By Adrian Ash | 25 October 2007
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PHEW! That was close. For a moment there, it looked like the collapse of the subprime mortgage market was going to wipe billions off financial earnings for years to come.
The bad debts were stacked up like poisoned nuts gathered by a crazed squirrel during the housing bubble of 2003-2006. Going bad— fast— in summer '07, they threatened to wipe out consumers, investors and businesses everywhere in a slow-motion replay of Japan's "zombie" banking deflation.
At least, that's how the credit markets saw the subprime meltdown in August. Two subprime hedge funds at Bear Stearns had gone bust in June; Ben Bernanke, head of the Federal Reserve, said in July that total subprime losses could total $100 billion; private-sector economists put the total nearer to $150 billion. Now MacroMavens in New York thinks we're looking at $210 billion to $346 billion— "and that's assuming the situation doesn't get worse."
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These billions in bad debt would seep into the broader economy, investors feared, and kill the market in new lending dead.
But hey, panic over!
"They revealed all of it," as a friend of mine— now senior analyst at a leading mutual fund here in London— told me over a beer or three late last week.
"Sorry Ade, but there's nothing left to hide. Nothing to see here... " |
This happy, if not quite sober view of "Subprime? So over!" is certainly what the banks announcing their Q3 numbers this month would like the world to believe. For all we know, they're sincere about it, too. And the write-downs sure look dramatic enough to mark the end of the crisis in subprime bad debt:
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In short, a litany of woe all 'round!
Still, thanks to the wailing and gnashing of teeth by hair-shirted banking chiefs this earnings season, it's clear to see that their subprime mistakes have now been settled in full.
Yes, subprime was a mess, but it's been cleared up and tidied away like the trash of beer bottles and bucket bongs after an 18th birthday party. The investment bankers' hangover is already starting to clear. Right?
Equity investors seem to believe so. Banking stocks have risen by nearly 13% from the bottom hit in August. And as proved by my night out at the John Snow pub on Broadwick Street last week (their beer, by the way, is shockingly cheap for London... and rightly so) professional analysts are happy to take the banking world at its word.
"Deutsche Bank joins a conga line of banks coming clean," says FinancialWeek. "Swiss bank exposes holes in Q3 results," adds a French newswire, reporting that UBS, the world's biggest wealth manager, expects to lose $3.4 billion on its subprime mortgage book.
"Coming clean... exposing holes... " This is the language of honest men 'fessing up and moving on. "While we're disappointed with our anticipated third-quarter results, we look forward to an improved fourth quarter," says Kerry Killinger, chief of Wamu.
"While it is very early in the current quarter and despite continued challenges in structured finance, we are beginning to see signs of a return to more normal activity levels in a number of markets," says Stan O'Neal, head of Merrill.
In short, "we see substantial opportunities in investment banking after this period of correction," as Josef Ackermann, head of Deutsche Bank, put it.
Indeed, the world's highest-ranking bankers have enjoyed what looks like a moment of clarity. From here on, their mortgage-backed losses of third-quarter 2007 will always serve to remind them: Don't lend to people with no income.
Only Goldman Sachs escaped the carnage— and even then, it seems, only on paper. "Common sense tells me that a lot of their losses were real and a lot of their gains were paper," says Charles Peabody, head of research at Portales Partners in New York.
"The opaqueness of Goldman's balance sheet makes us immediately question how they made money in the [third] quarter."
Goldman's stock still shot higher on its "yah-boo" earnings report, however, gaining some 7% since the firm announced— in stark contrast to everyone else— a stellar quarter between June and Sept.
Trading revenues at GS rose 70% from the same period in 2006, a massive $8.2 billion all told, taking the group's net earnings to a new record for the year so far. Merrill Lynch and UBS, on the other hand, reported their first quarterly losses in more than four and a half years as the International Herald Tribune notes, adding that:
"Bear Stearns posted its biggest earnings drop in a decade."
So how did Goldman— "increasingly perceived as the world's biggest hedge fund" according to the IHT— succeed where everyone else failed? The bank made no secret of its success in its Q3 report of Sept. 20th:
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Put another way, Goldman Sachs cleaned up during this summer's collapse in subprime mortgage bonds... by selling the subprime mortgage-backed market short. And why not?
