Monthly Archives: July 2007

Metaphors Mix Vision

I am not sure what to think about the fact that a money manager and I have been having the same feeling of “watching a train wreck in slow motion” as the current credit cycle unwinds.

Although I can safely say that he is more bearish than I am, I do agree with the overall sentiment that things will worsen significantly before we are out of this thunderstorm:

Jeremy Grantham: We’re Watching A Slow-Motion Train Wreck

But in the mean time, thankfully the creative side of our economy continues to elicit, if not lightning bolts, at least enough camera flashes to distract one from the clouds.

Although the GUI leaves something to be desired, this collection of start-ups confirms that ingenuity and creativity are booming:

The website attempts to use the “digg/filter” model to allow users to sort through the various new startups popping up out there.

I hope the name isn’t too ironic or foreboding of another turn of events in the web 2.0 space…I think the credit markets will be dark enough without another bubble bursting alongside it.

Like Dominoes

This article updates the spread of contagion to blue chip fund Sowood Capital Management LP. According to Bloomberg, the NY Times article I referenced below mentioning a drop of 10% is vastly understated, and instead the firm’s “two hedge funds plunged more than 50 percent amid the rout in credit markets.”

Citadel Takes Over Most Sowood Assets After 50% Loss

As the article also mentions, this fund suffered losses not in subprime loans, but in “corporate bonds and loans”. This surely is contagion in its clearest form.

Interestingly, as I discussed in the last post, Citadel, another hedge fund, still has adequate resources to step in and save off total implosion by buying some of the assets. In other words, at least in this case, the system is digesting the distress (albeit at a highly discounted level).

Unfortunately, I don’t think this will be the last headline like this, especially given the fact that those at the helm of this fund were former Harvard Endowment managers – aka theoretically some of the best in the business.

CCRM = Be Careful

The below article discusses a recent report by the Fed which focuses on Counterparty Credit Risk Management (CCRM) as a crucial component to reducing the risk of a system wide implosion

Fed Report: Risk Management Best Defense Against HF-Caused Market Failure

In English, this means that you should be careful who you are dealing with, especially when lending them billions of dollars.

Seeing how difficulties in underwriting the credit risk on something as simple as a home mortgage can have massive impacts when magnified to a large scale (aka the recent implosion in CDO’s and other mortgage back securities) leads me to wonder how inadequate CCRM – or not being careful enough with your hedge fund counterparties – will impact the balance sheets of prime brokers as the credit cycle plays out.

The NY Times today mentioned that woes are even spreading to blue-chip funds: $3 Billion Hedge Fund Is Down 10% for Year.

This further highlights how challenging it is to adequately implement CCRM in a dynamically changing environment while you are at the same time competing for business.

Finally, it looks as though funds may be feeling the back-lash from this reality setting in as Prime Brokers have started implementing stiffer terms for certain hedge funds: Hedge Funds Feeling the Heat

As with the regulation of subprime lending, closing the spigot too fast could cause greater volatility as the system looks to digest an increasing level of distress…Or maybe this is just enough CCRM to keep things from spiraling out of control.

Naive Optimism

One of the things most unsettling about the current situation in the credit markets is that it makes me question the integrity of the financing system behind the boom in the mortgage securitization market and the financing markets in general.

While this headline may be motivated by an investor’s misplaced frustrations, when I see the rapid pace at which the system has unraveled over the last few months, I am inclined to believe that this will be the first of many such accusations:

Wall Street often shelved damaging subprime reports

In defense of the big banks (and not just because I used to work at one and I have friends at many), there is some validity to the concept that each issuance includes the words “past performance is not necessarily an indication of future results” for a reason. It is difficult to know when and how events will change, and people’s predictive abilities are massively hindsight biased.

For the same reason that people are more likely to laugh at a joke when the CEO laughs first, individual buyers and sellers in a market are unlikely to depart from historical valuation methods unless someone else moves first. This causes people to move late and then in a herd mentality.

As an underwriter, it is likely impossible to predict the timing of such movements, and if “valuation” is defined by the market’s willingness to pay for something, then in a very real sense, until that herd moves you are justified and in fact almost mandated to price things based on historical performance.

In this case, I have no doubt that the rating agencies, as helped by the banks, modeled hundreds if not thousands of scenarios in each securitization transaction. Through these “Monte Carlo” simulations, they felt justified in thinking that the past performance and correlations were sufficiently predictive of future pricing to “rate” the securities accordingly.

As an investor in such a transaction, the onus would then be upon you to question the underwriting techniques – to anticipate future changes…and to perhaps even use a bit of creative thinking to try to predict when the market and herd would move.

Unfortunately, during the financing boom over the last five years, both buyers and sellers lost sight of the reality of a deteriorating credit (the american homeowner) underlying the system.

Now that we are watching the cards fall down and reflecting on some of the bad investments in the rear view mirror, it is only natural to point fingers, and to doubt.

But as I reflect – my naivete wins out – and instead of litigation I reach for learning so that we can perhaps minimize the contagion in this cycle and learn to prevent it next time around.

Housing’s House of Cards

This article provides a good assessment of the current situation with a focus on the dynamics underlying the house of cards – the housing market. The author focuses on the brutal reality that we are in for a long cycle of downward pressure on housing prices and this will have broad implications for the rest of the economy.

