And So It Begins...
Carlyle Capital Corporation Defaults
By blackhedd Posted in Carlyle Capital | default | Economy | Mortgage-backed Securities — Comments (91) / Email this page » / Leave a comment »
I hope I didn't scare you too much with my recent stories (here and here) about spreading contagion among holders of mortgage-backed securities (MBS). Keep some fear in reserve, because the news is getting worse.
Carlyle Capital Corporation (CCC), an entity formed by the famed Carlyle Group of Washington DC, is in default on a portfolio of about $16 billion worth of MBS, and will probably be liquidated by its creditors.
This is a big ripple in a big pond.
More...
As linked above, I wrote about the fire-sale of about $24 billion in Alt-A MBS by the Union Bank of Switzerland last week, and the effect that the sale would have on other holders of similar securities. The transaction essentially "marked down the market," not in a literal sense, but by increasing the risk aversion of the bankers who lend money to people that have purchased MBS.
That includes Carlyle Capital, which was formed last July and sold $300 million of equity to the public, which is now all but wiped out. (A statement which appeared this morning on Carlyle Group's website stresses that Carlyle Capital and Carlyle Group are separate legal and business entities and that the distress in CCC will not materially affect investors in Carlyle Group.)
The people who lent Carlyle Capital the money to buy their MBS have now decided that they want more collateral to match the newly-increased perceived risk of the portfolio. CCC has had $400 million in margin calls since last week, and expects to get another $100 million call today.
This is money that Carlyle might have to been able to bridge from someone, in normal times. Under the circumstances, no one is going to help them out, and their creditors will probably seize their MBS assets.
What will they do with them? Take a guess. If you're not familiar with how an unmet margin call works, think of it as roughly comparable to a mortgage foreclosure. Just as a foreclosing bank will try to get whatever they can for your house at auction, the same will probably happen here.
And that has everyone in the financial world biting the buttons of their cushy leather chairs with their anal orifices. What if there is a fire sale of Carlyle's assets, comparable to the one UBS did last week?
And what if it's even worse than the one UBS did? After all, the UBS asset sale was voluntary, not forced. A lot of dominoes may start falling.
Is there an appropriate policy response to this? I wish you hadn't asked.
The free-market approach is to let the chips fall where they may. We will probably end up with a massive de-leveraging of the financial system, and a long slow period of balance-sheet rebuilding. Ultimately, we'll get a stronger system out of it. But the Great Depression wasn't any fun, and Great Depression II won't be any fun either.
The aggressive-policy response is even worse. The taxpayers could end up owning several trillion dollars' worth of home mortgages. How are you going to fund that? And more importantly, what would the price be?
-Francis Cianfrocca ("blackhedd")
And So It Begins... 91 Comments (0 topical, 91 editorial, 0 hidden) Post a comment »
Could be hundreds of billions. And you're right about the impact on real-estate values. I was just starting to think that through this morning.
Or are they not consiodered big enough? Can whoever forcloses on them use the MBS securities to access the Fed money?
This does not look good if the answers to both questions are "NO". It doesn't look too bad if either is a "Yes".
Socialism doesn't work. It looks nice on paper, but it's been tried and it's failed miserably every time (usually accompanied by widespread death and suffering).
Proud member of the V.R.W.C.
I (was) with Fred!
The Fed Term-Securities Lending Facility is only for primary dealers.
I haven't been able to suss out yet who Carlyle Capitals's primary creditors are. Wouldn't be surprised if it turns out to be people like Merrill or Deutsche, except that when CCC was funded in July, Merrill was already pulling back from this market.
Without that data, I can't answer question number two.
But the TSLF is for liquidity enhancement, not for bailing out a distressed borrower. Whoever ends up holding this paper is going to have to decide what to do with it. Even if they did try to lend it to the Fed, they'd have to mark it to market somehow, and then they'd have to take a "haircut." (Same as with any loan, the TSLF will only lend up to some fraction of the collateral's value.) The mark-to-market is what will cause the follow-on damage to other borrowers.
So the answer to your second question is probably no.
LOL! I heard that in 1984-85 and lived through what happened then. The issue with marking to market is deciding what market is. Holder says market is 0-10% +- today and "buyer" wants it to be 20-50% below today. That is the problem the Big boys and the FED has, what is the market and more importantly to future holders, what is the market going to be. My price point would at least 30% below today and that may be too optimistic.
Also your point that this is Prime paper is vital. Prime is the only "value" asset some of these houses has left as security/saleable. When (and I do mean when) the mandatory write-downs start on the Prime paper, the fallout spreads and spreads quickly. Sadly, we are not there yet and the FED knows it.
Mortgage-backed securities have never had a liquid secondary market. That's not abnormal at all for an engineered debt product. But that's ok as long as everyone can keep holding them until the run off, as was the original plan. No sellers and no buyers is basically equilibrium.
As soon as you have sellers but not buyers, the market can't clear. The few transactions that do happen don't represent the long-term stable value of the assets, but they're all you have. And if you're required to mark your book to market once or twice a day, as many institutions are these days, that's what you have to live with. Hence the margin calls.
And then you have present reality, in which everyone wants to be a seller and no one wants to be a buyer.
Deutsche Bank and J.P. Morgan Chase.
And how's this for a real kicker?
The mortgage-backed securities that Carlyle is defaulting on are all issued by Fannie Mae or Freddie Mac.
By definition, these are therefore prime mortgages, not subprime or even Alt-A.
