Edmund M. McCarthy is President and CEO of Financial Risk Management Advisors Company. This piece was originally published in his newsletter.  

Obviously the above phrase refers back to that wondrous fantasy “ Alice in Wonderland.” Color the undersigned and a lot of other old credit hands as the afore-mentioned Alice! In the third week of March, (a week likely to escape a lot of notice as most of the worthies who have participated in the creation of our very own financial bedlam would have been scurrying to ski or head south for a four, five or more day Easter weekend) the Federal Reserve Bank “amended the recently announced universal bailout! For the brokers stuck trying to finance the alphabet soup creations they have sold the likes of Narvik, Norway, a little town in the Smoky Mountains of Australia and the Florida state run repository for the state’s unsophisticated muni’s (they thought they had a cash equivalent!)

WHAT CHANGES DID “BAMBI BERNANKE” AND HIS MINIONS SNEAK INTO THIS QUIET DAY IN THE MARKET?

We quote from a press release from an incredibly astute source in the industry which actually reads the fine print in the stuff regurgitated by our version of a central bank, but understood by us curmudgeons as the lapdog of the remaining Wall St. “Investment Banks.”

Background: The Fed, as those who have been following the gyrations of this august institution know, created a new “thingie” loosely called the PDCF or Primary Dealer Credit Facility (not to be confused with the TSLF, or more formally The Term Securities Lending Facility or the TAF or Term Auction Facility). The Fed has met this burgeoning crisis, not only with their usual (and in this case, panicked) interest rate cuts, but also through the creation of many new instruments, first for their bank constituency and, more recently, for a broader defined group, including investment banks which are qualified to bid on new government issues. Our folks at the Fed need to get Treasuries to this group and those “thingie’s” such as the TAF or Term Auction Facility, early on created for the banks a way to get around the unwieldy next day payback of Federal Funds borrowings. The original idea was that the Fed would give scarce Government Securities to the  “clearing banks” or takers of “Govies” for 28 days. The Fed was to receive as collateral stuff known as “Level 1.” We are presuming that this is the Level 1 known under the Basel Accord as Level 1. Such is the stuff in the “investment banks” that actually trades regularly and at some kind of spread smaller than the Grand Canyon.

GET THIS! From the Fed

THE FIRST TSLF AUCTION WILL BE A LOAN OF TREASURY SECURITIES AGAINST SCHEDULE 2 COLLATERAL RATHER THAN AGAINST THE SCHEDULE 1 COLLATERAL PREVIOUSLY PROPOSED”  

We are making the assumption (you know what an assumption can do to the “assumer”), and we may have to take the consequences - but we are equating Level 1, Level 2, etc. to Schedule 1, Schedule 2 etc.  

TO FACILITATE THE OPERATIONAL PROCESSES OF THE FACILITY, THE FEDERAL RESERVE HAS ALSO E X P A N D E D! THE LIST OF ELIGIBLE COLLATERAL FOR SCHEDULE 2 TO INCLUDE AGENCY COLLATERALIZED-MORTGAGE OBLIGATIONS (CMO’S) AND AAA/aaa RATED COMMERCIAL-BACKED SECURITIES (CMBS), IN ADDITION TO THE PREVIOUSLY ANNOUNCED AAA/aaa-RATED PRIVATE LABEL RESIDENTIAL MORTGAGE-BACKED SECURITIES (RMBS) AND OMO-ELIGIBLE (YOU FIGURE THIS OUT!) COLLATERAL.

Not only have they gone on down to schedule 2 or “Observable value” stuff, if our assumption is correct,  (which, since it ain’t been trading, could be demoted by a careful observer to schedule 3, “Unobservable values”), they have snuck in the whole next crisis in COMMERCIAL REAL ESTATE GARBAGE YET TO COME! 

THE LAST LITTLE SHOCK - AND DON’T SAY YOU DIDN’T KNOW IT WAS COMING - WILL BE THE BROKERS DOING THE MARKING ON WHAT THEY SEND THE FED TO GET AN EQUIVALENT AMOUNT OF GOVIE’S, BUT ALSO THE MARGIN WILL BE ON A TBD BASIS BY THE FEDERAL RESERVE OR, BABY, WHATEVER IT TAKES TO MAKE IT WORK!
 

WE HEREWITH RECHRISTEN THE FORMER FEDERAL RESERVE BANK AS “DUMPSTER OF LAST RESORT!” OR DLR TO HAVE AN ACRONYM IN PLACE TO BE USED HENCEFORTH. 

