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Commentary

Some international danger points

Citibank’s $11 billion writedown: more to come?

Citi had announced, on Nov 4, a record writedown (read: “money we have lost”) of between $8bn to $11 bn, due to CDO losses. A CDO, or “collateralized debt obligations” the concept of putting a lot of loans into a basket, and selling pieces of that basket. Citi still owned a considerable amount of the basket, it turns out. The basket is usually divided into tranches – some part of the tranches are “junk” meaning recovery may not be possible (rated: BB or lower) , and the best tranche is marked “AAA”.

Let’s now look at the Subprime CDO market – this is marked by the ABX index, (Asset backed securities index). So an index named “ABX-HE-AAA 07-2” meaning the index for Home Equity loans, rated AAA, made in the second half of ’07. That’s since July 1, 2007.

The index reflects what people are willing to pay for a $100 of the underlying loan. so an index value of 95 means people are willing to pay $95 per $100 worth of loans (the $5 being the return on the risk they take etc.) So lower the value, higher the underlying risk. Most importantly, the CDO issuer probably paid $100, so every bit lower is a value that is a loss.

Now check this out:

Citi probably holds a lot of the 07-2 series (probably, because they wouldn’t have been able to sell all of them yet). Now they announced on Nov 4 of their write downs. See what’s happened since then – a fall greater than 10%. And this is the AAA tranche. Similar stuff has happened with teh AA, A, and BB/Junk rated ABX!

This will obviously be hitting Citi big time, and probably the rest of the financial world too. They want to take this stuff “off balance sheet” by creating Special Investment Vehicles (SIVs) to fund the purchase of such securities. JP Morgan and bank of America are in on the game. Effectively, they setup another company to buy these securities because no one else will buy them. And the “off balance sheet” means: we’ll lose the money anyhow, but we won’t tell you how much anymore.

If this gets worse, Citi will be seriously impacted and the entire credit markets will unwind. Heck, they are probably unwinding.

Why do I care? This is the filter through which nearly all the liquidity in the world flows.

And the Yen carry trade is the other big source of liquidity. The yen is at 109.25 to the dollar as I write this, the lowest in about 18 months. People borrow the yen (which is available at ridiculously low interest rates) convert to dollars, and deploy the money in other markets. They earn higher returns, and use the returns to pay high interest.

Example: I borrow 108,000 yen at 1% when $-yen is 120, giving me $900. I then put $100 of my own, and invest the $1000 in say Indian equities, or better still, Indian govt. bonds giving 6%. I make an income of $60. Now I gotta pay back the yen guy 1080 Yen. If the yen rate is constant, That is only $9 – the remaining $51 I can keep for myself – it’s a fabulous 51% return on $100 investment!

Okay now what happens if the yen falls to 110? My payment increases by 10% – to about $10 in this example – and my profit comes down to $50.

The example I chose is simplistic because a) people borrow about 20x-50x their investment in yen (i chose 9x) and b) the interest rates depicted have wide spreads. So in reality a lot of guys have much closer spreads and high leverage, meaning that they get affected badly if the Yen appreciates 10%. Till now the Yen stayed above 110, and that seemed to be fine (the last time I heard this was an issue was at 114, but it was no big deal)

But at 110 and below I would see a lot of unwinding. And the Yen should appreciate on each leg of unwinding as people scramble to buy it back. Look at the graphs over the last few days, and you’ll see some scrambling.

Who in India has big yen loans? Uhm: ICICI Bank. $1 billion last year and $1.5 billion this year.

The liquidity crunch, yen-carry trade, etc. are all global issues that affect us only in a supplementary manner…and the impact may not be huge. Still, it’s worth watching out for.

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