It's not like Goldman is barred from shorting the investment markets that it helps bring into being. Nor did it have any special insight; all of the big investment banks were busy creating and selling subprime junk in 2005-2006.
None of the other big banks, however, had the chutzpah to short the very market in junk they'd given birth to— not yet, at least. And few banks seem to have created bonds quite as toxic as Goldman did.
Take last year's vintage, for example. In 2006, Goldman Sachs' mortgage-bond division— Alternative Mortgage Products (known as GSAMP for short)— issued 83 home-loan-backed bonds, valued at $44.5 billion. In the subprime sector, it grew its business by 59% from 2005, unloading some $12.9 billion on to unsuspecting, stupid and/or greedy investment fund managers who thought a bond under-pinned by home-buyers with no hope of repaying might be worth having.
According to Inside Mortgage Finance, that made GSAMP the 15th biggest issuer of subprime-backed bonds in 2006. And come the start of the third quarter this year, those securities were being downgraded by the credit ratings agencies faster than anyone else's.
Research from Citigroup, dated 22nd June, found that "portions of Goldman's GSAMP-issued bonds, which include subprime loans from a variety of lenders, have been downgraded a combined 69 times by Standard & Poor's and Moody's Investors Service in the year through June 15," as Reuters reported.
"Sixty of the GSAMP downgrades refer to classes from 2006 bonds," Citigroup added, and one of Goldman's 2006 crop— the GSAMP Trust 2006-S3— may actually be "the worst deal... floated by a top-tier firm," reckons Allan Sloane in the Washington Post.
In spring 2006, "Goldman assembled 8,274 second-mortgage loans originated by Fremont Investment & Loan, Long Beach Mortgage, and assorted other players," explains Sloane after studying the public record.
"The average equity [these] borrowers had in their homes was 0.71%... [meaning] the average loan-to-value of the issue's borrowers was 99.29%. "It gets even hinkier," Sloane goes on. "Some 58% of the loans were no-documentation or low-documentation. This means that though 98% of the borrowers said they were occupying the homes they were borrowing on— 'owner-occupied' loans are considered less risky than loans to speculators— no one knows if that was true. And no one knows whether borrowers' incomes or assets bore any serious relationship to what they told the mortgage lenders." |
Whatever the truth, one in every six of the 8,274 mortgages bundled together in GSAMP Trust 2006-S3 was already in default 18 months later. Whoever bought the S3 bonds will have either taken a 100% loss, or they're now waiting— and hoping against hope— for some other schmuck to turn up and take this toxic waste off their hands at a very heavy discount.
Meantime at Goldman Sachs, the profits made by shorting the subprime market flipped Q3 '07 from "significant losses" to "significantly higher" net revenues. Goldman creamed it by selling 'em twice, in other words... first as an asset... and then as a tasty short.
You don't need to think this is more than ironic to wonder why anyone— most especially your pension or fund manager— would trust investment bankers to look out for your best interests.
Nor does it matter how Goldman went short of the subprime market. It may have sold derivatives against an asset-backed index such as the ABX (which now looks close to winding down, by the way, because "securitizations have fallen so low, there may not be enough bonds to fill the series" says Markit, the index's developer). Alternatively, Goldman might have borrowed a fistful of mortgage-backed bonds and derivatives from poor, benighted investors... and dumped them into the market as it plunged between June and Sept. [[Good thing they got rid of the "up-tick rule"— just in time, too— almost as if planned... nah.: normxxx]]
Goldman may even have borrowed the bonds that it shorted from its own 2006 customers, but I guess it's unlikely. Yes, the sales team at GSAMP must own a Rolodex packed full of investors now looking to hide, bury or burn the "toxic waste" they bought last year. But can you imagine the phonecall from GS?
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Back in the US housing market, meantime— the source, remember, of all those defaults and delinquencies now hitting investment-bank profits— the trouble looks to have barely begun:
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"I foresee several million [foreclosures]," warns Bill Wheaton of MIT's Center for Real Estate studies. "I think that we could easily see 2 to 3 million people lose their homes and go back to renting, basically."