We have used up so many capitals in our indignation, righteous or not that we will revert to plain text. Anyhow, we can see further announcements down the road with suitable acronyms including AAA/aaa rated card securitizations, auto securitizations, boat securitizations, airplane securitizations (have to have something for AIG/Immelt/Welsh), etc. The DLR can fund direct from Hankjob and crew so they don’t have the fabled liquidity problem. There may be the odd central bank or sovereign wealth fund somewhere around the world that wonders at the securitization and purchase by the DLR of any amount of Wall St. Financially Engineered dreck, but we have private equity and the now commodity denuded hedge funds to put to work. 

All in all, it has been quite a frenzied period but must be considered another triumph (no matter how long or brief) for the initiators and ringmasters of the Great Global Credit and Derivatives Bubble. The Number 5 house on the street was carried out (litigation to follow, but without the Fed takeout on $30 Billion of Level 3 and other similar putrid assets, it will be hard to find a resuscitator.) Who knows, though, the hubris of some (Look at Lewis and the Bear) is beyond belief and there may yet emerge a prestidigitator. It will take a lot to find the debt side of any equation.

One question worth raising and, at least to the eye of this observer, it has not yet been raised, is the apparent lopsided aspect of this cycle. The havoc, wrought, Armageddon near quotes to be heard and spikes in the VIX are usually reserved for an economy much further down the road of deterioration  

At the moment, the unemployment rate is near a record low. The other indices are showing what can be called pre- or early-recession signs but nothing of the significance of past downturns to create this level of caterwauling. We can only surmise that the investment and big commercial banks have such a “schmozzle” in Financially Engineered” Securitized product that they not only have no bidders or market but have precious little way of simultaneously agreeing on a “mark” for a given piece of dreck to then conclude a sale. This new “Thingie” lets them all find a mark they can show the Fed, get the Fed to provide a reasonable margin and, PRESTO!, we have Level 2 liquidity and market just like 2006 with the only change being a single buyer, the DLR.  

This observer has never been attracted to the “vast conspirator” school of thinking and still is not, but a thought did occurre on the way to understanding the DLR.  

It was obvious last week that, in addition to the 25bp cut in the middle of the night to the Discount Rate, the Board would have to come up with another big cut to Fed Funds. They settled on 75 bps as big enough to keep equities rocking not crashing with promises of more to come.  

The dollar was in free fall and the commodities and/or that “near commodity/near currency” called gold, were on a tear. Since the big players were going to get the benefits of the marvelous TSLF, shouldn’t they help out as the Fed Fund rate was hammered? In no way would we intimate that there were any planned meetings, cabals or other get together which could ever be caviled at by the suspicious.  

IN A PERIOD WHERE ALL OF THE HEAD GUYS OF ALL OF THE BIG BANKS, COMMERCIAL AND INVESTMENT, WERE ALL DRAWN TOGETHER TO ONE EXTENT OR ANOTHER AND GIVEN THE FACT THAT EACH AND EVERY BALANCE SHEET IN THE ROOM WAS ILLIQUID LOAN LONG AND CAPITAL SHORT!

Is it not possible that the odd word or two was passed in the course of rescuing the dear friends from Bear (Conspicuously absent from the decade ago LTCM rescue but the “Ace” of that era was retired and remarkably light on any Bear exposure) that the Fed was going to have to cut and cut big along with the midnight ride to the Discount rate. Future historians can untangle the exigencies requiring that public relations blunder. Hey, these are all prime brokers. They all lend to the “hedgies” and there is even some bucks out to some pretty leveraged private equity players, too. The hedge funds, although they have experienced surprisingly few blow-ups so far (They really couldn’t be smarter than us, it must be an accident of nature!) are way over-levered in this oil/precious metals, foreign currency and commodity game. Why don’t we look for a little more margin, a little less leverage and like magic, the rates can be hammered down WITHOUT the metals, various other commodities, the politically important oil and those pesky foreign currencies going into orbit as the leveraged guys will have to do a great de-leveraging. The Fed and/or Cabal of Central Banks won’t even be accused of an intervention to support the dollar.

