Thank you, Dealbreaker.com, for the following moral failing on my part...

There is no excuse for the following link. None. I feel guilty even having read this article, let alone laughed at it. But screw it, I'm on holiday for a week

Meanwhile

Enjoy, and there will be more when I get back.

The carry trade old and new

The old version. Borrow in yen at low interest rates, convert in the spot market to dollars, buy dollar assets, and bet that the yen won't strengthen so much that the dollar profits are wiped out by FX losses. It worked fairly well, on average, from 1995 to 2006 or so, partly due to structural weakness in Japan.

The new version. Borrow in dollars at low interest rates, convert in the spot market to high yield currencies like the Rand or Real, buy assets in those currencies, and bet that the dollar won't strengthen so much the profits are wiped out by FX losses. It is working fairly well, on average, in 2007 due to structural weakness in the U.S., not least the newly found reluctance on the part of foreigners to buy U.S. securities.

What are you carrying today?

Filling the black hole

Earnings are contracting. The government is in trouble. How are they going to fill the hole created by a declining tax take without making themselves even more unpopular? Easy.

Cancel ID cards. Saving £18B.

Cancel the Trident replacement. Saving £76B.

Withdraw from Iraq and using the savings to equip the troops in Afghanistan properly. That should also reduce the threat of terrorism so the government could then cut the budgets of MI5, MI6, GCHQ and so on.

Close the non-dom exclusion and the corporate loopholes that allow UK companies to legally evade their tax responsibilities. Saving: at least £20B but probably more like £100B.

Enter into no new PFI contracts and get out of those existing ones which can be terminated. Cost saving: up to £170B.

Free speech

The whole point about free speech is that it applies to people you disagree with too. If you are not inciting the audience to violence or hatred, then you should be allowed to speak. (No one is obliged to listen, after all.) The whole brouhaha about the Oxford Union's invitation to a couple of unsavoury characters is therefore rather troubling. I was a member of the Union for some years, and I heard a lot there I disagreed with and some I found offensive (not least the Hooray braying in the bar). But that is what the Union is for. If it degenerates into a bland on bland festival of middle of the roadery then it becomes nothing more than another place in Oxford for students to get cheap beer.

Wot no liquidity?

The FT announced:

Fresh emergency action to pump funds into the money markets was announced on Friday night by the European Central Bank amid renewed fears that liquidity in the credit markets is again starting to dry up.

This is beyond a short term hickup. It will change how Banks view liquidity risk going forward in a profound way. The forced reintermediation of recent months will become voluntary, leading to falling securitisation volumes and less off balance sheet activity:

Mr Trichet hinted that he expected financial turmoil to result in structural changes, saying banks’ losses “may trigger a reassessment by some of them of the suitability of the so-called originate-and-distribute business model”, which relies heavily on loan securitisation.

Update. The FED is at it too. This is really really not a good sign.

The effect of the subprime squeeze on prime lending

Over at Calculated Risk, Tanta makes a very good point about the dramatic decrease of subprime capacity:

The main impact of subprime lending on the overall mortgage business was the take-out function. As subprime lending grew, you saw better “performance” of prime or near-prime mortgage portfolios. This was not because subprime lending did away with the traditional default drivers of job loss, illness, divorce, or disorderly conduct; it was because loans in that kind of trouble had a place to go besides foreclosure. Prime lenders could and did congratulate themselves on their low foreclosure rates as if it were a matter of their superior underwriting skills, but that involves a high degree of naiveté. It’s really important to understand this issue, because it gets to the heart of the “contagion” thing. It is not that subprime delinquencies are “spreading” to prime loans as if some infectious agent were in play. It’s that the drain got backed up: when subprime lenders go out of business, or investors won’t buy subprime loans, there is no place for the inevitable prime delinquencies to go except foreclosure. Prime delinquencies become “visible” because they don’t move out of the prime portfolio via refinance into the subprime portfolio, where we “expect” to see them.

