Here's a short history of the "Credit Crisis":
Its hard to say where it all began, but one of the first places it reared its ugly head was in the private equity market. It was in that market that we were introduced to "Pik-Toggle" and "convenant lite" loans as well as 
bridge loans that slowly transformed themselves into "pier loans." After setting all kinds of LBO records and seeing 6 of the top 10 LBO deals in history in a year-long period between 2006 and 2007 many industry types saw the writing on the wall. But, in the infinite wisdom of now unemployed Citigroup CEO Chuck Prince "as long as the music is playing you've got to get up and dance." Was his risk control officer sleeping?
Around the same time the LBO market was imploding, Main Street was getting introduced to what was alternatingly referred to as the "mortgage meltdown" and the "subprime crisis." For a while we couldn't go to a cocktail party without discussing the intricacies of "subprime", "alt-a","no doc", "pay option", "neg am" and all sorts of ridiculous loan programs. Then we watched and laughed as the mono-line mortgage companies like New Century Financial and Accredited Home Loans went under even though Tom Brown assured us these were solid
companies. Once those guys failed we realized that a lot of their mortgages weren't worth anything and we tried to trace them. At that point we stumbled across a veritable alphabet soup of structured vehicles apparently dreamed up by someone who clearly thought that securitization was fun and that acronyms were clever: SIV's, SIV-lite, CDO's, CDO squared, CDO cubed, CLO's, Conduits, CPDO's and all other kinds of "toxic soup." To monitor this mix of letters we visited Markit.com daily to watch the cliff diving in the ABX Index and tuned in to WSJ for our daily update on the fluctuations in the ABCP market. When we looked deeper we noticed that much of this "toxic waste" was rated AAA by the ratings agencies and was held all over the place. Some of it was hiding in our money market funds, some was in Europe and China and some was in our hedge funds.
Speaking of hedge funds, Bear Stearns had some good ones (or at least ones with good names): the High Grade Structured Credit Strategies Enhanced Leverage Fund and the High Grade Structured Credit Strategies Fund. It turns out these funds 
leveraged themselves to the hilt to buy CDO's full of loans that were extended to people with no credit history and no income -- in order to buy overpriced homes with no money down. Needless to say things ended badly. But Bear wasn't the only firm to take a hit. Goldman Sachs had to pump billions into one of its hedge funds and veteran investors from Paul Tudor Jones to Jim Simons to the guys at Sowood all took their lumps. It was around this time that Goldman's CFO David Viniar declared that the problem was that 25-standard deviation events were happening "several days in a row." Berkeley economist Brad DeLong helped bring Viniar's comments into perspective: "the universe isn't old enough for even one 16-standard deviation to have ever happened." Hmm . . one might get concerned if a large Wall Street Firm had a CFO that didn't understand standard deviation . . . or maybe not. After all, Goldman has come to this point in the credit crisis looking better than just about every other bank on the street.
To deal with the ongoing crisis in the alphabet soup mentioned above some brilliant people at SIV City (aka Citigroup) decided to fight fire with fire and came up with a nice little acronym of their own: the Master Liquidity Enhancement Conduit (MLEC). This quickly became known affectionately as the "Super SIV." Then someone woke up and realized that hiding things didn't make them go away and out went the Super SIV. It's a shame to because that would have been a fun experiment.
But we ultimately did find a "solution." In the interest of full disclosure and supposedly to simplify this situation all we had to do was familiarize ourselves with FASB 157 and start referring to assets as Level 1, Level 2 or Level 3 Assets. Level 1 assets are fairly familiar to us, these are friendly things like stocks, bonds and other exchange traded securities. You know, the boring stuff that we actually have prices for. Then there are the Level 2 assets. These are assets that don't have a quotable price but apparently you can "derive" the price from inputs or from other similar assets that actually have prices. These are usually fairly innocuous things like restricted stock, muni bonds and currency swaps. Level 3 Assets are really where all the action is. These are assets that trade so infrequently you can't actually say that there is a legitimate market for them. Not surprisingly most of the acronyms above fall into Level 3. These are the assets that banks and hedge funds "mark to model" according to their own assumptions in order to come up with pricing. I don't even want to start into discussing all the flaws associated with "marking to model." But, I do sincerely hope these are different models than the one's David Viniar builds over at Goldman Sachs to analyze standard deviation . . .
