Of termites and index mania

By Julian Delasantellis

My wife and I now find that we have reached the stage in our lives where our son and daughter-in-law ask us questions on how to be better homeowners, as the two of them have now been in their first home for more than a year. One of my choicest pieces of advice is, "If you see a termite, take it seriously, because there are probably tens of thousands more."

My wife and I are grateful that our son and his wife now, through the bracing gut kick of instantaneous maturity acquired by producing and nurturing our infant granddaughter (what sociologists call a "parental emergency"), know what they must do upon seeing a termite.

A few years ago, during their pre-parental militantly vegan days, they probably would have told us that they were organizing all the house's occupants, bipedal and multipedal, for voluntary attendance at a multicultural, omni-species, all-property group grievance and discussion session designed to raise consciousness of the Western patriarchy's historic oppression of the Isoptera order. Now they know: see one sign of trouble, don't ignore it - take immediate action.

Would that high-powered investors in US subprime mortgages had done the same.

In two Asia Times Online articles last March, I introduced readers to the woeful state of US real-estate lending to homeowners with less than stellar credit records and payback histories, what became known as the "subprime" mortgage market crisis. In my March 6 article, Rocking the subprime house of cards, I explained how the global equity-market selloff then under way was not, as the conventional wisdom was declaring, resulting from sharp selloffs in the Shanghai Stock Exchange. It was more due to a growing realization that the problems in the subprime market could spread to present insolvency problems for some of global finance's most highly respected names, such as HSBC and Bear Stearns.

My second article, The subprime dominoes in motion (March 16), illustrated how concerns about subprimes were affecting the stocks of the companies involved. The frontline subprime lenders, mostly fly-by-night suburban office-park lenders such as New Century Financial and Fremont General, saw their stocks decline 80% or more in just a few weeks, and even more "respected" US mortgage lenders, such as Washington Mutual and Countrywide Financial, were seeing their stocks suffer steep declines.

There it was, plain for everyone else to see. The first termite.

Very much in contrast to what they say in those soft-focus, soothing-themed television advertisements for stock brokerages, professional investors and traders at the great houses of money do not come to work, fire up their quote machine, and sit tethered to the trading desk for 12 hours of Brobdingnagian stress every day to finance your, or even their, retirement or child's education.

Good traders were probably able to fund those requirements for themselves in the first six months or so of their careers, and having done so means they sure don't have to care about doing the same for you. It has to be some other challenge that keeps them coming back every morning for another bracing dose of ulcers, cold Chinese food and hypertension. For many, if not most of them, what keeps them in the business is the challenge of beating an index.

Most people are familiar with traditional market indices such as the Dow Jones or the Nikkei, but in the past few years, a bewildering array of new indices have arisen that track just about anything and everything traded in the financial markets. You have big stock indices, small stock indices, very small stock indices, government, corporate and government agency bond indices, commodity indices, mutual fund indices, indices of other indices, even indices that measure the performance of hedge-fund managers.

Index mania originated out of University of Chicago Professor Eugene Fama's Efficient Market Hypothesis (EMH), which stated that investors could not consistently outperform benchmark indices of whatever sector they were investing in. The theory originally was meant to apply mainly to stock investing, with the performance comparisons being applied to long-established indices such as the Dow or the S&P 500, but eventually, indices were established as benchmarks across the full spectrum of current investment.

This served two purposes. For those who believed the EMH, and thus thought the search for outperforming individual stocks, bonds or whatever ultimately fruitless, index-specific investment products were formed that allowed low-cost (no need to pay those pricey fund-manager salaries) investment in a specific index, with profits or losses accruing with concomitant moves in the index.

The second main function of financial-market indices is that they give ambitious fund managers a specific numerical target for which to aim to beat. Traders whose investment performance beats their specific sector index get big fat bonuses and press releases from their firms touting their accomplishments - even more so if they beat both the index and the other traders in their sector. As for the trader who can't beat the index - well, he might have been the guy from the dealership who sold you your new Buick.

Therefore, it should come as no surprise that an index has been established to track the performance of subprime mortgage loans bundled together and then sold to bond buyers seeking higher yields than traditional US Treasury or high-grade corporate debt. This instrument is called an ABX index.

The specific ABX index most applicable to subprimes, the ABX-HE-BBB-, started the year just under 100, and then, as whispers of subprime difficulties started to spread through the markets and, in early February, as HSBC confirmed that, at least for that bank, the rumors were true, the index fell to 77.5 by late February.

