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Dilution Was No Solution

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  • Dilution Was No Solution

    Dilution Was No Solution

    March 24, 2008

    Independent Commentary from Interlake Capital Management, LLC


    Reflecting on the last few years--and especially the last few months--in the financial markets, one of the more remarkable subplots was just how convinced many participant-observers were that what started in subprime would stay there. The notion of "containment" never struck us as particularly plausible, but it sustained a furious bull run through mid-July, 2007.

    Though his Harper's piece isn't exactly news anymore (it appeared in the February issue), Eric Janszen captured the essence of the problem as well as anyone. Here's our favorite passage from a very good essay (emphasis added in bold):
    The U.S. mortgage crisis has been labeled a "subprime mortgage crisis," but subprime mortgages were only a sideshow that appeared late, as the housing-bubble credit machine ran out of creditworthy borrowers. The main event was the hyperinflation of home prices. Risks are embedded in price and lurk as defaults. Even after the faith that supported a bubble recedes, false beliefs continue to obscure cause and effect as the crisis unfolds.

    Consider the chemical industry of forty years ago, back when such pollutants as PCBs were dumped into the air and water with little or no regulation. For years, the mantra of the industry was "the solution to pollution is dilution." Mixing toxins with vast quantities of air and water was supposed to neutralize them. Many decades later, with our plagues of hermaphrodite frogs, poisoned ground water, and mysterious cancers, the mistake in that logic is plain. Modern bankers, however, have carried this mistake into the world of finance. As more and more loans with a high risk of default were made from the late 1990s to the summer of 2007, the shared level of credit risk increased throughout the global financial system.

    Think of that enormous risk as economic poison. In theory, those risk pollutants have been diluted in the oceanic vastness of the world's debt markets; thanks to the magic of securitization, they are made nontoxic and so pose no systemic risk. In reality, credit pollutants pose the same kind of threat to our economy as chemical toxins do to our environment. Like their chemical counterparts, they tend to concentrate in the weakest and most vulnerable parts of the financial system, and that's where the toxic effects show up first: the subprime mortgage market collapse is essentially the Love Canal of our ongoing risk-pollution disaster.
    The point here is interdependence, awareness of which never should have deserted investors. But it did. And some very high prices have been paid for such willful ignorance of the defining characteristic of modern life.

    Source
    Eric Janszen, "The next bubble: Priming the markets for tomorrow's big crash," Harper's, February, 2008

    See also: Risk Pollution, April 2006 when current problems were forecast in detail.
    Ed.

  • #2
    Re: Dilution Was No Solution

    part of the problem is that there are processes which re-concentrate the pollutants.

    my favorite martin mayer quote [emphasis added]:



    Derivatives markets guarantee a winner for every loser, but they will over time concentrate the losses in vulnerable sectors. Nature obeys Mayer's Third Law, which holds that risk-shifting instruments will tend to shift risks onto those less able to bear them, because them as got want to keep and hedge while them as ain't got want to get and speculate.

    Comment


    • #3
      Re: Dilution Was No Solution

      Originally posted by jk View Post
      part of the problem is that there are processes which re-concentrate the pollutants.

      my favorite martin mayer quote [emphasis added]:



      Derivatives markets guarantee a winner for every loser, but they will over time concentrate the losses in vulnerable sectors. Nature obeys Mayer's Third Law, which holds that risk-shifting instruments will tend to shift risks onto those less able to bear them, because them as got want to keep and hedge while them as ain't got want to get and speculate.
      Funny you should quote Martin. I was just about to send him an email:
      Martin,

      Regarding your prediction in 1999 of the aftermath of the eventual OTC credit derivative fiasco?

      "In the theater of over-the-counter derivatives contracts entered into behind closed doors, with no register of open interest, you cannot know NP, you cannot know whether ND or WD have kicked into the equation, and you cannot even guess the probability that when you go to the movies you will get out alive. A door that would be wide enough for you to pass through even if you are the tenth of 10 people rushing for the exit would be a killer if a hundred people were trying to escape at once. And in the derivatives context, there is a further problem that the more popular the analysis, the bigger the crowd—and the more likely that leveraging will fill the aisles with fat people at the first whiff of smoke. By the time the Fed bulldozes the wall to get everybody out, there are going to be lots of dead."

      Turns out that in the event the Fed shows up even before the fire starts to spray the room with taxpayer money. Nobody dies.

      Eric

      Comment


      • #4
        Re: Dilution Was No Solution

        Originally posted by EJ
        Turns out that in the event the Fed shows up even before the fire starts to spray the room with taxpayer money. Nobody dies.
        None of the bankers die, but the savers in the economy all collectively get a haircut. Hopefully only of hair...

        Comment


        • #5
          Re: Dilution Was No Solution

          Originally posted by EJ View Post
          Turns out that in the event the Fed shows up even before the fire starts to spray the room with taxpayer money. Nobody dies.



          Suggests to me that they had the fire truck parked outside beforehand, as if they knew the fire was imminent. Reminds me of the true story of a volunteer fireman who would set fires in vacant houses just for the excitement of putting them out.

          Comment


          • #6
            Re: Dilution Was No Solution

            There is much more to this than simply an increase in house prices. The other side of the coin has been the way the flood of phony money created by the leveraged mortgages was used in a reckless manner by private equity investors buying up companies, then leverageing them to the hilt and taking their profit before the result of their actions become apparent to everyone else.

            http://www.emii.com/Article.aspx?Art...8&LS=EMS169616
            Firms On The Brink Linked To PE

            Mar-24-2008 | Source: Hedge Fund Daily


            "More than half of U.S. companies on the brink of default have been involved in private equity transactions, according to Standard & Poor’s.

            The rating agency found that the so-called “weakest link” companies--which S&P rates at B- or less with a negative outlook--have been increasing in number since the middle of last year. There were 114 as of earlier this month, compared with 77 in December and 62 last June.

            Of the current figure, 93 are based in the U.S. The findings are “not surprising,” according to the report, given that “ a deluge of liquidity in the bond and loan markets in recent years has spurred a wave of leveraged activity, including private equity sponsors seeking to put cheap money to work on behalf of their clients.”

            The study suggests that PE firms appear to beef up their exposure in the lowest-rated companies, citing PE presence of more than 60% among CCC+ companies, but just 40% at the B- level. And, as CFO.com points out, 43% of companies rated CCC+ or lower file for bankruptcy within three years, compared with 28% of the B- rated firms.

            “The default risk exposure may be magnified this time around, because the current market conditions have constrained the typical exit options afford to sponsors,” says S&P in its report."

            http://www.emii.com/Article.aspx?Art...9&LS=EMS169616
            PE Cuts Valuations, IIs Suffer

            03-24-2008 | Source: Hedge Fund Daily
            People & Companies in the News"Injured by falling stock markets, institutional investors are now experiencing the added insult of learning that the private equity funds in which they put money are cutting valuations of portfolio companies by up to two-thirds. "


            At the end of the day, there are more chickens coming home to roost in the downstream process that will bring a second phase to this process of elimination of bad credit in the system.

            Comment

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