Thanks to SK for forwarding this article from the Fool walking through the nuts and bolts of why the Bush “bail out” is so bad. If you have a few minutes and are interested in a quick summary of some of the implications of the current attempt at putting a band-aid on a compound fracture to save some face on wall street, I would take a look.

Bush’s Bailout Bait-and-Switch

One note though: I think stopping the wave of ARMs is not a bad idea, I just don’t know why this can’t be done through private sector action. Why can’t the holders just re-negotiate terms with homeowners en-masse if necessary? I know there are challenges of collective action among other things, but if these financial institutions are sophisticated enough to tranche up and price a CDO^3, can’t they pick up the phone and talk to a homeowner who is about to be pushed off a cliff?

Things have surely turned dark quickly. It was just three months ago that the concept of a “put” to the government was somewhat in question as I discussed in September.

With three consecutive rate cuts not sufficing to convince the market that the put is strong enough (the market fell 250 points in less than 2 hours yesterday after the 25bps cut was announced), the central banks decided to pump some liquidity directly into the economy as discussed in the following article:
Banks act on meltdown fear

The Bank of England joined four other big central banks around the world yesterday in emergency action designed to prevent the worsening credit crunch derailing the world economy.

These moves coupled with the response to the government’s recent bailout attempt in the subprime market have only done more to stoke the fears that the worst is only yet to come: Bush’s Subprime Mortgage Freeze Stymies Bond Market

I wish that I could say that my sentiments were improving or that somehow these bail out attempts seem to have hope of preventing the onslaught of massive defaults that we are beginning to see emerge, but at this point, the spiral only seems to darken, and even continued attempts at bail out seem doomed.

This is a great sign. It looks like Yale already followed Harvard’s lead in dropping tuitions. Hopefully the tide will swell…

Yale to Join Harvard in Easing Student Cost, Schools May Follow

Yale University next month plans to announce a student aid plan that could rival Harvard’s initiative to ease costs for “middle-income” families.

Again what impresses me about this is both the moral fiber that these schools are showing by doing the right thing, but it can also be seen as a private market solution to the problem of increasing costs in higher education. This, among other factors, has been a major burden for the middle class. It is exciting and reassuring when powerful actors do the right thing to help solve the problems of the marketplace.

This is a really cool article about Harvard’s new policy regarding financial aid. It not only shows how progressive leading universities are now getting with regard to making a real commitment to socially-mobile education policy, it also shows that private sector reform can lead the way to education reform with the right leadership. I hope this is a sign of future reform in this direction as education truly is the most important piece of the puzzle.

Harvard Targets Middle Class With Student Cost Cuts

Harvard University will cut the costs of attending the Ivy League school by as much as 50 percent for families that earn $120,000 to $180,000 a year, making access easier for “middle-income” students.

These families will pay 10 percent of their yearly earnings to send a child to Harvard, the Cambridge, Massachusetts, university said today. The payments decline on a sliding scale, with those making less than $60,000 attending for free. The school also eliminated student loans, saying they will be replaced by grants as needed.

Case in point: if we had a better public education system, perhaps people buying homes at the peak of the real estate cycle with adjustable rate mortgages might have anticipated that this was not an ideal situation for the family budget.

On an unrelated note…
I just read an awesome piece on the credit crisis by Bridgewater. Will try to post about it later. But the punch line is this:

Just because I have been silent on increasing problems in the credit cycle over the last couple of weeks does not mean I feel they are dissipating. Bridgewater agrees, and although slightly more optimistic than me, they are only slightly – and probably ten times more specific in their fears.

Although this blog post is somewhat sensational (even more than me):
CDS Phantom Menace
It did have some pretty sweet pictures of how big the CDS market is getting.

For those who don’t know, basically a Credit Default Swap (CDS) is like an insurance contract. In principle, it lets someone who wants to own a company’s bonds but doesn’t want to risk the company defaulting buy insurance from someone else, who is willing to pay the buyer of CDS protection the face value of the bond if a default happens. In theory, these contracts are used for hedging purposes and are great for isolating the “default” risk of a credit instrument from other risks like the risk of interest rate changes.