In other words, because there is less subprime capacity to take out troubled loans that were made as prime, some of these loans will now default because they have nowhere to go. Subprime provided a valuable rescue function to the prime market, and now it is mostly gone, the consequences for both lenders and borrowers of a loan falling out of the prime performing bucket are much more severe.

This implies of course that there is a lot of money to be made by stepping up to the subprime plate now, with rigourous underwriting criteria, very prudent liquidity risk management and a whole shedload of capital. Just as we saw a lot of fresh capacity in non-life insurance after Katrina, so it would make sense for new players (those private equity players with a lot of money and nothing to spend it on, for instance) to come to support the mortgage market while the established players are licking their wounds and sulking in their dens.

Is this problematic?

Consider the following capital structure:

• Security assets, chiefly RMBS: $700B
  
• Unpaid principal balances on securities issued, mostly covered bonds (i.e. RMBS with a guarantee from the issuer): $1.5T
  
• Total stockholder's equity: $25B
  

Anyone spot a teensy weensy leverage issue here? And a single concentrated risk factor perhaps? Add in a Q3 2007 loss of $2B and things look even worse. Never mind, these are matters for the U.S. taxpayer: these are Freddie Mac data. (Figures taken from the latest [2006] Annual Report and the latest earnings release.) Despite most people believing the Agencies carry a government guarantee, Freddie is trading in the default swap market at around 70 over according to Bloomberg. You can short the stock too...

Update. Quel suprise. Freddie is recapitalising and cutting its dividend.

Friday in the crunch with George

The crunch is getting crisper if not more chocolatey. Currently suffering are:

• The monolines. CIFG for instance is about to get a capital injection according to the WSJ. Now would be a great time to set up a new monoline, writing pure muni business. Perhaps Warren will help?
  
• Any bank relying on the securitisation market for part of its funding, according to FT alphaville.
  
• The ratings agencies, who many people (including David Einborn) think screwed up big time.
  
• Fannie and Freddie, who need more capital, according to CNN.
  
• Anyone who was long equity: the markets have been falling, wiping out the gains so far this year on the S&P according to Bloomberg.
  
• RMBS, CMBS, CDO and even covered bond holders.
  
• As we said yesterday, the writers of liquidity lines and anyone who wants to issue ABCP:
  
  (This figure and the next one come from an article by Charles Calomiris.)
  
• And just to end on a cheery note, Hank Paulson says 2008 will be worse than 2007 for the U.S. housing market according to the Guardian. Not that 2007 was so wonderful:
  

I'm personally not in the the-world-is-coming-to-an-end school but these signals are undoubtedly strongly negative. Let's be careful out there.

Liquidity puts

It seems from FT alphaville that liquidity puts are not that well known. Here's the gig. In any structure where a vehicle issues paper backed only by collateral (such as a SIV, conduit or securitisation) but where the paper has a shorter duration than the collateral, there is liquidity risk: if no one buys the paper, the issuer can have a problem regardless of solvency. To protect against this liquidity risk, many sponsors have bought liquidity lines, aka liquidity puts. Typically the issued liabilities are ABCP, and the liquidity put is an undertaking from a large well-rated and liquid bank that if the CP market does not want the issuer's paper then (providing it is solvent) the bank will either buy the paper or lend the issuer money. This loan is often contingent on a general disruption in the CP market, and this type is also known as a backup CP line.

This structure was commonplace and many SIVs, conduits and other securitisation SPVs enjoy some form of liquidity support from a major bank. The problem is, as I noted earlier, many of these backup lines have been or will soon be triggered. You wrote it liquidity, you own it.

Timing risk and finite reinsurance

One of the murkier parts of the reinsurance world is finite reinsurance. Even finding a good definition is difficult. But here, rather than surveying the whole topic, I want to discuss one particular application, namely hedging timing risk.

