Saturday, October 11, 2008

How to Lose Money and Piss Off Lots of People

I just noticed that on my last blog post, someone has left a comment wondering why I haven't posted any opinions on the cataclysmic events in the stock market in the past few days (weeks? months? oh what the heck - it doesn't matter any more). I'm flattered and amused in turn.

That anyone would care about my opinion on the matter, when there are plenty of excellent minds who can offer far better insight into the complex issues involved. Gosh, you guys are sweet (...wait a minute, are you trying to pull a fast one on me?). Anyway, here's a nice bulleted and chronological list of my own progression through this matter, mercifully brief and laconic.

Early 2006: I was amazed when an acquaintance of mine told me that their house in Irvine, Orange County (OC) purchased in 2004 had nearly doubled in value when they sold it last week. I was convinced we were in the midst of a crazy housing boom, but I had no idea if we had peaked yet.

Late 2006: I was in the Silver Lake neighbourhood of LA and had to while away an hour waiting for a friend. I started walking around, saw a house for sale sign and decided to check it out just out of curiosity. The house was nice, but a bit old and insanely overpriced. The owner was a young man in his 20s who was very sweet and friendly, and when he asked me if I was interested, I excused myself by saying that it was a bit more than what I would pay ("bit more" ha ha ha).

Anyway, so we got talking and I found out that he owned a total of three houses, two of which were rental properties. Incredibly, he told me that he had acquired these properties with zero down payment. My jaw dropped.

TM: "So, by the way, what do you do"

Owner: "Oh, I'm a musician"

Take a minute to appreciate this. Most struggling musicians barely make minimum wages waiting tables - this one owned three homes with zero down payment - whose mortgage payments he was paying with rent from the other two properties.

I knew the peak had been reached, it was just a matter of a couple of months before the downward slide would begin.

Early 2007: I had signed up for a tour of downtown LA once, by virtue of which I would keep getting emails from a lot of residential property sellers. I noticed that week after week, I would keep getting emails from the same sellers promising exciting offers (discounts, upgrades) for apartments that would have been pre-sold just a year ago. Also, every time I would drive around, the house for sale signs were everywhere.

The decline had begun.

October 2007: The first rumblings of the sub-prime mess were being felt in the stock markets. The foreclosure rate was climbing, some of the mortgage backed securities were declining in value, affecting the stock prices of the companies holding these assets in their balance sheets.

However, the denial PR mechanism of the financial industry was in full force. The losses were inconsequential and the financial system was robust enough to deal with these shocks was reassuring line we were being fed.

In the meanwhile, this rather innocuous looking paragraph from the Financial Accounting and Standards Board Statement 157 was causing some discomfort to investment banks and sparking lively debate on investment forums:

"Fair value is the price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the measurement date."

Ok, sod accountant-speak, what this basically means is that you cannot pull a price out of your ass and stick it on your asset and claim all's well even if your asset is stinky rubbish that no one would pay two nickels for. And this applies to all types of assets, Level 1, 2, and 3.

Now Level 3 assets are of especial interest, since they are valued using significant unobservable inputs, which basically mean the company's own assumptions regarding risk and how the market would price it (refer "pull a price out of your ass"). There is no verification of these assumptions and valuation models (Hallelujah!).

Guess what is the most significant kind of these Level 3 assets? (hint: starts with an M, ends with an S and has a B in the middle. Yep, Mortgage Backed Securities).

These rules went into effect in November 2007, and the investment boards were buzzing with discussion about the huge amounts of such Level 3 MBS assets on the balance sheets of investment banks. Then, it was like a domino effect - suddenly people also started talking about the ridiculous levels of leverage taken on by investment banks - debt that was 20-30 times the equity invested.

Between 2004-2007, this leverage had given the banks fantastic profits and generated huge bonuses for the employees. Now, it was feared that leverage would brutally enhance every small loss suffered on the way down.

Everyone was convinced that the imminent demise of an investment bank was coming, and bets were being taken on who would be first. A lot of people guessed Lehman, simply because out of all the investment banks, it had the largest proportion of exposure to MBS. However, when Lehman declared their 2007 results, they maintained that they had suffered minimal damage from sub-prime exposure.

January 2008: Surprisingly, despite all the doom and gloom predicted by the bears, the market sort of wobbled along, dipping only slightly, giving a false sense of security. In hindsight, what basically happened was that there was there were a few shining new toys in town - energy, basic materials and commodities.

At first, the pat explanation was that oil prices were rising because of growing demand in emerging markets, but that could not account for the dizzying heights scaled by oil prices in a few months. It soon became obvious that the energy market had attracted a large speculator crowd who were not the usual players in the field. Between August. 2007-May.2007, the Energy sector on NYSE grew 26 per cent, Basic Materials went up 45 per cent. In the same period Financials declined 10 per cent and the S&P 500 declined 3 per cent.


March 2008: Everything changed on March 17th when news came that JP Morgan Chase was buying Bear Stearns for $2 a share. Of course investors knew Bear was in trouble - it's credit default swaps had shot up, its shares had been dropping considerably, and there was a huge volume of puts (a kind of insurance against price decline) on Bear shares in recent days. But seriously - $2 a share?

There was much talk of how the Bear headquarters alone was worth a substantial chunk of the price JP Morgan Chase was paying. Any reasonable person would soon put 2 and 2 together and wonder - was the price so low because the liabilities were so onerous and the assets had precipitously declined in value? But then, the CEO of Bear Stearns had famously assured the markets that his company was in good shape. If Bear was pretending all was fine, while it was being hollowed out inside, what were the others (and investment banks are kind of clones of each other - same business model everywhere) hiding on their balance sheets?

