CDO PIK: Satisfaction Guaranteed or Double Your Trash Back

When I attended the U.S. Army Northern Warfare School back in 1980, I was amused to see that all of the trash dumpsters at Fort Greeley, Alaska were stenciled with “Satisfaction Guaranteed or Double Your Trash Back”. I was reminded of this slogan the other day when I was doing some reading about the unfolding derivatives fiasco. I’ll get back to the quip about trash near the end of this blog entry.

Let me start with some background: Just like in the traditional bond world, with Collateralized Debt Obligations (CDOs) it is always the holder of the highest rated (“senior”) paper that gets paid first. Each grade level, “class”, “slice” or “tranche” has its own risk level. Starting from the bottom, the lowest level tranche and then moderate risk “mezzanines” have to successively support the more senior tranches. The very lowest level tranches (called “junk” or even “toxic waste” in the bond world) are the riskiest. In a default situation, those investors holding paper in the lower level tranches will probably get nothing, or perhaps 5 cents on the dollar if they are lucky.

Now here is where it gets interesting: Some of the folks that have established the tranche ratings for CDOs for the past few years have played a little fast and loose with their terminology, effectively over-rating them. A lot of “B” rated CDO paper really should have been rated “BB”, or even “BBB”. Indirectly, this has made the investments even riskier, because lower rated tranches have higher margin (“leverage”) requirements. When an investment goes bad, the degree of risk is directly proportional to the amount leverage employed. Highly leveraged investments can “go south” in spectacular ways. It isn’t unusual in the CDO world for some tranches to\ use 25-to-1 or even 30-to-1 leverage.

A recent Financial Times article titled “Credit crisis to worsen as banks cut and run” noted that as public scrutiny has increased, the margin requirements for various CDOs tranches are suddenly getting more stringent. The article mentions:
“The Bear Stearns hedge funds were big holders of these instruments and the news two weeks ago that the funds were in serious trouble has led to much greater concern about the valuation of CDOs of ABS [asset-backed securities] held by other funds.
According to bankers and hedge funds involved in these and similar markets, this has led investment banks to begin reassessing their exposure to funds that are investing in ABS and CDOs of ABS with borrowed money.
Matt King, analyst at Citigroup, has estimated that funds invested in CDOs of ABS are likely to see some significant increases in the amount of margin they are required to post against their investments.
This “margin” in simple terms governs the amount of leverage, or borrowed money, they can use in their investments.
For example, Mr King expects that for the safest AAA-rated slices of these deals, margin requirements would rise from about 2-4 per cent now to nearer 8-10 per cent.
At the other end of the scale, the riskiest equity tranches would see margin rates increase from 50-100 per cent, which is to say banks will not lend to funds investing in these slices of risk.
“Over the near term, the biggest risk is probably that of forced selling driven by potential margin calls or investor redemptions,” Mr King says.
“We argue that this is likely to be a big problem only for a small number of people, but that its full effects may not yet have been seen.”

In reaction to this article, Yves Smith, co-editor of the Naked Capitalism blog noted on the revised margin requirements: “The question now becomes how quickly this development will work through the system and now many players will be affected. We’ve already seen Brookstreet forced onto the shoals by margin calls; the question is how many other hedge funds will follow. The secondary effect will be that hedge funds who have subprime exposure are facing redemptions (some like United Capital Markets have halted them). They were already faced with the prospect of having to sell fund assets in a weak market to pay exiting investors; reduced leverage will only make a bad situation worse (the implicit vote of no confidence by the dealer community will make it less likely that speculative buyers will step forward). The good side is, if we believe the report in a recent issue of Bloomberg Magazine, hedge funds are smaller participants in the subprime-related CDO market than thought earlier, owning 3% of the investment grade portions and 10% of the equity tranches.”

