Where I was wrong

On Friday, August 10, 2007 I made an entrance titled Where I am optimistic. In retrospective, I was being wrong. I thought then: Posted by J. at 4:32 PM 0 comments Links to this post
Labels: Investment

Worldwide financial markets are in a panic and liquidity has evaporated, meaning that no one wants to buy American mortgage backed securities or debt, and without a market, they are worth nothing. Three Paribas Bank funds have stopped redemptions, because they could not be valued, in the words of the Secret Engineer, it is reasonable to suspect that the underlying instruments cannot be sold and therefore are worthless. As Max Langman, the Polish-born father of my uncle Lucio's wife, said: Things are worth what someone is ready to pay for it. Exactly.

The essence of illiquidity is that people prefers to keep its money instead of buying something or lending it. In this case, the issue is that the banking system has lent money to the lumpen to buy homes, the lumpen, by definition, is financially irresponsible and the debt was fictional or notional. You cannot consider a loan given to a slum drug addict as a serious financial instrument. I learnt that in my early twenties, when signed a contract with a alcoholic vagabond to work the farm I just bought in Alvear. This notional debt was renamed as subprime to camuflage its nature and sold to savers all over the world, an act that borders on the criminal. Therefore the problem is triple: (1) the worthless mortgages sold under different names (bonds, etc.), which are a net loss to the possessor. How much is this loss? Say there are 300,000 mortgages for 100,000 dollars each = the total loss is 300,000,000,000 dollars, that is, 300 billion dollars. I lot of money, but some will be recovered by selling the houses, so the actual loss after a few years may be cut by half. (2) The second problem is that these black mortgages were camouflaged so well that many classes of obscrure financial instrument created and sold by the same banks (Sachs, Bears, etc.), are suspect of being infected. Therefore, no one actually knows how much they are worth. And the owners, panicked of having been cheated, are desperate to sell these thingies at any price. (3) The third problem is an evaporation of faith and confidence in the world financial community. If the world's largest banks cheated people for so long, the same people is now afraid to do business with them, creating a crisis of confidence. Since billions are exchanged on cable on faith, the system stops working when confidence is damaged. From FT: The problem for financial markets now is that a functioning financial system ultimately comes down to trust. When trust is in short supply, there is no obvious price base for securities and credits that during the good times seemed to offer unimpeachable quality. Nor is this crisis of trust restricted to the corporate sector - national Treasuries have been busily debauching their own currencies with the help of the printing press. As Mr Greenspan himself admitted in 1999: "Gold still represents the ultimate form of payment in the world. Fiat money, in extremis, is accepted by nobody. Gold is always accepted."So the US now nurses concerns about credit quality and a possible credit crunch, a housing crisis, the sustainability of corporate profit margins and the logical response of consumer spending to deteriorating fundamentals. US lenders, mortgage brokers, investment banks and ratings firms will all, one suspects, enjoy their day in court.

But I am an optimist because there is an alert last resource buyer out there: it is called the Federal Reserve. And this night (in Kever Benjamin), the Fed infused $19 billion into the system by buying mortgage-backed securities. That comes on top of a $24 billion injection Thursday. All in all must be some 200 - 300 billion bad mortgages out there, so it is a very significative move. If the markets calm down, the crisis will pass and the loss will be absorbed. And hopefully they will have learnt their lesson: selling on credit to the lumpen is good as feeding pearls to pigs. The market forgot what sub-prime actually meant, that it was built on the supposition that the beneficiaries will work and pay back the loans. The French banks that bought subprime mortgages didnt stop a minute to think about what they were buying. They were so far removed from downtown Detroit... But having the central banks around to save the day, the damage will be absorbed. The lumpen sub-prime people, who will not pay their mortgages, are not worse off than before. The damage will be absorbed, apparently, by the Fed (that is the American taxpayer) and the cheated savers all over the world.