Wednesday, August 01, 2007

Rumsfeldian Knot

If only this "credit risk repricing" event that we currently find ourselves in were a simple Gordian Knot. Holders of "The Untraded" paper could simply come out of the closet and elegantly and simply cut the knot in two. In one move, they could create transparency, liquidity and erase a chunk of the uncertainty. Unfortunately, we are in a Rumsfeldian Knot: it's a metaphorical knot to which no swift solution is available. It is full of known unknowns, unknown unknowns, and very few known knowns.

Every fund that owns "The Untraded" either fears a shutdown, massive embarassment or simply doesn't realize that they own such toxicity because it never gets marked to market. We know that credit insurance is getting very expensive, spreads are breaking wide and the CDO indexes are imploding. The equity markets are responding to this violence with complete fear, shedding 4% a day, worldwide. Some funds are coming clean, especially the ones that got deep in the subprime CDOs. A chunk of the mortgage companies have gone under, most recently including one thought to have been primarily focused on higher quality Alt-A loans (relative quality - mostly option ARMs for the speculators).

We still have no idea how this paper is distributed - who owns it and how much do they own, and we have no accurate picture of pricing. We hear that the paper is spread out among the many - hedge funds, insurance companies, sovereign funds, banks, etc. But who owns the truly crappy stuff, the low rated junk and the so called equity and how much do they own? Is it more than the firms capital base in the case of leveraged positions? So many known unknowns.

Then, of course, the unknown unknowns are, well, unknown. What nugget of information will smack the market on the head as the true source of this worldwide market uncertainty? Will it turn out that the real problem is a US economy already in recession? Are we creating a self fulfilling the problem in this sell off, shutting off liquidity to this new age world economy? I think the name of the game is still liquidity; we now have too much and we are cleaning up the excess. Lets hope the sponge is not too thirsty.


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