Financial alchemy is the process of transforming something of little value into something worth much more. The unfolding crisis in global financial markets is a result of the unpaid price of that financial alchemy.
How does this medieval-sounding madness apply to today's financial markets? As this letter suggests, the financial alchemy took subprime mortgages, leveraged buyout loans, and other financial assets and turned them into Collateralized Debt Obligations (CDOs), many of which received AAA ratings from agencies such as Moody's Corp. (NYSE: MCO) and McGraw Hill Companies' (NYSE: MHP) Standard & Poor's (S&P), in a process of shopping for ratings which I described here.
The upshot is that investors in Asia and Europe -- eager for higher returns (estimated at 22 basis points above treasury yields) and comforted by the AAA rating -- recycled the cash generated from record energy prices and trade surpluses with the U.S. into these CDOs. There are roughly $2 trillion such CDOs outstanding against which those investors borrowed as much as 13 times the amount they raised in equity from investors, up from nine to 10 times as recently as late 2005 -- let's say $20 trillion -- to amplify the returns on the CDOs.
The unpaid price is hard to quantify. The CDOs may be worth less -- let's say their true value is 10% of the $2 trillion book value, or $200 billion -- but the banks that are clamoring for their $20 trillion would still be $19.8 trillion in the hole if they took possession of all the CDOs.
Can these investors find an additional $19.8 trillion worth of collateral? If so, what assets could they sell to come up with that much cash? Maybe these investors could sell stocks and government bonds, but I don't know whether they have enough to cover the whole $19.8 trillion. This amount exceeds the value of all U.S. stocks -- according to the Wall Street Journal [subscription required], the value of the Wilshire 5000 index of U.S. stocks was $17.7 trillion on August 17th.
Thus the banks will need to write off the balance of their bad loans -- perhaps $18 trillion worth. Do the lenders have enough capital to survive such a write off? Do global bank insurers -- e.g., governments -- have enough capital to pay nervous depositors in these banks should they chose to withdraw their funds?
The uncertainty about these questions and the possible cost of making good on all these obligations is the unpaid price of financial alchemy.
Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in the securities mentioned.
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Reader Comments (Page 1 of 1)
8-18-2007 @ 11:12PM
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8-20-2007 @ 2:06PM
say what? said...
I think Mr. Cohan is way off.
1) "let's say their true value is 10% of the $2 trillion book value, or $200 billion " Huh? The real property (collateral) securing these loans has not (and will not) depreciate 90%.
2) If we assume Mr Cohan is right and the CDO owners borrowed against the CDO's, WHAT HAPPENED TO THE $20 trillion they supposedly borrowed? It must be somewhere, and it can't all be in te $2T CDO market. More likely, the CDO holders paid $200B for for the $2T of CDOs, borrowing the remaining $1.8T.
So if the property depreciates 20%, the $2T CDOs will be secured by $1.6T of property, leaving the banks with a $200B loss.