Issue 38 - September 4, 2007


Summer Unwind

Global markets have experienced a significant retracement of the year’s gains since the July 19th high on the Dow Jones average. A confluence of events beginning with higher then anticipated mortgage defaults has led to an across the board rethinking of risk and an ongoing process of unwinding leverage.


There always exists a tipping point when that which was working suddenly no longer does. In the case of 2007, it began with the reckoning of defaults on certain lower rated mortgages that were issued in 2006. However it would not be fair to lay the blame of such a widespread action at the feet of a handful of first time homeowners. Current financial innovations were fueled by global liquidity while the gift of fear went totally absent.

Recent History

As we wrote in our 2006 year end newsletter:

Many large institutions which had been negatively impacted during the bear market of 2000-2002 began to look for alternatives to some of their traditional allocations to stocks and bonds. It became the common wisdom that stocks would only earn 6-7%, a far cry from their 10%+ averages of the late 20th century, and with ten-year bonds yielding 4% or less; there was simply no way for these portfolio managers to keep up with their mandates and actuarial liabilities. It was quite natural then for these institutions to look to their unique structural advantages for ways to enhance returns. Specifically, unlike individuals, they are not taxable and they have extremely long-term time horizons. Short-term gains look no worse than long-term
gains and any illiquidity required to drive returns back into the acceptable territory was manageable. Enter
the era of Alternatives. Investments in Hedge Funds, Private Equity, and Real Estate have certainly brought the returns that these endowments required and are all happy to advertise. But at what risk?

Not caring about certain risks is not the same as not having them. While an institution may have the ability to participate in more illiquid opportunities, it does not mean that they should not be compensated for taking on that additional risk. The same can be said for adding in leverage. Wall Street has traditionally valued risk in terms of price volatility to come up with a risk-adjusted return. The hallmark of these modern day alternative returns is their use of leverage and their overall lack of liquidity. It is exceptionally difficult to model these attributes to come up with any type of standard or historical data. Therefore the risk incurred in these allocations is a matter of debate. Have the institutions been fairly compensated for the risks they have incurred? All that has mattered is the absolute level of returns which has been quite good. Which brings us to a modern day definition of risk – one in which the risk of under performing is perceived as more problematic than the risks potentially incurred with leverage and illiquidity.

Lending Evolution

Wall Street never intentionally sets out to create a “moral hazard” but the unprecedented ability to carve up and sell cash flows in an ever escalating housing market meant that traditional underwriting processes and standards were no longer required. If the initial lending institution does not hold the loan and the buyer of that loan is merely a financial mechanic repackaging the cash flows into structures; no one in the process is particularly concerned with the quality of the loan. Further erosions in the process such a no down payments, no documentation or employment verifications have now discredited an entire class of securities. The rating agencies also played a role by playing to the demands of the mechanics rather than applying their usual high standards.

But as we said, the sub prime mortgage sector was merely the tipping point; leverage and illiquidity are always present in these scenarios as it is today. A little bit of bad news can go a very long way when assisted by leverage and when you can’t price or sell the illiquid securities you are forced to sell what you can. This has translated into extraordinary selling pressure on the best quality securities as players scramble to meet the twin challenges of margin calls and fund redemptions. And as history has taught us once again – when things go badly, all correlations go to 1.

Ancient History

The type of challenges currently facing the market have historically been addressed by the Federal Reserve’s lowering of their benchmark Federal Funds rate to such an extent as to allow for a market based solution. However, after almost two decades of this approach current Chairman Bernanke may chose to take another course and for good reason. Consider the following events and the role each has played in contributing to where we find ourselves today.

The S&L Bailout –
The rescuing of the Savings and Loan industry in the late 1980’s cost in the order of $150BB in 1990 dollars or 2.5% of GDP. This was a tremendous burden on the economy and led to the recession of 1990-1. In 1993, the Federal Reserve was faced with an unthinkable prospect of having to go through a similar bailout of the largest US commercial banks. The order of magnitude of this rescue would have dwarfed the S&L commitment. But in this instance Federal Reserve Chairman took another tack. He lowered the benchmark rate to a modern day record of just 3%. This allowed the banking system to earn its way back to health by borrowing at artificially low rates and reinvesting in higher yielding short duration, US Treasuries and Agencies. This approach was greeted with great success.

The Fall of Long Term Capital –
In the fall of 1998, the then smartest guys in the room where caught in an unexpected convergence of leverage and illiquidity on an unprecedented scale. Their exposure touched virtually every major bank and brokerage firm in the US. A failure of this size could jeopardize the entire US financial system. In this case Chairman Greenspan again used the power of his Federal Funds tool by orchestrating a coordinated unwinding of Long Term Capital’s positions in conjunction with a lowering of the benchmark rate. This quid pro quo with the banks allowed the institutions to have their losses cushioned as the painful unwinding process went ahead. But this action put in place a potentially undesired mind set; Wall Street began to believe that the Federal Reserve would ride to the rescue and lower rates any time Wall Street cried for relief.