The “hedgies” and private equity guys and the panicked folk they sold this trade to will be selling everything else to get the dollar as we de-leverage them. This all may be an illusion or hallucination on the part of this observer but it is WHAT HAPPENED! I am beginning to have a new respect for Bambi/Hankjob: They come up with all of this stuff piece meal so no political coalition is necessary. It doesn’t even get linked on the surface but is accepted as one necessary ”thingie” after another. The dollar, which at this point, yields levels so far below it’s competitors as to look ridiculous, was briefly held up by a combination of trusses, guy wires and machinations in other markets that don’t even spook the folks looking for that intervention which we all know never works for very long. (The question of how long this jury rigged play of de-leveraging will last is not a concern; we can always find another “thingie” (technical term). Sad to say, the rebound of the beleaguered buck couldn’t fight off the oncoming bad news that followed but at least a brief rally was better than a media frenzy over an admitted or rumored intervention and that card is left to play at a later date. On top of everything else we get our balance sheets closer to that mythical safety level. EVERYBODY’S A WINNER!  

SO FAR, AT LEAST, THE DELEVERAGING OF THE WALL ST AND THE BIG BANKS IS HAPPENING WITHOUT WHAT MIGHT BE CALLED A CRASH; JUST A CRUSH!

My colleague, Doug Noland, has a must read piece in this week’s Credit Bubble Bulleting on the Website Prudentbear.com. Once all the thingies are Rube Goldberging their way out of the current crush, if that is the correct term, the machinations over at the other Federal Reserve Bank, Fannie, Freddie and the FHLB are going to require some formal blessing and are in the process of getting it.  If THEIR “thingie” (The increase in the top amount they can lend and the reduction of the Excess Capital requirement imposed back when it was found that Fannie and Freddie had played with the numbers so badly they couldn’t produce numbers the Accountants would certify) works as intended, a ton of Balance Sheet Room will open up in the Investment Bank Production line as the “Other Fed,” Fannie and Freddie, are again wide open for business..  Somewhere in the other Fed, their head minion even opined that, with all of the regulatory easing changes proposed and in process, “The Other Fed” could produce as much as $1.4 TRILLION of new mortgage product, balance sheet and/or guaranteed by “The Other Fed” this year.

Presumably these “successes” will lead to further relaxation and even more growth thereafter, competing with the aforementioned newly revitalized Wall St pipelines and maybe, pray Lord, get a whole new housing boom and bubble re-inflated to humongous proportions. At a minimum, they will NATIONALIZE effectively some $7 Trillion, at a minimum of housing credit.  

DOES ANYONE, ANYWHERE COUNT THE TRILLIONS OF DEBT/DEBT GUARANTEE THE GOVERNMENT IS SO CASUALLY ABSORBING FOR TAXPAYERS IN THIS WHOLE EFFORT? The Fed is way over a trillion already, the nationalization to come by the GSE’s well over a trillion a year, hundreds of billions of proposed abrogation of foreclosure and debt escalation under way in legislation and McCain screaming “Bomb Iran.”  

WITH THIS ONLY THE VERY START OF A RECESSION/DEPRESSION, THERE ARE OBVIOUSLY MORE AND MORE TRILLIONS OF “THINGIE’S” TO COME. HOW IS ALL THIS TO BE PAID FOR?  

Not having a clue as to how to answer that question as the tax increases proposed by the Democratic contenders for the nomination don’t come close, and McCain wants further tax cuts; we raise the other unasked and unanswered question.  

CLEARLY WHAT THE FED IS GETTING AS COLLATERAL for all these “thingies” IS NOT STUFF WHICH WOULD BE RATED BY A REPUTABLE RATINGS AGENCY (IF WE HAD A REPUTABLE RATINGS AGENCY) AS TRULY AAA/aaa IN SPITE OF IT BEING SO RATED!  

HOW LONG IS THE REST OF THE WORLD GOING TO CONTINUE TO BUY OUR 2 YEAR PAPER AT LOWER THAN JAPANESE OR SWISS RATES WHEN WE HAVE AT LEAST A $400-500 BILLION DEFICIT IN 2008 AND BIGGER ONE’S AD INFINITUM AND A TRADE DEFICIT OVER $800BILLION. IS ANYONE ANYWHERE EVER GOING TO ASK HOW IT GETS REDUCED MUCH LESS REPAID?  

It does not seem so.  

We were going to belabor the next two big problems lined up to come down the pike but will only have room to do so briefly as, over the weekend, we glimpsed the tip of the biggest iceberg yet in the credit bubble implosion; the veritable 900 ton gorilla.  

