The Reality of the Credit Collapse
A long train of abuses and usurpations
by Kay Augustin

This is a guest column, apparently elicited by the guest column from Downsize DC on a similar subject, a couple of weeks ago.  Ms. Augustin works in the investment field and may be reached by contacting me here.


"Why should a hard working Chinese farmer be supporting US consumers of video games?"—CNBC correspondent

Today's credit collapse involves economic laws: Cost of capital.  Reducing the cost of capital artificially encourages investors to put money where the return is normally too low. Law of supply and demand.  More demand creates supply.  False (speculative) demand creates oversupply and bubbles.

As I have stated before, this is not just a housing but commercial RE and SIV misallocation.  SIVs were created by greed—off balance sheet entities created to capture the yield curve—invest long, borrow short.  The inverted yield curve collapsed these.

Insurance and hedges (derivatives)—Insurance companies invested in assets with now diminished values.  Prudent holders of risky mortgage paper (and muni bonds) bought insurance which is now potentially worthless.  I am talking about swaps, forwards as well as AMBAC and pals.

US treasuries are held mainly by China and Japan.  Japan has talked much about selling before they are sucked under.  China is backing away from prior "commitments" to invest in US financial companies.  The falling US$ is wiping away millions of wealth.  As one CNBC correspondent commented "Why should a hard working Chinese farmer be supporting US consumers of video games?"

The latest wild cards are the belly aches of shareholders in bankrupt Bear Stearns and the maybe too harsh mark-to-market accounting rules. The last only time will tell if they fanned the fear in an already fragile financial system.

As far as securitization (reselling debt to investors in pools), I have steered clear of these and always been critical.  But Merrill, Bear Stearns and others pushed these investments on retirees. 

Which brings up the other consequence of the low cost of capital:  Retirees and other savers are subsidizing younger people and spenders.  $1 million in savings only provides $20,000 of PRETAX spending.  So retirees are eager for anything with yield.  After all, as long as the securities are solid WHILE THEY ARE ALIVE, they can maintain their dignity. Tomorrow is a luxury they do not have.

The government has been tranching[1] mortgages for years and these CDOs have worked very well when they are transparent, that is, you know what you own. The "repackaging" and "reselling" many times destroys the trail.  Plus the myth of diversification taught to financial planners and in the "prudent man" rule provides a false sense of security.  When the ship sinks, all passengers go down.  Most markets are correlated.

Investors must seek out commodities and inverse derivatives.  Or have 20 FDIC bank accounts each with $100,000 and be able to live on $40,000 pretax and pre health costs (insurance alone is estimated to cost each person over $250,000 during retirement).

If the system survives this, it still cannot survive the health costs of the imprudent baby boomers.


[1] Tranche has two spellings but basically: Investment banker or originator (mortgage bank, etc.) creates a package   bundling many assets, loans)  Then they sell pieces to investors by "slicing off" parts by risk, expected maturities (time investor will receive her principal back) or smaller amounts easier to invest into.

So I can offer clients a three year bond, 15 year bond, or high risk bond, high quality bond, an "interest" in this million plus package confined to the characteristics the client desires.  The problem is that the evaluation is subjective.  Risk can be relative but not absolute.  A low risk tranche would remain lower risk than other tranches within the same package but could become risky as evaluations change. Example:  mortgage bonds 

Investopedia says:

Tranche is a term often used to describe a specific class of bonds within an offering wherein each tranche offers varying degrees of risk to the investor. For example, a CMO offering a partitioned MBS portfolio might have mortgages (tranches) that have one-year, two- year, five-year and 20-year maturities. It can also refer to segments that are offered domestically and internationally.

Financial & Investment Dictionary:


1.  Risk maturity or other classes into which a multi-class security, such as a Collateralized Mortgage Obligation (CMO) or a Remic is split. For example, the typical CMO has A, B, C, and Z tranches, representing fast pay, medium pay, and slow pay bonds plus an issue (tranch) that bears no coupon but receives the cash flow from the collateral remaining after the other tranches are satisfied. More sophisticated CMO versions have multiple Z tranches and a Y tranch incorporating a sinking fund schedule.

2. In the United Kingdom, fixed-rate security issues are often prearranged by governments, local authorities, or corporations, then brought out in successive rounds, termed tranches. One thus speaks of new tranches of existing securities. A variation of the term, tranchettes, refers to small tranches of gilt-edged securities (government bonds) sold by the government to the Bank of England, which then sells them into the market at times it deems appropriate.

3. Subunits of a large ($10-$30 million) Eurodollar certificate of deposit that are marketed to smaller investors in $10,000 denominations. Tranches are represented by separate certificates and have the same interest rate, issue date, interest payment date, and maturity of the original instrument, which is called a tranch CD. 

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