I have read that a lot of CDO derivatives contracts are written with a Payment in Kind (PIK) recourse clause. In the context of CDOs, a PIK clause guarantees that if an obligation cannot be paid in cash, then it can be settled with the transfer of additional CDO paper. When default rates spike (as they have done recently with sub-prime mortgages) and a CDO party stops paying current interest (for lack of cash), they can hand over additional debt obligations, as a payment in kind. But what if that paper is also worthless, or nearly worthless? (This is the “double your trash back” that I mentioned.) Worthless PIK settlements could very well happen in coming months, as the US coastal residential real estate market unravels. This could get very ugly in a hurry. Changing margin regulations may make some holders of CDOs forced sellers, setting in motion a downward spiral in CDOs. If the sub-prime CDO failures start to snowball, beware! The liquidation could turn into a reverse bidding or “race to the bottom” situation, as anxious investors try to recoup something, anything from their initial investment. If and when this happens, it could make the $3.6 Billion Long-Term Capital Management (LTCM) bailout and the more recent $4.6 Billion lost by Amaranth Advisors look like minor hiccups, by comparison.

Those of you that have read SurvivalBlog since its early days will remember that I’ve issued warnings about the derivatives market in general and the credit derivatives market in particular, since late 2005. My advice hasn’t changed much. It remains: Be aware. Be prepared. Diversify. Minimize your exposure to both the real estate bubble and the credit derivatives market–directly or indirectly.

Letter Re: Supporting SurvivalBlog

Mr Rawles:
I was shocked to see that only 1% of readers have gotten a [voluntary] 10 Cent Challenge subscription. I signed up after the second week that I began reading.your blog. There is no other site on the Internet that has the same amount of in-depth info on preparedness. Nothing even comes close. I am blown away by how much knowledge is piled up in your archives. I could spend two or three hours a day searching through news sites, financial advisory websites, backpacking websites, EMT websites, gun websites, food storage websites, and so forth, and still not glean what is contained in SurvivalBlog. Ten cents a day is tiny pittance compared to what I get out of it.

Because of you and SurvivalBlog, my family is now much, much, much better prepared than it was a year ago. SurvivalBlog has tons of useful info. Anyone that can’t see that is either a fool or an idiot. I figure that SurvivalBlog has saved me hundreds [of dollars] by giving wise advice that has kept me from making some expensive mistakes in prepping. What I learned from your blog allowed my to package my own storage food (in [food grade plastic] pails) instead of buying over-priced [commercially] canned food for storage. SurvivalBlog also steered me away from radio gear that had short range and pitiful security. ([Instead,] I bought MURS band [transceivers].) The blog also directed me to some outstanding firearms training that cost very little. (The [RWVA] Appleseed range days and “clinics”.) The blog convinced me to re-prioritize my life and cut out fast food. (Which did good things for both my budget and my waistline. I’m now down two full belt notches and about ready for my third notch.) The blog also motivated me to sell off some of my guns in odd calibers (like I had a 280 Remington, a .35 Remington, and a .41 AE [Action Express]) and get standard calibers. Now that ammunition has zoomed way up in price, I have a lot more options on where to buy and what to buy. Now I have all.308 [Winchester], .30-06, .30-30, 7.62mm (AK), .223 Rem., 12 ga., .45 Auto, .357 Mag., 9mm, .22LR and .22 Mag. guns. Like another guy that wrote a few months back, SurvivalBlog also set me straight on generators. (Now I plan to get a low RPM diesel, not gas!) So I figure that in the long run SurvivalBlog will save me thousands. Ten cents a day, by comparison, is a real bargain. So here’s my personal challenge to anyone that reads this: What is SurvivalBlog really worth to you? If SurvivalBlog were to disappear, would you miss it? If you value it, then support it! – Phillip G.

Odds ‘n Sods:

Remember that there are now just three days remaining for the $500 Interceptor Body Armor (IBA) vest special from BulletProofME.com. July 12th is the deadline. Anyone who has shopped for body armor knows what a great deal $500 is for a new Interceptor vest. Don’t miss out on this deal.

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Reader Andy L. mentioned an article about the ultimate in privacy for retreats: Your own island in the Bahamas.

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MP noticed this editorial in a Seattle, Washington newspaper: Disaster’s coming: Get ready. MP’s comment: “Sure, 10 days is still a bit weak but it’s a step in the right direction over the laughable three day idea [that is promoted in the region, mirroring the guidance from most Federal agencies.]”

