Notwithstanding the views of "Calamity Bill" Poole, it was time for the Fed to act. Observes Dominic Konstam, head of interest-rate strategy for Credit Suisse, the current subprime crisis is worse than the Long Term Capital Management hedge-fund fiasco of 1998. Then, "you could identify the illness and prescribe the right cure," he says. Now, nobody knows where the problem lies other than there was too much of a good thing" in terms of leverage.
Indeed, through the alchemy of derivatives, the risks have been dispersed, from subprime to CDOs and transmitted to the asset-backed commerical-paper market, and perhaps, to a money-market fund near you. When that happens, Bernanke & Co. is certain to take further action, including a cut in the funds rate.
*HOW DID THIS ALL COME ABOUT?* A (bearish) hedge-fund operator, in a letter to his investors, describes how a senior Wall Street marketing director recounted the genesis of the current situation:
"'Real money' (U.S. insurance companies, pension funds, etc.) accounts had stopped purchasing mezzanine tranches of U.S. Subprime debt in late 2003 and [Wall Street] needed a mechanism that could enable them to 'mark up' these loans, package them opaquely, and EXPORT THE NEWLY PACKAGED RISK TO UNWITTING BUYERS IN ASIA AND CENTRAL EUROPE!!!!
"He told me with a straight face that these CDOs were the only way to get rid of the riskiest tranches of subprime debt. Interestingly enough, these buyers (mainland Chinese banks, the Chinese Government, Taiwanese banks, Korean banks, German banks, French banks, U.K. banks) possess the 'excess' pools of liquidity around the globe. These pools are basically derived from two sources: 1) massive trade surpluses with the U.S. in U.S. dollars, 2) petrodollar recyclers. These two pools of excess capital are U.S. dollar-denominated and have had a virtually insatiable demand for U.S. dollar-denominated debt...until now."
These investors then had standing orders on Wall Street desks for any U.S. debt rated triple-A. Through the "alchemy of CDOs" and "the help of the ratings agencies," the CDO managers collected triple-B and triple-B-minus subprime and repackaged them so the top tier got paid out first. Then leverage the lower mezzanine tranches by 10-20 times and, "POOF...you magically have 80% of the structure rated 'AAA' by the ratings agencies, despite the underlying collateral being a collection of BBB and BBB- rated assets."
The letter concludes: "This will go down as one of the biggest financial illusions the world has EVER seen."
And to think it's all played out is even more laughable.