On the one hand, that gives me some hope that if there is a distress sale, it won't be a total killer.
On the other hand, it's scary that even agency debt is now being subjected to higher collateral requirements.
It's a wild, wild time. Yesterday I heard that you can buy a credit-default swap on US Treasury bonds, and the current price is 16 basis points. It should be closer to one or two BPs.
I can't remember a time ever in recent history when the default risk of the US Treasury was considered anything but negligible.
That's a lot of leverage. In more traditional hard asset financings, the equity contribution is around 15-20%, as opposed to the 3% in this case.
Loan covenants are there to protect the banks. Banks are generally flexible when it comes to waivers or restructurings. (For a fee, of course!) That they are unwilling to do so in this case may speak to a real drop in confidence in the fund's management more than the assets themselves.
We shall see...
...especially for triple-AAA rated securities with an implicit government guarantee, as was the case here.
Additionally, CCC's equity is actually closer to $1 billion, which changes your arithmetic. The entity was founded with $670 million in capital from partners in the Carlyle Group. They added $300 million in the public raise last summer.
Back in the Nineties, Long-Term Capital Management was buying US Treasuries at a 1-100 leverage ratio. Even that wasn't too far out of line at the time.
"We shall see": Since I published the piece a few hours ago, I heard that Carlyle has in fact collapsed.
as normal in finance as it is in marriage :>)
sometimes I have to shop for mutual funds to hold trust assets. Depending on the circumstances (absolute safety more important than yield), I will avoid the ones that hold securities with "implicit government guarantees". Perhaps it is my mental confusion of "implicit" and "illicit" and "explicit" as in porn!
...guarantees, then I submit to you that you're part of the problem.
No one, anywhere in the world, seems to want to own anything but US Treasury debt these days. The spreads between risk-free Treasuries and any other security are abnormally high. That's basically the definition of a credit crunch.
With respect to my own meagre finances, I have no standards. For example, I own Bear Stearns. (But with unrecognized capital gains, unlike most people!)
I also have tulip bulbs in the inventory. Which reminds me, it's time for their spring planting (you can do that in Texas).
Can't speak for confucius but holding on to a stock with little upside just to avoid capital gains tax is generally not a good idea (unless you think it will go down less than 15% and our next president will eliminate capital gains...)
That's why I recommend that my friends who can't spend the time actively managing their investments put their money in index funds that represent various levels of risk to match their liking - they tend to have the lowest cost ratios and in the long run as good a return as actively managed portfolios and definitely better than the most individuals passively managed holdings.
“.....women and minorities hardest hit”
...for business or consumer use, that will transmit the financial-market distress into the real economy. We'll get slower output-growth, slower productivity-growth, and eventually job losses.
So yes, I'm going that far. At the very least, I'm war-gaming the possibility.
It's time to start thinking of the (many) things that make today's economy different from that of the 1930s. For one thing, we're service-oriented rather than manufacturing-oriented. And with some ridiculous exceptions (like the misbegotten airline business), services are not as capital-intensive as manufacturing. That could cushion the blow.
Other factors include the de facto dollar standard that the world is on, and also the continuing savings glut from the emerging economies.
But I just started hatching a theory that the dollar is now drastically overvalued, just as it was from roughly the mid Twenties until 1934. More on that as I think it through,
...but your industry is something I'll never understand why anyone ever invested in.
Well, yes, I do understand. For many decades, air travel was nearly the most glamorous thing that humanity did. And I was totally caught up in the romance of flight when I was a kid.
As much as I bad-mouth them from a dollars-and-cents point of view, I still love airlines.
remark, if there was anyone at Kitty Hawk who was sympathetic to investors, he would have shot the Wright brothers down.
...for all the profit the entire industry has made across its entire history.
I personally admire him because he was one of the business world's great iron-asses.
How's he doing these days? Still healthy?
on the irrational behavior of airlines and their creditors. You will see him in the media from time to time.
Of course, anyone freed from pilot unions would get a new lease on life. (sorry, Jeff!)
Yes, I admire Crandall, too. Immensely.
As a pristine question, "free (ing)" them from pilot unions wouldn't be tough; when you have someone by the wallet, their hearts and minds follow. Even unions understand the difference between getting a paycheck and not getting a paycheck. The problem is that the airlines and the aerospace industry generally are so dependent on and regulated by the government. If you pick a fight with an airline union, the union uses its political influence and all of a sudden you have the undivided attention of the FAA and NTSB. All sorts of "safety concerns" start leaking out and half your fleet gets grounded or you're spending millions on some new inspection scheme or mandatory modification. Or you lose your contracts for government paid travel. Even the makers have to tread carefully; cross the machinists and you don't get that Air Force contract. Even when we've had Republican Presidents, with the singular exception of Reagan, they've been able to play this game successfully. That's why airline/aerospace is one of the few industries left that is majority union. And all the others share the same characteristics; they're either heavily regulated or heavily dependent on government funds - or both.
In Vino Veritas
its the undercapitalized, poor/no credit history, no ability to pay,no cash flow to service debt...deals that gave rise to the RE boom in the first place.
People who should never have gotten a home with ZERO cash, (pulled cash out at close in many cases) gave rise to "everyone wins" thinking. Chraging a 100% rate on a deal that fails means you lose. In RE the RE is usually worth something but if you do not have deep enough pockets to carry the property until it can be sold (ie. buyers come back into the market), you risk being out of business.
