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.

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Choosing Financial Stocks in a Time of SIVs and Credit Crunches

Many large commercial and investment banks announced painful writedowns and large losses for the third quarter of 2007. Some other banks, though, have announced relatively moderate writedowns and continued earnings strength. Are the latter a good buy?

One lesson from the high tech boom of the 1990s is that when you have a distressed industry, think carefully before investing in the apparent winners. Recall the telecom industry circa 2000 and 2001. Company after company was announcing writedowns and losses from aggressive expansion and industry overcapacity. Some companies folded. But WorldCom kept announcing strong financial results. You might have thought WorldCom would be a good investment.

Fastforward to June 2002. WorldCom publicly admitted to having engaged in an accounting fraud involving billions of dollars. Those glowing earnings reports were bunk. Shareholders were hung out to dry. The biggest difference between WorldCom and the losing telecom companies was that WorldCom was willing to lie about its performance.

The financial services industry is currently living in a world of turmoil, with much of the turmoil stemming from CDOs and other mortgage-related derivatives that are traded only by appointment and often have no open market price (especially not after the credit crunch began). These “assets” are the source of a lot of the recently announced losses. Valuing them is often a matter of judgment. The bank can use a mathematical model for valuation, but there’s wiggle room in the models and they haven’t been exactly spot on when it came to predicting cash prices (see http://blogger.uncleleosden.com/2007/08/how-computers-did-in-financial-markets.html).

Only the banks and their auditors know what actually happened with this past quarter’s accounting. But here are a couple of thoughts. A bank that wanted to avoid a bad third quarter this year could have given itself the benefit of the doubt at every turn and come up with results that didn’t look bad. This would have been a dangerous tack. If the real estate sector continues to decline (as many predict), circumstances in the fourth quarter may compel more writedowns at year end. And if a bank’s writedown this past quarter was relatively small, the writedown at year end may have to be relatively gargantuan (because those benefits of the doubt tend to evaporate as asset values slide).

Of course, there’s also the possibility that a bank with a serious CDO-subprime problem may have taken the opposite approach and been highly aggressive in writing down hinky assets. Then, at year end, it might report relatively positive results for the fourth quarter. Concerns have been aired that the banks reporting large writedowns may be creating "cookie jar reserves” that they could tap into in the future to smooth out more turmoil in their earnings. If such is the case, they are likely to have a problem with the authorities, since maintaining cookie jar reserves is considered bad accounting form.

Nevertheless, if you’re going to take a flyer on a stock in a volatile sector like financial services, do you want the one that might report improvement in the future, or the one that might have spent too much time primping in front of a mirror? Is it possible that the banks reporting strong results now simply are better managed and avoided riskier plays? Yes, that’s possible, and maybe it’s true. But WorldCom was considered a well-managed company until it blew up. Think and research carefully before plunging into stocks of banks and other companies holding volatile assets.

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