The typical situation this arises is where there either may or will certainly be claims on an insurance policy over an extended period, but their timing is uncertain and their maximum size is bounded. Suppose for instance we know that over the next ten years we will very likely have to pay out claims of £10M, but we do not know when these claims will be presented. This risk can cause significant earnings volatility: in years with no claims, our earnings look great, but if £8M or £9M of the £10M arrive all in one year, things will look less good for that year.

This earnings volatility can be hedged (for a price). Typically we transfer some assets, say £8M worth, to a reinsurer: these assets are invested. Simultaneously they write us a reinsurance policy capped at £10M on the risk, and receive a small premium to be thought of as an asset management fee. If claims arrive very early in the policy the reinsurer can lose money as the £8M will probably not have grown to £10M in the first couple of years. If the claims happen late, they make money as the assets will have grown to be worth more than £10M over eight or nine years if prudently managed. The reinsurer therefore takes some timing risk and some investment performance risk, but not much. It is a very large very well capitalised entity so it can handle the earning volatility much better than the ceding insurer.

There is even the possibility of passing some upside of good investment management and/or good claims management back to the ceding insurer via an experience account: for instance if the £8M has grown to £12M before claims of £9M leaving £3M at the end of ten years, then this could be split 50/50 between the reinsurer and the ceding insurer. With careful structuring this can mean that it is possible to transfer very little risk with a finite reinsurance policy yet achieve the desired aim of smoothing earnings, i.e. an accounting arbitrage.

This kind of technology emphasises that insurance can act as a form of capital. Without the policy, the ceding insurer would have to support the earnings volatility with equity. With it in place, capital requirements are reduced. The reinsurer is better placed to take the timing risk than the primary insurer and hence a deal is possible which makes sense for both parties.

Having your cake and eating it

The news that bids for Northern Rock are considerably below the current share price is hardly surprising but it does remind us that equity is a residual interest. It only has value if the firm can pay its debt in a timely fashion. Every so often shareholders forget that. Then when a firm fails, they clamour for restitution, as with Metronet or Railtrack: doubtless it will be the same with Northern Rock. These claims undermine the financial system: the logic is totally spurious. If equity holders want the returns that come from owning a residual interest, then they should take the risk, and bear any losses in silence. If they don't want that risk, they should not buy equity.

The priority now, as James Harding puts it in the Times, is first to depositors and the financial system, and last to shareholders. The best option may well be nationalisation. It certainly won't be something that leaves tax payers with exposure and grants a return to shareholders.

The economic value of a leader

Some tedious blogger who I won't glorify with a link challenged Paul Krugman to admit that Mrs. Thatcher was 'good for the UK economy'. That made me wonder how you would tell. At first it doesn't seem difficult: there are a number of indicators of which perhaps GDP is the most obvious, and Thatcher the Milk Snatcher did indeed have policies which seem to have resulted in faster GDP growth.

However thinking about it for a moment it is obvious how to produce higher GDP growth: don't spend on infrastructure and instead use the money to stimulate the economy. In the long term you reduce growth as the education system, transport and utility infrastructure can't support the needs of the economy and you have to raise taxes high to fix them. But in the short term you get an upswing.



My gut instinct is that that is what happened under Thatcher: her government chronically underspent on the NHS, universities, schools, railways and so on. This allowed her to cut taxes which stimulated the economy for a few years. But because the workforce is undereducated, you can't get around quickly and conveniently, and so on, eventually these constraints start to bite and growth is slower than it would have been if essential services had been maintained and improved. The present value of future earnings is lower without proper investment as any good private equity person knows. Of course measuring this long term decrease in potential GDP is enormously difficult to measure, but the phenomenon is certainly there. So perhaps even on economic grounds history will judge that Thatcher does not score that well.

Yes my CPDO is burnt

Completely predictable news of the week from the FT:

Moody’s [...] said on Monday that eight financial-company focused constant proportion debt obligations (CPDOs), most of which are currently rated AAA, had been put on review after their net asset values had been hurt by credit-market volatility.

[...]