I see the dominoes starting to fall in our economy. This is a bad thing. I've already seen my business drop way off - almost negligible (I sell insurance). Consumers are experiencing a major shock right now. They see gas prices rising and lots of doom and gloom on the TV and they aren't willing to spend us out of this recession. NO check from the government is going to change that. I just hope that we can figure out some way to reverse the damage that is going on.
Fighting for conservatism one day at a time.
Stop blocking the construction of nuclear power plants, enhance the ability of utilities to use coal to generate domestic power, start drilling in ANWAR, and enhance the abilities of Oil companies to build new refineries. That starts to take some of the pressure off consumers from the price of gas and immediately boosts consumer confidence. Next stop the foolish mandates for ethanol and renewable biofuels from food stuffs which takes pressure off consumers grocery bills and boosts confidence in the markets. With confidence returning, the ripples return the credit markets to the point where people can get credit for reasonable risk projects.
Now, getting politicians to agree to these changes... Well, THAT'S the hard part in normal times. In the current environment with the party that typically supports these sorts of change on the ropes for corruption and fiscal mismanagement (even though the other party is worse in reality), it's almost impossible. [sarc on] But maybe they can schedule another $600 check for each of us in November. [sarc off]
You can look at the MBS crisis as a mismatch between the short-term cost of capital and the value of the long-term securities that are funded with it.
But we went through a long period of extremely low volatility a few years back, when all of today's trouble was brewing, and risk spreads were exceptionally low.
You'd think intelligent investors at that time would know some history (or at least some mathematics) and avoid the overexposure that has now blown up in their faces.
So wouldn't you also think the only thing that would make an investor do that is if he's playing with the house's money?
In other words, the compensation structure of hedge fund operators and other professionals (which gives them upside but not downside) may be the root cause of the whole problem.
Yes? No? Maybe?
I got my MBA in 1979 and had worked the numbers for my MBA Thesis and with Inflation/Interest Rates where they were given the Fixed rate mortage average yeild to maturity, the system was in a strain.
By 1982 I was a Mid-level Manager (Bank Officer by 84) and saw what was happening to Financials of S&L's (holders of 80% of MTG's at that time). However, DeRegulation was under way and that was going to allow more "creative" options and save the Industry. "Creative" turned out to be more risk with the "peoples" money, not their own. End result S&L Industry gone, taxpayers pay the bill.
With S&L's gone MTG companies rushed in to fill the void. Here we are again in the same mess 20 years later for the same reasons-bad deals. The "Houses" money has been used to generate millions for some and Billions (in the hundreds) of losses, which the tax payer will pick up again.
Had these deals been required to stay "In-House" for say 2 years before they could be sold (means you take the risk of loss for 2 years), most would not have been done. The risk was just too great. But since it was going to be sold immediately into the secondary market (with points attached-meaning profit to seller), who cared.
So yes, when "houses" money is used all deals are good, when personal money used, much harder to say YES to deals.
...there are two ways we can work out of this mess.
First, we can do a big bailout and keep everyone's existing incentives untouched. That means we're setting the stage for the next bubble. Which will come rapidly because of the low policy interest rates.
Or we can go back to making money the old-fashioned way, by earning it. If we force a realignment of professional investors's and bankers's compensation with the risk they take (what a concept!), then we'll get considerably less economic growth (and maybe indeed something resembling a new Depression), but ultimately a much more sustainable and strong economy.
Your thoughts?
"First, we can do a big bailout and keep everyone's existing incentives untouched. That means we're setting the stage for the next bubble. Which will come rapidly because of the low policy interest rates."
Wow. I've got to admit. You sound a little bit like Ron Paul when he questioned Bernanke a few months back. I've been waiting for this to blow up since 2004. I need a cheap house, but not a pseudo-depression!
I wish I could opt with no bailout, but I have to live in this country, and we are quite snizzed. ----Fingers crossed----
-freedom
a combination of both. It is a sad day when a CEO/CFO Sr. VP's get huge bonuses for losing a company money. We have our bonus structure set up on after tax profit compared to forcasted year end budget. If loan processor gets bonus we all get bonus, if not, nobody does. That includes Loan Losses/Charge-off ratios. They go up, bonuses go down for all.
The bubble is upon us so it is better if we can deflate it slowly than have a complete burst but it seems the FED does not know the difference. The FED is stuck in a bad spot. If they keep interest rates low to stimulate economy while prices are rising (inflation), economically the cure is more painful later on (much higher rates to kill off inflation).
The Fed (hope not congress but they seem unable to keep their hands off-they want to buy votes) should keep liquidity available but try to give the dollar some support. If these "Free Trade Deals" had teeth, we could help the dollar through them but since we have given away the shop with them no much help for dollar there.
Liquidity is about all the FED can do now. Yes low rates will cause up tick in inflation but with Comodities/Oil-Corn-Beef...already on the rise, we just have to hold on until it works through the system, but they must keep the money spicket open for at least another 9-12 months, then we can attack inflation and the dollar.
liquidity are failing. They have lowered the interest rate repeatedly only to find that the credit markets have stopped following their lead. It's time for them to realize they aren't having the desired effect and head in the other direction.
The government floats the money to cover the industry (or at least key players), but the cost is that future bonus packages get changed to put CEO/CFO money at risk instead of just house? Maybe SEC and other government agencies take down some of the fly by nights through other means.
I hate the whole government regulatory mess it creates, and don't see how to pull back from it afterward. But right now they seem to be the only ones who've got "good" credit.
