Page 3 of 3 Of termites and index
mania By Julian Delasantellis
Times readers leafing through the
business pages on the way to check the latest
Paris Hilton news.
The Gospel of John
teaches that "the truth shall set you free"; in
1881, US president James Garfield tacked on to the
scripture the pithy addendum that "first, it will
make you miserable". Instead of marking to model,
holders of CDOs could now mark them to true
market values, and yes, this
made them really miserable.
Many of
America's most illustrious names of finance, such
as but not limited to Merrill Lynch, had been
using them as capital reserves for high-powered
lending or, like Bear Stearns, as collateral for
borrowing. Basel regulations no longer allowed
them to mark to model; in essence, just as in
real-estate lending, there were now "comps" that
were representing actual, much deflated prices.
The basic purpose of capital-reserve
regulations is to make sure the value of loans
made by financial institutions bears at least some
relationship to the actual assets possessed by the
institution. This prevents the tendency of
capitalist economies to go through wild cycles of
credit-fueled boom and bust. A bank with $100 in
deposits cannot, much as it might like to, make
$100 billion in loans. Various ratios exist for
how much can be lent out per each particular type
of asset held as a reserve.
This process
can, and recently actually has, acted as a great
wealth-creation machine when the underlying assets
of the reserve holdings stays stable or goes up,
as it allows a huge infusion of new capital into
the world's money supply. It, the employment of
once-dormant assets to facilitate massive new
lending, is the primary reason for the great flood
of world monetary liquidity that has supported
inflated prices for everything from North African
equities to Elvis Presley memorabilia.
But
things are quite different when you throw the
machine into reverse, as is happening now with the
subprime CDOs. If the value of the underlying
reserve assets declines, then Wall Street must
pull back on the quantity of lending that it can
base on it. This process is a lot like watching a
video of a building being constructed in reverse
as, brick by brick, the great edifice
disassembles.
The fear that stalked the
world's markets in March has returned. Bear
Stearns has announced that it will provide up to
$3.2 billion so that one of its struggling
subprime hedge funds, the High-Grade Structured
Credit Strategies Fund, can liquidate itself in an
orderly fashion; for investors in the other fund,
the more aggressive High Grade Structured Credit
Strategies Enhanced Leverage Fund, well, for them,
all the lifeboats seem to have left.
Even
as US stock markets trade nervously around their
recent highs, the Chicago Board Options Exchange's
VIX volatility index, the fever thermometer for
stock-investor unease, pushes back toward its
March highs. The initial public offering of the
private equity Blackstone Group (see my Febtuary
22 article on private equity, The highs and lows of
buyouts) has foundered, with the stock
now trading well below the IPO price. Considering
how substantial a role private equity has played
in the rallies of the world's major stock markets
recently, this is certainly an ominous sign.
ABX subprime indices are pushing to new
lows. If you would like a side order of
Weltanschauung (knowing the current state
of things) with your Schadenfreude (taking
pleasure from the misfortune of others), check out
the I Am Facing Foreclosure weblog
(iamfacingforeclosure.com). Here lies a
contemporaneous, near-Wagnerian saga of a young
Californian's 2005 glorious rise to the heights of
financial Valhalla, and current flaming fallback
into earthbound insolvency, all effected by
attempting to flip one two many investment
properties.
One in five subprime mortgages
is either seriously delinquent or has entered
foreclosure; the real fear is that this number
will skyrocket this year when millions of subprime
mortgages taken out over the past two years with
low initial "teaser" interest rates reset to rates
well above current market rates. Very much unlike
what they were told by their real-estate or
mortgage brokers when they originally bought their
houses, most of the borrowers have neither the
equity in their homes (which is actually
declining) nor the improved credit scores to bail
themselves out of this situation with the
real-estate industry's traditional life-preserver,
a refinancing.
As these homes hit the
market through foreclosure sales, further supply
pressure will be put on a real-estate market
already reeling from what could be only the
commencement of this process. Like autumn
following summer's joy and then winter's
desolation following upon that, any economic
historian will tell you that what is happening now
in US real estate is only the natural turning of
the economic cycle. The leaves of the boom have
faded and fallen away, soon to be followed by
lamentations resultant upon the bare branches of
winter's bust.
In the fetid slough that is
today's US public debate, it has been said that
the entire subprime mess is only the expected
result of attempting to make proper middle-class
homeowners out of an underclass that lacks
sufficient moral fiber to be so; all this proves
is that, much like the current debate on illegal
immigration, there will always be receptive
American ears listening for any argument that
blames all of today's troubles on people with
black and/or brown skin.
The real moral
deficiencies that led up to the subprime crisis
are not on Main Street but on Wall Street. It was
there that greed hatched the idea to turn the
once-staid and predictable market for housing
finance into something that could earn those big
fat top-of-the-hedge-fund-rankings returns. In
this tragedy, the only actual role of the
borrowers was something like that of Beaker on the
US children's TV program The Muppet Show, a
helpless and hapless subject of another one of Dr
Bunsen Honeydew's bizarre quasi-scientific
experiments at Muppet Labs. They tried to mate a
pokey groundhog, the slow and steady previously
existent market for housing finance, with a
glamorous thoroughbred, today's turbo-finance,
and, in doing so, may just have killed both of
them.
The I Am Facing Foreclosure site is
up for sale. Down the street from where I live, in
what is thought to be America's last red-hot
housing market, a prospective development of 50
single-family homes, cleared out of the verdant
northwestern US forest last winter with bulldozers
and ambition, lies dormant. The wind whistles both
through its acres of still-undeveloped dirt and
some prospective real-estate entrepreneur's fading
dreams of riches and glory.
As the rockets
glare red and the bombs burst in the air over
another US Independence Day this Wednesday, in the
housing sector, winter falls soon.
Julian Delasantellis is a
management consultant, private investor and
educator in international business in the US state
of Washington. He can be reached at
juliandelasantellis@yahoo.com.
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