Two of the deals facing downgrades are from ABN, the other six are from UBS.

Obviously ABN (the inventor of the CPDO) has had a certain amount of stick about this: see for instance Mark Gilbert who points out

One of the ABN CPDOs, called Chess III, went on sale in July priced at 100 percent of face value with that golden Aaa rating. This week, it was worth about 41.5 percent of face value, according to ABN prices.

So why hasn't it been downgraded already?

Anyway, apparently

The UBS deals were the first to face downgrades in the late summer and had all been either downgraded or restructured in September.

So some of these deals have been restructured once already and they are on review for the second time in four or five months. Impressive, huh?

Update. Moody's did the decent thing on the UBS deal according to Alea and downgraded it from AAA to C. In one go. Because, you see, investors have taken a 90% loss. That's the kind of risk you get in AAA investments. Oh yes.

Spread wide

Friday market update: from Bloomberg, we learn that

Merrill's 6.4 percent notes due in 2017 pay a spread of 2.24 percentage points, almost double the premium of 1.21 percentage points a month earlier

Meanwhile

Citigroup paid 1.90 percentage points more than Treasuries of similar maturity to sell $4 billion of 10-year notes on Nov. 14

That's nothing compared with the monolines in the CDS market. According to FT alphaville there is a one in three chance of monoline default, while Bloomberg gives more detail:

Credit-default swaps on MBIA more than tripled to 410 basis points since Oct. 15, according to CMA Datavision in New York. The price suggests that investors see a 28 percent chance MBIA will default, according to JPMorgan Chase & Co. valuation models. Contracts on Ambac have climbed to 620 basis points, CMA data show. They imply a 40 percent chance of default.

Things are interesting out there. Have a good weekend folks.

Update.Naked Capitalism estimates the likely cost of a monoline downgrade as $200B. (Is that all of them or just a big one?) Anyway, with the kind of impact, we had better hope someone at the FED plays golf with someone at the New York State Insurance department this weekend.

Credit support default: delivering quality collateral

Most OTC derivatives are done under ISDA documentation. Included in the typical package (master, confirm, definitions, schedule) is the CSA or credit support annex. This specifies what kinds of credit support, if any, each party to the contract has to give to the other. Commonly, for instance, the CSA might say (lawyerese for) 'each of us will post collateral monthly to the other if the net value of the exposure is more than $10M. Acceptable collateral is cash or G4 government bonds, and the party has three days to post the collateral after it has been requested.'

Failure to adhere to the terms of a CSA is typically a default event for the contract, resulting in the whole amount becoming due and payable.

The FT has an interesting story here in regard of one of the smaller financial guarantee insurers, ACA. Apparently ACA has written protection on the senior tranches of CDOs in the form of credit default swaps where the CSAs specify collateral in the event that the tranches are downgraded:

Such provisions require ACA to post cash equivalent to the mark-to-market loss of the CDS contract pursuant to a ratings cut.

That collateral could be substantial if ACA's CDOs have much subprime in them. Again according to the FT:

AAA rated subprime CDOs currently trade from the high single digits on junior tranches to 60% of face on super senior tranches.

If ACA can't find the collateral then presumably the whole MTM of the contracts become due and payable. Given that

ACA has only USD 1.1bn in claims paying resources, according to research by Credit Suisse

At that point the holders of the wrapped tranches will really have a problem.

Buying a broker

Should any of the large European banks seriously consider buying a Wall Street investment bank? Matthew Lynn at Bloomberg thinks so, arguing that Lehman, the Bear and Morgan Stanley are easily affordable by banks like Deutsche, Santander or HSBC. He has one delightfully acid little dig:

[...] it is very hard to understand what Royal Bank of Scotland Group Plc is doing taking control of ABN Amro Holding NV of the Netherlands with its partners -- let's remember, ABN is a fairly dull bank, with no great growth prospects -- when it could be buying Morgan Stanley instead.