Oh, and by 'cover' I mean they stay afloat but the bad deals get closed out over time so the remain debt is good when the government loans are paid back.
actually make this happen? New accounting rules. New ethics rules? New laws? I'm truly curious because I think you have brought out an excellent point about how the bubble was created?
I know a tiny fraction of what you do, but even I can see that there was zero incentive to NOT write a deal because there was no risk for the original lender. It was the buyer of the bundle that inherited the risk and then if everything blew up the taxpayers.
There are example after example of crazy loans coming to light in the media that never should have ever been approved, but when you get a bonus for writing it and no downside why shouldn't you?
I'm actually in favor of lots of banking regulations which probably isn't a popular position here, but somebody always seems to get too creative and/or abusive in their lending practices when there aren't any rules. This means that in the end the taxpayer ends up footing the bill after the "criminals" walk away with millions or even billions or thousands of suckered individuals get screwed. I'd rather a safer banking environment in periods where everything is good. Perhaps "creative" solutions are necessary in times of recession, but why take the risk the rest of the time.
Having said that, weren't there like 2 agencies which rated the bundled mortgages for risk? I vaguely remember they were suspect in this as well because the made money the higher things were rated and thus the more that were sold. So nobody anywhere had any desire to put the brakes on anything even if they thought there was a problem. Perhaps such ratings agencies should just get a flat fee, or should be payed based on their accuracy or something...
Well, truth be told, this all continues to stink like the cowbarn in the spring thaw, but maybe there's a silver lining that's long overdue.
For at least 20 years, there's been way too much emphasis on financial wizardry combined with (and enhanced by) an increasing (and irresponsible) disconnect from underlying reality.
Since I get to straddle the worlds of technology and finance, I get to see the narrow-minded self-blinkering on both sides of that fence. But I'll take the opportunity here to lambaste the over-supply of financial wizards who have made a virtue of knowing nothing other than playing financial games - and then running there own vehicles off cliffs.
Back during the 1990s dot-com boom, someone asked me at a cocktail party when I thought it would all end. Remember how silly it all became back then. The real driver behind the dot-com mania was that venture investors could put modest money into some sort of start-up (software-based businesses have low start-up costs), and then as quickly as possible "flip it" (the official phrase has always been "get to exit" but the reality was that this was more like flipping real estate speculation properties than true company-building) to an IPO - and get major-league bucks back. This was working - venture money went into things like "meetforlunch.com" (I'm not making that name up), and never mind profits - they'd get moved to an IPO in six or eight months before they even had any revenue.
In any case, to answer the cocktail-party question, my reply was that when the quick-flip scenario gave out - basically, when the investor-dogs stopped gobbling up the dot-com-vapor-company IPO dog food - then the whole thing would collapse.
And indeed that's just what happened.
Besides the obvious, there were two ugly consequences of this whole thing - one during and one right after.
The first was that it was almost impossible to get venture people interested in "real" companies during that period. A "real" company would turn into a "real" going business in maybe 2 or 3 years (after several sequential rounds of funding), and hopefully you get a good exit (IPO or sale) in 3, 4, maybe 5 years. Then you have a real business producing real economic activity.
Instead, money and energy were all flushed into basically worthless vapor that was designed only to produce a quick IPO and nothing more. The sad part is that there were so many dogs that now don't bark - that didn't happen because they couldn't get funded since they didn't fit the quick-flip mania.... and those would now actually be modest-sized, growing, and useful companies. A good example is IC ("chip") design companies - new ones basically stopped appearing during the dot-com mania and that's still the case.
I don't blame the venture firms directly for this - after all, they have to compete with folks like Goldman-Sachs to get their own investment dollars. The LPs (limited partners) are going to want the most bang for their bucks, and if firm A (or GS) is generating bigger bucks over the time period in question than is solid old firm B, firm B would be bereft of funds in the first place.
Oh, yeah, the second consequence of the dot-com bust was an unexpected collapse throughout the technology industry - even among the ranks of the outfits doing "real" things. It turns out that much of the business of the "real" companies actually involved selling stuff to the dot-coms. So when the bubble burst, not only were there no more dot-coms to buy up the gear - there was suddenly a glut of barely-used equipment (computers, networking gear, even office furniture) on the resale market at fire-sale prices.
The dot-com boom went away, but the whole mentality it spawned didn't. See "housing boom." Financial wizardry disconnected from underlying reality is like a drug - it can make you feel smart and god-like.... but reality has this way of re-asserting itself.
Anyway.... this got too long, but if there's a silver lining, maybe we'll finally get some of these financial geniuses brought back to earth or put out to pasture. Over the past 15 years, I've had one too many "conversations" (sic?) with self-anointed financial "geniuses" who had the humility of Eliot Spitzer and the clear attitude that they were the highest evolved form of human life and that anything they didn't know about or understand must by self-definition be trivial.
Finance world: Please use this opportunity to flush your over-supply of turkeys. Happy Thanksgiving.
the prospect of a bailout to people knowingly (or ignorantly) taking risks, and profiting from them, is vastly unappealing.
Is federal assistance needed to stave off a recession? Then it seems to me it'd be wiser to give money to those more likely to invest it well. Even giving it directly to individual taxpayers would probably have a better effect on the long-term economy.
A note on financial "wizards" - my skepticism began with hurried calls from hedge funds or bond guys asking for basic information about securities they were hawking, occasionally in the middle of a trade!
What economical credit research- don't do any. Of course, I politely informed them that I could not give them advice, just public information.
Thanks for the kind words.
I'll try to get back to this later; have to be out of the office most of the afternoon....