Housing Minsky Moment: 3 Factors. Prime Contagion, Record Foreclosures, and Publicity.

The piece I think he fails to address is that the entire system is driven by the credit securitization market and that the key to predicting the future trajectory/recovery of the markets will be determining how much the system can digest the elimination of leverage as mortgages underlying CDO’s continue to default. To the extent the diversification story is real, and default risk was somehow priced in at a somewhat realistic (although obviously underpriced) level, perhaps this cycle will be shorter than those in the past as resecuritization and out-of-court restructurings by alternative asset managers (aka hedge funds) lead the way.

Although it is scary to see headlines like this:
Financial crisis just one ‘Bear-like’ event away: Economist
and articles like this: Subprime coming home to roost?, the reality is that there are a bunch of very smart, very driven investors out there who will do everything they can to find a way to extract value out of the system.

One challenge that the housing market in particular will face, is that as individual homeowners feel the pain of the unwinding that has already begun at the ground level of the economy, they will complain to regulators, who will in turn look to point fingers. Lawsuits have already been filed, likely for good reason, by the NAACP and others against subprime lenders, and as mentioned here in another post, CFC and others have stopped selling 2/28 ARMs.

While regulatory oversight is likely needed to some degree and likely could have prevented the excesses of this cycle, as the market looks to correct closing the faucet on exotic securities en masse would be devastating. Hopefully, this will not be the result, and if regulators react as slowly as usual, perhaps it can be avoided.

The short answer is: nobody knows what tomorrow brings. So I will stay as Bullish as I can…and acknowledge my Paranoia.

Repricing Scorecard

Bernanke says not to worry, that this is nothing but a repricing of risk… Paulson Says Subprime Rout Doesn’t Threaten Economy

But this repricing is having some tangible effects in the financing markets. Not to mention that the rest of the economy can not help but notice that people are not buying new homes.

The Wall Street Journal did us a favor and collected a list of the major hiccups in the credit markets that have emerged over the last six weeks. Note the increasing pace…


Looking at this scorecard and the rest of the markets over the last few days makes me wonder whether Mr. Paulson and others are simply expressing wishful thinking. I hope he has more/better information than we do.

Today Is Visual

While I am not one for believing scary headlines in general, today’s reaction in the equity markets to the news discussed here yesterday in the credit markets may be the beginning of an ugly period for long-only investors across asset classes. If Bank of Japan or the Fed raises rates, this could be the nail in the coffin.

For now, I wish I was an options trader because there will be volatility all around as people try to sort out heads from tails and emotion from reality.

If you believe this article: Grim reapurr: The cat that can predict death then you should dive right in and start buying.

But today’s markets make me think that think that Taleb will be laughing as he looks in the rearview at this round of people who were
Fooled by Randomness

What Is Wrong With This Picture?

The picture may not do the point service, but on Friday, the headline read “A Low-Risk Investment in a High-Risk Lender” and today the stock is down more than 10% as the reality of lending to high risk individuals started to hit home for this pay-day lender.
This “reality” is starting to sink in across the markets, and although this validates some of the hypotheses discussed here, it makes me even more concerned for the short term future of the economy.
I remain optimistic that the creative spirit embodied in the growing number of internet based start-ups and tools will help the U.S. continue to lead the world in innovation (well, besides the Wii and all of these dope international Web 2.0 start-ups). Although the days where people are able to write such blatantly contradictory stories such as the one posted above are coming to an end. Perhaps this is a good thing, but sometimes reality bites.

Big Busted Bridges

For some reason these headlines make me think that we will see more pain in the banking sector as more mammoth buyout deals come to market (discussed here):

Banks Postpone Chrysler Funding Plan & KKR’s Banks Fail to Sell $10 Billion of Boots Loans

But maybe I am just too pessimistic and instead Moody’s is right to keep an optimistic take on all of this: US housing difficulties cause for concern but no systemic threat: Moody’s

According to Moody’s “The shock-absorption capacity of the ‘core’ of the financial system is very high.”

They point straight at the same banks who are now stuck with these massive bridge loans on their balance sheets for proof of that observation.

Shock absorbers are cool.

Bond King vs. Fed

This is truly one of the most brilliant things I have read in awhile…and not just because I agree with most of it. If you doubt my pessimism expressed over the last 8 months or so, maybe hearing it echoed by the greatest bond investor in the world will give it more legs.

Read this…and be nervous about the next few months in the credit markets…and realize that when Gross agrees with Buffett on issues regarding the rich, they are probably right.

Investment Outlook – August 2007 “Enough is Enough”

Maybe somebody should give the memo to the Fed:

Poole Says Inflation Slowing `a Bit,’ Subprime Damage Contained

Hmm… Who would you put your money with on this one: one of the greatest bond investors of all time responsible for managing upwards of $500b of assets, or a beaurocrat who is trying to stave off panic with the same (but now watered down) “containment” language?

Maybe the Fed got a sneak peak at Gross’s letter and wanted to stave off reaction at the pass. The chief took a shot at his tax commentary here: Fed chief stumbles into U.S. income inequality debate

It could just be coincidence I guess.