Sucheta Dalal :US exports poison
Sucheta Dalal

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US exports poison  

August 16, 2007

I am a long way from a properly functioning computer screen. But thanks to the miracle of mobile telephony I have been able to read BNP Paribas's explanation for prohibiting investors from cashing in more than a billion pounds of funds linked to the US subprime market.bnp_paribas.jpgBNP's statement is scary, to put it mildly. The giant French bank says that it cannot value the assets in these funds due to the "complete evaporation of liquidity in certain market segments of the US securitization market".

The terrifying bit is not BNP's citing of the disappearance of two-way trade in bonds and derivatives linked to poor quality US home loans, or what it calls the "evaporation of liquidity". That's just a statement of the obvious, bad news we've known about for some weeks.

No. What gives the game away is that BNP, the pride of France and one of Europe's biggest banks, doesn't dare take the long view and offer to buy these illiquid investments from investors who want to sell.

In theory, BNP should be able to ascribe an economic value to the assets in the funds, independent of their market price. And as a well-capitalised bank, it ought to be able to buy these assets at this fair value from investors and hold them to maturity or until normal conditions return to credit markets.

So why won't BNP do this? Could it be that it fears that the assets in the fund are toxic garbage that defy rational valuation?

Is there reason to believe that many of the securities manufactured out of subprime loans are worse than ordure?

I'm afraid so. Here are just three reasons:

1) As the FT pointed out this morning, many of the underlying subprime loans were taken out by fraudsters and will therefore never be repaid in full.

2) When repackaged as mortgage-backed bonds, they were given ratings by the credit rating agencies based on delinquency experience during the benign conditions of the past few years - which almost certainly means that the ratings flattered their innate (poor) quality. Or to put it another way, investors have bought the financial equivalent of poisoned mutton dressed as prime lamb.

3) Hundreds of billions of dollars of these mortgage backed bonds have been re-engineered as collateralised debt obligations. These CDOs are customised bonds of varying quality and varying yields. There is nothing intrinsically noxious about them. However there are CDOs made out of other CDOs, called CDOs squared, which are marketed as high quality investments - and they've been bought by the "one-born-every-minute" brigade. What's more, there's accumulating evidence that even the simpler CDOs have been bought by naïve investors, who had no idea what they were buying.

It is wonderfully ironic that a disproportionate share of losses from America's dodgy mortgages should be borne by financial institutions in France and Germany - and that the European Central Bank is pumping cash into the banking system to avert a possible crisis.

The incongruity is that the Anglo-American model of financial markets is despised in many European capitals; it is droll that their banks were seduced by Wall Street.

But although I allow myself a chuckle, it is a hollow one. I fear there'll be plenty more damage to come from America's exports of subprime poison.

-- Sucheta Dalal