In the Arabian Nights, the beautiful princess Scheherazade buys one day of life at a time by recounting fantastic fables that entrance the King who has condemned her to die. Investors and traders are currently telling each other fairy tales to buy one day at a time to stave off the inevitable.

Dramatic recent events are not symptoms of the disease but the cure. The “disease” is the excessive debt and leverage in the financial system. The “cure” is the reduction of the level of debt (the great “de-leveraging”).

The initial phase of the cure is the reduction in debt within the financial system. The overall losses to the financial institutions (net of re-capitalisation via new equity issues) are $400 to $600 billion and may well go higher. This requires reduction in financial sector balance sheets through reduction in lending and asset sales.

The second phase of the cure is the higher cost and lower availability of debt to the real economy. This forces corporations to reduce leverage by selling assets, reducing investment and raising equity. This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.

Feedback loops mean reduction in investment and consumption lowers economic activity placing stresses on corporations and individuals setting off defaults that trigger losses for the financial system that further reduces lending capacity. De-leveraging continues through these iterations until overall levels of debt reach a sustainable level determined by lower asset prices and cash flows available to service the debt. The process of destruction echoes W.B.Yeats’ words: “All changed, changed utterly: A terrible beauty is born.”

Fairy tales in financial markets focus on the “superhuman” abilities of regulators and governments to avoid the de-leveraging under way. Central banks and governments have taken progressively more aggressive actions to try to influence events.

Central banks have aggressively supplied liquidity to the money markets accepting an increasing range of collateral. Central banks may soon accept football cards and Lehman, Bear Stearns and Washington Mutual (“WaMu”), Fortis and Dexia memorabilia (mugs, stress balls, desk-decoration cubes that open up to reveal Lehman Brothers’ key operating principles. - “demonstrating smart risk management”).

Government and central banks have also “bailed out” a number of financial institutions using a variety of strategies to limit contagion. Most recently governments have resorted to injecting equity into selected banks and providing extensive guarantees supporting bank borrowings.

The actions have been increasingly directed at three areas. Banks are being forced to write-off bad loans without delay. Bank capital needs are being addressed by forced mergers and restructuring, new equity issues and (in the absence of other options) nationalisation or liquidation. Central bank guarantees of all major borrowings and other transactions to reduce solvency risk for banks are designed to enable normal transactions between parties in the financial markets to resume. The necessary coordinated global action appears at last to be under way though significant differences in the doctrines and details have emerged.

Lower interest rates and increased government spending have also been used to try to reduce the effects of the financial crisis on economic activity in the “real” economy.

The initiatives are sensible short-term measures to stablise markets. In the longer run, they transfer the problem onto the government and taxpayer balance sheet. For example, US Government support for financial institutions in this financial crisis is already approaching 6% of GDP compared to less than 4% for the Savings and Loans crisis. The bailout of Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) has almost doubled US national debt. This will ultimately place increasing pressure on the US sovereign debt rating and vitally the ability of US to finance its requirements from foreign creditors.

It remains to be seen whether these global initiatives achieve the required re-capitalisation of banks improves the normal supply of credit to sound borrowers and also reduces fear of default allowing normal activity between institutions to resume.

The key issues remain availability of capital and liquidity. The perceived abundance of liquidity was, in reality, merely an illusion created by high levels of debt and leverage. As the system de-leverages, it is becoming clear unsurprisingly that available capital is more limited than previously estimated.

Central bank reserves and sovereign wealth funds are often cited as evidence of the amount of available capital. These reserves are invested in US dollar denominated US Treasury bonds, GSE paper and highly rated securities. It will be difficult to mobilise the funds and convert them into the home currencies of the investors without large losses.

The risk of a severe dislocation in global capital flows remains a real risk in the present environment. Some have called for a global conference (along the lines of Bretton Woods) under a respected chairman (Paul Volcker is the obvious choice) bringing together all the major players to address key structural issues within the global financial system. Any such conference would focus on economic reforms (capital flows, currency policies, fiscal disciplines, trade barriers) necessary to find a resolution to the crisis.

A principal objective of this conference would be ensuring supply of funding for the US in the transition period. Recent comments by China about US responsibility for the crisis and its resolution miss the point. As China’s Premier Wen Jiabao observed the U.S. financial crisis may “affect the whole world”. As Wen noted: “If anything goes wrong in the U.S. financial sector, we are anxious about the safety and security of Chinese capital…” All creditors have much to lose if the de-leveraging process becomes dis-orderly.