Abuse aside, though, the case is less clear. A firm like the Bear has a uniquely American culture that would be a very poor match with a retail bank like HSBC or Santander. Even a closer cultural fit - Deutsche with Lehman for instance - would still be a massive integration challenge. Perhaps Lynn's really out of the money option is actually the one that would work best: ICBC using its inflated stock to buy American. I wonder what kind of protectionism would be wheeled out if the Chinese really did bid?

What should capital requirements be like?

I don't think the answer to the title question is clear. But some desireable criteria are becoming apparent. I suggest:

• At any point in time, larger risk should imply larger capital, i.e. there should be portfolio risk sensitivity.
  
• Overall, market wide changes in risk premiums (and in particular market crises) should not change capital requirements.
  
• An element of capital should depend on stressed liquidity, i.e. how liquid the institution's assets are in a crisis.
  
• Only limited capital reduction should be permitted for risk transfer of assets originated by the institution. This ensures alignment of interests and reduces the total amount of risk leaving the regulated financial system.
  
• Transactions which reduce capital without reducing risk should (ideally) not be possible or, if they are, forbidden by other means. Regulatory capital arbitrage should not be counternanced.
  
• Incentives should not exist for risk to move from more advanced banks to less advanced ones. The menu approach for credit risk does this at the moment in Basel 2: standardised approach banks have lower capital charges for the worst quality borrowers than IRB banks. Internal models approach should always give the same or (slightly) lower capital than standard rules in order to preserve the incentive to meet the standards for internal modelling.
  
• The capital regime should incorporate larger charges for assets of uncertain value (level 3 assets in the FAS 157 hierarchy) and lower ones for level 1 assets.
  

Level 3 and default correlation

Suppose you take a collection of assets of known price and put them into an SPV. The SPV issues tranched debt. Obviously the sum of the values of the tranches equals the sum of the values of the original assets (unless there is some external credit enhancement for the SPV which adds value, or some other external influence).

Clearly too in a conventional tranching structure the senior tranche bears the least default risk and the junior tranche the most. But what is the fair value of each silo individually?
This is the problem many banks are facing at the moment. They have either retained tranches in their own CDOs or purchased tranches in other people's, and these securities have not traded for some time. Therefore level 1 (mark to an observable market price) valuation is impossible. The assets have to be valued, though, so they have to do something, albeit in level 3.

The basic modeling problem is to assign value between tranches. This assignment depends on something that is popularly known as default correlation, but should properly be called default comovement: if the occurrence of one default in the CDO assets makes another much more likely, then the senior tranche is less valuable. If one default is more or less unrelated to another, then the senior is safer and hence more valuable.

Default comovement is idiosyncratic. There is no reason to believe it will be the same between one pool of mortgages and another, let along between one diverse pool of ABS and another. Some limited information on it in particular cases can be inferred from the prices of the few liquid securities - the iTraxx tranches and the ABX, for instance - but there is no compelling reason to believe this carries over to other asset pools. This means that more or less any CDO tranche at the moment is a level 3 asset and any valuation necessarily has a measure of model risk and/or model parameter risk.

Wile, Gisele, and the dollar

It was always going to take one more push to get the dollar into that Wile E. slide. Perhaps the news from Gisele was it? Here (from barchart.com via Calculated Risk) is the recent action on the U.S. dollar index Dec futures

I trust regular readers will be impressed by my restraint in not using the story about Ms. Bündchen to post a gratuitous picture of her. The tricky decision we now face is what to do first: call her to offer advice on FX hedging, or to attend to our own portfolios. Transaction or relationship people?

Update. Gisele and Ben in conversation at Long or Short Capital is worth reading.

Too friendly?

