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4 Cold turkey for financial
addiction By James Cumes
writing about current financial
instruments and the "system" they have contrived.
The unease, verging on panic, about
subprime mortgages has given us a glimpse of what
is ahead. But let us be very clear, it has been
only a glimpse. Subprime securitized mortgages are
only a relatively tiny part of the huge credit and
debt structure involved in what we may group under
the generic name of
derivatives. They include
credit derivatives, hedge funds, private-equity
deals, mutual funds, pension funds and the whole
gamut of financial instruments that have flooded
not only US markets but markets around the world,
especially in the past five to 10 years.
However, if the subprime crisis has given
us only a glimpse, it has also given us a
terrifying preview of what is yet to come. The
first clear point is that the various pieces of
financial paper do represent debts that have to be
repaid or somehow liquidated. Creditors demand
their money, and debtors must find the money to
pay them, with the penalty for default heavy
losses, with possible bankruptcy. The latter is
especially likely in a world in which credit has
become tight.
The second crucial point is
that we don't know the "value" of the financial
paper except in nominal or notional terms. On the
books of the debtor it is "marked to his model";
and, most likely, on the books of the creditor, it
is "marked to the model" of the creditor in the
same way, or even more advantageously. However,
the only thing that really matters in the end is
how it is or will be "marked to market" at the
moment of time when the market is called upon to
pass judgment by giving it a cash value.
In this regard, we should note that
financial assets worth trillions of dollars are
from over-the-counter (OTC) transactions for which
there is not and never has been any "market" to
mark them to. They will not have an authentic
market value until the moment comes for the deals
to be liquidated in one way or another.
In
a bull market, financial paper might be sold well
above the "mark to model" price; but it is not at
that point that the holder might be most likely to
sell - or, most important, be forced to sell. It
is when the market has become nervous, when
confidence has been diminished and when the bears
have begun to crowd the markets that the price
will become most relevant and crucial.
Then, with the markets as we have seen
them in the past two months, the price of the
securitized paper is likely, as one analyst put
it, to go "Pouf!" In other words, as we have seen
with some of the paper of such a previously highly
respected firm as Bear Stearns or a major bank
such as BNP Paribas, the paper can become or be
seen to be worthless, or very nearly so.
Does that result in real losses? For
someone, it certainly does, however much the
institution may say that it is in a position to
bear those losses - of a few billion, tens of
billions or, in some cases, hundreds of billions
of dollars. Recently, the spotlight has been on
subprime mortgages; but this is only because the
collapse - the inability to pay outstanding debt -
happened to appear there first.
We should
have expected that. The mortgages, or a high
percentage of them, were, it would seem
deliberately - certainly with a high degree of
studied negligence - designed to fail. They did
fail; but the important thing is that, even in the
wider housing-mortgage market, prime mortgages
have been failing too - and they will continue to
fail.
Household debt in the US and some
other countries is more enormous and potentially
more crippling that it has ever been before. In
more and more instances, the mortgagee will be
unable to service his debt - a real debt, whose
failure, in aggregate, will have a real impact on
the national and global financial situation and,
eventually but fairly rapidly, on the productive
economy.
So the infection will become an
epidemic that will spread to the whole housing
market; and markets other than housing have been
deeply involved in the structured-finance caper.
Credit derivatives of all kinds, a rapidly
proliferating range of hedge funds, private-equity
groups and the rest have shown no hesitation to
exploit smart financial and above all, highly
leveraged opportunities wherever they may have
been offering.
Most of that enterprise has
thrived - and can thrive only - in a booming
market in which more money flows into the schemes
than goes out; so there is a Ponzi element in much
of current creative financial enterprise that
makes its collapse as inevitable and potentially
as destructive of value as the subprime mortgage
debacle has been.
When the net inflow of
funds into these schemes becomes a net outflow,
the whole structure must inevitably begin to
crumble. Hedge funds have been particularly -
perhaps we can say, inherently - susceptible to
collapse. Thousands have come into existence in
recent years; and thousands of them have gone out
of business. That has happened characteristically
even when markets were booming. In recent years,
those who exited the business were fewer than
those who entered.
But now that the boom
has turned more clearly in the direction of a
bust, hedge funds heading for the exits have been
increasing in numbers. If the exits are not
crowded yet, it won't be long before they will be.
Only those in the more traditional style of hedge
funds - hedging genuinely for themselves and
others who may be their clients - may survive.
One analyst has suggested that the current
credit crunch has given us a chance "to see the
hedge-fund emperors without their clothes". It has
also been "an opportunity for investors to get
some insight into an industry whose activities are
often cloaked in secrecy and which has wandered
far from its original purpose of hedging
volatility" (Sharon Reier). That original purpose
was to manage market risk by, for example, hedging
long and short positions with modest leverage.
The contrast with the funds as between
6,000 and 10,000 of them have now evolved is
stark. Even of the widely respected "quants" - the
computerized quantitative or black-box models of
the mathematical whizzes - Donald Pinto, an
experienced hedge-fund manager himself, is quoted
as saying, "The programs are quite sophisticated.
They do work in stable markets, but they have a
fundamental weakness. There is no room for
judgment. When markets behave erratically - as
they have recently - the inability to use common
sense to make investment decisions, combined with
a high level of leverage, is a recipe for
disaster."
With the hedge-fund industry
claimed currently to be the volatile repository of
about $1.7 trillion, this can only give cause for
acute alarm.
The fragility of the "system"
can be seen further by analyzing each of the
various elements contained in what is high-risk,
speculative, "ownership" investment. That
"investment" looks principally to profits through
asset appreciation. The prices of assets are
driven up because of a speculative fever and that
fever, as in many asset-price booms of the past,
is embedded in a conviction or expectation that it
will feed on itself to drive prices to ever more
feverish and ultimately unsustainable heights.
These booms persist only as long as funds
are there to nourish them. If the flow of those
funds diminishes or, more particularly, if their
flow is reversed, the booms have historically and
characteristically been prone to sharp collapse.
The present financial situation is more
complex than any we have known before and has
tended to draw in all markets - for stocks, real
estate, currencies, gold, commodities and the rest
- if only because what we may call the broad
category of "derivatives" characteristically
"derives" from those markets. Despite this spread
and complexity, we may still postulate that the
fundamentals of market behavior remain the same.
It is in that context that we might
consider some elements in the present global
financial situation. One such element is the carry
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