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Readers Michael A. and RBS both sent this piece from The Financial Times: Nestlé chief fears food price inflation.The article begins: “Food prices are set for a period of “significant and long-lasting” inflation because of demand from China and India and the use of crops for biofuels, according to the head of Nestlé.”

Letter Re: Asian Avian Flu is Still a Major Threat

Jim,
I am a regular reader with 40+ yrs of prepping and a 10 Cent Challenge subscriber. My current career is as a Hospital Staff Respiratory Therapist.
We recently had a seminar on the coming Avian Flu Pandemic that scared the heck out of me. The timeline for human to human vector is 3 to 5 years, if it follows the current rate of mutation. It will probably come out of Thailand, and with air travel, will quickly spread around the world, with entry to the US through the major international airports. With luck and area quarantines, they may be able to limit the spread.
When it hits, they expect a desertion rate of at least 30% of all services: Health Care workers, Police and Fire, even National Guard.
CDC, FEMA and individual hospitals are stocking up on supplies in anticipation of a mortality rate of 10% to 20% of infected cases. Hospitals may become armed camps to control the panic. Basic hospital services will become limited and rationed, no elective surgery, etc.
Hand washing, use of a particle mask and eye shields will be your best defense.

And that’s the good news

The world and even the USA is not prepared for such an event. It may take 3 to 6 months to develop a specific vaccine for the flu mutation, and the flu may mutate even more.
We do not have the capacity to handle the death rate. Figure bodies stored in Refrigerated Trucks, mass graves, or cremation.
We do not have the hospital beds to handle a Pandemic. We may have to go to a ward set-up again.
If you bring in a family member, you may be drafted to help provide basic care, and you may be the best way to have good care for that person. The professional staff will be overworked.

The main killer for the Avian Flu is Acute Respiratory Distress Syndrome (ARDS). ARDS requires intubation and use of a ventilator for survival. We do not have enough ventilators, and we are being inventive and are thinking outside the box for this one. We may have to “gang” patients on Ventilators, or recruit people to hand squeeze AMBU bags to keep people alive.
We may have to “Triage” patients and use the available resources to try to save the salvable. Factors such as chronic illnesses, morbid obesity, or even advanced age may resign patients to the “sink or swim” ward. We staff may have to do this to our own friends or family.

Contrary to my own survival instincts, I intend to be on the job when it hits. They tell us that the staff may take double the percent casualty rate of the general populace. I will keep you updated to any useful information that comes my way. – Sput

Letter Re: How and Why to Get Physically Fit

JR-
With regard to the article on getting into physical conditioning and buying used exercise equipment, here is a general rule for readers to remember. They are like room heaters, air conditioners, pools, and lawn mowers etc. They are very seasonal. I have friends who work at thrift stores, and I can assure you the time to buy any exercise equipment is during the warmer months like right now [in the northern hemisphere]! The Ski Machine you refer to that costs almost $1,000 for the higher end models can be had for song during the summer months. Sometimes pennies on the dollar over the cost of buying new. In fact, I know of personal experiences where one was sold for less than a dollar to a person who was willing to ask about a unit sitting out back of the store. It was in almost brand new condition.
In the summer months, when everyone is physically active and the days are longer, very few folks are thinking about exercise. Folks are too busy enjoying their summer months to exercise indoors. These “junk” and thrift stores generally cannot sell them and don’t want to fill up valuable floor space with retail “dogs” when there are items that will move fast. With all the garage sales, flea markets, and yard sales, that are going on the supply is great and demand is low. They don’t tend to sell well there either so they accumulate at the local thrift stores as donations. This rule of thumb also applies to treadmills, weight benches, and other high quality seasonal items. One thing to remember about this kind of equipment is that everyone has great intentions about exercise equipment but very few of us ever really dedicate ourselves to our lofty goals. As a result, why ever buy new equipment, when you can let someone else absorb the new sticker price and second if you decide to stop or lose your motivation, you wont be stuck with buyers remorse.
With respect to thrift stores and the like, each one is different so you may have to find the right place to do business with. Don’t be afraid to make friends with the store workers and let them know what you are trying to find. Above all else be sincere. Then visit the store and remind them that you are still on a quest. Depending upon the circumstances, it’s generally just a matter of time and patience before what you are looking for, finds you. Also don’t be afraid to reward the employee or manager with a cold pop or a tip (if allowed) once you take delivery. This is very much appreciated by the employee and you will be remembered the next time you are on another “quest”- since so few people will ever display this kind of courtesy or generosity.
This same rule of seasonal supply and demand applies to other items you will need like clothing, insulation, building supplies etc,. Buy your necessities in the “off season” and be patient and most times you will find what you are looking for at a very reasonable price. That is the heart of the concept of preparedness on a budget. Tis Better to be the Ant with a mindset for what is coming than to be a Grasshopper caught up only in the moment with fiddle in hand.
A local auctioneer always sums it up best during his sales pitches before he starts the bidding on a piece of exercise equipment at his sales: “Folks, I have been in this business for over 30 years and I have yet to sell a worn out piece of exercise equipment!” Food For Thought. Keep it in mind the next time you are looking to buy “used” exercise equipment. – RBS