Well, we'll see what happens. For 20+ years now, "financial wizards" have been the top dogs of the world and have been raking in the big bucks (bigger and bigger in fact) - while becoming more and more disconnected from any underlying reality, and at the same time becoming more and more arrogant and pompous. Maybe their run is finally coming (mercifully) to an end.
Given the string of messes they've made, some sanity is long overdue. If there's any common thread to the boom-and-bust waves we've had over the past whatever number of years, it's been financial wizards playing games to chase transient high returns and get out before it all caves in so that they can move on to the next game. It's like a rolling series of Ponzi schemes. All this wealth flushed into fast-buck but ultimately near-worthless activity.... it's a real shame to think of all the great things that didn't happen because of all this mis-directing of resources.
I really don't know if we can finger some underlying cause, and I doubt there's a quick fix.
Just a couple of quick worrisome observations from my bunker/perch in the tree - the first specifically about the financial wizards, the other involving them and also others more broadly.
The first is that the financial wizards became mind-boggling arrogant and stuck-up - WAY more than was even reasonably justified and WAY above any level that should have lasted. When people are able to unplug from reality and just manipulate money with no anchors to anything real, it quickly goes to their heads - and they basically become ineducable and impossible to talk to. They know everything important, and anything they don't know can't possibly be important.
The second applies to the financial wizards but also more broadly - and this disturbs me even more than the swell-heads in the financial world. I am completely agog at the shallowness, superficiality, and boneheaded impatience of people in important positions of control and authority. I know we're all busy, but this is beyond that. It's become almost impossible to get people who should be level-headed and thoughtful to consider it possible that there is more to important matters than just a few quick "always-true-that" rules that are always and everywhere applicable - with no intellectual capacity for even entertaining the notion that reality is complicated and difficult - and that's why ability and experience are supposed to be important parts of commercial leadership. It just is amazing how many people in high positions basically know nothing about the basic nature of the business they are actually in.
Best scare example I can give you is a meeting that I was invited to a few years back involving a group of top chip industry execs. This was a big chunk of the A-team - companies and names everyone would recognize. To make a long story short, it became clear after a few minutes of discussion that they basically had no clue of what actually goes on at the rubber-meets-the-road of designing and manufacturing ICs - absolutely squat. All they could do was parrot empty clichés that bore little relation to any reality - just notions that there was no fundamental problem that couldn't be solved by someone emitting a four-page memo. The nadir was when I realized that I was trying to explain the basics of chip manufacturing stability to.... the director of manufacturing for a large chip manufacturing company.
I haven't yet recovered from the looking-glass quality of that meeting....
The shallowness and buttheadness is costly in many ways, but one is that it creates vulnerability to being sold a bill of goods if it comports with your shallow and clichéd (and wrong) understanding of how reality works. I have a good half-dozen horror stories along those lines, but I'll stop there for now.... and just note that I have one major clean-up (more like a salvage operation) in progress because people who should have known better were played like cheap violins and sold a carefully crafted pack of nonsense by a great bunch of snake-oil salesmen....
to run ANYTHING. Finance, budget, administrative processes are the place where the old saw, "those who can do, those who can't teach" is most true. God, I've been subjected to so many pimply-faced punks and prostitutes posing as management consultants over the years - but they all had MBAs!
In Vino Veritas
I went to school at night to get it. It's actually very good training for business. But not essential.
The problem is the attitude that the degree constitutes ability and automatically deserves extreme deference. This is a problem whether we're talking MBA, JD, MD, Journalism, etc.
Note to personal file- ditch the Toyota and get a Beamer or Benz. If I'm a pimp, better start living large! Standards are standards :>)
to get it, you had some real world work experience to go with it. Most of them hear Pomp and Circumstances and a few months later are out in the world telling people who actually do stuff how stupid they are. Hate them!
In Vino Veritas
"I believe we must adjourn this meeting to some other place." - The last recorded words of Adam Smith.
who also has an MBA, but I'd never hire someone right out of college based on the MBA or even someone whose whole resume is an MBA and floating from consulting contract to consulting contrack. That whole game is about coming in and rearranging the org chart, getting paid, and getting the Hell out before anyone figures out you didn't fix anything or made things worse.
In Vino Veritas
I had a "real" food mfg co during dotcom era that was very profitable and growing. Kicking around exit strategies I inquired about going public. The feedback was to slap a ".com" on the end of my name and start losing money then they might be able to take it public ;) Ended up selling to a fortune 200 in '03.
These booms and busts are human nature. When all speed bumps/ checks & balances get removed a train wreck is guaranteed. When using OPM with no checks/balances train wrecks are guaranteed.
In my biz I used compensation plans to steer the organization in the direction I wanted to go. Especially for sales people.
Look at the similarities of our government to this situation. Our "elected elite" use OPM, have little or no checks and balances = train wreck.
In the mortgage fiasco basically nobody had much accountability during the process. A bad thing.
Change brings opportunity. What opportunities exist for investors/entrepreneurs in this current scenario and next few years? I am getting itchy to do something!
Ask not what I can do for my country, ask what my country can do for me. Washington Elected Elite
Back in the late Nineties, the question I was asking was "Where the hell is all this money coming from?" In retrospect, a lot of it was fallout from the Asian crisis in 1997, and later, too-low interest rates after the Long-Term crisis and in the run-up to Y2K.
What are the financial wizards smoking?
I certainly have a strong opinion on the subject: they're smoking neoclassical finance, aka modern portfolio theory.
