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* Understanding The Subprime Mortgage Mess - 1 messages, 1 author
http://groups.google.com/group/misc.consumers.frugal-living/browse_thread/thread/758f81a90cb008df?hl=en
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TOPIC: Understanding The Subprime Mortgage Mess
http://groups.google.com/group/misc.consumers.frugal-living/browse_thread/thread/758f81a90cb008df?hl=en
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== 1 of 1 ==
Date: Fri, Oct 26 2007 10:37 pm
From: PaPaPeng
Pants on fire
By Chan Akya
October 27, 2007
http://www.atimes.com/atimes/Global_Economy/IJ27Dj01.html
Results announced by Merrill Lynch on Wednesday have created a massive
problem for headline writers in the financial media. That's because
the firm's iconic image of a bull would normally lend itself to
headlines such as "Bears maul Wall Street's Bull", but unfortunately
enough, the bear as in Bear Stearns was also mauled a few weeks ago
when it reported results.
Other animals and birds are over-used in related headlines already
"Inflation porked up" and "Retail sales drop like dead ducks". There
is now therefore a search for the most appropriate animal imagery that
can properly convey the sense of angst being felt in financial markets
and especially in the increasingly shaky board rooms of major banks.
Financial writers of course always have used such imagery, reflecting
the "animal spirits" that John Maynard Keynes talked about many
decades ago.
But I jest. The figures for the third quarter (July to September)
released by Merrill were really nothing to laugh at. At the very
least, the losses of some US$8 billion for the period showed singular
asymmetry with past financial results. The figure was more than what
the broker made for all of last year (2006), and about four times its
entire compensation figure, ie bonuses paid to employees for the same
year (we will circle back to this later).
It was also about one-sixth of the company's market capitalization.
Each one of those comparisons deserves introspection, albeit by
different people - for example, while stock market regulators would
focus on the first and employees on the second, retail stock investors
must take some time to think about the last point.
In the old days, that is until about five years ago, investment banks
were purely in the business of intermediating risk. This meant
advising companies on what to pay for buying another company, buying
stocks and other investments on behalf of investors, pricing and
launching new equity transactions (IPOs) or bonds. They would trade
across a number of markets ranging from foreign exchange and
commodities to credit and equities to ensure there was enough
information available at all time for the firm to properly advise its
clients.
For example, to advise a mining company on what to price its new stock
offering at, the firm would need information on the equity valuation
of related companies in the business across the world, expected growth
rates for customer in various countries that the company was selling
its products in and other information such as the comparable cost of
capital by using debt markets instead. On the other side of the
equation, the investment bank would advise investors on why (or
whether) they should purchase the new IPO, expected return and the
like. The bank would collect a fee from both sides - a lump sum from
the mining company, and brokerage commissions from investors for
selling them the stock.
The last major crisis that investment banks faced pertained to these
businesses, and in particular the technology companies during the
dotcom bubble period in the 1990s. In that situation, the investment
banks were found wanting in their analysis of prospects for companies
that they were advising to "go public", ie sell their equity to
investors. Exaggerating the revenue potential was one thing, but it
soon turned out that the major investment banks didn't believe in
their own baloney, in essence looking for a fall guy that turned out
to be the average retail investor - the person who was investing his
savings or his children's education money based on the advice of his
broker, who turned out to be rather untrustworthy after all.
With US regulators jumping on the case, a cathartic process that let a
new governor to emerge in New York (Eliot Spitzer, the attorney
general for New York who championed the case for investors against
Wall Street banks), and the business model soon changed. Unable and
unwilling to manage such conflicts of interest, the investment banks
were forced to increase their reliance on trading revenues. This in
turn meant that they had to take a lot more risk on their balance
sheets.
Investment banks like to pretend that they employ many an Einstein in
their ranks, but the truth is, of course, far more mundane. It is
usually difficult to make money trading something that everyone knows
and understands. The three banks down the road from you will probably
offer pretty much the same interest rate on your deposits for that
reason alone, in essence making your choice of where to put your money
dependent on sundry factors like the length of the teller's skirt.
For the investment banks, this absence of people to stuff (retail
investors) meant that financial products simply had to get more
complex for them to make any money. Complexity in this case doesn't
mean cleverness so much as a lack of transparency - if your
competitors cannot see what you put in your sandwich, it is difficult
for them to understand just how much money you make selling it. This
meant that other banks either had to hire your people at a fat premium
or figure out for themselves areas where they could manufacture
increasingly complex products themselves. This would in turn engender
other banks to hire your people ("poach" in industry parlance) and so
the circle went, creating billions of dollars in compensation for
workers across the financial system.
The increasing complexity of derivative products was encouraged by
rating agencies, who wanted to increase their own fees, and were
therefore willing to casually assign the highest ratings to products
that were in essence the most leveraged exposure to bad ideas
imaginable. This was also a good business model, but more akin to the
"traditional" view of investment banks that I highlighted in an
earlier paragraph. Rating agencies may soon be forced by the US
Congress and other regulators to mend their ways, and reduce conflicts
of interest
The fish, the fish
Continuing with the animal analogies, the great investor Warren
Buffett once compared bond markets to a game of poker with the
immortal lines, "There is always a fish at the table. If you don't
know who the fish is, it's you." This bit of gaming outcomes was all
too apparent in the world of finance. Investment banks sold complex,
opaque products to unsuspecting investors, but the value of the
product depended very much on the likelihood of demand.
To some extent therefore the price of complex derivatives can be
compared to what happens in any fish market. If for any reason no
buyer shows up, prices of fresh fish fall dramatically as they have to
be sold as either frozen food or worse, as fish feed. That leaves very
little room for maneuver for the average fisherman.
The world of investment banking, by creating increasingly complex
products, also went down this same path wherein demand for its
products was the only real proof of prices ever available. In other
words, the fact that an investor bought a security from you at say 100
meant that the value of the security was 100. If there was no
investor, then by logical deduction there was no price either. You
could argue that by reducing the price to 90 there would be buyers,
but once again that needed to be proven.
This is where the "honor among thieves" broke down. Investment banks
all hold billions of such complex financial products, for which there
is no obvious source of demand left. Most of the other US brokers like
Bear Stearns, Lehman Brothers, Goldman Sachs etc, when announcing
their results last month for the June-August quarter (different
investment banks have different financial year end), assumed certain
values for these unsold securities.
Barely a month later, other banks, including the investment banking
arms of various US commercial banks, reported earnings that were
markedly lower. The worst of these was unarguably Merrill Lynch, whose
results on Wednesday showed a dramatic reduction in the prices of
various securities - in some cases, investments that had been priced
at about 90 at the end of August were reduced to 30 or 40 at the end
of September.
Extrapolating from this, it is clear that the investment banks which
reported previously may well have more losses on their books. In that
case, their stock market values will fall more dramatically in coming
weeks as investors get used both to the losses and more importantly,
the lies. The banks could certainly claim that their own models are
correct while those of the banks posting losses this month were wrong,
but given the cross-pollination of people that I talked about
previously, this looks vastly unlikely.
There is a silver lining to all this though, at least for Americans.
This week, Bear Stearns and China's CITIC Securities announced that
they had exchanged a US$1 billion stake in each other to foment
greater business cooperation. That announcement goes back to the point
in my earlier articles that Asia will be called on to bail out the US
financial system. Just like finding a buyer for a bear, a buyer for
the bull will be found. The circus will continue, but the applause
increasingly looks forced and sounds false. There are people out there
whose pants are on fire, but who has the courage to start singing
"Liar, liar"?
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