Market Turmoil - The Perfect Storm

Here's the latest missive from our very own 'Highly-Placed Professional'.

'You gotta know you're in real trouble when the New York Post starts talking about the inability of investment banks to price their CDO holdings. (The Post says they may be out by as much as 20%, so it's probably far worse than that.)  Ok, so they're some 3 months late with the news, and it's something we market pros have been going over with a fine tooth comb since the Summer, but it tells you that the American tabloids are now shifting focus away from Britney's latest antics to Wall Street's biggest ever crisis of confidence.

The term 'perfect storm' is much over-used, but refers to the simultaneous occurrence of events which, taken individually, would be far less powerful than the result of their chance combination. Why this markets crisis is like no other is because the coincidence of MESS is so perfect!.  You have CDOS (just think BONDS) that were basically badly rated and represented, some say, in a fashion that points to collusion between investment banks and rating agencies. You then have new FASB 157 rules (just think INTERNATIONAL REPORTING STANDARDS ) which meant the banks had to report DAILY the swings on their portfolios, which adds to the fear factor. You also had monoline insurance companies (which insure bonds using their AAA status) slapping more AAA ratings on esoteric instruments, and receiving fees for doing so that now seem pretty paltry - given the risks they were taking.

But by far the biggest problem in this whole mess is LIQUIDITY. And Liquidity is the sine qua non that broke the camel's bac, and was behind the fall from grace of Northern Rock. Because, in the event of a liquidity crisis, even if a bank holds CDOs which merits their triple-A rating, if you rely on market funding (rather than your depositors) in order to finance these positions, then you are staring a mathematical problem in the face - as it will start to cost you more to finance these positions than the return you receive from the CDOs themselves (something called a negative carry trade). 

And then there's another problem. Since there's now a buyers strike because people can't finance their positions, you can't really put a value on these investments. So you have to keep marking them down. And FASB 157 is pretty strict about when and how you mark your positions to market. Assets are then sold at fireside prices to raise money. And more mark downs and forced asset sales, of course, result in increased fear, and less liquidity - so the whole thing keeps feeding on itself. So here we are in the midst of the proverbial perfect storm (only this time it's not actually proverbial).

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