But would that scale of wipe-out on Main Street matter to Wall Street?
If the whole problem has been dealt with in one quarter, why would US Treasury Secretary Hank Paulson— a former chief of Goldman Sachs, no less!— want to bang heads on Wall Street and get this deal set up? And if the trouble in subprime were over, why didn't Goldman Sachs step up to join Paulson's bail-out baby? Does GS plan to short the mortgage-bond market— and keep shorting it— as 2007 turns into 2008... ? |
"[The banks] may firmly believe this gets everything out of the way," says one analyst of the mass confession given in Manhattan, Frankfurt and London this month. "But I think there's going to be further reserve additions in future quarters."
"I'm pretty bearish on the whole banking sector," he adds. In our humble opinion, that sounds a fair call.
All told, the ongoing subprime crisis is just one more reason why we're sticking with gold, rather than paper promises.
Because there's more trouble to come in paper. Much more.
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On August 8th of this year, just one day before the sudden and savage "credit crunch" that Alan Greenspan— former head of the US Federal Reserve— now says was "an accident waiting to happen," the Investment Council of Oregon State voted to change the way it invests public retirement funds.
"Members of the council and staff from the state Treasury voted to gradually sell billions of dollars' worth of US stocks," reported The Oregonian the next morning just as the S&P index was beginning its 3% plunge for the day.
The plan? To "reinvest the proceeds in somewhat riskier real estate, private equity and international securities."
Fair enough. The State Treasury had said all along that it wanted to "broaden [the] investment universe" for its real estate and alternative plays in 2007.
But even after voting unanimously this summer to put $150 million into the Rockpoint Real Estate Fund... plus a $200 million commitment to Blackstone Real Estate... and another $125 million into the Fortress Fund V, which targets "a broad range of real estate and other asset-backed investments using 65% leverage"... the Oregon Investment Council was still very late to the mortgage-debt party.
By the start of June, the General Retirement System of Detroit held nearly $39 million in the highest-risk portions of three subprime-backed bonds, according to a Bloomberg report.
The Teachers Retirement System of Texas owned $62.8 million of subprime "equity" tranches— "equity" being the banking world's jargon for "highest risk, most likely to never pay up". The Missouri State Employees' Retirement System held another $25 million; the New Mexico State Investment Council owned more than $222 million of these high-risk products.
Indeed, the New Mexico State Investment Council opted as recently as April '07 to buy another $300 million in subprime equity according to David Evans in his June 1st report for Bloomberg. That would have taken high-risk mortgage debt to nearly 3.5% of its total pot.
But US state pension funds weren't alone in piling up those mortgage-bonds most likely to go bust. Buying subprime exposure has been a crowded trade.
You may well be long some "toxic waste" as a result. Everyone else is, it seems, whether they chose to be or not!
1. Money Market Funds
By the start of Sept. this year, new cashflows into US money-market funds had outstripped 2006 inflows for the same period more than three times over according to data from the Investment Company Institute.
US equity funds, on the other hand, saw net inflows drop by one-quarter. Money-market funds only grew more attractive to safety-seeking investors as the threat of recession, inflation or some kind of financial meltdown— if not all three at once— became obvious to anyone reading the newspapers in early 2007.
But while fund buyers missed out on near-8% gains in the S&P, at least they could also hope to miss out risk, right? After all, money market funds are designed to offer "immediate liquidity, safety and a reasonable rate of return" according to Bruce Bent, founder of the Reserve Fund 35 years ago.
Subprime mortgage debt "doesn't have a place in money market funds," as he told Bloomberg recently, adding that "it's inappropriate."
But in a world of sub-5% yields, inappropriate doesn't mean you don't buy it.
"US money market funds have invested $11 billion in subprime debt," writes David Evans in the latest issue of Bloomberg Markets. Paper debt "laced with subprime home loan securitizations" accounted for more than 5% of Wells Fargo's Advantage Money Market Fund in June; Credit Suisse's Prime Portfolio had 8% of its assets exposed to subprime mortgages; two funds run by A.I.M. held $2.64 billion in collateralized debt, much of it based on subprime mortgages.