There is no question in the writer’s mind (and in the minds of a large number of knowledgeable Commercial Real Estate entrepreneurs the writer has spoken with) that there is a $Billion plus problem coming for the banks in the loans they made in the latter stages of the housing bubble to the Commercial Construction industry. Three reasons are given.  

The banks and the builders got in late on the housing bubble and had to get terms as good as the sub-primes were getting to make deals work (at cap rates which were predictions of lower left to upper right) and the banks had to find a double digit growth bubble to take over from flagging residential.  

THE THIRD REASON WAS THE USE OF THE “CMBS” WHICH PRACTICALLY DIDN’T EXIST IN PREVIOUS CYCLES. AS WITH MOST OF THE ALPHABET SOUP, HERE ARE A LOT OF THESE DONE BOUTIQUE STYLE BETWEEN BUILDER AND FINANCIER (HEDGE FUND-PRIVATE EQUITY) AND NOT AS READILY EVIDENT AS THE DAYS WHEN THE OCC ALWAYS WANTED TO LOOK THERE FIRST IN THE BANKS.  

The other big one (we won’t bore you with the mundane under a Trillion card problem to come or the fractionated losses on loads of upside down autos (they don’t run well in that position). We are talking about the magnificent world of home equity. With the exception of the rare state of the State of Texas, where 20% equity has to be in the home to make home equity loans, the last few years have seen the magic Trillion dollar mark exceeded in this new game of home equity loans and lines. They were just magnificent fodder for securitization with the generous interest rates a second lien can command and still leave lots on the table for all concerned. In most places 105% loans, piggyback loans and other monikers emerged as all sorts of originators came. Like termites, out of the woodwork to lend the real and/or fictitious equity in your house to you to go forth and keep spending.  

It may be the curmudgeon in me but I wonder how many buyers of the thereafter “financially engineered” securitized product were “fully informed” of the fact that, if a first lien stood in front of them (and almost inevitably it did) the only way out for their servicer to realize any “equity” in the event payments stopped, was to pay out that pesky first lien (usually by then 100% of the “equity”) without even taking into consideration legal fees and other miscellaneous fees in order to accomplish this. Who knows? Maybe Hillary to the rescue will buy out all those firsts using a pile of taxpayer money.  

Enough on these pesky problems, let’s get to the BIG ONE!  

As past readers know; I have been railing about something called the credit default swap market for years now.  

I has always puzzled me how all of the powers that be (You know who I am referring to) could ignore something that globally grew to $44 Trillion + in a very short time.  

Unlike interest rate and foreign exchange swaps, this derivative (recent history has proven) has the capacity for actual risk to approach or even reach 100% of notional risk.

For, as a famous writer calls them “Newbies” by the time netting (another arcane term we will let pass) is completed, real risk in interest rate and foreign exchange derivatives seldom get up to much less over 1% of notional and 3% would be historic. Therefore, powers that be, maybe something toxic enough to rise in risk to 100% should have gotten more notice.  

The trading and creation of this stuff was done by phone and Bloomberg largely.  

It was so sloppily done, the Fedhead NY a couple of years ago had to get excited and demand that the +30% of deals done were unconfirmed be dealt with. (There apparently is some teens % hanging out there without complete documentation.  

The fees were gorgeous and obviously so were the rewards to all the players in the chain.

What essentially was a pure insurance product got dolled up as a derivative. Therefore, no reserves were required. Collateral might or might not be there in whole or in part depending on whether the coffee was from Dunkin Donuts or Starbucks. Capital was way back in some distant parent not in the entity doing the deal. Can you imagine insuring your house with a company with no reserves and no capital and without a written and verifiable policy? Welcome to parts of the $44 Trillion world of credit default swaps.  

Awhile ago, the first crack in this Hoover dam full of toxic material appeared when a company named Aon (fine firm with rating and reputation which had written one of these things) paid out a measly $10 mil and then sought to collect from the “counterparty” they had bought a hedge from. Lo and behold, there was some difference of opinion on Aon’s right to collect. Resolution to follow as not presently known to the writer.  

Over the weekend, in the Credit Bubble Bulletin, Doug Noland picked up on some difficulty Merrill was having on collecting on some $3.1 Billion in this wonderful world of credit default swaps. It’s not clear to Merrill why they didn’t get the $3.1 Billion (They already have plenty of writeoffs/downs and are going to fight).  

My point made earlier is we are in the very early stages of economic slowdown and credit defaults are few, but if this “thingie” is an example of what happens when they get worse. Credit default swaps may well be bigger than anything so far seen in the media might surmise.