2000 Stock Market -
The most dramatic use the Federal Funds rate as a solution to a market calamity came as the stock market fell in 2000. Chairman Greenspan ultimately took rates down to 1% and left them there for a full year before embarking on another two year journey to restore a normal rate of interest. This extraordinary low level of rates spurred a literal land rush into real estate. Money was inexpensive and real estate appeared to be far safer than the treacherous stock market. Add in Wall Street’s innovations and what was a stock market bubble transformed itself into a housing bubble.

What’s a Chairman to Do? Losses, Leverage, and Liquidity

It is certainly understandable given the historical precedents that current market participants are demanding their rate cut. They have been excoriating the new Chairman for acting too slowly and for being too much of an academic for the reality of Wall Street. But there may be another possibility; Ben Bernanke may just be a very good student of history. It would seem most desirable to provide a solution that addresses the actual problems without further reinforcing or creating new Moral Hazard.

In regards to the losses that have been generated due to higher than anticipated defaults on mortgage products, those are real and painful. They will have to be recognized over the coming few months as funds are required to post their returns. A rate cut can not undo that damage and it was these very rate cuts that led to so many of the excesses in the first place. It is hard to imagine that this Chairman would choose the “hair of the dog” as his preferred solution.

In regards to leverage and liquidity, it appears that the Federal Reserve has made the conscious decision to employ the US commercial banks as the agent of the unwinding process. It has made ample liquidity available to those entities at generous terms in terms of rate and acceptable collateral to post. In this way, it has a partner which is genuinely invested in seeing that their loans are made to worthwhile counterparties at terms which compensates them appropriately for the risk they are taking on. This process will take some time but it will not go on indefinitely. Light is a great disinfectant. As the reality of true valuations comes to the surface, more and more decisions can be made and liquidity will pick back up. The shabby lending practices will not likely return anytime soon, but traditional lending will go on. It is likely that regardless of the Federal Reserve’s actions, they will continue to be vilified for not providing cheap enough money. Old habits die hard.

The impact to the economy will not be negligible – the Bank Credit Analyst estimates that the losses on sub prime mortgages will amount to approximately 1.5% of GDP which would be spread out over a few years. However, a return to rational and sustainable business practices will have the likely effect of providing better long term prospects than the fast and loose conditions of recent years. Risk has already been re-priced and many of the markets legendary value buyers having proclaimed their interest at accumulating new positions at current levels. Warren Buffet, Wilbur Ross and Howard Marks have all publicly added to portfolios across the credit spectrum. Volatility will likely remain with us until the unwind process is a bit further along. We will be watching closely for indications on how the economy performs given the re-pricing of risk and de-leveraging of positions.



In this Edition

  • Summer Unwind
  • Dominos
  • Recent History
  • Lending Revolution
  • What's a Chairman to Do?

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

37 - 06.05.07
Rally Time /Attribution Encore/Outlook

36 - 04.03.07
Q1 2007: Two Sides of the Same Coin
Flat Water
The Need to Ease

35 - 02.28.07
Unhappy Tuesday
The Road Ahead

34 - 12.18.06
2006 - The Good, The Bad, & The Very Good
Risks and the Gift of Fear
2007 - Outlook

33 - 9.21.06
Steady As She Goes
Wide Open Range
Just the Facts
Financial Turbulence

32 - 8.11.06
The Pause
Headwinds and Tailwinds
Winning with Defense

31 - 5.19.06
Petulant Markets
What's a Chairman to do?
Recipe for Volatility
Restoring the Foundation

30 - 03.09.06
Out of the Gate 2006
A New Captain/A Long Race
The Bear's Den/ The Value of Preparation

29 - 12.01.05
Determined Not to Yield
Bond Market History Lesson
2005 Home Stretch

28 - 10.03.05
The Pennant Race
Just the Facts
Fourth Quarter Implication

27 - 08.11.05
Back to the Future
Reports of Demise
Greenspan Countdown

26 - 06.09.05
Measured Conundrum
Possible Explanations
Implications of an Uncoupled Market

25 - 04.13.05
1st Quarter 2005:
Up, Down, Sideways
Calm on Top, Turbulence Below
What's on Deck?

More Past Issues
can be found in our

Newsletter Archive


Market Highlights

  08/31/07 06/29/07 03/30/07 12/29/06 12/30/05 12/31/04
DJIA US 13357.7 13408.6 12354.3 12463.20 10717.50 10783
S&P 500 US 1473.99 1503.35 1420.86


1248.29 1211.92
Nasdaq US 2596.36 2603.23 2421.64 2415.29 2205.32 2175.44
EAFE Int'l Equity 2187.29 2262.24 2147.51


1680.13 1515.48
5 Yr Treasury 4.149 4.896 4.53 4.676 4.355 3.649
5 Yr AAA Muni 3.72 3.92 3.58


3.50 2.79
10 Yr Treasury 4.595 5.072 4.664 4.718 4.403 4.257
10 Yr AAA Muni 4.050 4.140 3.79 3.79 3.89 3.64
30 Yr Treasury 4.824 5.121 4.832 4.799 4.497 4.817
30 Yr AAA Muni 4.64 4.590 4.19 4.18 4.39 4.58
EUR Currency 1.3665 1.3498 1.3304 1.3170 1.183 1.3652
JPY Currency 116.48 123.39 118.04


117.48 102.48
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