"I don't think the typical money market investor in his wildest dreams would assume he has exposure to the risk of subprime CDOs [collateralized debt obligations]," says Satyajit Das, ex-Citigroup banker and a leading authority— and former exponent— of today's most exotic high-finance offerings.
Take for example the PayPal money-market run on behalf of Ebay, the online auction phenomenon. "No. 2 among 248 first-tier retail funds over the past five years," according to Reuters, PayPal's money market fund invests all of its current $1 billion holdings into a "master fund" run by Barclays, the third-largest bank in London.
No prizes for guessing what Barclays "master fund" is exposed to, starting with the "special investment vehicles" (SIVs) that investment banks have used to fund and expand the subprime-mortgage bond market. The performance of PayPal's money market fund, says Reuters, has matched Barclays master fund tick-for-tick.
2. Mutual Funds
If you've got money in a bond fund— and financial advisors never tire of saying you should— it may well contain more subprime spice than you expected.
Sure, plenty of mortgage-bond meals state their exposure right there on the can: Pimco Total Return Mortgage... Huntington Mortgage Securities... Vanguard GNMA. And if you know what you're eating, at least you'll know who to blame if you feel sick in the morning (meaning you).
But the difference between cheese-flavor and real cheddar is starting to show up outside the pure mortgage brands, too. "The annual report filed for the Regions Morgan Keegan Select High Income Fund offers a rare window," says Diya Gullapalli for the Wall Street Journal, "into how mutual-fund firms are reporting and valuing their holdings in the wake of this summer's subprime-mortgage crisis."
Total assets at the High Income fund are down from $1 billion to around $420 million since the start of this year, according to Morningstar data. On a valuation basis, the fund has dropped by around one-third, says Gullapalli. But that still includes all the "mark-to-model" work put in by its bean-counters. Prices for some 60% of the High Income's assets had to be based on "fair value" rather than market prices.
Because, it seems, there simply ain't no market price to quote.
"The annual report also outlines some important steps taken by the funds' adviser and affiliates to help cope with recent losses," the Journal's sleuth goes on. "These include stepping in to buy about $55.2 million in shares of the High Income Fund and $30 million in [Regions Morgan Keegan's] Intermediate Bond Fund from the beginning of July to the end of August, to help provide liquidity."
Next time you fancy nibbling a bond fund, it might be worth checking the ingredients. Regions Morgan Keegan, meantime, restated the net-asset value of seven funds this Monday, revising them from what might be called last Friday's "guess-timate".
3. Private Pension & Insurance Funds
Investors don't sue if they don't lose any money. Hence the lawsuit now being brought by insurance giant Prudential (US) against State Street, one of the world's largest fund managers.
State Street Global Advisors is charged with failing to mention a change of policy that let it put subprime-based derivatives into two "low risk" funds. Prudential apparently took an $80 million hit in August as a result.
Poor State Street! The $2 trillion behemoth— is also being sued by Unisystems, a New York publishing group, in a class action. Unisystems says that 25 of its employees held $1.4 million in State Street's Intermediate Bond Fund, and three of the fund's top ten holdings are mortgage-backed securities, courtesy of Wells Fargo, TBW and Bank of America.
Between July and Sept. this year, the suit alleges, the Intermediate Bond Fund dropped by 25%, even as the index it's supposed to track "actually increased".
Indeed, State Street looks like the proverbial "barn door" right now for lawyers seeking new instructions. The US states of Idaho and Alaska may sue it too, with Alaska's Dept. of Revenue telling the Wall Street Journal that it's considering whether the funds it bought were "more risky than our board had been told about." The Public Employee Retirement System of Idaho, meantime, has got some $570 million in State Street's Intermediate fund.
"Prudential's legal action against State Street has a faint echo of Unilever's negligence action against Merrill Lynch Investment Managers, which led to a [$150m] settlement in 2001," says Renée Schultes at FinancialNews.com.
"In both actions, the plaintiffs said the managers took risks they should not have done with their money. Both managers had won huge sums of money to manage in previous years."
