“The world, one had to
remember, was analog, not digital, in the way it operated. And
‘analog’ actually meant ‘sloppy.’” The Teeth of the
Tiger, by Tom Clancy.
We
wrote that last month (please visit our Web site
www.HamiltonAdvisors.com) and will include it again this
month as “sloppy” cannot begin to describe what we have seen
lately in the stock and bond markets.
Remember the old adage that the only three things you had to
know about real estate were Location, Location, Location! Now
you have to add Credit, Credit, Credit and more Credit! And
Leverage in many cases involving billions of dollars.
The
markets have been extraordinarily sloppy, and frightening,
because of U.S. and Global credit policies over the last five
years and because the Financial Geniuses have been able to
spread the risk from this country to the entire world. And the
entire world has bought into it hook, line and sinker!
The
banks and Wall Street have developed, and more importantly sold,
to the buyer and the seller, mortgages that have at times
equaled 100% of properties’ market values at the time they were
issued. Often those mortgages did not even require the buyer to
include more than his or her name, presumably their real name,
although in the end that really wouldn’t make much difference.
These were called “No-documentation” or “no-doc” loans. Billions
of dollars worth of these mortgages were also sold, where one
could not only buy the property at 100% of stated or sometimes
overstated value, but also with interest-only payments.
Or,
one could buy a 30-year mortgage and pay interest only for two
years and then enter into a more conventional financing
arrangement at a very high interest rate for the remaining 28
years. These were known as 2/28s and were the rage in 2005 and
2006, particularly at a time when house prices were skyrocketing
and interest rates on mortgages were at there lowest in memory
if not in history. Subprime loans rose to more than $600
Billion in 2005 and 2006 versus $160 Billion in 2001 when they
were primarily used for home-equity loans. Later homes were
used as ATMs and offered many of the biggest and “best” bets
imaginable.
It
was a Win-Win situation for everyone --- the house buyer and
seller, the real estate agent, the insurance broker, the
mortgage broker, the lawyers and the first-time lender, usually
a bank. As the business grew, the loans were “packaged” or
“securitized” and sliced into tranches where the poorest credits
(“junk”) were at the bottom of the pyramid while the highest
quality credits (AAA) were at the peak. The ratings agencies
often assigned their highest ratings to the entire pyramid.
It
is important to understand that this process effectively
transferred the risk of owning a mortgage, or a package of
mortgages, from the first lender – the bank – to the ultimate
mortgage holder – the investor. The investor often does not have
a second-party against whom he could make a claim in the event
of a default. The investor, as mentioned above, could be
anywhere in the world during these halcyon days and could be a
hedge-fund, an endowment, a retirement system or pension fund,
et cetera, et cetera. Nobody really knows who or where all the
investors are, let alone how much money has been invested in
subprime mortgages. What is known is that the amount of money
involved is beyond a mere mortal’s comprehension. Further, the
investor did not and still does not, in the overwhelming number
of cases, know or is able to find out the “real value” of his
“asset.” Furthermore, the investor in the subprime mortgages no
longer had the Fed or deposit insurance to fall back on as
before.
Who
could have been so naive as to think of a world where house
prices would plummet and mortgage and interest rates in general
would rise? It was supposed to continue to be just the opposite.
But
contrary to conventional wisdom the worm turned, and housing
prices have been plummeting while interest rates have been
rising. For example: If one bought a home for $100,000 and paid
nothing down and “interest only,” what would one expect to
happen when that buyer can or will no longer pay the interest
only, or pay the higher interest due when the mortgage resets
(meaning a higher interest must be paid by the home owner on his
interest only, 2/28 mortgage or ARM – Adjustable Rate Mortgage)?
The lender paid $100,000 in the beginning, but the house is now
worth, say, $70,000 more or less.
The
homeowner decides he cannot or will not pay the mortgage or
interest on his home where he owes $100,000 on a property that
is worth only 70% of that. What happens when that owner sticks
his key in the front door and walks away? The bank or lender
takes over a loan investment that now carries a $30,000 realized
loss. Multiply this situation by an estimated 7,000,000 times in
the coming months, and you can see how some people can become
upset – like right now! What is happening today is that the
lenders, in many cases, are trying to “unwind” or sell their
securitized mortgage packages where they have in many cases
leveraged themselves by borrowing 7, 8, 9 or 20 times the amount
of their cash investment in order to purchase those high
interest bearing mortgages.
The
most dreaded words in the investment business are NO BID, and
that is what is happening now. Potential buyers have either said
NO BID, having no interest in buying the mortgages or other
assets, or they are offering very low prices that if a
transaction occurred at that level would in turn necessitate the
hedge-fund’s or other investors’ possibly having to mark down –
devalue –their entire investment portfolio.
These investments in many cases had previously been marked to
the investor’s “model” – often their cost - rather than marked
to the “market.” But that is a different subject for a
different day as it brings up the extraordinarily important
question of how valid the previous performance records of many
“investors” have been since the “real value” of the investors’
assets could have been worth far less than the value stated in
their “models.” The validity of performance results in recent
years is brought into question. And the conflict is that the
money managers, for the most part and to a very large degree,
get paid on their performance. We will soon get more
evidence as to how much recent years’ performance results have
been overstated. The degree of accuracy of reported performance
results will be the subject of the SEC’s and other federal and
state agencies’ investigations as the story unfolds, and the
truth becomes clear.
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LOW RATES, A
WORLD AWASH IN MONEY AND MORE CREDIT
The
U.S. Federal Reserve bank lowered the federal-funds rate to just
1% in June 2003 and kept it there for more than a year. The
idea, as told to the public, was to avoid deflation.
