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February 21, 2008

Alphabet-soup debt fallout: Maybe we ain’t seen nothing yet

John Markman is talking about truly exotic debt-shuffling financial instruments such as tender-option-bond programs and auction-rate securities.

They all stem from the increasing reliance, or perhaps we should say, overreliance, on debt in the financial world of the last decade or two:
In a gentler era, debt was important but not as vital to world finance. In recent years, debt became the oxygen of the world financial system, along with a fanciful means of transferring its risks from borrowers and issuers to investors. To the extent that neither debt nor its conveyances are now trusted, even from organizations once considered rock-solid, the entire global banking system is asphyxiating before our eyes. …

Now, with our antennae up, virtually every week we discover a new large but obscure corner of the U.S. and world financial system that -- unknown to all but a few practitioners -- depends on the confidence of debt buyers in order to survive. And they are all today gasping for breath. …

We are not quite talking about a terminal illness here, but close enough. This slow-motion asphyxiation is worse than a flu or pneumonia, and it's more resistant to treatment than cancer. And that's why the problems besetting the market are not solvable by conventional fiscal or monetary policy changes, political gestures or mere tens of billions of dollars in new investments.

Markman then gets to the price tag:
To breathe a meaningful amount of new oxygen into the financial system, and thus effect a lasting reversal in the fortunes of major banks and stocks, experts now believe will require hundreds of billions of dollars just as a baseline.

And no, the Warren Buffets of the world can’t help:
Until U.S., European and Asian central banks, investors and governments can coordinate a solution on an unprecedented scale, all interim white knights are doomed to fail. With them will go every minor stock market rally such as the one that kicked off at the start of this week.

And, here’s why all that money is needed:
Australian derivatives expert Satyajit Das figures there is $1 trillion to $2 trillion in SIVs, leveraged loans, warehoused loans and other assorted junk coming onto banks' books, all of which will tie up liquidity. Add to that the $150 billion to $250 billion in losses already recorded. Then add the roughly $100 billion that authorities believe will be required as reserves to shore up the troubled monoline insurers Ambac Financial Group (ABK, news, msgs) and MBIA (MBI, news, msgs). Call it $1.5 trillion in total (the midrange). So to reserve against that, Das figures banks need at least $250 billion to $400 billion in new capital, because the deficit is constantly growing.

At present the global banking system has about $2 trillion in capital in total. So banks need to raise something like 10% to 25% of that amount in short order at a time when the market is scared and earnings are plunging.

In short, Ben Bernanke can’t even bubble us out of this situation unless a lot of banks engage in a lot of make-believe, combined with inventing some new off-sheet investment vehicle to replace SIVs.

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