How much has been lost— and how much is yet to be lost— by other institutional investors claiming ignorance of what the funds they hired were up to? Just how much cash will now go to lawyers suing one fund on behalf of another, regardless of the original pension-savers' best interests?
4. Public Pension Funds
You might wonder, as several blogs do, quite what the State Investment Council of New Mexico was thinking when it piled up more than $220 million in high-risk real estate bonds? Hell's teeth— it funds educational services! Doesn't it know that minors shouldn't play with subprime derivatives?
But the fact is, the SIC was only doing the same as everyone else: chasing yield in a world gone mad with cheap money.
Picture this: You used to earn 10% per year for your fund just by holding US government bonds.
Now you go to work one day... fresh from eating breakfast at the granite-topped plinth in the 250-sq.ft kitchen you somehow managed to bag when you last re-mortgaged and moved home... to find that 10-year Treasuries are paying less than 4%.
Okay, you kinda knew in the back of your mind that lower rates equaled a bigger house for you and your family. But it also meant miserable returns for your employers— in this case, the would-be pensioners of Oregon State, the teachers of Texas, or the kids of New Mexico.
Investment-grade corporate bonds were also paying peanuts compared with a decade before; between the late '80s and 2003, the yield on mid-risk investment-grade bonds shrank by one-half. And even if you tried to make the jump when official Fed interest rates sank to their "emergency low" of just 1%, the extra income you'd earn over Treasury bonds was fast vanishing, too.
But rat-a-tat-tat! Help is at hand! That's an investment-bank salesman at the door, carrying a bundle of AAA-rated home-loans set to pay market-beating returns, secured against the non-stop boom in US real estate.
And not a moment too soon.
Who Can Blame the Buyers?
"We got very interested in [equity tranches] because a broker brought them to our attention," says Kay Chippeaux, head of the fixed-income portfolio in New Mexico.
On behalf of the state, her fund bought the highest-risk portions of mortgage-backed bonds from Bear Stearns, Citigroup, Merrill Lynch and Morgan Stanley. Wachovia also pitched to New Mexico, Chippeaux says. But remarkably, she seems to have turned them away!
"We manage risk through who we invest with," she goes on. "I don't have a lot of control over individual pieces of the subprime"— and nor should she, of course, for as long as New Mexico's subprime investments don't produce a subprime-sized loss.
But a quick glance at history might have advised against putting public money into subprime and complex mortgage-based bonds:
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All this made the headlines less than 15 years ago! Short memories sure help when you've got "innovative" financial products to sell.
As for the Federal Reserve, it's unlikely to face court as a result of its "emergency" rate cuts in 2003. But if it did, the case might go a little something like this.
The Bush administration, along with every major Western government of the last decade and more, said it wanted home-ownership rates to rise. Here in London, Prime Minister Brown has made a "home-owning democracy" one of his key targets— and the magic of mortgage-bond securitization, sparked by the collapse in government bond yields, proved to be just what Washington and Whitehall longed for.
US home ownership rates rose from 65% to 69% of the population in the 10 years to 2005, says the Atlanta Federal Reserve in a new research paper. The introduction of new mortgage products accounted for perhaps two-thirds of the increase. For the "younger cohort" of new home-buyers, roughly 80% of the 1995-2005 increase came thanks to new mortgage instruments.
The Atlanta Fed doesn't guess how much of Wall Street's bumper earnings over the last five years came from home-loan innovations as well. But now the US home-ownership rate is falling for the first time in 13 years.
The world's biggest banks meantime— and as if by pure chance— have just lost well over $20 billion among them on mortgage-backed investments, too. There's more trouble to come judging from Merrill Lynch's statement this week. It's extending its June-Sept. losses by another $2.4 billion, barely three weeks after confessing to a $5.5bn hit.
Merrill's continues, however, to hold almost $21 billion in subprime and collateralized loan obligations. UBS also holds around $20 billion in subprime securities according to Brad Hintz at Sanford C. Bernstein & Co.
And the rest? Who knows.
Until the next raft of write-downs show up— and the lawsuits are filed after "unapproved" risks lead to "unexpected" losses— few investors can say with certainty that they're 100% free of subprime.
That's before doubt and fear infect the wider markets again.
Normxxx
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