It's now possible to process risk using differential equations. People slice it, dice it, price it, hedge it, move it around from portfolio to portfolio, and generally convince themselves that their total exposure on any given day can be calculated precisely.
As it turns out, they're wrong. The era of modern portfolio theory has seen more asset bubbles, crashes and panics than almost any previous age. But still everyone continues to have faith in the CAPM, VAR, and all the rest of it.
What I'm wondering is whether this will be the final straw and forces a re-evaluation of modern portfolio management. That would result in some vast changes.
But again, unless the financial incentives change for the hedge fund operators, nothing else will fundamentally change. They need to become fully exposed to the downside as well as the upside. A good place to start would be to sharply reduce or eliminate the 2% annual management fee that private funds charge. Possibly also add a minimum equity participation from the general partners of a fund, that is considerably higher than the current norm.
Yes, I'm proposing additional regulation of the financial industry. Would you prefer to hear what the Democrats would do instead?
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"If we want to take this party back, and I think we can someday, let’s get to work." – Barry Goldwater
the rigorous models of the classroom do seem to be bastardized and jerry-rigged when put into commercial practice. People always want verified what they want to know, and the purveyors of the resarch products are willing to oblige, and they themselves are usually caught up in euphoria over the flavor-of-the-month.
So all the Wall Street people eat the forbidden fruit of self-deception and when the bubble bursts, there are never enough fig leaves to go around!
A Phd buddy at a hedge fund gets pressured often by traders/his bosses to hide losses and not update daily P&L completely. Human nature and temptation to hide ones mistakes happens more than we think. Many people that have losses, (personal or institutional) stick their head in the sand and HOPE! No wonder things get out of hand when stuff finally hits the fan.
Ask not what I can do for my country, ask what my country can do for me. Washington Elected Elite
The reason portfolio theory works is because of human nature - human are the unpredictable chaos that drives the behaivior (my favorite place to observe this is not markets, cause it is more subtle most of the time, but traffic patterns).
I think it is too early to tell how wrong modern portfolio theory was, the inclusion of liquidity risk into the models is relatively young and we don't have enough of a history to say this was a legitimate long tail event.
...to the critique.
If you construct a portfolio using CAPM or a derivative, so that you target a particular beta range, you're making assumptions that the relative risk profiles of each asset class will maintain their relationships with each other.
There's a reason that all the models assume infinite liquidity. It's because the math is impossible to do any other way.
How would you add poor liquidity to a model? Obviously, you could feed it through into higher trading costs, etc. Maybe it would have an effect on your effective beta or something.
But there's a big problem with that. Poor liquidity isn't a systemic factor. It's actually an effect, not a cause. It's an effect of something as old as markets themselves: when people get fearful, they stop trading and start selling.
The effect that this has on portfolio modeling is to totally destroy the risk-covariance matrices that the models depend on.
You might as well try to predict global warming.
Actually, it is very similar to trying to predict global warming - and that is why my other posts warns about mistaking models of reality for reality itself.
Your right, the feedback mechanism are complex and not altogether well known (or even completely knowable) so unexpected reactions are inevitable. The models are directionally useful to the extent that they incorporate a range of experiecnes that include the current situation - as situations that were not included in the model happen it will break down but we can learn from taht, incorproate those relationships into the model for better precision in teh future.
Of course if you are out on a limb relying on the model to never miss in its short term view of reality of course you will get burnt - even at its best it is just a statistical distribution of possible events and not an oracle into events themselves.
In the end, their is no substitute for an astute understanding of the underlying assets/businesses and their markets, a broad knowledge of the markets history and some luck. Models can formalize that but if you don't understand the inputs yourself, you will pay for it.
Back in the late Nineties, the question I was asking was "Where the hell is all this money coming from?"
Well, it came from many places of course - and like anything, once the machine starts generating high returns, it's going to attract even more money. I don't know $$ amounts, but one thing that really happened big-time during the 1990s was the stupendous amount of $$ from large university endowments that sloshed into venture funds seeking returns. There was also of course the huge boom in pension fund $$ (both public and private - think CALPERS) but I don't know off-hand if those were feeding directly into venture funds.
However, much of this was a kind of self-feeding perpetum mobile - in which all the cash generated by all those vapor IPOs was feeding back into the system to create more of it. There were new "venture investment firms" springing up all over the place like weeds. Back then, one of my cronies in the Valley wrote out his five-step plan to becoming a multi-billionaire....
1) Go shake a tree in Menlo Park until some venture capital people fall out;
2) Scream "internet," "world-wide-web," "e-commerce," "new economy" at them repeatedly;
3) Take the money they give you for your .com start-up;
4) Take it public and become an instant centi-millionaire;
5) Go hide in a tree in Menlo Park.
Crude, but surprisingly accurate.
What are the financial wizards smoking?
I certainly have a strong opinion on the subject: they're smoking neoclassical finance, aka modern portfolio theory.
Well, I hope that you haven't forgotten the apotheosis of hubris from that period - Long-Term Capital Management.
When I was an undergrad, I was endlessly amused by the way the econ students were obsessed with "econometric modeling." My short take on this was that it was all an attempt to pretend that economics was actually physics and calculate things to multiple decimal places just because you had a computer to do it. It was silly enough as it was - and one crack back then was that the only disinterested party actually rooting for Quebec separatism was econometrics guys, since they really wanted to see how well their models worked out.
