“Whew, that was a close one,” exclaims Pimco’s Bill Gross, in his July investment outlook. The one in question is, of course, poor old Bear Stearns and its subprime woes.
Shame on you Mr. Stearns, or whoever you were, for scaring us investors like that and moving the Blackstone IPO to the second page of the WSJ. We should have had a week of revelry and celebration of levered risk taking. Instead you forced us to remember Long Term Capital Management and acknowledge once again (although infrequently) that genius, when combined with borrowed money, can fail.
But what was the problem he wonders? Surely, given the investment grade, or even AAA, rating of these RMBSs, CDOs and the like, the architects were prudent men? Perhaps not.
AAA? You were wooed Mr. Moody’s and Mr. Poor’s, by the makeup, those six-inch hooker heels, and a “tramp stamp.” Many of these good looking girls are not high-class assets worth 100 cents on the dollar. . And sorry Ben, but derivatives are a two-edged sword. Yes, they diversify risk and direct it away from the banking system into the eventual hands of unknown buyers, but they multiply leverage like the Andromeda strain. When interest rates go up, the Petri dish turns from a benign experiment in financial engineering to a destructive virus because the cost of that leverage ultimately reduces the price of assets. Houses anyone?
Gross has struck upon another strand to this particular tale. One London hedge fund type was musing to FT Alphaville just this morning that we’ll have a few, painful weeks while the effects of marking this stuff to market filters through the system. But next come the serious questions to the likes of S&P and Moody’s - and the conclusion that assessing such instruments in a rear-view-mirror fashion, on their limited history is - well - not very robust at all.
But it gets worse, says Gross. Those that point to a crisis are looking in all the wrong places - houses is where it’s at. The rows of homes financed with cheap, and in some cases gratuitous money in 2004, 2005 and 2006. Currently, he adds, 7 per cent of subprime loans are in default. That percentage is set to grow and grow like a week in your backyard tomato patch.
AAAs? Folks the point is that there are hundreds of billions of dollars of this toxic waste and whether or not they’re in CDOs or Bear Stearns hedge funds matters only to the extent of the timing of the unwind. To death and taxes you can add this to your list of inevitabilities: the subprime crisis is not an isolated event and it won’t be contained by a few days of headlines in The New York Times.
Of course this will all hit the US economy, says Gross. And other areas - high yield, bank loans and so on - should feel the cooling winds of a liquidity constriction. This may be what the Fed has been looking for - easy credit becoming less easy; excessive liquidity returning to more rational levels. But he’s looking for an “insurance policy” from the Fed in the form of a lower benchmark rate over the next 6 month. He concludes:
This problem — aided and abetted by Wall Street — ultimately resides in America’s heartland, with millions and millions of overpriced homes and asset-backed collateral with a different address — Main Street.