Enronitis: The United States of Subprime
Tuesday, 16 October 2007 Written by Garrett Johnson
Wall Street has a problem, and that means you have a problem.
Wall Street's problem is that it can't put a dollar value on its assets. That means that Wall Street can't put a dollar value on your 401k, IRA, and life savings.
What does that mean? It means that your 401k statement you receive in the mail may be accurate, or it may be a work of fiction worthy of those "true stories" you find in the back pages of a Playboy magazine.
Only time will tell.
" Transparency in corporate financial statements is essential for an investor’s assessment of risk and trust in stocks."
Before I can explain this, I have to introduce you to the idea of risk.
The idea is that the riskier the bond (i.e. the bigger the chance of the borrower defaulting on the bond), the higher the yield (aka interest rate) that the bond purchaser will demand to compensate for the risk.
Another concept to understand is that when it comes to bonds, price and yield are inversely correlated. As the yield on a bond goes up the price goes down, and visa versa.
Why this matters is because the largest asset classes of the entire bond market ($10.6 Trillion worth) has gotten dramatically riskier.
In fact, it's gotten so risky that starting in July of this year the pool of potential investors that normally bought these bonds almost completely dried up. This left Wall Street holding hundreds of billions of dollars of Asset-Backed Securities (ABS) that no one wanted to buy.
Here's a simple question: what is the value of an asset that no one will buy at anything other than fire sale prices? The answer to that question depends, at least partly, on whether the seller of those bonds agrees to the price.
The hazards of this new age of uncertainty became clear at Dillon Read in March, when rising defaults by homeowners were hammering the value of mortgage securities. John Niblo, a hedge-fund manager at the firm, acted fast. He twice slashed his fund's valuation of securities tied to "subprime" mortgages, knocking them down by about 20%, or nearly $100 million, say traders familiar with the matter.
But managers at UBS AG, Dillon Read's parent company, were irate. The Swiss banking giant was carrying similar securities on its books at a far higher price, the traders say. In conference calls, the UBS managers grilled Mr. Niblo on his move. "I'm marking to where I could reasonably sell them," Mr. Niblo responded during one call, according to the traders familiar with the conversations.
UBS later shut down the in-house hedge fund, and Mr. Niblo was let go in August. Last week, UBS announced a $3.7 billion write-down on $23 billion of securities with mortgage exposure, including securities from the shuttered fund.
"A complex and opaque financial reporting gives no idea about the true risks involved and real fundamentals of the company."
Properly pricing financial assets has become the biggest problem on Wall Street. It's gotten so bad that less than half of all securities that trade on exchanges have "readily available price information". That means that the securities in your 401k, your pension fund, your IRA may be worth a lot less than what your statement say it is.
As a result, money managers can no longer gauge with certainty the value of some assets in mutual funds, hedge funds and other investment vehicles -- a process known as marking to market. An official at the Securities and Exchange Commission said recently that some bond mutual funds might be using outdated or unrealistic prices to value their portfolios.
Billionaire investor Warren Buffett advocates more transparency in pricing. "Some marks can be pretty imaginative," he says. "They call it 'marking to market,' but it's really marking to myth."
During this summer's credit crunch, more than 80% of investors in bonds tied to the mortgage market said they had trouble obtaining price quotes from their bond dealers, according to a survey of 251 institutional investors by Greenwich Associates, a Connecticut consulting firm.
The bottom line is that mortgage banksters were making $256 per loan in 2005, but lost $50 per loan in 2006.
So why don't we know the price of these products? Because the large investment banks on Wall Street are doing everything they can to keep that from happening. For instance, the huge investment bank Bear Stearns, recently cut a deal with a hedge fund known as a "mandatory auction call" concerning about $1 Billion in shaky subprime debt. This deal would involve Bear Stearns selling all those suspect assets to the hedge fund on the agreement that Bear Stearns would buy the stuff back a year from now.
The entire purpose of the deal is simply to "get it off the books" for a year and hope that something good might happen in the meantime. You might recognize that strategy - its the same one President Bush had for the Iraqi "Surge".
It doesn't stop there. The great 3rd quarter that Goldman Sachs reported is based on paper gains not hard cash payments from trades.
"The opaqueness of Goldman's balance sheet makes us immediately question how they made money in the quarter," says Charles Peabody, analyst with Portales Partners.
And of course we aren't just talking about actual bond funds. This toxic paper runs through all sorts of financial channels, primarily commercial paper.
Even Treasury Secretary Hank Paulson and Fed Chief Ben Bernanke have recently admitted the obvious that something serious is wrong in the mortgage-backed securities market.
“I’d like to know what those damn things are worth,” Mr. Bernanke said in response to a question after his speech. Until investors “are confident in their evaluations,” he added, “they are not going to be willing to fund these vehicles.”
But the big news happened just this past weekend.
Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co., the three biggest U.S. banks, agreed to set up a fund of about $80 billion to help revive the asset-backed commercial paper market, according to people familiar with the discussions. . . . . The fund will buy assets from structured investment vehicles (SIVs), units set up to finance purchases of securities such as bank bonds and mortgage debt.
Other banks may join the fund, which would help SIVs avoid selling their $320 billion in holdings at fire-sale prices, further roiling the credit markets, the people said. The Treasury Department in Washington initiated the talks between the banks after a shutdown of the commercial paper market left SIVs and other sellers unable to borrow, forcing sales of about $75 billion of assets.
This very clearly means two things:
1) The credit market troubles are not over. In fact, we have at least one more round of turmoil to go.
2) If these huge investment banks are willing to drop $80 Billion of their own money, then there is real potential of the losses being many times larger.
How can that be? After all, subprime mortgages that are in trouble are only about 2% of the entire mortgage market.
Well, for starters, it isn't just the subprime market. The Alt-A market is also in serious trouble. But more importantly, each one of those mortgage-backed securities has a multiple of 20 times or more worth of leverage (borrowing on credit) built upon it. To put it another way, "a single dollar of 'real' capital supports $20 to $30 of loans."
Right now there is no telling just how long and deep this mess will be. Even Wall Street doesn't know. My advice is simple and logical: if you don't know what you are getting into, then don't get into it unless you are prepared to lose everything.
You don't get into a car if you can't count on your brakes working. You don't make a bet in Las Vegas if you think the game is already rigged against you. So don't send your life savings to Wall Street if you think they are lying to you.