trigger and cut the discount rate, completely contradicting what it said two weeks prior.

The near-term reaction, after a few tenuous downside tries, was seemingly what the panel wanted: higher prices, albeit mutedly so.

On Monday, we learned that Deutsche Bank borrowed money from the FOMC's 5.75% discount window. While the amount wasn't disclosed, sources say that the move was orchestrated to show support for the Fed as it continued to combat the credit squeeze.

As we powered up for trading yesterday, the chief executive of WestLB, one of Germany's largest banks, warned that "foreigners were increasingly loathe to extend credit to financial institutions in Europe's largest economy, which could spark a crisis."

Those comments followed similarly strained sentiments from German lender SachsenLB, which said it required a credit line of $23.2 billion due to investments affected by the U.S subprime-mortgage crisis, and IKB Deutsche Industriebank,
which required a similar bailout.

Germany's finance minister, Peer Steinbrueck, remained optimistic in the face of the news, offering that he saw no signs of the German economy being affected and that he believed "those involved have the situation in hand."

Shortly thereafter, as the U.S market readied for trading, Mr. Paulson, ahead of his closed-door meeting with Fed Chairman Ben Bernanke and Senate Banking Committee Chairman Christopher Dodd, stepped back on stage to assure us that we were enjoying the benefit of a "strong global economy" and a "healthy financial system."

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