An article in the New York Times raises one of those issues that is unmentionable in most company - do companies discriminate against the childless? A moment's thought indicates that most of them do: think of maternity and paternity leave or staff leaving early or arriving late because their child is ill or for a parent's evening/school play/whatever. These excuses for, well, not working, seem to be treated as if they were morally better than 'I was hungover', 'I wanted to visit a gallery' or 'my friend was ill'. The answer is to offer the same benefits regardless of the reason: some firms for instance permit their staff to take 4 half days a year in addition to their vacation for whatever reason and on short notice. This covers everything from doctor's appointments to interviewing a new dog walker and goes a long way to tackling the inevitable resentment the childless will feel if work/life balance is only seen to apply to those with children.

In this context then, the recent news that Gordon Brown wants to give flexible working rights to 4.5M extra parents is particularly annoying. Why just parents? Don't the rest of us deserve a work-life balance too?

BoA fun

Ken Lewis, BoA Chief Executive, said a month or so ago that

I’ve had all the fun I can stand in investment banking at the moment

Recently discovered footage shows some of that BoA fun: click here to watch. Definitely it's BoA. Unless I'm confused of course. Management isn't. They say that CDO dislocations may effect their results. Shurely shome mishtake.

The curious case of falling mortgage capital requirements

This table is from QIS5, the 5th (and latest) quantitative impact study into the effects of the new Basel Accord. Since Basel 2 was approved recently in the U.S. (markedly behind much of the rest of the world) I thought I would commemorate the date by looking at the effects of Basel 2.

Group 1 are the largest banks: Group 2 are somewhat smaller. What we see here is the impact on minimum capital requirements (MRC) of the various new rules. The big winner for both classes of banks is retail mortgages: these contribute falls of 7.6% and 12.6% respectively in total capital required. And which category of business is causing a massive credit and liquidity crunch, endangering institutions from banks through broker/dealers to bond insurers and money market funds? Oh, retail mortgages.

Update.Alea has a nice set of links and discussion on the procyclicality of the New Accord. I'm still not convinced that regulatory capital is that big a motivation unless it is scarce, but still the incentive structures in Basel 2 cannot be helping matters right now.

What is the nature of a model price?

In an otherwise excellent post on mathematical finance and its fallacies, Epicurean Dealmaker says something that might be confusing:

Black-Scholes works not because it describes some external ontological fact about how pricing relationships between securities and their derivatives have to work; it works because everyone agrees, more or less, that that's how prices should work. It is a convention, not a physical or financial law.

Black-Scholes is a convention for quoting prices. In particular when we say '6000 strike 5 year FTSE puts are trading at 21 vol' what we mean is 'if we put 21% into Black-Scholes along with all the other parameters, we get the right price for this option', that is our expected cost of hedging it. What we do not mean is that the dynamics of the FTSE follows a log normal diffusion as Black-Scholes assume.

Things get dangerous when we go from interpolation to extrapolation. Using Black Scholes to deduce the price of the 5950 strike if we know market price of the the 5900 and the 6000 strike options is fairly safe. Using it to deduce the price of a ten year option when we only know the prices of five year instruments is more dangerous, especially in the presence of persistent fat-tails and autocorrelation. Using it (or indeed anything else) to bet large numbers of dollars on the cost of delta hedging a path dependent exotic option is alarming (unless you are leaving before the real cost of the hedge strategy becomes clear).

Now, about those $100 strike oil digitals...

It's still all about liquidity

Tony Jackson in the FT agrees with the analysis I tend to support that the current crisis is one primarily of liquidity not default. He points out:

The investment banks have been caught two ways. First, they have been hit by warehousing risk. In the absence of buyers, they are stuck with assets held for sale, such as leveraged loans and assets awaiting repackaging into asset-backed securities.

Second, they face the threat of having to take special purpose vehicles such as conduits back on to their balance sheets.

Add to that the warehousing problem and you have a big number – somewhere well north of $1,000bn globally, I would guess. That amounts to a balance sheet explosion.

For what this means, take the UK example. According to the Bank of England, total new funding required by UK banks to finance those assets could come to £170bn. That is equivalent to 14 per cent of the total stock of lending to UK corporates and consumers.

