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Author Topic: (Non Cricket) - On Risk, Liquidity, Subprime etc...- some viewpoints  (Read 1853 times)

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keep-it-cool

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Marking to myth
Warren Buffett
Chairman and CEO, Berkshire Hathaway

Many institutions that publicly report precise market values for their holdings of CDOs and CMOs are in truth reporting fiction. They are marking to model rather than marking to market. The recent meltdown in much of the debt market, moreover, has transformed this process into marking to myth.

Because many of these institutions are highly leveraged, the difference between "model" and "market" could deliver a huge whack to shareholders' equity. Indeed, for a few institutions, the difference in valuations is the difference between what purports to be robust health and insolvency. For these institutions, pinning down market values would not be difficult: They should simply sell 5% of all the large positions they hold. That kind of sale would establish a true value, though one still higher, no doubt, than would be realized for 100% of an oversized and illiquid holding.

In one way, I'm sympathetic to the institutional reluctance to face the music. I'd give a lot to mark my weight to "model" rather than to "market."
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Sachin Tendulkar gave the muhurat clap for 'Awwal Number' - that apart, he hasn't done much wrong in the last 20 yrs!

keep-it-cool

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Re: (Non Cricket) - On Risk, Liquidity, Subprime etc...- some viewpoints
« Reply #1 on: August 23, 2007, 11:11:54 AM »

The most dangerous words on Wall Street
Wilbur Ross
Chairman and CEO, WL Ross & Co

I recently overheard two men arguing about who was better off. One boasted about his new car, the other about a plasma TV and so on, until one proclaimed, "I am better off because I owe more than you are worth." The second man conceded defeat. This anecdote summarizes the mortgage bubble. Americans spent more than they earned in 2005 and 2006 and borrowed the difference. The federal government did the same. Everyone secretly feared this was unsound but wanted immediate gratification, so there was applause for talking heads who said global liquidity would make these borrowings safe. Alan Greenspan went so far as to suggest that people take out adjustable-rate mortgages.

Liquidity, however, is not about physical cash; it is mainly a psychological state. Subprime problems have consumed only trivial amounts of global cash but already have burst bubbles by shocking lenders. Clever financial engineering effectively had convinced lenders to ignore risk, and not just in subprime. A major hedge fund participated in a loan to one of our companies, but sent no one to a due diligence meeting. So I called the senior partner to thank him and tell him about the non-attendance. He responded, "I know. For a $10 million commitment, it wasn't worth going to a meeting."

When subprime issues first surfaced this spring, many major institutions said they had none, but recent quarterly write-offs show they did. They weren't lying; they just didn't know what they had. Their embarrassment has brought risk control back into vogue. It was always silly to lend to weak credits at discounted interest rates, and without documenting income and balance sheets and without appraisals. No amount of model building should have enabled Wall Street to take $100 of such paper and alchemize it into securities sold for $103. Models inherently assume a future similar to the past and therefore they fail when multiple standard deviations occur. Subprime models also did not capture ever more lax credit standards nor that real estate might suffer severe and protracted price declines, again proving that the two most dangerous words in Wall Street vocabulary are "financial engineering."

Now that we have identified the cause of the disease, how severe and how contagious is it? The present $200 billion of delinquencies will grow to $400 billion or $500 billion next year because $570 billion more low, teaser-rate mortgages will reset to market and consume more than 50% of the borrowers' income. Therefore most of the loans will be foreclosed or restructured. Probably 1.5 million to two million families will lose their homes. Meanwhile, few lenders will put mortgages on the foreclosed houses, so the prices will plummet. Despite these tragedies, total losses will probably be less than 1% of household wealth and only 2% to 3% of one year's GDP, so this is not Armageddon. However, even prime jumbo mortgages will be more expensive and more difficult to obtain.

Similar excesses occurred in corporate debt markets. Leveraged buyouts were financed with few or no restrictive covenants and with some borrowers able to "toggle," or issue more bonds to pay interest in lieu of cash. The debt-to-cash-flow ratio hit record highs, and more than 60% of junk bonds issued are rated B or lower. Only 13% of high-yield issuance proceeds was for capital expenditures for expansion--87% went for sponsor dividends, stock buybacks, LBOs, or refinancings, none of which inherently advance credit worthiness. And this exotic lending paid only 2.5% to 3.0% more interest than Treasury bonds' 5.5%. Therefore investors received only 8% or 8.5% interest on bonds that had a 25% probability of defaulting, the same ignoring of risk as in subprime.

The cause was also the same. Wall Street made $100 of these credits into tranches of securities that sold for $102 or more. Again we had securitization pseudo-alchemy creating fool's gold. The weakest 5% or so of a $2 trillion universe of leveraged loans and high-yield bonds will crater. This is only 1% of GDP, but lending standards will tighten for a while, just as they did after the telecom bubble burst.