Odds ‘n Sods:

I recommend market watcher John’s Mauldin’s astute observations on the derivatives implosion and the tremendous downside risk in sub-prime Collateralized Debt Obligation (CDO) trading, titled “Where is the Real Risk in the Subprime Debacle?” It can be found in this PDF. (BTW, I highly recommend subscribing to John’s free weekly E-letter.) Meanwhile, Bloomberg has more news on troubled derivatives: United Capital’s Devaney Halts Hedge Fund Withdrawals

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Commodities market signs of the times: Keg Thefts Rise with Metals Prices, and Power line theft leaves South Africa in dark

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From a recent Daily Reckoning e-newsletter: “And here’s the latest mortgage scam – ‘equity stripping.’ Of course, equity stripping is what homeowners have been doing themselves for more than 10 years. Until the early ’90s, the typical homeowner owned nearly 70% of his house, free of debt. Now, the figure is only 52%. But now, as the housing slump deepens, more and more homeowners are faced with losing their houses. The American Bankers Association says that 19% of sub-prime mortgages are either delinquent or already in foreclosure. This has created a whole new mini-industry – helping people save their homes. Fast-moving finance companies read the published lists of houses entering the foreclosure process. They visit desperate owners, offering to restructure mortgages in order to prevent foreclosure. Then, they get owners to sign the houses over to the finance company, which strips out any remained equity – and then some. When the homeowners finally realize what has happened, they find themselves even deeper in debt…and the finance company no longer answers its phone.”

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We note the latest entrant in the Blogosphere with a penchant for preparedness: SHTF Daily. Check it out.

Jim’s Quote of the Day:

"Of all the contrivances for cheating the laboring classes of mankind, none has been more effective than that which deludes them with paper money." – Daniel Webster

Note from JWR:

If you find what you read in SurvivalBlog useful, then please become a 10 Cent Challenge subscriber. These subscriptions are entirely voluntary. Presently, only 1% of readers who visit at least once a week are subscribing. Our goal is 5%. For details on how to subscribe–including an anonymous method for those of you that keep a very low profile–see the 10 Cent Challenge Web Page. BTW, for those of you that have already subscribed, please don’t forget to mark your calendar for your annual renewal. We don’t send out e-mails to pester anyone about renewing. Unless someone opts for a PayPal recurring payment, renewals are initiated solely by subscribers. Thanks!

Letter Re: Advice on Pistol Caliber Carbines

Jim and Family:
I just found out that I can get a 16″ rifle here in Hawaii. I was considering an Uzi but am uncertain about the differences between model A and B. Also, the stamped metal doesn’t excite me, but I think having such a gun fills an important role in my armory.

For travel out of the stronghold, it takes the place between carrying a .223 or .308 rifle suitable for home defense and reaching out and touching someone and walking about with a handgun.

