OH, CANADA ...WITH GLOWING HEARTS WE SEE OUR DOLLAR RISE ...

THE CANDADIAN AND THE US DOLLER ARE AT PARITY. ONE "LOONEY" CURRENTLY STANDS AT .9983 AMERICAN.

NEW CLEAR DAYS ALBUM BY THE VAPORS

TURNING JAPANESE, COULD WE BE TURNING JAPANESE, SOME REALLY THINK SO.

Remember the song “Turning Japanese” by the British Band The Vapors? The song was a huge hit in 1980 and 1981. It was off of the "New Clear Days" album.

This post is not intended in any way to denigrate the Japanese, as the song may have been interpreted. Rather, this post discusses an article from MSN.Money in which a credit-derivative expert states that the US economy could fall into a prolonged and intractable recession similar to the Japanese recession in the 1990s.

The article is entitled “Are We Headed for an Epic Bear Market” by Jon Markman. The article features an extended interview with Satyajit Das, a leading expert on credit derivatives.

DAS ROUNDS UP THREE TIMES THE USUAL SUSPECTS.

The root of the liquidity crisis and the subprime meltdown is less a story about Americans defaulting on mortgages (although that is a Big Story, the Biggest Story for dudes and dudettes that can’t meet their mortgage payments) than a story about a whole class of investment instruments that cannot be sold and cannot even be accurately valued.

Das' view sounds cynical, but it makes sense if you stop thinking about mortgages as a way for people to finance houses and think about them instead as a way for lenders to generate cash flow and create collateral during an era of a flat interest-rate curve. Although subprime U.S. loans seem like small change in the context of the multitrillion-dollar debt market, it turns out these high-yield instruments were an important part of the machine that Das calls the global "liquidity factory." Just like a small amount of gasoline can power an entire truck given the right combination of spark plugs, pistons and transmission, subprime loans became the fuel that underlays derivative securities many, many times their size.

Here's how it worked: In olden days, like 10 years ago, banks wrote and funded their own loans. In the new game, Das points out, banks "originate" loans, "warehouse" them on their balance sheet for a brief time, then "distribute" them to investors by packaging them into derivatives called collateralized debt obligations, or CDOs, and similar instruments. In this scheme, banks don't need to tie up as much capital, so they can put more money out on loan.

The more loans that were sold, the more they could use as collateral for more loans, so credit standards were lowered to get more paper out the door -- a task that was accelerated in recent years via fly-by-night brokers now accused of predatory lending practices.

Buyers of these credit risks in CDO form were insurance companies, pension funds and hedge-fund managers from Bonn to Beijing. Because money was readily available at low interest rates in Japan and the United States, these managers leveraged up their bets by buying the CDOs with borrowed funds.

So if you follow the bouncing ball, borrowed money bought borrowed money. And then because they had the blessing of credit-ratings agencies relying on mathematical models suggesting that they would rarely default, these CDOs were in turn used as collateral to do more borrowing.

In this way, Das points out, credit risk moved from banks, where it was regulated and observable, to places where it was less regulated and difficult to identify.


“GIT YA CDOs. FRESH FROM THE LIQUIDITY FACTORY. GIT’EM WHILE THEY’RE HOT!”

So how and why did sophisticated financial players outdo the proverbial drunken sailors? Simple. Returns were high, the CDOs were steadily rising in value. What could go wrong?

The liquidity factory was self-perpetuating and seemingly unstoppable. As assets bought with borrowed money rose in value, players could borrow more money against them, and it thus seemed logical to borrow even more to increase returns. Bankers figured out how to strip money out of existing assets to do so, much as a homeowner might strip equity from his house to buy another house.

These triple-borrowed assets were then in turn increasingly used as collateral for commercial paper -- the short-term borrowings of banks and corporations -- which was purchased by supposedly low-risk money market funds.

According to Das' figures, up to 53% of the $2.2 trillion commercial paper in the U.S. market is now asset-backed, with about 50% of that in mortgages. (AUTHOR’S NOTE: Commercial paper are short-term loans by large organizations, usually purchased by other large organizations or highly-sophisticated investors.)

When you add it all up, according to Das' research, a single dollar of "real" capital supports $20 to $30 of loans. This spiral of borrowing on an increasingly thin base of real assets, writ large and in nearly infinite variety, ultimately created a world in which derivatives outstanding earlier this year stood at $485 trillion -- or eight times total global gross domestic product of $60 trillion.

Without a central governmental authority keeping tabs on these cross-border flows and ensuring a standard of record-keeping and quality, investors increasingly didn't know what they were buying or what any given security was really worth.

“CDO GOING OUT OF BUSINESS SALE. NOTHING STAYS BUT THE FOUR WALLS.”

Here is where it gets scary.

Now here is where the U.S. mortgage holder shows up again. As subprime loan default rates doubled, in contravention of what the models forecast, the CDOs those mortgages backed began to collapse. Because they were so hard to value, banks and funds started looking at all CDOs and other paper backed by mortgages with suspicion, and refused to accept them as collateral for the sort of short-term borrowing that underpins today's money markets.

Through late last month, according to Das, as much as $300 billion in leveraged finance loans had been "orphaned," which means that they can't be sold off or used as collateral.

AND BEFORE WE KNOW IT, WE HAVE A “VICIOUS CYCLE”. AND THE LEVERAGE LORDS SHOW THEIR UGLY SIDE.

One of the wonders of leverage is that it amplifies losses on the way down just as it amplifies gains on the way up. The more an asset that is bought with borrowed money falls in value, the more you have to sell other stuff to fulfill the loan-to-value covenants. It's a vicious cycle. In this context, banks' objective was to prevent customers from selling their derivates at a discount because they would then have to mark down the value of all the other assets in the debt chain, an event that would lead to the need to make margin calls on customers already thin on cash.

Now it may seem hard to believe, but much of the past few years' advance in the stock market was underwritten by CDO-type instruments which go under the heading of "structured finance." I'm talking about private-equity takeovers, leveraged buyouts and corporate stock buybacks -- the works.

So to the extent that the structured finance market is coming undone, not only will those pillars of strength for equities be knocked away, but many recent deals that were predicated on the easy availability of money will likely also go bust, Das says.

SO WHAT HAPPENS IF WE ARE “TURNING JAPANESE?”

Das notes that Japan in the 1990s lowered interest rates to zero and the country still suffered through a prolonged recession. His timetable for the start of the next serious phase of the unwinding is later this year or early 2008.

But there are a few more things to think about. The Author wrote about it in his recent post, “US DOLLAR FACES FLIGHT IN WAKE OF FED RATE CUT".

If US short rates fall, and long rates retreat in turn, then foreign capital will find higher returns in foreign economies. Capital will flee, the dollar will fade, and government deficits will be difficult to fund.

AUTHOR’S CONFESSION

These are interesting financial times and the Author is struggling to stay abreast of developments and formulate them in some understandable ways. It is not easy. But he will do his best and continue to keep you loyal readers informed and educated as best he can. And just like Mad Magazine, the free Desert of the Real website is still cheap.

‘WHAT? US WORRY IN THE DESERT OF THE REAL!