Ultimately, “all the king’s horses and king’s men” cannot prevent the de-leveraging of the financial system under way. The extent of de-leveraging is substantial and likely to take time. In recent years, money was cheap and other assets were expensive. As each of the global economy’s credit creation engines breaks down and systemic leverage reduces, money becomes scarce and more expensive triggering substantial adjustments in asset prices in a reversal of the process.

David Roche of Independent Strategy, a consulting firm, estimates that $4 to $5 of debt is now required to generate $1 of economic growth. As credit creation slows and debt levels fall, the sustainable level of global economic growth may fall as well.

At best, the government and central bank actions can smooth the transition and reduce the disruption to economic activity in the transition to a lower debt world. The risk is that well-intentioned steps prevent the required adjustments from taking place, delay recognition of problems and discourage action that must be taken by financial institutions, corporations and consumers.

Like a giant forest fire the de-leveraging process cannot be extinguished. Thoughtful actions can create firebreaks that limit preventable damage to the economy and the international financial system until the fire burns itself out.

The Arabian Nights had a happy ending. The King after 1,001 night of enchantment and three sons pardons the beautiful Princess Scheherazade who becomes his queen. Despite the fairy tales that investors are putting their faith in currently, the de-leveraging that is at the heart of the current financial crisis may not have such a happy ending.

© Satyajit 2008 Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

Hope of an early resolution to the credit crisis seems to be fading. In the words of Lily Tomlin, the American comedian: “Things are going to get a lot worse before they are going to get worse.”

The total level of sub-prime losses is still far from clear. Estimates of losses range between US$ 500 and 2,000 billion, not all of which has been written off to date.

Interest rates on large volumes of sub-prime mortgages – are due to reset. Interest rates and repayments will rise significantly. The impact on delinquencies and losses are unknown. The rate reset freeze plan (which has not been in the news since being announced) and its impact are also still unclear.

As America’s mortgage markets unravel, economists initially pointed to sub-prime mortgages issued to low-income, minority and urban borrowers. Closer analysis reveals risky mortgages in nearly every corner of the USA. Analysis by The Wall Street Journal indicates that from 2004 to 2006, when home prices peaked in many parts of the country, more than 2,500 banks, thrifts, credit unions and mortgage companies made a combined US$1.5 trillion in high-interest-rate, high risk loans. The potential losses on these loans are unknown.

There are also emerging concerns in the US$915 billion credit card debt markets. Credit card providers are all boosting loan loss provisions. There is anecdotal evidence that cash strapped mortgagors are using credit cards to make mortgage payments. Analysts expect credit card delinquencies to increase if consumers unable to use home-equity lines of credit to pay off their credit card debt start running up higher card debt. A number of banks have begun to boost reserves against anticipated losses.

Financial institutions have already incurred losses of over US$500 billion. A substantial volume of assets is likely to return onto bank balance sheets as off-balance sheet structures and hedge funds are forced to sell. The total amount to be re-intermediated by banks may be in the range of US$2 to 5 trillion. This will make substantial depends on bank liquidity and capital.

There are already signs that the major banks are hoarding liquidity in anticipation of the return of assets. They will also inevitably have to raise substantial amounts of capital.

Asset backed conduit vehicles and SIVs (“Structured Investment Vehicles”) may need to sell assets as they breach their rules. Hedge funds face substantial redemption requests in the coming months. This will exacerbate the demands on bank capital and liquidity.

The credit issues have widened beyond banks, investors and hedge funds active in structured credit.

In the conventional mortgage market, Fannie Mae (Federal National Mortgage Association) and Ginnie Mae (Government National Mortgage Association) have recorded losses and been nationalised. This suggests that the problems in the housing market are deep seated.

Mortgage insurers and monoline insurers have suffered serious collateral damage. The significant downgrade in the rating of insurers will be particularly damaging. It will affect around US$ 3.5 trillion of municipal bonds guaranteed by the insurers. It will also affect other bonds wrapped by the insurers. This may trigger further selling pressure and contribute to decline in prices as well as absorbing increasingly scarce liquidity.

The US$ 2 trillion of European pfandbrief or covered bond markets have also experienced liquidity problems.

The sub-prime model is also used for leveraged funding in private equity, infrastructure and commercial property financing.

The crisis has spilt over into other markets. In Great Britain, Ireland, Spain, Australia and other markets strong house price appreciation similar to the US led to similar growth in mortgage and real estate lending. If economic growth slows and housing prices fall then similar problem may emerge in those economies as well.

There are already signs that there will be significant litigation against the banks. There may also be regulatory investigations and potentially prosecutions. State Street recently provided over US$250 million against future litigation claims. The total cost of all this is still unknown.