For travel when the world is in quasi-collapse and I want more rounds and accuracy than a pistol but don’t want to use a full assault rifle. I like the idea of an Uzi type gun, tucked under my jacket. Lightweight is also a plus. If the world becomes lawless, the barrel could also be shortened. So, what gun do you recommend? Uzi A, B or other? Thanks guys. – Fred in Hawaii

JWR Replies: I do not recommend full size semi-auto Uzis. In relation to the power of the cartridge that they shoot (the 9mm Parabellum pistol cartridge) they are quite over-sized and heavy. A Linda, TEC-9, or a Mini-Uzi is actually more practical if you want a high capacity 9mm with a fairly long sight radius. If you want a semi-auto 9mm carbine, then the Marlin Camp Carbine is actually a better choice. For that matter, an M1 Carbine is more powerful, and nearly as compact as an Uzi carbine (at least when one is in a Choate or M1A1 replica folding stock.)

I generally try to steer my consulting clients away from 9mm, .45 ACP or even .30 M1 carbines, except if they are strictly relegated to secondary/small game/training use. As previously discussed in SurvivalBlog, long guns chambered in pistol calibers lack penetration and stopping power. They generally give people a false sense of security. A semi-auto Uzi has a high quotient for drama, but is not a very practical gun. A .223 M4gery is far superior and versatile, capable of dealing with two-legged predators out to 300 meters. (That would be quite a stretch for a 9mm carbine!) If compactness is your primary goal (rather than long range accuracy) some pistols chambered in intermediate rifle calibers include the OA-93 pistol, the Kel-Tec PLR-16, and “Krinkov” AK pistols. Just be forewarned that they are quite noisy and have a big muzzle flash!

You have a unique situation in Hawaii, since “pistol” high capacity magazines are banned there. This is quite a limiting factor. If I understand the Hawaii magazine ban law correctly, if there is any pistol made that uses rifle magazines, then those rifle magazines are also banned. For example, there are currently pistols made that use AR-15 and AK-47 magazines, and there were also a few hundred pistols made back in the 1970s that used M1 Carbine magazines. (The Universal “Enforcer” pistol.) So 10+ round M1 Carbine magazines would be classed as high capacity “pistol” magazines in Hawaii. I did some searching and found this in a digest of state gun laws at The Hawaii Rifle Association web site: “Hawaii state law prohibits greater than 10 round detachable pistol magazines (including rifle magazines capable of use in any pistol, such as the AR-15/M16, M1 Carbine, H&K carbine, Thompson, and aftermarket Ruger .22 magazines) unless blocked to hold 10 rounds or less and ‘not readily restorable.’ Possession of illegal magazines is a misdemeanor, and possession of a handgun with one inserted is a class C felony.” Based on this, you may have to do some more legal research and plan accordingly to stay within the confines of Hawaii’s draconian gun laws.

Ethical Preparedness for WTSHTF, by SF in Hawaii

What (if anything) are you willing to kill for post-SHTF? To consider this question, first let’s start with a quote on justifiable homicide from Wikipedia:
Under early Athenian law, it was considered justifiable homicide to kill an adulterer caught in the act or a burglar caught in the act at night… in eighteenth century English law , it was considered a justifiable homicide if a husband killed a man “ravishing” or raping his wife (Blackstone, Wm. at p. 391), but modern law treats this as only a circumstance that will mitigate murder to a conviction for manslaughter . In other words, the socialization of modern men is supposed to result in less violent responses to provocations.
… in some cases in the United States . A homicide may be considered justified if it is done to prevent a very serious crime , such as rape, armed robbery, or murder. The assailant’s intent to commit a serious crime must be clear at the time. A homicide performed out of vengeance, or retribution for action in the past would generally not be considered justifiable.
In cases of self-defense, the defendant should generally obey a duty to retreat if it is possible to do so (except from one’s home or place of business). In the states of Florida and Louisiana , and other Castle Doctrine states, there is no duty to retreat. Preemptive self-defense, cases in which one kills another on suspicion that the victim might eventually become dangerous, is considered criminal, no matter how likely it is that one was right. Justifiable homicide is a legal gray area, and there is no real legal standard for a homicide to be considered justifiable. The circumstances under which homicide is justified are usually considered to be that the defendant had no alternative method of self-defense or defense of another than to kill the attacker.

