Page 1 of 2 Widgets and wrecks
By Julian Delasantellis
Do you want to know what the world's financial markets were like last week?
Imagine you're on a broad, flat, straight highway, such as in the American
Midwest. It is sunset, and you're headed east. Looking in your rear view
mirror, you can still see the last flickers of sunlight, perhaps dancing over a
brimming, full and verdant harvest.
But in front of you is complete and total darkness. You don't know where you
are headed, and you don't know what you will find
when you get there. All you know is that you are headed into a time much
darker, less clear, than where you were.
Our allegorical traveler has no choice but to press forward into the void, into
the future, to his destiny. In the financial markets, one has another option.
You can sell stocks to make yourself less vulnerable to whatever misfortunes
the darkness might hold.
For Macdonwald in Macbeth, "The multiplying villanies of nature do swarm
upon him"; for the financial markets, it is the multiplying villanies of an
ever increasingly dysfunctional financial and banking system that is swarming
down on it. Just as a person with an immune system suppressive disease such as
HIV or certain forms of cancer eventually succumbs not from the disease itself,
but from another opportunistic disease that attacks a body without a fully
functioning immune system, all the calumnies now making headlines in the
financial pages across the world stem from a single causation.
As a result of the damage spreading from out of the subprime mortgage crisis,
the markets are no longer certain that the world's free market financial system
is going to be able to fully execute its core function, to provide capital, at
reasonable rates of interest, to those who need it.
The week started with the mob seizing Citigroup chief executive officer Charles
O Prince and impaling him on the apex point of architect Hugh Stebbins' late
modernist Citigroup Center, but still, the wild horde's ( or, as they may be
more commonly known, Citigroup stockholders) thirst was far from slaked.
Citigroup's stock, falling along with the rest of the banking, financial and
brokerage sector, lost over 17% of its value from just Monday to early on
Thursday before rallying a bit late on Thursday and Friday. The stock has lost
44% of its value this year, that's about $130 billion in stock book value wiped
out just in this stock alone.
Subprimes are the overwhelming reason for the bloodbaths in this sector in that
nobody really knows just how bad the total exposure to this problem the big
banks actually have. After leaving the hands of the poor subprime borrowers,
the subprime mortgage papers got packaged and re-packaged, borrowed on and lent
out, until they settled in the portfolios of the big names in the form of
something called structured investment vehicles (SIVs). SIVs are margined, or
borrowed on upstream, at many times the actual value of the subprime mortgages
they originated from out of downstream, so even relatively small quantities of
losses, of subprime mortgages not being promptly paid on time, can lead to huge
losses in the SIVs.
It is certainly not helping the effort to restore confidence in the financial
system when the sector refuses to come clean on just what its potential
exposure to the subprimes and subprime-related SIVs really is. Like the used
car dealer who won't tell you if the "lightly used" minivan on his lot was
primarily used every Sunday to drop the kids off at football practice or the
bags of cocaine from Tijuana while being chased by the police, the very fact
that the banks are hesitant to actually tell the markets just what their
exposure is makes the markets' apprehensions grow ever larger.
The banks' private-sector effort to deal with this problem, the proposal to set
up a Master Liquidity Enhanced Conduit (M-LEC) "superfund" that would have, in
effect, spirited the SIVs out the banks' back door under cover of night, has
ended as the flop-filled farce as it was always going to be, just as I said
would happen when the idea was first floated. (See
Subpri me fallout: Save Our Souls Asia Times Online, October 23, 2007.)
As for now, the banks are attempting to restore investor confidence by fairly
regular announcements of "writedowns".
Since the general media do not really understand what writedowns actually are,
they cover them somewhat innocuously, almost as if it was something said by a
teenager cutting in line at the mall and apologizing by saying "my bad". When
you understand the reality, you realize the seriousness. Writedowns are what
happens when a company admits that it just isn't worth as much, by the amount
of the writedowns, as it was before.