Because of this outlook, WL Ross portfolio companies raised $2 billion this year to eliminate outside financing needs. More recently, we provided a modest $50 million debtor-in-possession financing to American Home Mortgage, the tenth-largest subprime lender, as it entered bankruptcy. Ultimately, we will make a major move into mortgages, because lending to weak borrowers makes sense at premium rates with proper due diligence and appraisals. After Japan's real estate bubble burst, we used a similar strategy to rehabilitate Kansai Sawayake Bank. It was earning 17% a year on equity after one year, almost twice the return typical of a Japanese bank.
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Sachin Tendulkar gave the muhurat clap for 'Awwal Number' - that apart, he hasn't done much wrong in the last 20 yrs!

keep-it-cool

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Re: (Non Cricket) - On Risk, Liquidity, Subprime etc...- some viewpoints
« Reply #2 on: August 23, 2007, 11:15:25 AM »

Market corrections are coming.
Jim Rogers
Founder of the Rogers Raw Materials Index

We've had the worst bubble in credit we've ever had in American history. As the bubble got bigger and bigger, it spread to emerging markets and leveraged buyouts and all sorts of things. And it hasn't been cleaned out yet. I don't think you can have a bubble like this and clean it out in six months or even a year. It has always taken longer.

Look at homebuilders, for instance. Historically, when an industry goes through a retrenchment like this, you have two or three big companies going bankrupt and most of the companies in the industry losing money for a year or two or three. Well, we haven't gotten anywhere near that in the homebuilding business, so I think that bottom is a long way off. As far as the credit bubble, we have another several months, if not more, of mortgages that are going to reset and people who are going to find themselves with even higher monthly payments. There are many, many more losses to come, most of which we won't know about for weeks or months.

Normally you have markets go down 10% or so every couple of years. We haven't had a 10% correction in the stock market in nearly five years === FP, PLS NOTE - REFERENCE THE SAINATH LECTURE ===. I don't know if this is the beginning of it, but we've got a lot of corrections coming. It wouldn't surprise me to see a little bounce--say if a central bank cuts rates. But that will just lead to the markets falling further late this year or next year. It would be better for the market, it would be better for investors, and it would be better for the world if we went ahead and cleaned out the system. If they do cut rates in the U.S., it would be pure madness. Because the market's down 7% or 8% from an all-time high? My gosh, what's that going to say about the dollar? What's that going to say to foreign creditors? What's that going to say about inflation? The Federal Reserve was not founded to bail out Bear Stearns or a few hedge funds. It was founded to keep a stable currency and maintain its value.

I have been and continue to be short the investment banks and the commercial banks. If they bounce up, I'll probably short more. I'm certainly not buying anything. The market's only down 8%. I don't consider that a buying opportunity. The things that I'm short, some people probably think are buying opportunities, but I don't. I've been short the banks for close to a year, and for a while it was not fun. But I added to my positions, and now it's a lot of fun.
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Sachin Tendulkar gave the muhurat clap for 'Awwal Number' - that apart, he hasn't done much wrong in the last 20 yrs!

keep-it-cool

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Re: (Non Cricket) - On Risk, Liquidity, Subprime etc...- some viewpoints
« Reply #3 on: August 23, 2007, 11:20:27 AM »

A bubble of liquidity
Jeremy Grantham
Chairman, GMO

The world was moving slowly but very steadily against risk. They've been taking far too much time. The risk premiums had hit a world-record low back in February. It was probably the lowest point in history and across a very broad base of assets. But the essence of the bubble was risk-taking.

It was a bubble of liquidity and a consequence of liquidity.

The proximate cause of this is subprime. That does not seem that profound a problem globally. Of course, unfortunately, that is the local cause. The general cause is that risk was mispriced on an extensive basis globally. By risk, I am referring to elaborate fixed income instruments typified by subprime but also to leveraged debt to private equity, junk bond spreads, credit default swaps. They're using this as an excuse, which they refer to in China as the U.S. subprime problem. But really they're using this as an excuse to reflect the real problem, which is the broad-based mispricing of risk.

The selling might accelerate. On the other hand the markets could easily rally. But in the end risk will be repriced. Whether it's now or in 18 months, risk premiums will be more normal.

The focus of the mispricing is in fixed income. That was more impressive than mispricing in equity markets. But the equity markets were also mispriced. The junky companies were selling at a premium to the blue chips. We had never seen such a deviation in performance between the junky rated companies versus the really high quality companies. It's been going on since September of '02.

The leakage into the equity markets from the fixed income is of course private equity. Private equity is a function of how much debt you can get, the cost of the debt, etc. That fed right through into overpaying for fairly expensive companies. And then of course the ordinary investor, both institutional and individual, began to guess where the next deal would be. And when they saw one, they tried to position around similar ones. That was a real mechanism to feed easy credit and low rates.

I think this is the very early stages of repricing risk, particularly in the stock market. It may be rapidly entering the middle stages in the fixed income market, although I think it will go quite a lot further in the next couple of years. But the equity markets have barely started to address this issue. Still, today the risky stocks are badly mispriced relative to the blue chips. They have a long, long way to go. I have no doubt they will do it. The pendulum always swings completely. In other words, you can guarantee that one day there will be a substantial premium for high quality companies.

There is a lot of pain still to be had in the equity markets, particularly aimed at the risky end of the spectrum. We think the fair value on the market is about a third lower in the U.S and EAFE from today and about a quarter less in emerging markets.