But what was worse than pretending to be physics was that they were imitating what they thought physics was rather than what it actually is. To too many non-participants, physics involved covering whiteboards with heaps of deterministic differential equations - and after a lot of manipulations, "truth" appears. That's not even close to what physics is really like, but too many money people believed it. That's what gave us the Black-Scholtes hubris that you could write out financial differential equations and get "risk" into two terms which canceled each other - meaning that you could be risk-free! What's worse than the breathtaking stupidity of that conclusion is that people actually believed it. Nicely done, as the collapse of LTCM in 1998 nearly destroyed the world economy.
The final mind-boggling part of that disaster is that the whole mess should have totally discredited all these pompous financial wizards and caused them to be put out to pasture - but it didn't.
The problem with financial wizards is not hubris, it is greed (not neccesarily a bad thing). Black Sholes etc. are just models and as with all models they simplify the real world to make it easier to test anrrow cause and effect. In and of itself, that can be useful and Black Sholes does have useful applications (as does much of modern finance models). The problem is when one replace reality with the models and assume them to be the same (this is a fundamental failing of those who believe that a pure free market approach will always lead to optimal equillbirium based on more basic economic models of markets).
It is not hubris that leads some people too smart for their own good to see the theoretical potential of these models to make them extremely wealthy - it is the basic human motivation of greed. It leads them to forget it is just a model and, as always, where models seem perfect reality will disappoint. In this case, when illiquid markets make volatility measrues unreliable, or long tail risk events actually occur, or prices don't precisle follow a log-normal distribution over time etc. the model will fail. If you are betting too much of your bankroll (or a highly leveraged multiple of your bankroll) when that happens you are done.
Greed makes people stupid, it led to the bowling bubble in the early 60's when everyone knew that every american would bowl two hours a week, and it led to misapplication of financial models.
There was plenty of greed of course in LTCM, but what really made that whole thing stand out was the mind-boggling hubris of it all.
If you have your head put on properly, one thing you quickly learn at any attempted intersection of mathematics with reality is that if your mathematics shows something that violates common-sense.... stop. If something makes absolutely no sense, it's because.... it makes absolutely no sense. Something has gone horribly wrong, so back up and start over.
Getting two risk terms to cancel - meaning that risk had been completely eliminated - just makes no sense at all. They should have had the humility to realize that it couldn't be right.
It would be nice to think that such hubris is confined to the soft-subject world, but the disease is spreading. There was a notorious incident a few years ago where a university group was continually playing around with mathematics and found that their math was showing "negative capacitance" in a particular class of semiconductor devices. Sane people would have called time out and stopped since such a thing makes absolutely no sense at all.
But no. This had to be some great new discovery of new physics, and with a disturbing collection of groupies they waltzed around trumpeting this "achievement." It would have been embarrassing except they were such arrogant jerks about it. It was a good two years before some semblance of sanity crept in and they basically dropped the notion....
HTML Help for Red Staters
"If we want to take this party back, and I think we can someday, let’s get to work." – Barry Goldwater
Is it complete anarchy in the streets? Total collapse of civilization? You guys are scaring me. Do I need to invest in MRE's and more ammunition? Is it going to be as bad as the 30's? I have been reading your posts for quite sometime now blackhedd and wanted to thank you for some very astute observation. Do you have your own blog about just financial stuff? If not you should. I look forward everyday to reading your posts, but is there no good news or is it going to be doom and gloom for the next couple of years?
as long as you are living within your means. Those who are not living withing their means (spending more than they make) are going to have some rough times.
If your family income is 3000 a month and your bills are 5000 a month, you can see there is a problem. Some have been using their home equity to get the other 2000 per month and now that that option is gone they are in big trouble. But they were in trouble all along they just did not want to admit it-and didn't.
As basic advise, you should always keep at least 6 months normal living expense set aside somewhere (savings acct, MMA cash...not in EFT's , stock or bond market). Then just spend less than you make each month. Sure there will be months when the water heater blows up or auto repairs are needed but that is not every month. It is when a 72" plasma TV is "needed" (wife also needs new stove-frig-washer-clothes) and you finance it (at 22%) that you start down the path of trouble.
Think of it this way. You go to buy an Auto. The window sitcker say 25,000, the dealer says he can make you a great deal today only, it costs you 40,000. You say WHAT?? No Deal I can't afford that much!! That is exactly what you do when you finance it for 72 months. So you lease it-another bad decision but to much to discuss here. So you are correct- you cannot afford it but you but it anyway, afterall you will get a raise, overtime, nothing is going to go wrong with the house-no one is getting sick-no income decrease possible...for the next 5-6 years. Think it through and you see why so many get THEMSELVES in trouble.
How about saving for a year and pay cash for the plasma TV, but too many want instant gratification (and impress your friends with what you can "Afford") and do not stop.
The best answer I can give to the question "How can I get Rich"--Answer--one dollar at a time.
just in these uncertain times. Now that we're kidfree, we're pretty much back to the "one easy payment" plan, but when they were in HS and college, we did just about all of the wrong things that just about everyone else in the Country was doing; God was that an expensive time, most of it totally unnecessary!
Of course now that we're largely retired, our great fear is that the government resorts to inflating its way out of all this and eats our retirement income. Saw this happen to my ex-wife's parents in the seventies and early eighties. It was ugly!
I still work some and can work more if I need to - sure don't want to, want to lay around on my boat and fish. In my business, hard times are good times. Hard times means stasis or concessionary bargaining, so some employer will pay me to cross swords with a union or some union will pay me to cross swords with an employer. On man's famine is another's feast.
