The US Treasury - just like Lehman - has spent months holding onto the mantra that the banks are not to blame. Fear and fear alone was causing trouble for the banks, was the parroted line. The whole wrong-headed architecture of the Tarp was prefaced on the same worldview: more liquidity and more confidence was needed, not more capital ...
It has taken Paulson two long weeks to come around to the idea that the banks need recapitalising.
That’s two painful weeks to face up to the fact that actually, the banks’ problems were not mere fictions conjured by the scurrilous iconoclasts of Greenwich, CT, but were real, palpable, and destabilising.
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Firstly - on “providing a market for toxic instruments”. Let’s take mortgage-backed CDOs as an example, since they are the archetypal ‘toxic’ instrument at the heart of the current crisis. This explanation is a little simplified, but hopefully it catches the gist of the matter. It’s right to say, as Peston does, that hedge funds were often the happy buyers of the lowest tranches: the mezz and equity pieces that support above them a far greater number of AAA-rated senior tranches and are nominally considered the “toxic” pieces.
Alas, the “toxicity” of CDOs is nothing to do with the equity or mezz pieces.
The problem with CDOs is that the senior, AAA-rated pieces were mispriced. Consider: relatively speaking, who has lost more in the current market: buyers of BBB-rated equity pieces, who always knew what they were buying was risky, and got paid accordingly, or buyers of AAA-rated super-senior pieces, who thought the paper they were holding had a near-zero chance of defaulting? Answer: AAA ...
Many in the market - particularly hedge funds - knew that the AAA CDO tranches were artificially secure and accordingly mispriced. There was, in technical parlance, a “correlation” problem waiting to happen in CDOs. Which is why the smart money stopped buying the senior pieces a long time ago.
Banks still wanted to issue CDOs though - something they couldn’t do without any AAA tranche buyers. To keep the money-machine turning, they found otherways to shift the AAA. They kept it on their balance sheets and hid it with derivative contracts issued by monolines (negative basis trades). Or else they loaded the tranches into huge, opaque funds backed by commercial paper markets (ABCP conduits). These actions allowed the CDO market to truly develop into a bubble over 2006/07. Had the banks not have artificially created AAA buyers, many of the riskiest CDOs would never have been created.
When defaults did eventually tick up and damage CDO structures in a far more violent way than predicted, these actions by the banks in artificially propping the AAA market had two profound effects. Firstly, those banks that had kept AAA-rated CDO pieces on their own balance sheets had to take huge writedowns and suffered from crippling capital impairment charges. No-one knew exactly how much bad AAA debt banks had hidden and thanks to shoddy reporting, it has taken 18 months to come clean. This has had a profound and lasting effect on market confidence. Secondly, those that had stuffed the AAA-rated tranches into funds backed by commercial paper, caused the fear to instantly spread to the highly conservative commercial paper (CP) market. Being one of the biggest and supposedly liquid markets in the world, this instantly turned the crisis into a systemic problem. And not a hedge fund in sight.
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