Monday, March 29, 2010

Market Shrink

The root cause of of the Great Recession, and indeed most all such phenomena, is human nature. I know , what a shock. And as humans maybe we need professional help. By "we" I mean the "market" because the market is just made up of humans after all.

When things went wrong from the excesses of subprime lending made by non traditional lenders to people who never should have gotten the loans in the first place, people/markets panicked. The panic, which itself may have been irrational, however lead to real problems, which had rational negatives consequences. If just the subprime market went down,the economy could have rather easily absorbed the losses. The subprime mortgage market was only a small fraction of all home mortgages, and even they didn't all go into default, at least at first.

Of course the unregulated credit default swap market really fed the hysteria. The rumor mill went wild with headlines abut CDS exposure which approached the value of all of the world's markets combined! The best example is Lehman Brothers who was rumored to have $800 Billion Dollars of CDS exposure. The reality, which came out in bankruptcy proceedings where the trades were all sorted out ( by net outing the trades and ignoring the massive multiple counting of the same single trade), turned out that Lehman's real exposure was $2 Billion Dollars--- oops, but too late. Yes $2 Billion is still a lot of exposure, but maybe its problems could have been dealt with better and bankruptcy avoided.

Why do people/markets panic? Where are "the cooler heads" who should have "prevailed?" What is it about human nature that we are prone to excesses and irrational behavior? People might respond by saying look the market was right and the economy did in fact collapse. But was that just a cascading self-fulfilling prophesy? What would have happened had people/ markets not panicked? We'll never know, as we dig ourselves out of the mess we're in.

Because of the panic, market prices sank, which lead to a perceived reduction in wealth, which lead to a reduction in buying, which lead to a fear of reduction in business profits, which lead to jobs cuts, which lead to further reduction in buying etc, etc. That's what happens when companies cut back, stop hiring ,lay off workers, cut back on travel and investments and so on and so on -- people who have lost their jobs stop shopping and traveling and so on and so on-- you get the picture.

Lately there have been basically 4 types of workers out there. (1) Those who have lost their jobs;(2) Those who are worried they will lose their jobs;( 3) Those who may have jobs they won't lose, but are worried about the success of their companies and therefore their jobs; and (4) Those who are so well off they have no real worries. None of this leads to a great economic recovery because everyone is cutting back on their spending, including #4 above . For example, a friend of mine related to me a comment made by a billionaire friend's wife --- She said "I've cut back on my spending by half because it just feels so unseemly in these hard economic times to keep on spending like I was." Wow are we in trouble.

Sure we had gone to excess. We were over leveraged and living on borrowed funds more than we should have. Yes we needed to modify our behavior, but come on, why a full fledged nervous breakdown? How did so much of these values just vanish? Maybe they weren't there in the first place?

Experts thought it could never happen, but the problem is the experts were thinking rationally. What happened ,at least at first, wasn't rational. Sadly however it became all to real.

You have to ask yourself , are we crazy now or were we crazy before and have just realized how crazy we were?

What we really need is a Chief Shrink, or Czar in current parlance, who can talk us down from our panic before the panic turns into a real live rationally based crisis.

I read somewhere about a developing science of analyzing ,and of course benefiting from, this sort of market mass psychosis. The problem is that people and markets don't always act rationally, and the trick is not to think in a rational way but rather in an emotionally based way.

At the time of the subprime loan panic, the default rate for commercial mortgages (CMBS) was .4% (that's right point 4% not 4%) and stayed that way for many months. There was no rational reason to panic just because less credit worthy borrowers who may have been "tricked" or certainly enticed into taking out loans they couldn't afford to repay began to default on their mortgages. Nevertheless the market value of CMBS securities plunged because residential(RMBS) subprime loans began to default. Of course once the value of the securities plunged and the recession began those commercial loans are now increasingly going into default. But what came first?

I remember listening to a story at the time the CMBS default rate was .4% but the subprime crisis was in full stride. This story was recounted by the chief economist for Wachovia. He told me about a Swiss debt trader who approached his boss about an opportunity to buy mortgage back securities at an attractively discounted price. His boss said absolutely not. The trader persisted and said that the pool of securities in question had no subprime loans of any type in them. The boss emphatically said no again. When the trader again pointed out that not only were there no subprime mortgages but that there were no residential mortgages at all in the pool, the boss asked whether the word "mortgage" was in the name of the securities. When the trader replied that yes these were commercial mortgages, the boss ended the conversation by saying if you bring me any investment again with the word "mortgage " in its name you are fired!

Of course, the boss turned out to be right because once everyone stopped buying anything with the word "mortgage" its name the whole market value for those securities crashed. Eventually this lead to the crash of the whole market which lead to the slow down in business activities which lead to the lay offs of millions of workers which lead to a real recession which in turn lead to the impending crash of the commercial real estate market with the result that CMBS default rate is now predicted to go to 8.5% by June.

Either that boss in Switzerland was very very smart or understood what can happens in a panic or was just lucky in avoiding the consequences of the crash he helped create. In any event how do you "calm" the markets before the panic takes over? Maybe we need a shrink to tell us "just because something bad happens that the world isn't falling apart and if we only refrain from panicking everything will be just fine". Since rationality and logic didn't seem to work--- remember those commercial properties were just fine - full of busy workers who received pay checks which they used to buy things and travel and the like - until a group of home buyers with less than stellar credit began defaulting on their crazy mortgages they were "tricked " into getting, that the government should never allowed to be made in the first place. As the guy from Saturday Night Live would say --- What's Up with That?

Who knows maybe a Psychiatrist-in-Chief or a Shrink Czar is what we really need.


Tuesday, March 2, 2010

On second thought

In light of AIG's sale of it's Asian subsidiary to Prudential UK for $35.5 B and its expected deal to sell another US subsidiary to Met Life for $15B, the government has sharply reduced its estimate of TARP losses.

However, the thing that caught my eye in reading an article on this subject today was the following:

"The unlikely stars of the bailouts are the US Banks, which have paid back their capital infusions faster than many analysts anticipated when TARP was launched in 2008." One analyst noted that "everyone loves to bash the banks, but that is not where the problem is." He called the return on the government's investments in the Banks a "home run".

Even when things like this make the press, and even when people read or hear the facts; nevertheless, taking their cue from politicians and the press, they still talk about all the money we just gave the Banks. It's as if they just got to keep it for free (like other government programs).

If it sounds like I'm a cheerleader for the Banks, you haven't read all my posts. There is no doubt we are suffering through the greatest economic recession I have ever seen. Some of the conduct of some financial entities share significantly in the blame , but this crisis was brought on by more than just the Banks.

As I wrote in the beginning, my intent in doing this blog is to reveal facts that are overlooked because they don't fit conventional popular views. Unfortunately, so many of those unpopular facts these days relate to Banks.