MBA 821 Module 1 Reflections

Reflect on your exposure to bonds and bond pricing. Whether you have invested personally in corporate, government, or municipal bonds, certain key characteristics impact their value. One of the important factors is the risk associated with the issuing entity. Many people have purchased or received a U.S. government savings bond.

When would you consider investing in government bonds?

The answer is yet to come - we will have to sift through the comments below. What should we do is not academic anymore - so we will attempt to theoretically discuss the liquidity issue at hand created by the virtual and magical world of the financial institutions - what is real and what is virtual - problem as discussed is that

WE DON'T KNOW - do you agree with my statements and concerns??

The only time to invest in bonds may be just around the corner. You would purchase bonds if the stock market becomes bearish and the economy goes into a recession. This sub prime mess is being blamed on the wrong groups and the root cause must be acknowledged by the government, the regulators, the banks themselves, etc. This mess was created by the incredible greed of people - trying to turn debt into real money. Many people stood by and allowed all of this happen, which includes the regulators and the credit rating services. The analysis is as such:


Probably not a great time to invest in treasuries right now. This statement is due to the fed dropping the Fed Rate to 4.75%, a weak economy, and an even weaker dollar. Treasuries are becoming a bad investment, short-term, for foreign investors. The interest rates are dropping and the their currency is strengthening as the Fed drops the rate even further, all things staying even. Also think about foreign investor borrowing funds from the US, due to lower rates than their own countries. They could borrow at very low rates (would be willing to borrow at higher rates than Americans - due to currency exchange rates) and invest in their own countries bonds etc at much higher rates. This in turn could cause a global crowding out effect. This creates a liquidity issue potentially for the US Government - if no one wants to purchase treasuries. The fed could demand the banks to purchase them, but would tighten the money supply, etc. Round and round, but we get the picture.

The only time to buy in this market is of the foreign investors needed short-term money right now and could not get the money through borrowing. This would cause them to dump the treasuries on the open market, causing the prices of the these treasuries to drop or sold at a large discount - this in turn would cause the yields of these sharply discounted bonds to rapidly increase. Again an issue with global liquidity could cause dramatic events to take place.

Read a number of articles. A few dealt with Satyajit Das, an expert on the derivatives market and the entire CDO, CMO, and CLO magical financial instruments.

This whole mess is due to the allowance of financial engineers creating a "liquidity factory" built on underlying assets of mortgages, etc. They created instruments that over leveraged the "loop holes" and increased the money supply in a way not intended by anyone. They further increased the "money supply" or the multiplier of any monies injected into the economies. The regulators allowed it, all of investors (hedge funds, etc) did not understand them - just the high yields, and banks enjoyed all of this liquidity with their "off-balance sheet" transactions. They were lending out more money and basically getting around their reserve ratio requirements.

The yield curve was flat, which sharply reduced the spread and encouraged lenders to search for cash flow, etc. These lenders needed higher cash flows, due to lower spreads in order to fuel or meet their aggressive and greedy need for growth and acquisitions to fuel this growth. Since in acquisitions, the acquiring company basically pays a 20 to 40 % premium - this premium had to come from some place. So instead of Banks being traditional and underwriting as well as fund the loans - they just acted as originators of these loans. These loans were wrapped up into CMOs, CDOs, CLO, etc. This allowed the banks to take these "loans" off their balance sheets and then "magically" have more money to make further loans. They used debt - CDOs - as collateral to fund more loans.

Foreign investors, mutual and hedge funds, etc leveraged their investments by buying CDOs, etc. with their borrowed money. Basically had debt purchasing further debt on so on and so on - How deep does this rabbit hole really go? No one really knows!!

The credit rating services also either did not understand or chose not to dig deeper and understand, which placed everyone at great risk. No one wanted to be the whistle blower and end the gravy train that all the greedy were eating off of - at our expense. The credit rating services stuck by their out dated or irrelevant mathematical models and believed this output without full knowledge or understanding of the inputs. They chose not to challenge the flawed mathematical models of the financial engineers that created this magical instruments of wealth - these money creating machines! This all allowed the debt to move from heavily regulated institutions into less regulated instruments and institutions - and all with AAA ratings! This was further fueled by bankers "stripping" all apparent assets out of these instruments - further increasing the loan to value ratio in a sense. It is being said that a single dollar of capital or the true/real underlying asset was turned into $20 to $30 of debt or a highly leveraged scenario. Compare this to the reverse ratio requirement of being dropped to only 5 % or even 3.5% from the current 10 %!! This translates into a huge injection in the money supply, except it is all smoke a mirrors! No real money was actually there. Seems to be very similar to the margin calls of 10% during the 1920s that lead to the crash of 1929. Currently banks are fighting to ensure that these derivatives are not being sold at a discount because these being sold at a discount amplifies these discounts of the true underlying assets even further. This was also fueled by the stock market valuations through MBOs, LBOs, stock repurchases, takeovers, acquisitions, etc that have inflated the market somewhat - all that money came from these highly leveraged CDOs, etc instruments.

It is also apparent that blame is going around like wild fire and who is the one who created the fantasy - but the Financial Accounting Standards Board (FASB) and their "level 3, under statement 157". This level 3 is a way for fair value to be measured using "unobservable inputs". What companies claim they can not see and these unseen items are assumed to change their fair values of their assets and liabilities - they are allowed to use their own subjective assumptions (make it up as they go in order to inflate their assets and liabilities). This level 3 treatment magically transforms subjective assumptions of make-believe into reality with a stoke of their own assumptions. Should not the FASB be pushing for conservative approaches and advocating against these off-balance sheet transactions? Also where are the regulators validating "these level 3 subjective assumptions?"

The world of structured credit is living in the make-to-model fantasy world and is being embraced by Financial Institutions and FASB. If you are over leveraged - so what, just use the level 3 magic wand and mark the debt as anything they wish through subjective (and self servicing) assumptions. They all now think they should be allowed to declare - Predict the future gains, based on past gains (even though every single mutual funds, broker etc states a declaimer that past results do not predict future results) and then amortize them into income. This makes the financial statements of financial institutions worthless and unbelievable. You have worthless financial income statements of these financial institutions - many running virtual S&Ls through a fantasy/virtual off-balance sheet entities.

Is this a video game or an excursion of the website second life? No it is and has happened. We have been warned numerous times about blurring reality and real life with the made-up, fantasy of the virtual world.

Why did no one see the mess coming? Off-balance sheet entities and their transactions are just that virtual. You can not see them - so how can you understand or any issues/problems of something you can not see??

Commercial paper - currently in an illiquid environment. Banks are holding over $300 billion of LBOs, etc that they have committed to finance. Assets based CPs - many of them need to be refinanced and no one right wants to touch the refinancing of these CPs. A big problem. Everyone is scared and watching out for the lesser rated tranches of commercial mortgage backed paper.

Now enter the world of Structured Investment Vehicles (SIV) and Special Purpose Investment Vehicles (SPIV). All of these are "Off-Balance" sheets and they operate in the virtual world with NO rules to govern their actions, etc and there is NO ONE to regulate what they are doing. The financial institutions are utilizing more leverage than legally allowed, but they are getting away with it. No one understands what they are doing and it seems that the regulators and FASB do not wish to dig deep and truly understand what they are doing.