Self-evidently, this will cramp the banks’ ability to lend. It will also lead to further hoarding of liquidity to help with that funding, thus prolonging the liquidity crisis.

This is further exacerbated by the pro-cyclicality of regulatory capital requirements and most economic capital models. Corporates without long term funding will find life difficult going forward, and a lot of people will need a good measure of endurance to pass through this unscathed.

Meanwhile the bond insurer story moves on apace. Bloomberg reports that Fitch is considering downgrading one or more of them. The CDS market is taking this seriously: MBIA is now at 520 over and Ambac is over 700 over. The monolines guarantee $1T of bonds between them. Endurance, people, endurance.

Between a rock and an accounting rule

Naked Capitalism makes two interesting points about Citi:

• Reading the Wall Street Journal we find:

  Citigroup's subprime exposure -- and source of its problems -- are two big buckets that together total $55 billion, the bank said. The first bucket totals $11.7 billion, including securities tied to subprime loans that were being held, or warehoused, until they could be added to debt pools for investors. The second, totaling $43 billion, covers so-called super-senior securities.

  This position is larger than Merrill's and so we can expect further very chunky write-downs from C at some point.
  
• Moreover unlike mother M., Citi does not appear to have done much to reduce its position. Why might that be? One possibility is that if Citi had sold, they would have had a mark, and that mark in turn would have had to have been used for the same assets in their conduits. Those conduits would then have missed the OC tests, forcing Citi into the unpalatable decision between providing them with implicit support or suffering the reputational damage of not doing so. If this really is the case, Citi is going to have its work cut out staying afloat as these securities decline further in value.

It is worth thinking about what would have happened before securitisation. Had Citi had the same assets then, they would all have been on balance sheet in the banking book, and hence not marked at all. They would have had considerable discretion about the size and timing of loan loss provisions, and the only write-downs would have been from actual experienced losses. In short we would not have had any real idea of how bad the problem was. I rather prefer it this way round.

How bad could it get?

Short of green men landing in the City and eating everything within a mile of Bank station, how serious could the credit crunch get, given what we know? The following is not a prediction, more of an exercise in generating plausible worst case scenarios.
Firstly the possibility of the failure of a systemically important institution cannot be ignored. The rumours surrounding further write-downs are too pervasive for that. Undoubtedly a rescue would be organised, but confidence would be very severely shaken and massive injections of liquidity would be necessary to stabilise the markets.

In this context we could expect a series of hedge fund failures too, and a widespread deleverage and flight to quality across the system. Significant falls in equity markets, moves in low yielding currencies vs. the dollar (as carry trades are unwound) and spikes in implied volatility are also to be expected. The securitisation markets would remain shut for an extended period of time, ABCP would be very difficult or impossible to roll, and the swap spread would go out significantly.

Another possibility is the failure of a monoline (such as MBIA, Ambac, FGIC, FSA or Radian) or a large insurance company involved in the credit markets such as Ace or XL. This is more problematic in that the parties who would be involved in a rescue are less clear and the majority of the systemic risk related to such a failure would be confined to the wholesale market. On balance though in the circumstances I think a rescue would be more likely than not. We have not seen a failure like this before so the consequences are harder to predict, but certainly the impact on the muni and structured credit markets would be considerable.

We can reasonably assume that the largest firms have the resources to attempt to mark their books. For smaller banks or fund managers that may not be the case, so there could well be medium sized institutions that are sitting on losses that are significant given their capital base without knowing it. This won't be as bad as a big player going down, but on the other hand a struggling tiddler might actually be allowed to fail, depending on the country. That would cause further spread widening and deleverage across the industry.

