Sunday, November 18, 2007

Thankfulness Amidst Subprime Mortgages, SIVs, Conduits and Credit Crunches

Let us note, in passing, that Thanksgiving will be this Thursday. Christmas decorations already festoon many stores. A few homeowners have put up their holiday lights. Retailers have shamelessly leaked to the media word of special sales beginning as early as midnight of the day after Thanksgiving. But, before we move on to the year end spenderama, perhaps we should reflect on a few things we should be thankful for.

Less financial lunacy. Before this summer, large numbers of highly educated and extremely well-compensated people on Wall Street acted as if they believed that the real estate markets would rise continuously forever, and that people with poor credit histories and no demonstrated ability to pay were good risks for adjustable rate mortgages, no matter how onerous the terms. Many fewer people today subscribe to these notions. A reduction of lunacy is always good.

Unregulated banking activities revealed. Many major banks have quietly financed a lot of activity through unregulated vehicles called SIVs, conduits and other odd names. Until recently, not much about these entities was known to bank investors, depositors or regulators. But we now know that they played a significant role in fostering the still ongoing credit crunch. Even though many problems remain to be addressed with respect to these off-balance sheet vehicles, more information in the market is better than less information. Had they remained buried in the footnotes of Forms 10-K, the problems they present might have remained unknown, and the risks they present to the financial system could have grown even greater than they are.

Derivatives defenestrated. Contrary to the mantras tediously chanted by their acolytes, derivatives have proven not to reduce volatility and make markets more efficient. Instead, they have turned out to increase risk levels and ensnare market participants worldwide in intertwined liabilities that can't be easily unwound without seriously wounding the financial system. Derivatives have been used, not as the hedging mechanisms they were advertised to be, but rather for speculation. And, because they are unregulated and information about them is either scant or nonexistent, the thicket of entangled exposures they created among major financial institutions went virtually undetected by regulators until both the worms and the can had become very large. The asset-backed securities market has already shrunk. Other derivatives markets, such as for default insurance and other credit derivatives, may be shrinking as underwriters demand increased premiums for the fact that risk never dies. Derivatives, to be sure, are no more magical or bulletproof than common stock or convertible subordinated debentures. They are just another type of financial instrument, with advantages and disadvantages. And that's good for people to know.

Hedge funds humbled. The new masters of the universe for the 2000s have proven, as they did in Tom Wolfe's superb novel, to have feet of clay. For the sake of getting a few basis points over Treasuries, they dove into an impenetrable mass of opaque asset-backed investments that proved illiquid when one would have given a kingdom for liquidity. Holders of capital who invested in the hedge funds that took losses are now finding out that when you invest in an unregulated vehicle, you're on your own when things go badly. There are no regulators to help you out. Good luck, because you'll need it.

Regulators required to rethink. The financial regulators have largely been caught flat-footed by the subprime mess and the credit crunch. They evidently didn't know how bad things were in the subprime mortgage market until it was too late. They apparently didn't realize how much stress had built up in the financial system with the creation of so many poorly conceived loans. They seem to have been unaware of the risks and problems presented by the bank-sponsored SIVs and conduits that are now desperately seeking a bailout. The regulators have muddled through thus far without a serious breakdown in the financial system. But the smarter ones among them know that muddling through isn't good enough for the future. It appears that basic regulatory issues are being reviewed and reconsidered in Europe. U.S. regulators, on the other hand, seem to be doing a pretty good imitation of Calvin Coolidge on a slow day. But with more losses to come from the subprime mess, and a presidential election coming in less than a year, that may change.

Executives exit. Two high profile CEOs and various other senior executives at a variety of financial institutions are now pursuing other interests as a result of losses at their firms. This is good. Nothing promotes accountability as much as holding people accountable. Given the magnitude of the losses, most of which fall on innocent investors, accountability is badly needed.

Markets like mattresses. Like a well-made mattress, the stock market has absorbed blow after blow from the subprime mess and credit crunch, and dropped only about 7% from their all-time highs. The Dow, S&P and Nasdaq remain up for the year. Unemployment is around 4.7%, virtually full employment level. Inflation remains moderate, albeit with hints of less moderation to come. A visitor from another planet might wonder why the enormous uproar. Of course, there's a point where the markets will turn south in a big way. But we're not there now, and perhaps won't get there.

Terrific fall colors. Perhaps it's because of the drought, which may be due to global warming, but the fall colors of leaves, at least in the mid-Atlantic area, are gorgeous. If you remember that some things in life are timeless, your time in life will be improved.

Babies smile at parents. Regardless of the fact that the ABX index, which tracks credit default swaps, continues to decline, babies still smile at their parents. Thirty years from now, that's what you'll remember best about these times.

Happy Thanksgiving.

Collector's News. If you want something very few other people will have, buy a piece of the Eiffel Tower.

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