The financial elements of the credit crunch are becoming clearer - higher credit costs; lower availability of debt; forced de-leveraging of hedge funds and conduits/ SIVs; significant capital losses for financial institutions. The real economy effects will be slower to emerge. Higher credit costs and tighter credit standards will affect all business.

The US housing industry is badly affected with no immediate prospect of a quick recovery. The outlook for US house prices is poor. Growth forecasts for the US have already been lowered. The dreaded “R” word – recession – is now being talked about.

The fall in asset prices has “wealth” effects. Then there are employment and income effects. Wall Street has already issued “pink slips” by the thousands as banks and mortgage lenders shed staff. More will be issued in 2008 as the slowdown in the financial services business continues.

A slowdown in economic activity will affect many financial transactions. Corporations with significant debt face refinancing challenges. All financing has slowed, the cost has risen significantly and terms have tightened.

Private equity deals in recent years were predicated on a combination of a growing economy, cheap debt and a buoyant stock market allowing the quick resale of the company. Weaker earnings and more expensive debt could lead to losses and distressed sales over time. Recent private equity deals also face re-financing risk. Some US$ 150 billion of leveraged loans come due in 2008 and 2009. Financial engineering techniques – toggles, pay-in-kind securities and covenant-lite (lack of maintenance covenants) structures – will delay the problem but probably cannot forestall the inevitable rise in defaults.

Non-investment grade bond issuance over the last few years was concentrated in the weaker credit categories and is vulnerable to deterioration in economic conditions. Since 2003, 42% of bonds of high yield bonds issues were rated B- or below. In the first 6 months of the year that percentage rose to around 50%. Some commentators believe that the losses of corporate bonds will peak between 10% and 20% leading to significant losses.

Warren Buffet once observed that: “it’s the weak link that snaps you…in financial markets, the weak link is borrowed money.” In the present credit crisis, all companies and business models reliant on debt – especially cheap and abundant debt - look vulnerable.

The real economy effects will feedback into the financial markets setting off new phases of the crisis.

CDS contracts used to hedge credit risk have significant documentation and operational problems. If actual defaults in markets increase and the contracts do not function as intended then there would be additional complexity. A significant volume of CDS contracts is with hedge funds and other investors secured by collateral agreements. The counterparty and performance risk of enforcing the contracts may be challenging. It is important to note that the structured credit market in its current form is substantially untested. If defaults rise and the CDS contracts prove to be difficult to enforce then bank exposures to losses may well much higher than anticipated.

Markets remain gloomy. They are waiting anxiously for “the shoes to fall”, except it seems that the shoes are from Imelda Marcos’ collection.

At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.

© 2008 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

Will Rogers once remarked that: “You can't say that civilization don't advance; for in every war they kill you a new way”. In the current credit crunch, the behaviour of inter-bank rates is proving deadly to a new generation of traders.

The difference between inter-bank rates (LIBOR or the London Inter-bank Offered Rate or it equivalent in other currencies) and central bank rates or government bond rates has increased sharply. This is making inter-bank and corporate borrowings expensive contributing to problems in the credit markets.

This difference is the “swap spread” also known as the Treasury Eurodollar (“TED”) spread - the margin between inter-bank rates and government bond rates of the same maturity.

Swap/ TED spreads are up 30/40 basis points per annum to around 60/70 bps. During the 1998 Russian/ LTCM episode swap spreads peaked at well North of 100 basis points per annum.

Swap spreads are first and foremost generalized market credit spreads. Historically, they track the credit spread of AA /A rated bonds issued by financial institutions. During good economic times, swap spreads decrease as overall credit risk diminishes. The opposite happens when the economy slows. Swap spreads also increase when funding requirements rise, asset volatility (e.g. equity volatility) increases and financial leverage is high.

During market disruptions, swap spreads are affected by the “flight to quality” – the switch to the safety of government securities. Dealers are ruled by the adage: “don’t panic but if you are going to panic, panic first!” In crises, bank credit is re-priced driving up swap spreads. Higher credit spread volatility also force dealers to hold additional capital increasing spreads.

In the current credit crunch, bank credit risk has deteriorated sharply as a result of losses on sub-prime (currently around US$ 100 billion plus and still counting). There is palpable fear of a bank defaulting in the money markets reflected in the very wide spreads in the credit default swap market currently are testimony to this fear.

Investors have sought “safe harbours” buying government bonds driving down Treasury rates, especially at the short end of the Treasury curve. Repo rates, closely tied to Fed funds and discount rates, have fallen. Credit spread volatility is very high forcing dealers to hedge.

All this means that inter-bank rates (LIBOR and Euro-IBOR) have stayed high while government bond rates have fallen sharply. This has increased swap spreads.

