...investors in Asia and Europe -- eager for higher returns (estimated at 22 basis points above treasury yields) and comforted by the AAA rating -- recycled the cash generated from record energy prices and trade surpluses with the U.S. into these CDOs. There are roughly $2 trillion such CDOs outstanding against which those investors borrowed as much as 13 times the amount they raised in equity from investors, up from nine to 10 times as recently as late 2005 -- let's say $20 trillion -- to amplify the returns on the CDOs.
The unpaid price is hard to quantify. The CDOs may be worth less -- let's say their true value is 10% of the $2 trillion book value, or $200 billion -- but the banks that are clamoring for their $20 trillion would still be $19.8 trillion in the hole if they took possession of all the CDOs.
Can these investors find an additional $19.8 trillion worth of collateral? If so, what assets could they sell to come up with that much cash? Maybe these investors could sell stocks and government bonds, but I don't know whether they have enough to cover the whole $19.8 trillion. This amount exceeds the value of all U.S. stocks -- according to the Wall Street Journal [subscription required], the value of the Wilshire 5000 index of U.S. stocks was $17.7 trillion on August 17th.
Thus the banks will need to write off the balance of their bad loans -- perhaps $18 trillion worth. Do the lenders have enough capital to survive such a write off? Do global bank insurers -- e.g., governments -- have enough capital to pay nervous depositors in these banks should they chose to withdraw their funds?
For more perspective, the U.S. gross domestic product is roughly $13 trillion. What I've come to understand over the last few days is that the U.S. bailout package isn't a plan to fix this mess...it's triage.
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