[Draft 8-3-07]

Project Death Star

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Part I: Money Market Instability

Interconnected Crisis

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 The Liquidity Engine
Capital pulls deals through the global financial markets.
These deals include everything from mortgages to LBOs.

Financial
Capital Markets
Deals

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 It’s Adaptable
This Liquidity Engine changes dimensions depending on
the amount of capital and deals, but capital is the key.

– Early in the cycle, Financial

Capital Markets Deals
capital is in excess.

– Later, capital and deals

Financial
Capital Deals
match - an efficient market. Markets

– Finally, a confidence crisis

Financial
dries up capital and the Capital Markets Deals

engine stalls.

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 Fueled by Capital
By “capital” we mean money seeking returns globally. In
the last 5 year period of unprecedented liquidity expansion,
there have been several clearly identifiable sources:
– Global GDP growth in the [3%-5%] range – quite high by
historical standards.
– China and India (1/3 of world population) emerging dramatically
on the global economic scene with annual GDP growth in the
10% range.
– Petrodollars flowing from (i) higher demand caused by economic
growth and (ii) tighter supply due to upstream and downstream
scarcity concerns.

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 Liquidity Engine or Economic Engine?
While all part of one system, it is helpful to think of them
separately for the moment. The Liquidity Engine provides
a framework for understanding the global money markets.
The Economic Engine serves the same function for the
entire global economy.

To extend the metaphor, one might say that the Economic

Engine provides the feedstock (capital) for the Liquidity
Engine.

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How Does the Economic Engine Start?
If the Economic Engine provides the feedstock for the
Liquidity Engine, what starts the Economic Engine?

Ignition comes from dramatic change, in this case three

major events in the last 20 years:
– End of Cold War
– Information technology and telecommunications revolution
– Political change in China (Deng Xiaoping) and India (1991
Reforms)

Ignition

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 And How Does It Work?
Capital is created by ignition, which in turn needs to be
invested somewhere. This investment begets financial and
physical assets like houses and mortgages. Finally, those
assets create more capital by yielding a return and by
spurring further economic growth.

Capital
Investment
Creation
Ignition

Assets

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 The Players
With the stage set, we can move to the players. In the
money markets we have
– Hedge Funds
– Private Equity Funds
– Banks
– Institutional Investors
– Rating Agencies

Then we have the mortgage industry.

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 A Typical Mortgage Today
1. Buyer Finds Real Estate Agent.
2. Buyer agrees to buy home.
3. Mortgage Broker connects Buyer to Mortgage Lender.
4. Mortgage Lender makes loan – a Mortgage.
5. Mortgage Lender sells loan into a portfolio of mortgages
which, in a process called securitization, are packaged
and sold to investors – a Mortgage-Backed Security.
6. Banks take the Mortgage-Backed Security, and using
credit derivatives, slice it into different tranches based
on the risk of default. The least likely to default, or best
credit risk is deemed AAA. The opposite is “equity.”
7. These tranches are bought by various investors.

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 The Mortgage Industry
How does the residential mortgage industry work?

Residential Credit
Mortgages Securitization
Housing Derivatives

Real Estate Mortgage Banks Banks

Developers Brokers

Home Mortgage Rating Hedge Funds

Builders Lenders Agencies

Real Estate Mortgage Rating

Agents Servicers Agencies

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 May I Have A Rating Please
The rating agencies have a significant role in this
interconnected web of relationships. They provide ratings
for the Mortgage-Backed Securities, the credit derivatives
built on them, and most of the financings underlying the
M&A boom.

One of the most interesting new developments has been

the creation of the synthetic AAA security based on the
CDO tranche that is affected last in a liquidation.

Like other players, they have generated a great deal of

revenue from their role in the Liquidity Engine.
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 Bank On It
Banks have several roles in the Liquidity Engine.
1. Many are originators and servicers of loans including
mortgages.
2. Banks hold part of these loans on their books, but sell most.
3. They create, structure and sell Mortgage-Backed Securities.
4. They create, structure and sell Collateralized Debt Obligations.
5. Banks make markets, trade, and invest in these securities.
6. Banks lend money to private equity funds and their targets for
LBOs.
7. They create, structure and sell securities for long-term financing
of these LBO targets.
8. Banks lend to hedge funds to allow them to take bigger bets.
9. Banks buy and create private equity and hedge funds.

