ABCPs& liquidity puts:derivatives on steroids

March 19, 2008

Its late but a key element in the financial mess on Wall street is the financial derivative connected sub prime mortgages and the collateralized commercial paper that was created out of them and then sold in a leveraged fashion to investment buyers. These buyers had built into their purchase agreements liquidity puts which allowed them the right to sell back to the original seller the `"asset" at its original price should it go sour.(Check out the term liquidity put in the New York Times and on google) Since the leveraging was of the order of 30 to 1 in many cases this has had disasterous consequences for the original buyers of the sub primes who found themselves obligated to take back the hot potatoes when the derivative buyers no longer wanted them.The financial consequences of the failure of these financial derivatives based on the sub primes has been enormous.
What has clogged up the markets at least until yesterday was the fact that many of these large liabilities for obscure acounting reasons are not properly shown on the balance sheets of the big financial firms that were involved in them making informed investors very reluctant to buy the stock. As more and more information emerges the need for greater regulatory oversight has become very clear. There is a lot of work to do in the coming months.

One of the areas that is going to need regulation is the practice of leveraging investments with borrowed funds at a ratio of 30-35 times to one, a dangerous practice which should be prohibited. It is even more dangerous when the original investment is inherently very risky. It was this practice that led to the demise of the Long Term capital Management hedge fund that involved the liquidation of billions of dollars of heavily hedged and leveraged invested capital in   1998 and necessitated the intervention of the Federal Reserve to prevent further systemic damage.It is perhaps prophetic and salutory that Bear Stearns at the time refused to participate in the consortium of investment banks that helped rescue the fund and prevent it from further damaging the financial system   by buying it up with the assistance of the Fed. It was then subsequently liquidated at a small profit when markets recovered.

One would have thought that after that episode controls would have been put in place to prevent similar practices being repeated. Such was apparently not the case.