Friday, April 25, 2008

New York Financial Diary: First quarter market review

New York Financial Diary
First quarter market review
By Alexandra Lebenthal

Everyone hoped that January 1 would be a fresh start of a new year after a rough 2007. Instead it will be a time that will be remembered for unprecedented destruction.

To understand this quarter we must to go back to 2007, since most of what happened is directly related. In the early part of 2007 life was good. The stock market and housing markets were going up. Everyone, it seemed, was either in hedge funds or private equity and making a killing. The terms Credit crunch, CDOs, or Sub-prime mortgages were unknown.

It looked as if there was no end in sight.

This is usually a sign that something is coming to an end. It may be months, it may be weeks, but it is coming. Whether tulips, railroad stocks, radio stocks, internet stocks or real estate this last time around, the end always comes. (note to self- get out of clean energy and green technology before that happens -- not now -- just “before”).

But in the summer of 2007 some rather severe cracks in the market occurred amid rumblings then eruptions of problems in “mortgage backed securities” and an increasingly cooler housing market.

Seemingly overnight, “credit” which for Wall Street gave them the ability to “leverage” by borrowing more than the value of securities owned, dried up

Essentially, in a $20 million portfolio but with actual collateral of only $1 million, the additional $19 million has been borrowed. In a “credit crunch”, the counterparty loaning the $19 million demands more interest and more collateral for that. What’s more, those counterparties are also having a hard time financing their loans, thus the ability to finance becomes even tighter. Multiply this by billions and billions and you can fast see how leverage works in the upside, and does not in the downside.

Stan O’Neal
Merrill Lynch
 
Through the autumn, aside from a small recovery in September it was clear that serious problems existed; credit problems, housing prices and the uncertain value of complex securities not only resulted in assets continuing to be written down but also several well known CEO’s tumbled as well.

As 2008 dawned, many hoped the worst had been baked into 2007, but there clearly were still too many credit problems and regular announcements of multibillion dollar write offs. As the winter wore on and the end of the quarter approached, many of the same problems that plagued the markets 6 months earlier reappeared. Some very well regarded funds specializing in mortgage backed securities- the same investments that caused problems in the summer went under. This caused a panic.  

The Federal Reserve, which had been lowering rates since the crisis began took further extreme steps and announced that it would open its “discount window” to non banks, which meant investment banks, thereby allowing those firms to essentially fund themselves through the US Government as opposed to all those other firms that continued to hoard their own credit lines.

But ironically it came too late for the fifth largest securities firm, one of Wall Street’s legends, Bear Stearns founded in 1923. Bear Stearns was clearly a firm that would have used that facility and in the words of its CEO still be here today.  

  Chuck Prince
Citigroup
March 14-17 will go down in Wall Street history as Bear was tumbled not only because of their concentration in Mortgage backed securities (and to be fair they had significant other business), but also by “the market” which decided that Bear was no longer a bet it wanted to take. The run was so quick and fierce that it was forced to sell itself at first for $2 per share and ultimately for $10 per share a week later. Regardless of the five fold increase in value it was a far cry from the $170 it was worth a year before or even $80 only a week before.

When markets tumble it is like a waterfall that changes direction- not something you could imagine and full of intense, reverse force. For all the talk that has gone on in the last several years about managing risk- the reality is that risk was spread across the system. The result? Everyone scrambled to shore up their financing and therefore everyone suffered. Risk, instead of being managed, became systemic.

The quarter ended with perhaps- perhaps- the thought that we hit bottom. While it may have the question is how long is the trough and when does the climb upward begin.

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