As it dawned on the world's investors that there might be a nightmare of spreading financial insolvency wrapped in the core of the great American dream of universal home ownership, the world stock selloff of the last week in February and the first week in March at last diverted the media's attention from the more important story they had been covering, namely where Anna Nicole Smith's methadone-pickled corpse would be interred.

Then, as the financial markets are frequently wont, the unexpected happened - nothing.

Things started to look brighter than the gloom and doom that pervaded the financial markets in early and mid-March. the US and world equity markets recovered (as did, to a much lesser extent, the ABX), quickly surpassing the levels of late February prior to the selloff. Although any and all of the statistics that measure the health of US real estate (new and existing home sales, prices, mortgage delinquencies or foreclosures) were coming in far weaker than in previous years, it began to be thought that the basic underlying strength of the US economy would act as a counterweight to the problems in the real-estate sector.

It was delicately noted that many of the subprime borrowers had skin colors other than white; if Wall Street had gone more than 200 years without caring about this population, it sure wasn't going to start now. (A Fox News financial commentator even used the subprime crisis as an argument against Bank of America's policy of giving credit cards to undocumented workers - as if US finance had to be forever vigilant against the dangers of extending excessive credit to "those people".)

Most important, it was thought that few of the great houses of US finance had been so rash as to have been much involved with subprimes.

It was surmised that many of the home-mortgage borrowers who got into trouble taking out more of a subprime mortgage than they could handle would be spared the ultimate sanction of foreclosure, since that option was said to be a difficult, time-consuming and not particularly profitable option for the lenders (not to mention being absolutely catastrophic for the borrowers).

Indeed, late May saw reports that some hedge funds (those without ongoing relationships with public relations firms, no doubt) were actually unhappy with what they saw as the sluggish pace of lender foreclosures. These funds had initiated trades that hoped to profit from a further fall in the ABX; for them, foreclosures would have in essence represented a climactic consummation of the act of seeking bliss from the gathering financial misery of the subprime borrowers.

And so, as June began, the sound of corks popping out of champagne bottles drowned out the sound of the termites continuing to eat through the foundation underneath US finance capital. Then it happened. Somebody put his hand through the wall, or tried to nail a picture, and all the sawdust started pouring out.

In my July 6, 2006, article Hedge funds: Playing dice with the universe, I explained that one of the major reasons hedge funds were able to exert such disproportionate market influence was that, besides the substantial pools of money the hedge funds were raising from their investors, they were also funding the huge positions they were taking in the markets with substantial borrowing, what the markets call leverage, in amounts sometimes up to 20 times their capital base.

The Bear Stearns brokerage house thought it had come up with some really neat ideas. It would set up two in-house hedge funds, the Bear Stearns High-Grade Structured Credit Strategies Fund and the High Grade Structured Credit Strategies Enhanced Leverage Fund. The funds' strategy for achieving those juicy hedge-fund-type returns would be to invest in pools of subprime mortgages bundled together with other loans into bond packages called collateralized debt obligations (CDOs).

Then, Bear Stearns had an even better idea. It would not just buy the CDOs and then sit on them until the mortgages were paid off in 10 or 20 years or so; that would have earned the funds a return roughly equal to the coupon yield of mortgage bonds, about 8-10% a year. That's a decent enough return for us average investing mortals, but for hedge-fund managers obsessed with having their names and pictures at the top of the performance rankings, it wouldn't even get them in line to rent a chaise longue at a public beach in the Hamptons - a popular vacation spot on New York's Long Island - this summer.

In today's era of turbo-finance, the distinctions between who the borrowers are and who the lenders are have become blurred; many borrowers borrow so they can immediately turn around and lend the proceeds to others, who will then do likewise. For Bear Stearns, instead of just buying the CDOs and sitting on them for a decade or two, it would now have the funds use them as collateral for big new loans from other financial institutions.

With the borrowed money, they could go back into the market and buy lots more high-yielding subprime-mortgage-based CDOs, in essence using the borrowed money to do more lending. Their high yields would substantially boost the reported returns of the funds and, since returns are measured against the percentage appreciation of the fund against its capital base, not the leveraged base, the funds would instantaneously be able to report much higher rates of return. For the fund managers, the temptation was irresistible - a better life and a shiny trophy wife were just the next reporting period away.