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 Basel 2 To You Too
The Basel Accord provides a framework for assessing and ensuring
the stability of the global banking market. Among other things, it
dictates how reserves are calculated and how much reserves are
needed for a bank to be safe.

The successor Basel 2 Accord has been finalized, and will come into
effect in [2008]. It provides a new risk-dependent methodology for
calculating reserves. This provides an incentive for banks to stock up
on AAA-rated paper.

AAA-rated companies are rare today because of (i) current corporate

finance theory, which stresses the importance of debt in the capital
structure, and (ii) cheap debt.

Synthetic AAA paper from CDOs has provided a great source. Banks
have stocked up in preparation for Basel 2.

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 Cheap Debts
The spreads on High yield Debt have steadily dropped in
the last 3 years to reach their lowest-ever levels.

[Insert chart]

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 Don’t Hedge Your Bets
Hedge Funds place large, risky bets to generate large
returns. They are generally unregulated, and they use a
wide array of strategies to make money.

One of these strategies is to borrow heavily to buy the

riskiest tranches, the so-called equity, of Collateralized
Debt Obligations. This risky paper is sometimes called
toxic waste.

Because of the large bets and high leverage, they can

make money on very small changes in the underlying
fundamentals. They can lose it too.
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 Hedge Fund Accounting 101
Hedge funds report their results infrequently. When they
do, they have to value their investments and positions.
Under current accounting regulations, they and others have
been using new modeling-driven methodologies to
calculate value when there is no good way to mark to
market.

In the event a given position is unwound, a market value

can be obtained. The data arising from sales of similar
positions within a fund or by others can allow positions to
be marked to market, translating a theoretical value to a
real one.

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 The Prisoner’s Dilemma
Credit derivatives are not very liquid. They do not change hands very
regularly. Values are generally derived using models rather than
market data.

In the event a hedge fund wants to unwind a large number of positions

quickly, market values can suddenly become available across the
industry, allowing other funds to mark to market. But a rushed
liquidation can mean a drop in prices. In a bear market for a given type
of security, this can force many funds to reduce their value, forcing
more liquidations, which in turn reduce prices and values, until a
downward spiral is in full force.

This scenario occurred when Bear Stearns management stepped in to

close [2] funds after large losses. After seeing this problem begin to
unfold, management stopped completely and decided to absorb any
losses.

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 A Confidence Game
The global capital markets are an astounding and intricate
web of relationships. But like the prototypical bank, they
are all built on confidence.

If confidence is shaken, a period of instability occurs, the

Liquidity Engine, and possibly the Economic Engine stall,
and the process begins again.

The LDC Debt Crisis, the S&L crisis, the Texas Real Estate
and Banking Crash, the Asian Market Crisis, and Long-
Term Capital were all examples of this phenomenon.

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 Anatomy of a Confidence Crisis
All dates approximate
6/06 Real estate prices peak.
9/06 Teaser rates on ARM mortgages begin to expire
12/06 Sub-prime mortgage (the riskiest borrowers) default rates
increase.
3/07 With spooked investors, sub-prime originators are unable to
place more paper. The market begins to dry up. Several
originators are suddenly in trouble.
5/07 With worries about certain mortgages and more attention on
how risks are allocated, credit standards and spreads increase,
making it harder to buy real estate. Inventory and downward
price pressure increase.
6/07 Several hedge funds announce large losses and plans to
close.
7/07 Other markets get jittery as overall confidence wanes.
12/07 Unknown. Does the spreading of risk around the global
system create stability or does it create a domino effect?
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 Phoenix
The Death Star Project believes that there will be a
significant financial crisis, led by the residential housing
market, over the next 12 – 36 months. However, as with
most cycles, the free global market for capital will allow
losses to be taken and new winners to be created.
Winners who will buy low and sell high.

This bearish scenario creates an opportunity to create a

Phoenix that will rise from the ashes.

Is it a certainty that a crisis will occur? No. But is there a

reasonable probability. Yes.
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