The 100 Year Storm
In his latest MSN's Jim Jubak explains in detail, how the damage from imploding derivatives, CDO's, CLO's & LBO's could cause more than collateral damage, a must read.
"No one ever insures against the worst possible storm that they can imagine. It's simply too expensive to take out coverage for such a low-frequency event.
So homeowners pay premiums based on the worst storm of the last 100 years or 50 or 20.
Same with the high-risk slices of debt pools. The more debt in these slices, the less that can be sold -- with higher ratings and lower yields -- in the BBB, A and AA tranches.
Once that insurance is breached, (which has already happened with the sub prime debacle), two very bad things happen.
First, the investors who elected to buy the equity tranche (BBB rated with the highest yields) , attracted by the possibility of an equitylike return on a fixed-income investment, get killed.
Hedge funds bought about 10% of equity tranches in 2006, according to Bear Stearns. But pension funds bought more -- 18%. Insurance companies bought even more -- 19%. And asset managers bought even more -- 22%.
When pension funds take big losses, parent companies have to make up the loss or workers have to take smaller pensions. When insurance companies take the loss, insurance rates go up.
When asset managers take the loss, well, we all cry when we open our monthly mutual-fund statements.
And second, after the insurance is stripped away, the prices of higher-rated slices of the debt pool start to tumble to reflect that greater risk.
That's the worry facing the market right now. Merrill Lynch's attempt to auction off the collateral from the sinking Bear Stearns Fund revealed that the market is well beyond the 5% price drop that Grant's Interest Rate Observer pegged as a danger point.
Merrill Lynch succeeded in auctioning off some collateral at 90 or 95 cents to a dollar, but other collateral didn't sell at all, even at discounts of more than 50%."
"No one ever insures against the worst possible storm that they can imagine. It's simply too expensive to take out coverage for such a low-frequency event.
So homeowners pay premiums based on the worst storm of the last 100 years or 50 or 20.
Same with the high-risk slices of debt pools. The more debt in these slices, the less that can be sold -- with higher ratings and lower yields -- in the BBB, A and AA tranches.
Once that insurance is breached, (which has already happened with the sub prime debacle), two very bad things happen.
First, the investors who elected to buy the equity tranche (BBB rated with the highest yields) , attracted by the possibility of an equitylike return on a fixed-income investment, get killed.
Hedge funds bought about 10% of equity tranches in 2006, according to Bear Stearns. But pension funds bought more -- 18%. Insurance companies bought even more -- 19%. And asset managers bought even more -- 22%.
When pension funds take big losses, parent companies have to make up the loss or workers have to take smaller pensions. When insurance companies take the loss, insurance rates go up.
When asset managers take the loss, well, we all cry when we open our monthly mutual-fund statements.
And second, after the insurance is stripped away, the prices of higher-rated slices of the debt pool start to tumble to reflect that greater risk.
That's the worry facing the market right now. Merrill Lynch's attempt to auction off the collateral from the sinking Bear Stearns Fund revealed that the market is well beyond the 5% price drop that Grant's Interest Rate Observer pegged as a danger point.
Merrill Lynch succeeded in auctioning off some collateral at 90 or 95 cents to a dollar, but other collateral didn't sell at all, even at discounts of more than 50%."
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