As long as the CDOs that Bear Stearns borrowed against maintained their value. As long as the ultimate money behind the CDOs, the homeowners who actually took out the subprime mortgages that made their way into the CDOs, kept making the mortgage payments that got passed through to the owners of the CDOs.

Uh-oh.

By early June, Bear Stearns and other titans of US finance had, both as borrowers and lenders, their subprime-based paper spread all over Wall Street, and that definitely presented a problem. The lenders who had accepted Bear Stearns' paper as collateral saw the price of the ABX index heading south once more, and knew that it meant that more subprime mortgage holders were becoming delinquent, and thus facing foreclosure, on their loans.

Of course, this implicitly reduced the value of the CDOs that Bear Stearns had proffered to be used as collateral. (I say "implicitly" because no one really knows what these CDOs are worth at any given moment - they are not traded, with reportable trade results, as are stocks and bonds. In financial-markets lingo, this is said to make them "illiquid".)

This put the lenders in a fairly tricky position. Written into the loan agreements in which they lent money to Bear Stearns' hedge funds were covenants that in essence allowed the lenders to seize the collateral that Bear Stearns put up as security, the CDOs. In essence, the lenders had the right, like Harry Dean Stanton and Emilio Estevez in the 1984 cult classic Repo Man (but without the glowing aliens or the weirdo nuclear scientist) to repo the CDOs and take them back to the yard.

This presented the lenders with another dicey situation. Much like the players in the classic game-theory exercise Prisoner'S Dilemma, there was a tremendous incentive for the lender who acted first; later lenders might find that quicker players might have already seized all Bear Stearns funds' capital away.

It was Merrill Lynch that sent the tow trucks in first.

So what did they get when they lowered the CDOs down from the hook?

Do you want to borrow some money from the bank, using the equity in your home as collateral? Fine, "just write us at the bank a check for about $500, so we can hire an appraiser to check your home's current worth". A core way that will be done is to have the appraiser check the recent sales prices of comparable homes in your neighborhood, what the trade calls "comps". No way will the bank allow you to borrow anywhere near what your house is worth. If you default, the bank wants to be sure it can get back the value of the loan through a foreclosure sale of your property.

Bear Stearns had to go through no such indignity. As CDOs are not actively traded in any secondary market, there were no available comps to compare their value against; in market jargon, they cannot be "marked to market". Instead, the international bank capital reserve regulations known as Basel II allow CDOs to be valued through an arcane process called "marked to model".

This involves Bear Stearns hiring some hungry underemployed math PhD, and having him construct a CDO pricing "model", in essence a series of complex algorithms, that allowed the company to enter a CDO's particulars on the front end, and then having the model spit out a SWAG (scientific wild expletive-for-posterior guess) value to Bear Stearns' liking out of the back end. The lenders, Merrill Lynch among them, knew full well the questionable nature of the process that valued the loans; then again, Bear Stearns was paying them a whole lot more on their loans than US Treasury bills were paying.

Merrill Lynch's traders virtually tripped over their Bruno Maglis in their rush to sell the seized CDOs. When they did, boy were they in for a surprise.

The CDOs were not fetching anywhere near the values the pricing models said they should. On June 24, New York Times finance columnist Gretchen Morgenson wrote an article about this; her editors gave it the title "When models misbehave"; evidently, the Old Gray Lady's honchos were hoping to get some interest from Times readers leafing through the business pages on the way to check the latest Paris Hilton news.

The Gospel of John teaches that "the truth shall set you free"; in 1881, US president James Garfield tacked on to the scripture the pithy addendum that "first, it will make you miserable". Instead of marking to model, holders of CDOs could now mark them to true market values, and yes, this made them really miserable.

Many of America's most illustrious names of finance, such as but not limited to Merrill Lynch, had been using them as capital reserves for high-powered lending or, like Bear Stearns, as collateral for borrowing. Basel regulations no longer allowed them to mark to model; in essence, just as in real-estate lending, there were now "comps" that were representing actual, much deflated prices.

The basic purpose of capital-reserve regulations is to make sure the value of loans made by financial institutions bears at least some relationship to the actual assets possessed by the institution. This prevents the tendency of capitalist economies to go through wild cycles of credit-fueled boom and bust. A bank with $100 in deposits cannot, much as it might like to, make $100 billion in loans. Various ratios exist for how much can be lent out per each particular type of asset held as a reserve.