In practice, as you can see from the below graphs, the CDS market has become an area where people can either hedge entire portfolios of securities by buying a portfolio-based CDS. Or it allows people to speculate on the implosion of other companies by basically “shorting” the bonds (i.e. if you buy CDS protection and the company goes kaput, you get paid much in the same way that if you short a company’s stock, you get paid if they go belly-up).

What makes the above graphs scariest for me is what is referred to as counter-party credit risk. Basically this concept is why people like to put their money in FDIC-insured banks – if you enter a trade with the bank (i.e. I give you my money, you give it back when I need it with maybe a little interest), you don’t want to worry about them renegging on the deal.

Well in the wild world of CDS-trading, not all counterparties are as credit worthy as the FDIC. In fact, according to a structured derivatives expert I spoke with yesterday, and as discussed in this oldie-but goodie article: Buyers and sellers of CDSs not all sellers are created equally. In other words, there is a chance that the person writing your insurance won’t be there if the fan really gets hit.

Given the current conditions of the market, such a scenario does not seem that far afield. Let’s just hope I am just being paranoid.

But if a recent blog post regarding CDS exposure in insurance cos is any indication, there are major cracks in this market already beginning to form.

Lawrence Summers, former Chief Economist of the World Bank Secretary of the Treasury and President of Harvard, wrote an OpEd this weekend in the Financial Times that echos much of what you have read on this blog. The full article is linked here: Wake Up to the Dangers of a Deepening Crisis

Several streams of data indicate how much more serious the situation is than was clear a few months ago. First, forward-looking indicators suggest that the housing sector may be in free-fall from what felt like the basement levels of a few months ago. Single family home construction may be down over the next year by as much as half from previous peak levels. There are forecasts implied by at least one property derivatives market indicating that nationwide house prices could fall from their previous peaks by as much as 25 per cent over the next several years.

…

Second, it is now clear that only a small part of the financial distress that must be worked through has yet been faced. On even the most optimistic estimates, the rate of foreclosure will more than double over the next year as rates reset on subprime mortgages and home values fall. Estimates vary, but there is nearly universal agreement that – if all assets were marked to market valuations – total losses in the American financial sector would be several times the $50bn or so in write-downs that have already been announced by big financial institutions.

…

Third, the capacity of the financial system to provide credit in support of new investment on the scale necessary to maintain economic expansion is in increasing doubt. The extent of the flight to quality and its expected persistence was powerfully demonstrated last week when the yield on the two-year Treasury bond dropped below 3 per cent for the first time in years. Banks and other financial intermediaries will inevitably curtail new lending as they are hit by a perfect storm of declining capital due to mark-to-market losses, involuntary balance sheet expansion as various backstop facilities are called, and greatly reduced confidence in the creditworthiness of traditional borrowers as the economy turns downwards and asset prices fall.

I am glad to be in school right now so that I don’t have to face the pragmatic consequences of the largest train wreck in history that we have been watching since June.

Another land mine was revealed recently when it Citi and others acknowledged that they basically wrote put options on CDO liquidity. For those who aren’t options savvy, in English this means they agreed to bail out up to $25B of CDO’s to the extent they run out of money.

This article discusses the details, but to me this is just one more in a chain of events suggesting that the full brunt of the credit unwinding that we are currently in the midst of will not be known for at least a year and maybe longer:

The $25bn Citi CDO liquidity put – and who else has one

Happy Thanksgiving!

Google rox. As the blogosphere has been buzzing about they are pushing – not a phone – but an open source type alliance for building the next generation of cell-phone operating systems and software.

Here is a video that will make you smile from the Official Google scoop on the matter:

This site is really funny:

Predatory Lending Association

A nice source for all the know-how you need to be an awesome predatory lender.

I just stumbled on this gem of a press release from S&P in April 2005:

S&P Comments On Risk In Newer Mortgage Products, As Discussed At Industry Event

There are really a lot of good quotes in here for a one page article, but here is a good one from a research analyst discussing Zero Amortization Subprime loans:

“Despite these risks, there isn’t any performance information available on any of these products just yet because they are still very new to the subprime market. Due to the time lag associated with delinquencies and losses in RMBS pools, and the nature of these risks, it will be several years before the product performance is tested. It is anticipated that all risks associated with these loans have been adequately covered.”

Well…I guess they have been “tested” now. So much for adequate coverage.