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Markets: Trouble in Paradise?
New York: August 06, 2007
By John R. Stephenson

Mama said there would be days like this, but this is getting ridiculous. The markets have been in a tailspin for a while now, with real fear in the air that things are going to get worse before they get better. Maybe. All this trouble is because of some shaky mortgages and a bunch of greedy private equity guys who offloaded boatloads of debt into the market to help finance their acquisitions.

It never seems to fail. A financial product gets invented, the regulators don't do anything about it, and the banks sell the crap out of it until it breaks. This time round the product was subprime mortgages.

Figure 1: The Dow Jones Industrial Average Takes a Tumble

It used to be that a mortgage was a very serious undertaking. Banks and other providers of mortgages used to scrutinize buyers carefully, making sure that they had a big down payment and were capable of writing monthly checks for decades to ensure that they could eventually own their homes free and clear.

Traditionally, banks that wrote mortgages carried them until maturity and earned the difference between the monthly payments and what it cost them to fund the loan. This system worked well, but limited the bank's capital to all but a select few who could come up with sufficient security (down payment) to be considered a good risk. But there were many renters eager for a slice of the American dream and the low interest rates coupled with another financial innovation — securitization made subprime loans a possibility.

By packaging a variety of mortgages of dubious credit quality together, investment banks could go out and find buyers for various tranches (slices) of these rebundled mortgages which were now known as mortgage-backed securities. Of course, certain buyers were skeptical and risk adverse. Institutions, such as pension funds, were afraid of the risk and needed additional inducement to purchase these mortage-backed securities based on looser credit lending standards (subprime mortgages). To induce these more skeptical investors to buy, investment banks created another product, a form of insurance, called credit default swaps, which were supposed to backstop these mortgage-backed securities should a problem arise.

These credit default swaps were backstopped by investment banks or hedge funds that guaranteed the loans for a given mortgage-backed security. The plan was a roaring success. The combination of low interest rates, loose lending practices and legions of eager homebuyers created a huge proliferation of these loans and accompanying insurance. Not only that, but hedge funds soon discovered that with low default rates on subprime mortgages, it was pretty easy to borrow like crazy to fund these collateralized debt obligations.

What resulted was a sea change in the U.S. mortgage landscape. Banks that once had to hold their mortgages to maturity all of a sudden simply wrote them and then sold them off to the market, frequently in a matter of weeks. With debt now becoming a liquid, fungible commodity, like oil and natural gas, the rush was on for banks to produce as much of this product as possible.

But banks weren't the only ones active in supplying loans to this exploding market, there were new players who sprung up to capitalize on this new bull market in loans to the U.S. housing sector. Nonbank companies such as General Electric and H&R Block, sprung up to make loans in this area and gobbled up market share.

And then the wheels came off. With interest rates starting to back up, there was a string of defaults and two huge hedge funds run by Bear Stearns and Co., a U.S. investment bank, started to unravel. All of a sudden, subprime loans had gone from a windfall to a pratfall for hedge funds and investment banks. The jig was up. It all worked as long as no one defaulted and the investment banks and hedge funds could trade this paper amongst themselves. Today, this is no longer the case.

With rumors swirling that yet another high profile hedge fund or investment bank is in trouble, there is nowhere to go to trade this type of product. There are few, if any, buyers and the ones that remain are asking for steep discounts if they buy these products. If you and I knew that our local grocery store had twice the fresh produce that they normally carry and they had to get rid of it, we'd wait until they really started slashing prices before we picked up any. All of a sudden, risk has come to the forefront.

Not only that, but for a while now, private equity firms have been taking many mid-sized manufacturing companies private and funding these purchases by issuing oodles of debt. Companies such as KKR and Blackstone Group specialized in levering up companies and stripping out the cash flows for themselves and their investors. But now, with the stock market stumbling and hedge funds and investment banks in full retreat, there is some $250 billion of financings that have been hung up looking for buyers for this debt. This has only made the problem worse.

But the problem that we have been witnessing lately in the stock market is not a problem of fundamentals (supply and demand), it is a credit-related problem. Interestingly, it has been the financials that have led the market down in the days when the steepest sell offs have occurred. Banks and hedge funds have been selling whatever they can get their hands on to lower their leverage and to fight another day. It will get worse before it gets better.

For savvy investors, there is a silver lining. The bet that we have been suggesting is that you orient your portfolios around the oil and gas, base metals, utilities, food processing and gold companies that should do well regardless of what happens in the U.S. housing markets.

While things are looking ugly in the U.S., that isn't the case in the rest of the world. Recently, the International Monetary Fund raised their global GDP forecast to 5.2% for both 2007 and 2008. Most of this growth is coming from the new global growth leader — China, which has been posting some pretty impressive numbers. While the market may remain a treacherous place for a little while yet, we are just setting the stage for another rally upward in the commodity-oriented producers who are levered to global, not U.S. led, growth.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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