Just as Sarbannes Oxley was a (-n over) reaction to Enron, so we can expect to see revisions to Basel 2 and to the accounting framework for conduits and SIVs. These will be a slow burn rather than sudden changes, in all likelihood, but depending on how far they go, they have the potential to reduce the intermediation of risk and decrease bank profitability, at least until the industry figures out how to arb the new rules.
Meanwhile we can expect the U.S. housing market to trend down for an extended period, until mid 2009 at the earliest, and contagion into other bubbly markets such as the UK and Spain is entirely possible. Specialist mortgage lenders, REITs, builders, and the holders of 2006 and 2007 vintage MBS paper are likely to suffer most. The impact on the economies concerned will be considerable, and full blown consumer-lead recessions are entirely possible in the U.S. and the UK.

The equity markets seem particularly vulnerable at the moment: perhaps we are seeing the start of an inevitable repricing of risk, but with many established equity markets close to their all-time highs, large falls from here are possible. Bank debt must also be vulnerable: while spreads have blown out, they are still rather tight compared with the potential downside in some of the scenarios I have outlined. This will have a knock-on effect in credit markets generally as risk capital is withdrawn and investors become much more risk averse.

None of this is inevitable, or even -- so far at least -- likely. But looking at what the future might bring is always a useful exercise, particularly in the heat of a crisis. Look on my stress tests, ye Mighty, and despair:

• Failure of your largest (by notional or PFCE) bank counterparty.
  
• One day equity market fall of 25%, followed by a further 40% over six months. Private equity cannot be sold.
  
• Short rates go to 2%, long rates to 6%, and the swap spread is 100 bps.
  
• Interbank borrowing is impossible for three months. Securitisation is impossible for ever.
  
• One day dollar fall of 5% followed by a further 20% over six months.
  
• All asset-backed securities except RMBS become completely illiquid and halve in value. (Remember this has an effect on collateral from clients and on SIVs and conduits too.)
  
• Default rates on prime retail mortgages are the worst ever experienced historically plus 10%. Subprime assets are worthless.
  
• AA- or better credit spreads for financials go out 100 bps. 150 bps for A to BBB. 300 bps below that. Corporate spreads go out by half those amounts, as do emerging market spreads. (Or if you want a riff on this, BRICS spreads tighten.)
  
• All monoline or credit insurer protection is worthless. Monoline spreads are 500 bps.
  
• All hedge funds concentrating in ABS default. Default probabilities triple for the rest.
  

Where are the ABX 08-01s coming from?

Watch it. The ABX index of a given vintage is supposed to have 20 bonds in it. At the moment, issuance is so light, only 3 qualify according to Wachovia via CreditFlux. That will make it extremely difficult for the ABX to continue in its current role of barometer of the crash, assuming it goes into 2008.

Alea further points out the bid/offer spreads are so wide that even now the veracity of ABX-derived marks is somewhat questionable. Certainly trying infer the possible losses of a player - Merrill, UBS or Citi for example - from the ABX is a very approximate business. This is particularly so for the AAAs since the ABX index member may have significantly different subordination from the position held. In some securitisations, for instance, there are as many as 5 AAA bonds, with the real supersenior much safer than the lowest AAA.

Why subprime is going to get worse

First, many subprime mortgages are simply unaffordable for the mortgagee. As Naked Capitalism points out, the true interest cost for many buyers is more than 50% of their income:

Right now the full force of this has not been felt yet as many of these mortgages are in their teaser period where the rate is artificially low: the yellow shows the distribution of actual payments including the teaser rate, the blue what it would have been without the teaser. The current low rates change soon, however, as this picture of the notionals resetting by mortgage type shows:

As Stan might say, oops.

How linear is Goldie?

A non-linear position translates a normal distribution of market returns into a non-normal distribution of P/Ls. It used to be reasonable to assume that trading revenues were normally distributed. For instance, here is Goldman from Q3 2004 (picked up via Alea):

Now, though, some of the broker dealers are strongly non-linear. Here's Goldman Q3 2007:

Morgan Stanley for the same period is similarly non-normal:

There's nothing inherently wrong with this, but it does mean that any old style investment model (CAPM, for instance) which relies on normal returns won't deal with stocks like this correctly, and concepts like beta with the market are less meaningful.