Mr.
Greenspan said in August 2005, six months before retiring:
“History has not dealt kindly with the aftermath of protracted
periods of low risk premiums.” But what the Fed, i.e. Mr.
Greenspan and Mr. Bernanke, did not foresee was the deluge of
capital pouring into the U.S. from oversees. The effect was to
keep our banking system awash with capital. Interest rates
remained low, at least lower than they should have been, in our
opinion. Mr. Bernanke has referred to foreigners putting their
reserves into U.S. Treasury obligations a “global savings glut.”
The Drudge Report as recently as July 20th stated:
“Foreigners put more money into American stocks and bonds in May
than in any previous month in history.”
WE WROTE TO OUR
CLIENTS ON JUNE 1Oth WHEN THE MARKETS WERE HITTING NEW HIGHS:
“Risk still exists although it
is not mentioned in polite company and certainly not on TV.
“In other words, it has taken seven years and two
months for many of the averages to get back to where they were
in the halcyon “dotcom” days --- the craze that exploded in
March 2000. Not surprisingly, there are now a number of other
excesses that are sources for legitimate concern.
“The U. S. economy seems to be coming in for the
much desired “soft landing” and global money supply is at a
level never seen before. However, continuing problems in housing
and with the extraordinary financial leverage used globally by
Hedge Funds and Private Equity groups could scuttle today’s
market euphoria.”
And
we have not even mentioned the Leveraged Buy-Out Crowd and
Private Equity folks out there who may have to be funding up to
$500 billion under these conditions to complete their previously
announced deals. There are many on that very large hook for $500
billion.
Again we would like you to note the following relevant comments
from the Financial Times.
On
November 7, 2006, the
Financial Times carried an article titled
“Big buy-out collapse
‘inevitable.’ “The collapse of a large buy-out is ‘inevitable’
and could ultimately pose a threat to the stability of the UK
economy, Britain’s main financial watchdog warned yesterday as
it became the latest national regulator to turn its attention to
the private equity industry.” “The US justice department also
recently launched an inquiry into potential anti-competitive
behaviour among US buy-out houses.” There is currently a
short-term approach and speculation in the financial sector in
general that is bad for the economy. It must become more
sensible. When you see groups buying one company after another
and then another, you start to ask questions….” “The default of
a large private equity-backed company is increasingly
inevitable….” “Such defaults would have negative implications
for lenders, purchases of the debt, orderly markets and
conceivably, in extreme circumstances, financial stability and
elements of the UK economy.”
The
results of a financial blow-up – or melt-down - will affect the
US markets and ultimately the economy, just the same as in the
UK and elsewhere in today’s Global Economy. In other words, each
of us would be negatively and seriously affected.
Also note from the Financial
Times on May 3, 2007 an article titled
“NY Fed warns on hedge fund
risk.” The first sentence began:
“The risk hedge funds pose to
the global financial system has reached levels by some measures
comparable to those just before the Long Term Capital Management
fund imploded in 1998, the Federal Reserve Bank of New York said
yesterday.” “The bank’s study is the latest contribution to a
debate that has seen regulators and analysts express concern
over the risks and leverage taken on by hedge funds, the private
investment vehicles that are increasingly influential in
financial markets. The hedge fund industry has mushroomed in
recent years and now accounts for an estimated $1,500bn ($1.5
trillion to us Americans) of investments.”
The
following is a quotation from “Et Tu, Paribas? (Review &
Outlook) on the Opinion page of the August 10th Wall
Street Journal:
“What’s becoming clearer by the
day is that we’re watching the unraveling of a global real
estate financing bubble. The U.S. subprime market is the heart
of the problem, but financial innovation has spread the risk
around the world in a way that wasn’t possible a generation ago.
Long-term assets – real estate – have been financed by hedge
funds with short-term debt instruments, and the amount of the
debt now exceeds the value of the collateral in these subprime
investments. Somebody is going to have to swallow the
difference….”
We
will be the first to admit that we are unable to call market
highs or bottoms. Imagine the markets to be like a pendulum that
when at rest its “real” or “true” fixed point (or value in this
case) is at 6 o’clock. Bull markets always overshoot to the
upside, for example to 9 or 10 o’clock and bear markets to the
downside, for example to 3 or 2 o’clock.
We
repeat we are not in the “gloom and doom” business --- just the
opposite. Nevertheless, the above articles and comments are from
eminently respectable sources that we take very seriously in
view of our experiences having spent careers in the investment
business in excess of 110 years. It is part of the struggle to
Preserve Capital as well as to make money, and we have learned
over those years that one of the best ways to “make money” is to
keep from loosing it.
The
tip of the Iceberg: If what has happened to Bear Stearns
(two hedge-funds holding more than $20 billion of assets just
several weeks ago requiring $1.6 billion – the numbers are still
vague), Goldman Sachs (its Global Equity Opportunities
Fund needing a $3 billion cash infusion after a 30 percent loss
of its value last week and its flagship formerly $10 billion
Global Alpha fund down 27% for the year as of last Friday, June
10th) and KKR, can such problems crop up
anywhere else or with different forms of financial instruments?
Take a guess. And keep in mind, while these players are not
exactly warm and cuddly, they probably have had the most
experience working with many of the “smartest” people inhabiting
these non-eleemosynary intuitions.
The
problem is years of unwise credit expansion and unwise use of
leverage with the result that the Chickens are now Coming Home
to Roost. The Trillion dollar question is how many Chickens
are coming home and how long they will be staying
