By Richard Shaw
August 27, 2007
SourceWe can still remember when people were telling us that the subprime crisis was confined to U.S. housing — that it was not a big deal in the final analysis. Well, the final analysis is not in yet, but oh were they wrong.
Not only is the subprime crisis not confined to U.S. housing — it is rippling through the entire U.S. and world economy. The Federal Reserve, European Central Bank [ECB], and the Bank of Japan [BOJ] have injected liquidity . The ECB and BOJ have talked about deferring expected short-term interest rate increases. The People’s Bank of China has been talking up the dollar in response the crisis.
One U.S. money market fund issuer has filed for bankruptcy and the large French insurer, AXA, had to infuse money to avoid “breaking a buck” on one of its money market funds.
The U.S subprime crisis is not just a U.S. housing problem, it is an overall problem for the U.S. and world economy. For a further example, last week, the Bank of China (#2 bank in China) announced that it holds $9.7 billion of U.S. subprime mortgage debt and has begun putting up new loss reserves for that. The reserves are only $152 million so far, but when Chinese banks start having U.S. subprime problems, we’d say the problem is not domestic, is not contained and is not likely fully revealed.
We’d like to add an anecdote from our firm’s direct experience to further illuminate the situation.
Last week, we managed the bid process for a municipal bond refinancing and the market information was astounding.
In a municipal bond refinancing a city that has muni bond proceeds that need temporary investment prior to use will invest the bond proceeds to generate income to pay the coupon on the muni bonds. One method — the one we were hired to manage — is to ask a major institution to provide a guaranteed fixed return for a specified period for a particular sum of money, but with full flexibility for the municipality to withdraw funds as may be required during the life of the guarantee. That is called a “flexible bond repurchase (repo) agreement”.
Normally, the bid manager (that’s us) would send a request for proposal to a significant number of large, high credit quality banking, insurance and investment banking institutions; and then sort through the responses, organize the data in a consistent way and recommend to the municipality which to chose.
The selected repo issuer then puts Treasury securities in the amount of the guarantee in the hands of a third party custodian, and the custodian passes the muni bond proceeds to the repo issuer.
Normally, there is serious competition from institutions to get the business, but not last week. We sent proposal requests to 20 major institutions that routinely do muni flexible repo business asking for a 90 day repo for $20 million and a 1 year repo for another $20 million. Of the 20 institutions only 3 submitted a proposal, while 17 (85%) sent declinations. That level of non-availability is unprecedented.
The reasons given in the responses from the 85% that did not make an offer were of two types: “We have no collateral available” or “We are not currently offering collateralized products.”
NO COLLATERAL! NO COLLATERALIZED PRODUCTS! Those two statements represent a depletion of resources for new investment in the first case, and a general shift away from risk in the second case. The problem is popping up everywhere, and everybody is impacted.