The beginning of 2008 brought some relief for banks. TED or swaps spread fell as the difference between inter-bank rates and official targeted central bank money market rates declined. In mid January the spread actually went negative - the overnight rate US$ LIBOR (“London interbank offered rate”) closed below the Fed Funds target rate. The 3 month US$ LIBOR for dollars also fell sharply - by around 20 basis points to 4.06%. This was its biggest fall since 19 Sep 2007 when the Federal Reserve Open Market Committee’s cut the Fed Funds rate by 0.50%.

The decline in the spread was technical. Fears of a recession mean that the money markets expected a sharp cut in US official rates. The inter-bank rates were merely anticipating the cut. When Fed Funds rates were cut (by 0.75% pa) then the TED spread became positive.

Swap spreads will continue to be under pressure and remain volatile until the underlying credit risk conditions in the bank market change.

The outlook for bank credit remains uncertain. Major global banks will record significantly lower profits and in some cases losses in 2007.

A large volume of assets - somewhere between US$ 1 and 2 trillion - held in off balance sheet vehicles such as collateralised debt obligations (“CDOs”), asset backed security commercial paper (“ABS CP”) conduits and Structured Investment Vehicles (“SIVs”) are likely to return onto bank balance sheets. A known unknown is the further amount of securities held as collateral for loans to hedge funds that may come back onto bank balance sheets. This re-intermediation is forcing banks to raise substantial volumes of term debt placing additional upward pressure on bank credit spreads. Banks have also been hoarding cash in anticipation of higher funding needs.

Bank capital positions have been sharply impaired. Recapitalisation of the banks is heavily dependent upon the investment appetite of sovereign wealth funds and banks in Asia and the Middle East. Given the size of the requirement and the frequent trips, this well is at risk of running dry.

The quality of the banks credit portfolios remains questionable. In 2007, the banks losses were related to large mark-to-market changes in the value of structured securities (mortgage backed securities and CDOs) and leveraged loans. There were few actual defaults.

As the economy slows and borrowers need to refinance, actual losses may occur. Lenders to non-investment grade companies and private equity transaction look vulnerable. Consumer lenders have already reported slowdowns in consumer spending and increase in write-offs. Automobile loan delinquencies are also rising. Also if the mortgage rate freeze plan does not have the intended effect, mortgage losses in the US may also increase beyond anticipated levels.

Financial institutions also face a subdued profit outlook. Key areas of recent profitability (mortgages, securitisation and structured credit) are not likely to return to previous levels for some time. Corporate finance and mergers and acquisition revenues are slowing. Strong trading revenues will slow as risk appetite and capital available for risk taking reduces.

It is unlikely that the credit quality of the banking system will rebound drastically. Certainly, the current share prices and credit default swap (“CDS”) spread are not optimistic - in January 2008, a ‘A’ rated industrial company was able to issue bonds at a spread below that of a ‘AA’ rated major bank.

An additional complication will be the CDS market itself. Banks have used this market to lay off risk. There are significant documentary complexities – some untested. The efficacy of the CDS will depend on the quality of the counterparty to which risk has been transferred. If actual defaults occur and the CDS market does not function then uncertainty about who is holding which risk and concerns about bank credit quality may re-emerge.

Central bank rate cuts have had minimal effect on the swap spreads. Bank and corporate lending rates that price off swap rates have remained largely immune to the palliative of lower rates.

On Wednesday 12 December 2007, central banks - the US Federal Reserve, the European Central Bank, the central banks of Canada, England and Switzerland with the support of the Bank of Japan, Sweden's Riksbank and Australian Reserve Bank – took the unprecedented step of conducting auctions to provide funding directly to banks. This was specifically targeted at reducing the swap spread and bringing down inter-bank borrowing costs.

The current initiatives of central banks have minimal effect on the spread. In fact, they may make the position worse. If the central banks withdraw the emergency liquidity as the European Central Banks (“ECB”) intends then money market liquidity condition will tighten. If the central banks continue to supply liquidity then they may set of inflationary expectations causing longer-term rates to increase sharply. This may be their strategy in any case.

The current spread in US$ between the 2-year and 10 year Treasury is around 120 basis points. In 2003 after the Fed cuts short-term rates to 1.00%, the spread went to 275 basis points. Traders currently expect the 2/10 spread to hit 250 basis points. Higher long-term rates will affect the cost of mortgage debt and term borrowings. This will not help the housing market and may in turn lead to higher defaults.

Regulators and central banks have few policy tools to directly influence the market driven swap spread. Cuts in central bank rates and pumping liquidity via money market operations into the system has little if any impact on the swap spread. It is only change in overall credit conditions and especially bank credit risk that will affect the swap spread.