For banks and financial service companies, the vast majority of corporate
assets are composed not of the cappuccino machines in the breakrooms or the
stations in the corporate gym, but by the outstanding loans, paying money in
the form of interest payments back to the bank, that is the basic wealth at the
core of the institution. What a bank can lend out is determined by complex
calculations and ratios that, at their heart, rely on just how much in assets -
current loans that are being paid back on time - that the bank has on its
books.
In other words, cutting back on assets with writedowns cuts down on the amount
of future loans, and then profits, the bank is going to be making in the
future. For the system as a whole, it means fewer new loans to come, and less
liquidity in the system as a result. Less liquidity means less money to support
prices of everything else in the economy, including, and especially, real
estate.
This may be the core reason why the banks are choosing the gradual drip drip
drip water torment (but not water torture, oh, no, never, not with America's
new Attorney General Michael Mukasey, no sir!) of writedowns over full and
immediate transparency of what their subprime/SIV exposure really is. This
question would be a lot easier to answer if only the full extent of a bank's
subprime exposure was some dark hidden number, concealed behind the back wall
of the vault. It's not; it's a dynamic process that, as things get worse,
conditions get set up for even further losses.
Let's say that a first group of subprime borrowers default, as they are now
doing at a rate of a quarter of a million a month. Their houses get
repossessed, and put up for auction. The now excess supply of houses in a
particular neighborhood or region then pushes down most home values in that
area. For the next group of subprime borrowers, this dials their situation a
notch down further, from desperate to irreparable.
The only hope they ever really had to stay in their homes for the long term was
always to be able to refinance into standard, fixed-rate payments before their
low, initial "teaser" mortgage rates reset to higher rates, with attendant much
higher monthly payments.
Now that there is more housing supply in the markets there will be more
downward pressure on prices, on the equity values in houses. Without sufficient
equity in their houses, the second subprime borrowers group will not meet
newer, more stringent bank rules on refinance eligibility, they also will go
into default, be repossessed, then their houses will be thrown back onto the
market, and so in this process everything gets kicked another level down.
For the SIVs on the books of the big banks such as Citigroup, the perfect
conditions necessary to keep these complex debt instruments liquid and tradable
are receding further and further into the distance, and the result, bank
writedowns, are draining ever-more liquidity out of the system, setting up a
scenario for more losses in the near future.
American financial institutions have announced US$40 billion in writedowns so
far this year. It was Citigroup's announcement of $11 billion of writedowns
last weekend, with no guarantee that billions more were not soon to follow,
that had Citigroup's Prince cleaning out his desk and handing in his key to the
executive washroom last Monday morning.
Prior to last week it was thought that the stocks of the technology sector,
where companies actually build real things instead of just producing complex
mortgage debt with pie in the sky valuations, might be able to hold up a role
as the safe port of call in the subprime storm.
Not anymore. As banking and finance found a small plateau of support late last
week, the sellers' bull's eyes zeroed in on the tech sector, and the resulting
artillery barrage of selling would stun any gunnery captain with its ferocity.
Just from late Tuesday to late Friday, networking leader Cisco Systems lost
almost 18% of its stock's value. Apple Computer was down 14%, Dell 11%, Intel
lost 9%. Tech high-flyer Google, a stock that has doubled since mid-2006, lost
11.5% of its stock value in those three days, a fairly significant sum of
wealth for a company whose market valuation, its collective stock worth,
exceeds that of General Motors, Ford, US Steel, Boeing and Microsoft combined.
It is in last week's tech wreck that we see just how potentially pernicious
this situation is becoming. It's bad enough that the earnings of the banking
and finance sector now make up 30% of the S&P 500's earnings, up from 8% in
1950; Gretchen Morgenson of the New York Times notes that far more of America's
wealth now goes to financial engineers than it does to mechanical engineers.
That only goes to show just how enamored corporate America has become of making
big money through shuffling paper rather than hammering steel.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