In Vino Veritas
which I already follow. Don't have any bills but cost of living and morgtage. Just worried about having a job.
depends what you do for a living. Anyone in financial services should be very worried right now, and I think anyone in a profession that is impacted by real estate decline (e.g. construction) should also be worried.
But other areas- like healthcare- should be relatively safe right now.
...according to the government statistics that come out every month (and yes, I read them, so you won't have to) are:
government, education, healthcare, retail, professional services, and law firms.
Everything else is shrinking.
All those make sense to me except retail (unless it is just part of their seasonal cycle). Demand for healthcare and education are not terribly sensitive to economic downturns (education a little more so, particularly the parts considered luxuries like music or art) and professional services and law firms are transactional costs that probably do better in downturns as more volatility and more churn create more transactions. Government, well that just grows until it collapses under its own weight.
Because none of the areas that are growing are amenable to productivity improvements. If this continues, the economy will get somewhat bigger but no one will feel any richer.
This is the biggest downside of a government takeover of healthcare. Since it will do nothing to control costs, healthcare will continue to grow as a proportion of the economy. And you can make a case that healthcare expenditures (contrary to conventional wisdom by conservatives) are not as economically valuable as other kinds of spending.
It isn't a good picture.
Having the gov be a growth industry.
Banks and other institutions conclude its smart to drop their MBS portfolios at fire sale prices when the larger economic effect is likely to rebound and catch them anyway.
In other words if there is a huge write down in overall MBS value and multiple companies go under after getting credit denials and margin calls - the larger economic tsunami created will eventually hit the very banks and investment funds making the calls as well as those who thought they were "smart" enough to dump their funds in the first place.
I agree with you that it leaves the system in better shape a decade from now but it could be a very painful experience.
....MAY be nearing an end. Nobody knows for sure, but that's some VERY good news. So good that it turned a 220 pt intraday loss into a 35 pt gain (give or take, I haven't seen the final closing number).
“.....women and minorities hardest hit”
They said the write downs on SUBPRIME ABS may be done but they expect to see more write downs in other security classes. So it is paintaing anything but a rosy, we've turned the corner picture - the ripple effect is ongoing and the extent is still unknown.
Let's just say the fat lady isn't even in da house yet to even warm up.
Ask not what I can do for my country, ask what my country can do for me. Washington Elected Elite
...into gold? Then move up to Idaho and buy a cabin on Ruby Ridge and live off the land?
“.....women and minorities hardest hit”
a monthy check, open up a free health clinic near you, give you free food from farm subsidies and all the "Corn" liquor-oops make that fuel- you need. Then you will be set. But we first need to put a GPS Chip in you so we can keep track of you!
http://www.carlylecapitalcorp.com/Financial%20Documents/2007/item10272.p...
Issued 2/27/08, and outdated two weeks later!
Look at last page - already some troublesome signs.
The Bear Streans news this morning seems to match your prediction exactly. Luckily, the Fed moved to back up Bear enough to keep it from toppling the rest of the market.
Socialism doesn't work. It looks nice on paper, but it's been tried and it's failed miserably every time (usually accompanied by widespread death and suffering).
Proud member of the V.R.W.C.
I (was) with Fred!
No particular prescience on my part. Vultures have been circling around Bess for months now.
Bear Stearns isn't out of money. But they're a broker-dealer, and they're the sell-side of a major part of the market's trading. And they also have a huge backoffice operation, clearing trades for all kinds of people.
Since they got involved in mortgage finance to an extent that none of the other Big Five firms did, there's a lot of questions about the quality of their portfolio.
If you're on the buy-side or you have Bear clearing your trades, you don't want even a whiff of a question about what's going to happen. As soon as there is a question, no one will trade with Bear anymore, and they will collapse.
And of course that would trigger a meltdown.
For people who remember the Long-Term crisis of 1998, the irony is so thick you can cut it with a knife.
In 1998, Bear Stearns was the preferred clearing agent for much of Long-Term's trading. And they were the ones that made the margin calls that triggered the collapse.
...the lead for playing that role.
I'm used to valuing technology companies, not financial companies. As far as I can tell, BSC has 36-odd billion dollars in balance-sheet cash net of long-term liabilities, and a total marcap (today) of 4 billion dollars and change.
This should be an easy acquisition, no? Especially if you discount the equity to something closer to what is probably its true value (zero).
with their Bear Stearns Bailout plan. Let the Taxpayer Bailout begin! Paulson thinks it is a good plan also and will turn the markets around. Dow down how much right now LOL!
Like I said yesterday-Liquidity is what is needed and lots more of it to come.
suppose it's possible the Fed could move aggresively enough to create calm. But based on what the current climate looks like - with Drudge screaming headlines like "Bear Stears bailed out by Fed" that there is a serious risk that even the Fed won't have the muscle to soft land this one.
Plus who knows what is hiding in the woodwork. Notice this quote two days ago from Bear Stearns chief Alan Schwartz.
"We don't see any pressure on our liquidity, let alone a liquidity crisis,” Mr Schwartz told CNBC yesterday. He said that Bear had finished fiscal 2007 with $17 billion of cash sitting as a“liquidity cushion”. He added: “That cushion has been virtually unchanged. We're in constant dialogue with all the major dealers, and I have not been made aware of anybody not taking our credit.”
Above from CNBC interview.
The tax payers will end up with a boat load of under collateralized Mortages, which if history holds true, means billions in losses and devalued Real Estate.