The TED spread has a parallel in commodity markets – the “Dead spread”. This is the spread between live hogs and pork belly future contracts. At present, bank traders like the unfortunate pigs are getting killed as their funding costs continue to spiral upwards.

© 2008 Satyajit Das

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

In good times, financial markets embrace Capitalism. In bad times, financial markets re-discover Socialism. Currently, the US Federal Reserve is engaged in a dangerous strategy to look after its Wall Street friends.

The origins of the current credit crisis lie in loose monetary policy and excessive capital flows that was turbo-charged by “financial engineering” techniques used by banks. Borrowing bought more borrowing fueling price increases in financial assets - debt, equity, property, infrastructure.

In recent months, major banks have reported losses of around US$ 45 billion on their investments. Up to US$ 1 trillion of assets are also on their way back onto bank balance sheets as complex off-balance sheet structures (Collateralised Debt Obligations, conduits issuing Asset Backed Commercial Paper and Structured Investment Vehicles) are unwound.

The major regulatory response has been cuts in the US Fed funds rate (0.75 % pa) and the discount rate. In recent weeks, the differential between inter-bank rates and the central bank targeted rates has widened to levels not seen since August. This points to further potential cuts in both rates by the end of the year. Lower cuts are inconsistent with above target inflation levels resulting from high oil prices, higher food prices, increasing cost pressures in emerging economies such as China and the potential inflationary effect of a weaker US dollar.

The US central bank’s strategy is clear. The current credit problems require a substantial reduction in the level of borrowings and leverage in the global financial system. Asset prices ramped up by excessive debt need to adjust. The adjustment can take place via a “crash”. This would be de-stabilizing and would wreak further havoc on already weakened banks. Alternatively, the de-leveraging and price adjustment can be achieved by creating inflation through loose monetary policy. If asset prices remain at current levels, higher inflation allows values to fall in real terms. Higher inflation also reduces the value of the borrowings that must be paid back allowing the required reduction in leverage.

Between January 1960 and December 1974, the Dow Jones Industrial Average was substantially unchanged. This is despite significant periodic rallies during the “go-go years”. If inflation averaged 5% pa, then the value of the market (ignoring dividends) lost around half (50%) of its value in real (inflation adjusted) terms.

The Fed strategy also assists affected banks. The large writedowns in risky assets and the expected re-intermediation of assets means that some banks need large infusions of capital. Given recent performance and subdued profit outlook, it would be difficult for them to raise this capital at acceptable prices.

Lower short-term interest rates allow banks to borrow cheaply. The money can be used to purchase government bonds that provide higher returns than the cost of borrowing. This generates profits for the bank without the banks having to hold capital against their assets (banks generally are not required to hold capital against government securities). The profits help re-capitalize the bank. An added benefit is that the US government can fund its deficit by selling its debt to the banks. This would be handy if foreign demand for US Treasuries decreases in response to the weaker dollar. The Bank of Japan used the same strategy to re-capitalize the loss making Japanese banks after the collapse of the “bubble economy” in 1989.

Higher inflation expectations are already evident in higher gold prices, the steeper US yield curve (long term rates are higher than short-term rates) and the weaker US dollar. Foreign investors, especially large sovereign investment funds, are switching from financial assets (bonds) to “real” assets (companies with real businesses) reflecting higher inflationary expectations.

The strategy is dangerous. Inflation can lead to a significant transfer of wealth from investors to borrowers. Inflation once embedded in the economy distorts economic activity such as investment and savings. The experience of the late 1970s and early 1980s highlights the difficulties in recapturing the inflation beast once uncaged. Paul Volcker, then Chairman of the Federal Reserve, bravely increased interest rates to stratospheric levels to squeeze inflation out of the financial system.

The strategy may also not work. The cuts in rate do not appear to have had the desired effect in improving market liquidity conditions. Default risk concerns continue to inhibit lending and other routine financial transactions. Lower rates may set off further bubbles – for example, in equities and emerging markets. Asset prices may fall sharply anyway. In fairness to Dr. Bernanke, he has limited policy alternatives available.

Central bankers have stated that “errant” banks and investors will not be “bailed out”. Actual actions suggest otherwise. Banks have played their “nuclear” option well. The specter of “systemic risk” – whether real or not - is one a central banker cannot ignore. The strategy has attracted little scrutiny or comment despite being implemented by unelected officials with public money and without any transparent political debate.

The banks continue to privatize gains and socialize losses. Socialism for Wall Street will prevail, once again.

© 2008 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).