(The Bear share price was later upped to $10 per share, but that was still small change compared to its book value).

This is a table that someone had uploaded on an investment forum around that time (don't know where he got it from, but if anyone knows, please let me know and I'll quote the source).



Note where Lehman Brothers is on this table - right at the bottom. At a time when Merrill went ahead and wrote down some of their MBS to 22 cents on the dollar, Lehman stubbornly refused to mark its investments down.

And the rumour mills just won't stop churning.

Right after Bear got bought out, Lehman credit default swaps shot up and its share price suffered its first significant decline. Of course the Lehman CEO famously blamed short sellers. In fact, the man continues to blame short sellers for his firm's fall. A lot of people were convinced that Lehman was next. But Lehman continued to insist that its fundamentals were strong and it had adequate capitals to support asset write-downs.

September 2008: After months of speculation and denials, the inevitable came to pass. An initial trickle of clients deserting it to go to other investment banks had turned into a steady stream. The stock price was declining steadily, assets were losing value, and its creditworthiness was getting shot. Whatever Lehman did at this point was too little, too late.

This is where the story starts to get murky. Was Lehman the proverbial straw that broke the camel's back? Or was the systemic rot spreading so fast at this point that it was but the first act in the grand spectacle of chaos that was to unfold? I honestly don't know. I'm sure Lehman's failure added to the woes, but AIG, Fannie Mae and Freddie Mac's problems predate Lehman. In fact, if Bank of America hadn't bought it, perhaps Merrill would have met the same fate sooner or later.

October 2008: Let's do a slight digression at this point and check up on the pesky little thing that started it all - declining home prices. The Case Shiller Index for US residential properties went from 185 in 2007 quarter 1 to 155 in 2008 quarter 2. Obviously as the economy gets worse, this index would decline further.

The crisis of confidence in the financial markets though is several times worse than that in the housing market. Let's see what we've got on our plate so far:

1. Of the major banks - every one of them have suffered major write-downs of assets. One has gone bankrupt (Lehman), four bought out (Bear, Merrill, Wamu, Wachovia), and one tottering on the brink (Morgan, plagued by rumours that Mitsubishi no longer wants to buy a stake). A number of smaller banks are on the edge as well, about to keel over at the first major knock to their share price.

2. Yesterday they settled credit default swaps on the debt of Lehman brothers. Which means that if A sold a credit default swap to B guaranteeing Lehman's debt, then A has to pay B based on whatever Lehman's debt was valued at. Based on this valuation, A has to pay B nearly $270 billion, which is a neat pile of cash in these troubled times. And that's not all - there's Wamu and Icelandic banks to come (poor Iceland just cannot get a break - first it's currency gets assaulted by hedge fund short sellers, now its banks are kaput).

3. The difference between the Treasury rate and the LIBOR rate (the so called TED spread) has widened dramatically. What this basically means is that banks perceive a lot more risk and are charging a lot more to lend to each other.

4. Commercial paper, short term loans used by companies for ongoing expenses has been in crisis in the past few weeks. The panic is so great that no one wants to lend money for fear of it getting entangled in bankruptcy claims if the company suddenly goes under.

5. When you need money on home turf, global ambition is the first thing to be scuttled off. And hence, large sell-off by American hedge funds and investment banks had started in the so called BRIC markets - Brazil, Russia, India and China. Noticed how Indian, Chinese and Brazilian stocks listed on NYSE have been losing tremendously over the last month? (speaking of which, I saw that a big loser was Mahanagar Telephone Nigam Limited ADR. Who the hell was buying MTNL in the first place?)


October 12, 2008, 12:35 a.m.: Where do we go from here? Well, I heard a talk on the credit crisis a few days ago that really appealed to the optimistic side in me (my other side is cynical and would make "Irrational Exuberance" by Robert Shiller required reading for everyone). So this person, who's a hedge fund manager said (and I paraphrase)

Right now, we have a climate of pervasive fear and a heightened sense of risk. No one wants to either invest their money or lend it because no one can accurately assess the inherent risk in these activities. However, there's plenty of global capital that will need to be invested at some point. Bonds will mature and then would have to be re-invested.

Someone, somewhere, would stick his neck out, decide that the return is worth the risk and put his money out there to work for him. Slowly others will follow suit, and we'll have a functioning financial industry again. How long will this process take? No one can tell. It could be 6 months, 2 years or even 6 years. But recover we will, no matter how many doomsday scenarios you hear about.

In the meanwhile, chin up a la the Brits, shore up your savings, and keep those spirits flying.

8 Comments:

Blogger MEDITERRANEAN KIWI said...

the comment about the musician who owned three houses, none of which were freehold and were proabably all bought with a zero downpayment, is just a typical case of very foolosuh lending behaviour on the part of US banks. this would never happen in Greece; one of our sayings goes like this: to lend money form the bnak, you have to have a bank account with the same amount of money that you are lending

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Blogger thalassa_mikra said...

Hi Maria - yes what a terrible mess no? But you know what, I guess Kriti is still untouched by all these predatory lending practices, but alas these things have reached Athens too. I've heard all kinds of stories about the families of my boyfriend's friends, people taking out loans on their homes to buy brand new Mercedes and so on.

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