Thursday, August 23, 2007

When the Credit Crunch Losses Will Become Known

Much of the difficulty with the current financial markets credit crunch is that we don't know how bad the fallout may be, and where and how large the losses are. Known losses, no matter how bad they might be, would provide a degree of certainty. Asset prices could adjust and volatility would lessen. Of course, those that realized losses would be disappointed, and those that realized a lot of losses would be more than disappointed. Losses--and disappointment- are coming, though. It's only a matter of time. Here are some dates to keep in mind.

LATE AUGUST 2007: this is the end of the third fiscal quarter for many brokerage firms. These firms often have fiscal years ending in late November, so that they can close out their books before the end of the calendar year and pay employees bonuses by the end of December. (Bonuses are a crucial part of brokerage firm compensation, but may be less than glorious this year.) With the close of the third fiscal quarter, the publicly traded brokerage firms will likely announce their financial results in early September. These announcements will give us an early look at the situation. We will get only part of the picture. But the brokerage firms are crucial intermediaries in the mortgage markets, and may have exposure to much of the fallout from the problem. Their problems could include not only CDOs and other such instruments, but also losses from bridge loan obligations for private equity deals that have been unable to find bond market financing. The firms might also have losses from credit derivatives contracts and other derivatives market exposure that is essentially impossible for an outsider to predict. The hits the brokerage firms disclose will give us some idea of the magnitude of the problem.

SEPTEMBER 30, 2007: this is the end of the third quarter for many banks and other public companies that are involved in the mortgage mess. They will probably announce their financial results for the third quarter in early October. Banks, thrift institutions, mortgage companies, and homebuilders may be among the public companies reporting losses. Much will become clearer at this point, although this, too, will be only part of the picture.

HEDGE FUNDS: hedge funds are not public companies and will generally not make public announcements. However, there is news from time-to-time about a hedge fund going under. Pay attention, because the hedge fund sector is in the belly of the beast, where some of the greatest losses likely were taken. When a hedge fund collapses, banks that loaned money to the hedge fund probably feel pain, and the hedge fund's investors probably feel a lot of pain. If you see news of a hedge fund freezing its assets and refusing withdrawal requests, count that as a situation where losses are likely. Some of the freezers try to characterize their problems as a lack of liquidity and make comments about how their assets are undervalued. Both statements may be accurate to some degree. But there is a major repricing of risk taking place, and the CDOs and other asset-backed securities that these hedge funds hold--whose risks have become clearer and larger--may never recover the values they had before July 2007. That means, ultimately, losses are likely. In today's economy, the hedge funds, which serve as the actual lenders for many credit transactions, are effectively a form of bank, albeit unregulated. And we now have a run on this sector of the banking system. The more hedge fund closures and freeze-ups there are, the worse things will be.

COUNTRYWIDE: the largest mortgage mortgage company in America is Countrywide Financial Corp. Early in the mortgage market crisis, it put on a confident face, hiring mortgage brokers laid off by failed competitors and predicting that the problems of others would give it opportunities to expand. Since then, the waters have proven rough indeed. Last week, Countrywide borrowed $11.5 billion from a syndicate of banks. On Wednesday (8/22/07), Countrywide announced that it had obtained an additional $2 billion from Bank of America through a sale of convertible preferred stock. The preferred stock is convertible into Countrywide common stock at $18 a share, which was trading around $21 when the preferred stock sale was announced. The discounted conversion price caused some speculation that things at Countrywide might be rather gloomy, although the common stock which Bank of America would get in a conversion would be subject to restrictions on its sale for 18 months. Those restrictions could explain the discounted conversion price. Nevertheless, the infusion of $13.5 billion into Countrywide in the last couple of weeks is a sign that things there aren't entirely copacetic. If Countrywide goes under, hold onto your hat.

LATE NOVEMBER 2007 and DECEMBER 31, 2007: these will be the ends of the fiscal year for brokerage firms, and many other public companies, respectively. More information will be revealed at these times.

LATE FEBRUARY 2008, MARCH 31, 2008, LATE MAY 2008, JUNE 30, 2008, etc., etc., so on and so forth: The losses are likely to continue for years, as adjustable rate mortgages reset their rates. A fair number of adjustable rate mortgage loans made last year have rate resets scheduled for as late as 2011. Depending on where interest rates are by then, and how strong or weak the real estate market is, that could be a time of discontent. Recall the real estate bust of the early 1990s. Four or five years into the bust, prices in some of the formerly hot markets (like southern California and eastern Massachusetts) had not recovered their losses. Many homeowners were under water on their mortgages and refinancing was difficult.

If the losses are big (and that's what's often rumored), the regulators will no doubt face pressure to allow deferrals of loss recognition. Dispensation is not in order. While reports of large losses can lead to investor and depositor concern, not recognizing losses leaves capital misallocated and hinders recovery. This was--and continues to be--Japan's experience. Concurrent with the 1989-1990 crash of its stock market, Japan also suffered a real estate market crash. Its economy went into recession. The Japanese banking system's losses were staggering. A number of major Japanese banks were probably insolvent. However, the Japanese authorities allowed (and indeed encouraged) the banks to defer recognizing many of their losses. The result was that loans to failed businesses continued to be funded (with a little help from the taxpayers), and Japan's economy stagnated. Japan's banks did not fully recognize their losses until perhaps fifteen years later. One could say that Japan's unique social contract explains these events, and perhaps the Japanese people consider this their best alternative. Nevertheless, during that 15-year period, Japan had a number of years of recession or minimal growth. Capital that could have been devoted to new investment was instead misallocated for a decade or more. Japan continues to pay the price today.

Whatever the social contract in Japan may be, 15 years of stagnation would be unacceptable in America. The regulators should hold the line when asked for variances from the accounting rules. The plus side of losses is that realizing loss is where recovery begins. Asset prices can be firmed up (even if at lower levels). End-of-the-world market hysteria, such as when yields on 3-month Treasury bills went from around 4.8% to 2.5% in a matter of a few weeks, will hopefully subside. Rational evalution of risk can be restored, and the flow of investor funds into repriced riskier investments may resume. Enthusiasm for asset-backed securities will probably be damped for years to come. But that would be a good thing. Like perhaps some highway bridges, these instruments have been too finely engineered. A little more ruggedness and stability are in order. For at least the next few years, investments that can run reliably for 300,000 miles on little more than oil changes and tune ups are likely to be favored.

Fashion News: luxury lederhosen. Expect to see them at the Oscars.

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