Underlying "assets"

David Ignatius:

"If something is 'unsustainable,' that means it won't be sustained." This bit of financial wisdom is attributed to the late Herbert Stein, a former chairman of the Council of Economic Advisers. And it comes to mind now, as a warning about the underlying problems of the financial markets.

Wall Street has been breathing a sigh of relief since the Federal Reserve cut interest rates last week by a half a percentage point. The Dow Jones average has regained much of the ground it lost in July and August -- including a 336-point jump the day the Fed announced its sharp rate cut, which was the market's collective shout of "whoopie!"

But among seasoned traders, I find a much gloomier mood. They warn that the Fed's actions will have only a limited effect on the imbalances in the financial markets. An analyst for TheStreet.com last week asked Satyajit Das, an expert on exotic credit derivatives, whether we were in the third inning of the credit crunch. Das laughed and responded that we're still in the middle of the national anthem.

The best summary I've seen of the current financial picture is the September quarterly report by the Bank for International Settlements in Basel, Switzerland, which acts as a kind of executive committee for central bankers. It warned of the "dark shadow over global financial markets" caused by the collapse of the U.S. market for "subprime" mortgage loans, which was the industry's polite term for mortgages that didn't meet normal credit standards.

The credit market is still locked, months after the subprime problems became clear. Investors can't value their portfolios because they can't sell the underlying assets. Debt that was rated triple-A turns out to be triple-C. In the complex market of credit derivatives, traders tell me it can take weeks to figure out what positions are worth. "That's why the market has frozen up," explains the manager of one leading hedge fund. "We're still in the early stages" of this financial reckoning, he warns.

What's scary is that the financial system has become opaque as assets are bundled and turned into tradable securities. Once upon a time, getting a mortgage was a highly personal transaction: A lender in Des Moines, say, provided money to a local borrower whose income and credit history he knew well. If the borrower got in trouble, the lender could arrange a workout or other repayment terms. The system was transparent, and responsive.

Then the financial engineers took over: The mortgage now is often written by a national lender that has little contact with the borrower; then it is bundled with hundreds of other loans and turned into a tradable security. In theory, the new system spreads credit risk more efficiently, so that each investor can buy the level he wants. But because of deceptive credit ratings (generated by rating agencies eager for fat fees), it turns out investors didn't understand their actual risk positions. And how can they value assets if they can't sell them? That's the meaning of illiquidity.

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I have done a good bit of due diligence work on public finance offerings involving the sale of bonds to finance utilities in districts where developers were improving lots for sale to builders who in turn would sell the homes to people who would be the ultimate taxpayer. But, until that sale took place primary taxpayer in the district was the developer and the builders all of whom were highly leveraged, i.e. they had borrowed money in order to do the development or building. You had to look at the developer's financial statement, his loan agreement and his builder contracts to get an idea of his ability to sustain the development and pay taxes during the early stages of the development. We would also require the developer to indemnify the district and the financial advisers and underwriters for the bonds.

I one had a young financial adviser ask me why I was so keen on looking at all those documents when we had the developers indemnity to protect us. My response was, that if he had the capacity to pay on the indemnity, he would have paid the taxes to begin with and avoided being in the situation where we would call on his indemnity. In other words, the indemnity was mainly to focus the mind of the developer on the importance of the process.

Somewhere along the line in the development of these financial instruments that focus seems to have been lost. What is really curious is the bundling of various credit risks together has apparently had the opposite of the intended effect. Instruments that were created to increase liquidity are also having the opposite effect.

I think what investment bankers will do next is unbundle some of these instruments. Within the bundle are assets of both known and unknown value. Those of known value can be rebundled into instruments that would be immediately liquid. Those assets of varying degrees of value can be separated into instruments with discounted values and higher risk where profits could be significant of the underlying asset recovers. Curing the unknowns is the way out of this morass.