This process can, and recently actually has, acted as a great wealth-creation machine when the underlying assets of the reserve holdings stays stable or goes up, as it allows a huge infusion of new capital into the world's money supply. It, the employment of once-dormant assets to facilitate massive new lending, is the primary reason for the great flood of world monetary liquidity that has supported inflated prices for everything from North African equities to Elvis Presley memorabilia.

But things are quite different when you throw the machine into reverse, as is happening now with the subprime CDOs. If the value of the underlying reserve assets declines, then Wall Street must pull back on the quantity of lending that it can base on it. This process is a lot like watching a video of a building being constructed in reverse as, brick by brick, the great edifice disassembles.

The fear that stalked the world's markets in March has returned. Bear Stearns has announced that it will provide up to $3.2 billion so that one of its struggling subprime hedge funds, the High-Grade Structured Credit Strategies Fund, can liquidate itself in an orderly fashion; for investors in the other fund, the more aggressive High Grade Structured Credit Strategies Enhanced Leverage Fund, well, for them, all the lifeboats seem to have left.

Even as US stock markets trade nervously around their recent highs, the Chicago Board Options Exchange's VIX volatility index, the fever thermometer for stock-investor unease, pushes back toward its March highs. The initial public offering of the private equity Blackstone Group (see my Febtuary 22 article on private equity, The highs and lows of buyouts) has foundered, with the stock now trading well below the IPO price. Considering how substantial a role private equity has played in the rallies of the world's major stock markets recently, this is certainly an ominous sign.

ABX subprime indices are pushing to new lows. If you would like a side order of Weltanschauung (knowing the current state of things) with your Schadenfreude (taking pleasure from the misfortune of others), check out the I Am Facing Foreclosure weblog (iamfacingforeclosure.com). Here lies a contemporaneous, near-Wagnerian saga of a young Californian's 2005 glorious rise to the heights of financial Valhalla, and current flaming fallback into earthbound insolvency, all effected by attempting to flip one two many investment properties.

One in five subprime mortgages is either seriously delinquent or has entered foreclosure; the real fear is that this number will skyrocket this year when millions of subprime mortgages taken out over the past two years with low initial "teaser" interest rates reset to rates well above current market rates. Very much unlike what they were told by their real-estate or mortgage brokers when they originally bought their houses, most of the borrowers have neither the equity in their homes (which is actually declining) nor the improved credit scores to bail themselves out of this situation with the real-estate industry's traditional life-preserver, a refinancing.

As these homes hit the market through foreclosure sales, further supply pressure will be put on a real-estate market already reeling from what could be only the commencement of this process. Like autumn following summer's joy and then winter's desolation following upon that, any economic historian will tell you that what is happening now in US real estate is only the natural turning of the economic cycle. The leaves of the boom have faded and fallen away, soon to be followed by lamentations resultant upon the bare branches of winter's bust.

In the fetid slough that is today's US public debate, it has been said that the entire subprime mess is only the expected result of attempting to make proper middle-class homeowners out of an underclass that lacks sufficient moral fiber to be so; all this proves is that, much like the current debate on illegal immigration, there will always be receptive American ears listening for any argument that blames all of today's troubles on people with black and/or brown skin.

The real moral deficiencies that led up to the subprime crisis are not on Main Street but on Wall Street. It was there that greed hatched the idea to turn the once-staid and predictable market for housing finance into something that could earn those big fat top-of-the-hedge-fund-rankings returns. In this tragedy, the only actual role of the borrowers was something like that of Beaker on the US children's TV program The Muppet Show, a helpless and hapless subject of another one of Dr Bunsen Honeydew's bizarre quasi-scientific experiments at Muppet Labs. They tried to mate a pokey groundhog, the slow and steady previously existent market for housing finance, with a glamorous thoroughbred, today's turbo-finance, and, in doing so, may just have killed both of them.

The I Am Facing Foreclosure site is up for sale. Down the street from where I live, in what is thought to be America's last red-hot housing market, a prospective development of 50 single-family homes, cleared out of the verdant northwestern US forest last winter with bulldozers and ambition, lies dormant. The wind whistles both through its acres of still-undeveloped dirt and some prospective real-estate entrepreneur's fading dreams of riches and glory.

As the rockets glare red and the bombs burst in the air over another US Independence Day this Wednesday, in the housing sector, winter falls soon.

Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.

(Copyright 2007 Asia Times Online Ltd. All rights reserved.)