There are two questions to ask ourselves. One, if SHTF happens gradually and some law and order still exists, how might the standards of justifiable homicide change? Secondly and more important, in our own minds and hearts, what degree of force are we willing to react with in difficult situations. Certainly if today a group of men stole your picnic basket you wouldn’t open fire against them, even if your wife made your favorite bacon, lettuce and tomato sandwiches. Now let’s change the scenario. It’s SHTF time and you wake to find a group of armed strangers stealing your food? Now how about your next door neighbor stealing your food for his starving kids? You’ve already been charitable and now he’s getting into your deep larder, but you used to drive his kids to the local soccer match where they played together.

Would you shoot a black masked, private mercenary thug that the governor called in and deputized that tried to disarm you forcibly? How about a well-meaning young kid in the National Guard who, pointing a gun at you, told you he had orders to disarm you (of your only weapon), contrary to the constitution and the needs of your family’s protection during a Katrina style disaster. You know that rapists and murders will be out at night while he’s safe asleep in his barracks. He’s too young and stupid to know what he’s doing is wrong. Still, there you both are. How about the local cop who got the same order. You’ve been fishing with him. He’s a good man, except for the fact that he’s about to violate his constitutional oath.

It’s better to go through these moral exercises in advance and have your line in the sand already drawn. Of course we cannot know what we will really do when confronted with difficult choices, but freezing up at the moment of truth while we work out our ethical dilemmas is not the best option. We need to know what we are willing to do, and how far we are prepared to go in advance so that when the time comes, we can act decisively, already having made peace with the righteousness of our decision. – SF in Hawaii

JWR Adds: I am a strong proponent of storing extra wheat, rice, beans, and honey to dispense as charity. Buy as much as you can afford. Shop around for the best prices, buy in bulk, and pack it properly to prevent spoilage and the ravages of vermin (as described in the“Rawles Gets You Ready” preparedness course.) Bulk foods also make good barter items for paying neighbors that might become your employees in the event of TEOTWAWKI (farm hands, security guards, et cetera.)

Odds ‘n Sods:

Novelist Michael Z. Williamson sent us a link to a PDF on Combat Loads in Afghanistan. Mike’s comments: “It shows march, approach and combat loads of troops in Afghanistan, for reference for building bug out bags. Obviously, a civilian bag will be lighter on batteries and ammo, and heavier on food, water and shelter. But this is a handy reference for comparison.”

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A pointed history lesson from the Von Mises Institute: Inflation and the French Revolution–The Story of a Monetary Catastrophe

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From The Chicago Tribune: Layoff fears part of ‘new normal’ — Affluence, college education no protection from job market that cycles quickly through workers. Every family should develop a home-based business that they can fall back on, in hard times.

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I spotted an interesting thread over at The Oil Drum with some observations from Uganda, on improvised battery charging. My comment: Every family should at the very least have a small photovoltaic panel and a “jump pack” battery, for recharging small NiCd and NiMH batteries. (See the recent thread on SurvivalBlog for sources.) As a minimum, you need to be able to recharge batteries for your MURS walkie-talkies, intrusion detection sensors, and night vision gear. These are essential for retreat security!

Notes from JWR:

The high bid is now at $210 in the SurvivalBlog benefit auction for a batch of 10 brand new original Imperial Defence SA-80 (AR-15) steel 30 round rifle magazines. The auction ends on July 15th.

Today we present another article for Round 11 of the SurvivalBlog non-fiction writing contest. The writer of the best non-fiction article will win a valuable four day “gray” transferable Front Sight course certificate. (Worth up to $2,000!) Second prize is a copy of my “Rawles Gets You Ready” preparedness course, generously donated by Jake Stafford of Arbogast Publishing. I will again be sending out a few complimentary copies of my novel “Patriots” as “honorable mention” awards. Round 11 runs for two months, ending on the last day of July. Remember that articles that relate practical “how to” skills for survival will have an advantage in the judging.