San Diego Housing Bubble News and Analysis

because they either have to boost reserves and/or use the money they would otherwise lend out to these other businesses to cover losses on the POS CDOs

Im with you, but the reserve increases are a only few basis ponts, and the POS CDO's were supposed to be insured. Is the insurance less than required, or lost in their leveraging or bankrupt?

FEAR

Interesting day wouldn't you say. So the FED will open the credit window. Two injections today. We have found a buyer for the mortgage backed securities....great! You would think the market would jump for joy but so far that isn't happening. If you want to know how serious this is, the last time Japan, Europe, and the US all injected liquidity at the same time was after 9/11. From my view the FED is not inspiring confidence. They appear to stumbling along not really knowing what to do. And they also look like they are being bullied by Wall Street. I don't like it! We are in an environment where there is no margin for error and I have a feeling these guys are going to error. My real worry is a dollar crisis and they are taking baby steps into that scenario right now.

From what I read....many didn't even build reserves into the risk from all the low-grade mortgages.

I'm not a securities guy, but CDOs are not insured to my knowledge in any way.

Forgive me for a somewhat pedestrian stab at explaining my understanding of what is going on, but here goes:

A bank (and hedge funds) makes money by borrowing money and turning around and investing it in hopes of a higher return than they borrowed it at. Interest rates have been so low, that the mortgage CDOs offered a little boost over the standard rates of return on safer investments. Perhaps an important sidenote I have been reading about is the fact that a lot of these investments were rated higher than they should have been. So some CDOs that were rated in the A's weren't really all that safe.

So the bank borrowed short term at low rates from conservative investors looking for a quick place to park cash and turn around and used the money to buy POS CDOs and get rich. Then...

from today's WSJ:

"short term borrowings had to be renewed frequently. And when investors realized that their collateral for the borrowings included U.S. subprime mortgages, they shut off the spigot"

So what is happening is that the people with cash to loan to their banks (and banks to the hedge funds) right now HAVE NO IDEA what has been done with their money. For all they know, it's ALL invested in subprime crap. So they are "shutting off the spigot". It's a credit crunch. Money is there. Just nobody wants to lend it because they think something stupid might be done with it.

A simplified example: If I thought there was a chance that my Credit Union had been taking my 2.5% savings account money and used it to buy POS CDOs, I'd pull it out until I knew they had their act together again. If I don't know what they did with it, right now I'm going to play it safe and pull it anyway (that's the fear factor).

I'm just using my credit union and and my own little savings account as a highly simplified example but this all plays out at the institutional level and these people are dealing with sums well beyond discussion of any insurance.

So until it all gets sorted out and everybody is satisfied that all of the holders of these POS CDOs have been identified, it affects everybody, not just the mortgage market. They are afraid the person they have been loaning money to won't be able to pay them back. Also, there seems to be an entire reevaluation of risk at all levels now as well. If some of the crappy mortgage securities are turning out to be not as safe as they were rated to be, what could be hiding in non-mortgage related securities too? This is all going to take a long time to sort out.

Front page story on the Wall Street Journal today about the little German bank that just got bailed out is a good soup-to-nuts story of how things go wrong.

My guess is that market manipulation by the hedges will come to light in the next few weeks. There was a change in short sale rule that makes shorting much easier. Last couple of weeks have been very unusually volatile and this is probably the cause.

The dirty little secret is CMOs are not the only toilet paper in the portfolio. The credit market was drunk and bought a lot of "covenent lite" (commercial/junk) paper, that they are now suspecting will follow the path of "Ninja Loans" i.e. illiquid and eventually worthless. With that much capital loss/illiquidity + fear, condition is ripe for an extended credit crunch. Add to it the fact that a lot of these "investors" were overseas with weaker understanding of US markets, you can see why they would develop a renewed "fear of the foreigner".

The best thing that can happen right now is to take a very painful short term correction and flush it all out of the system as soon as it can be found and marked down. Then we can get back to working towards the next bubble. We don't want a decade long quagmire like the Japanese whose banks refused to acknowledge their crap loans for so long. I think that is what will happen. We are very short-term oriented in this country.