Most of that is not because P/E's are high. The great weakness in equities is that profit margins are off the scale globally. They're off the scale for the same reason that the risk premium got so low--that we've had wonderful global conditions, wonderful global growth, wonderful global liquidity, wonderfully low inflation. That will do it every time, without fail. So the profit margins went steadily up under a constant series of pleasant surprises: Global growth was always a little better than expected, consumption in the U.S. was always a little stronger than expected.

Pleasant surprises are the key to profit margins. If you can put together three years of constant pleasant surprises, you will have fabulous profit margins. It isn't to do with productivity, it isn't to do with China or India. It's to do with pleasant surprises. And of course, the longer the pleasant surprises, the higher the hurdle. The hurdle is now desperately high. It is virtually impossible to pleasantly surprise the world now. And profit margins will of course drift or drop down to normal and below. That's the pressure on the markets. That is what causes the market value to be a third less than it is today.

And people don't get that. People always look at P/E and take great comfort. Often it's perfectly fine to do that. But today it's horribly misleading because the main pain is in profit margins.

In five years, I expect that at least one major bank (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private equity firms in existence today will have simply ceased to exist.
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keep-it-cool

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Re: (Non Cricket) - On Risk, Liquidity, Subprime etc...- some viewpoints
« Reply #4 on: August 23, 2007, 11:23:47 AM »

The failure of central banking
Stephen S. Roach
Chairman, Morgan Stanley Asia

For the second time in seven years, the bursting of a major-asset bubble has inflicted great damage on world financial markets. In both cases--the equity bubble in 2000 and the credit bubble in 2007--central banks were asleep at the switch. The lack of monetary discipline has become a hallmark of unfettered globalization. Central banks have failed to provide a stable underpinning to world financial markets and to an increasingly asset-dependent global economy.

The current post-bubble shakeout is hardly an isolated development. Basking in the warm glow of a successful battle against inflation, central banks decided that easy money was the world's just reward. That set in motion a chain of events that has allowed one bubble to beget another--from equities to housing to credit.

When the bubble burst in early 2000, the optimists said not to worry. After all, Internet stocks accounted for only about 6% of total U.S. equity-market capitalization at the end of 1999. Unfortunately, the broad S&P 500 index tumbled some 49% over the ensuing 2 1/2 years, and an overextended corporate America led the U.S. and global economy into recession.

Similarly, today's optimists are preaching the same gospel: Why worry, they say, if subprime is only about 10% of total U.S. securitized mortgage debt? Yet the unwinding of the far broader credit cycle gives good reason for concern--especially for overextended American consumers and a U.S.-centric global economy. Central banks have now been forced into making emergency liquidity injections, leaving little doubt of the mounting risks of another financial crisis. The jury is out on whether these efforts will succeed in stemming the rout in still overvalued credit markets. Is this any way to run a modern-day world economy? The answer is an unequivocal "no."

It is high time for monetary authorities to adopt new procedures--namely, taking the state of asset markets into explicit consideration when framing policy options. As the increasing prevalence of bubbles indicates, a failure to recognize the interplay between the state of asset markets and the real economy is an egregious policy error.

That doesn't mean central banks should target asset markets. It does mean, however, that they need to break their one-dimensional fixation on CPI-based inflation and also give careful consideration to the extremes of asset values. This is not that difficult a task. When housing markets go to excess, when subprime borrowers join the fray, or when corporate credit becomes freely available at ridiculously low "spreads," central banks should run tighter monetary policies than a narrow inflation target would dictate.

The current financial crisis is a wake-up call for modern-day central banking. The world can't afford to lurch from one bubble to another. The cost of neglect is an ever-mounting systemic risk that could pose a grave threat to an increasingly integrated global economy. It could also spur the imprudent intervention of politicians, undermining the all-important political independence of central banks. The art and science of central banking is in desperate need of a major overhaul--before it's too late.
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Sachin Tendulkar gave the muhurat clap for 'Awwal Number' - that apart, he hasn't done much wrong in the last 20 yrs!

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Re: (Non Cricket) - On Risk, Liquidity, Subprime etc...- some viewpoints
« Reply #5 on: August 23, 2007, 04:08:30 PM »

kic, noted. i hope you'll have noted that there's more to the lecture than just the reference to the stock market.
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Re: (Non Cricket) - On Risk, Liquidity, Subprime etc...- some viewpoints
« Reply #6 on: August 24, 2007, 02:06:31 AM »

Don't worry about the stock market ...It will go up .Now enjoy this ...

http://www.aapkavideo.com/desi-video/jsp/tVideo_Zoom.jsp?v=H963V2&c=3&st
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keep-it-cool

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Re: (Non Cricket) - On Risk, Liquidity, Subprime etc...- some viewpoints
« Reply #7 on: August 24, 2007, 03:54:06 AM »

kic, noted. i hope you'll have noted that there's more to the lecture than just the reference to the stock market.

I am sure. As I said, I havent gone beyond the first 10-15 minutes.
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Sachin Tendulkar gave the muhurat clap for 'Awwal Number' - that apart, he hasn't done much wrong in the last 20 yrs!
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