So what's next? Well today we added "Counterparty Risk" to the ever expanding lexicon of the credit crisis. Counterparty risk isn't news to those around Wall Street but like the rest of the alphabet soup it will probably be news to those on Main Street. Counterparty risk basically describes the risk that one party in a trade can't cover its losses. The major problems are probably going to come in the Credit Default Swap (CDS) market. This is the market where one party assumes the risk, for a price, that a bond or loan will go bad. Many investors use this market to remove credit risk from their portfolios or to hedge a balance sheet exposure. Other investors speculate in this market and oftentimes don't have the capital to pay their liabilities in the event of a credit event. We know the speculators are out there because the market is a $45 trillion market. It is a market bigger than the credit market that it aims to protect and is roughly equal to the total amount of bank deposits in the world. It is also a popular market with hedge funds looking for ways to amplify their returns.
Just yesterday, ACA Financial Guaranty Corp. revealed that it is trying to unwind the roughly $69 billion
of credit protection it sold to investors. If you ask me that's a lot of credit protection for a firm with less than $500 million of liquid assets. The problem started when S&P downgraded ACA Financial to junk status and now the firm is clawing to stave off bankruptcy. Something tells me that they aren't alone. As firms scramble to determine their exposure to counterparties like ACA Financial we could see some sort of seize-up in the CDS marketplace. In the meantime we'll probably see some sort of bailout or massive liquidity injection for ACA. Remember when you hear about a liquidity injection think about adding 60 seconds to a ticking time bomb: the goal is to add just enough time to run away before the whole thing blows up.
The next shoe to fall? . . . . could be in the commercial real estate world. Just look at the rising spreads in the CMBX market or follow the continuing saga of Harry Macklowe in New York or Ian Eichner out in Las Vegas. It is clear that many of the loans granted to buy or build commercial properties were based more on the ability to refinance rather than the ability to actually pay the loan. The result will probably be similar to the lending problems in the residential market. Rising defaults will lead to a decline in the desire of investors to purchase more packaged debt and the market will begin to unravel. And since commercial real estate cycles typically trail residential real estate cycles by 6-8 quarters we are just now entering the danger zone for CRE. The other area to watch are all those heavily over-leveraged companies that recently went private during the private equity boom. Many will struggle in the event of a recession and when they are unable to refinance their heavy debt loads will be forced to pursue bankruptcy and/or restructuring. Finally, some of our favorite hedge fund managers will reveal that they are not immune to this crisis. They too will take their versions of the "write-downs" that public banks are taking right now. After all they own the same alphabet soup and have exposure to the same counterparties as the big money center banks. I think it is safe to assume that there will be a few more "Amaranth/LTCM/Sowood" blow-ups before all said and done.
So what can we do to save ourselves? Well for starters, now that we have Bernanke's blessing
we'll probably see a big fiscal stimulus package (update, $150 billion announced today!) and maybe even a surprise rate cut. All of this will be too little, too late and won't bail the US out of the solvency crisis it finds itself in. I wish I could take credit for having the foresight to predict these events, but the award for hitting the nail in the head has to go to Nouriel Roubini who was bearish far before it was popular and has nailed every twist and turn of this ongoing saga as if he can see the future.
So what will we have learned when things start to stabilize? At the root of all is this is the central premise that the whole world of "structured finance"-- which was created under the auspices of diversifying away risk -- has actually hidden and obscured risk. Now it certainly feels like risk is
hidden everywhere and pops up whenever things start to get boring. In many ways the past year has been a bit like a sophisticated game of Whac-a-Mole, the carnival game in which you use a mallet to hit moles that pop out of holes at random. In a financial system that depends upon trust and liquidity, this current round of Whac-a-Mole represents a major crisis of confidence in the financial system and will likely lead to a recession and a bear market. The bottom line is that risk by any other name is still risk. You can slice it, you can dice it, you can package and re-package it, you can name it, re-name it, acronym it, and even insure against it but ultimately it doesn't go away. It is still there lurking, waiting for one of those 25 standard deviation events that comes every 3 years.
Well, apparently Ben Bernanke is an avid reader of this blog because he read my post last night calling for an emergency rate cut and promptly cut rates 75 bps before the open of the market this morning. The move was welcomed by the street and the market reacted positively, rebounding from a miserable open that saw the Nasdaq down almost 5%.
