Little could I know that just hours before filing this column Thursday, many of the fears expressed therein -- regarding the consequences of America's mortgage and credit mania -- would come to pass.
Yet, as this has been a near-constant theme in my columns for the past several months, the events of Thursday should not have taken Wall Street by surprise. Here is what I wrote the day before news of the combined impact of BNP Paribas (BNPQY, news, msgs) and quant funds rocked the markets:
Contemplating the nuances of the financial-dark-matter universe can confuse most people. One exception might be the word "conduit," readily understood to mean a channel through which something is transported. Innocuous enough, unless you're talking about structured-credit conduits. This variety has managed to snake its way to money-market funds. The potential threat to this safe investment is among the updates I'll share with readers this week, as I continue to chronicle the consequences of America's mortgage and credit mania.
However, Wall Street lately has focused not on the fallout but on hopes of a bailout, in the belief that Fannie Mae and Freddie Mac will be able to expand the size of their portfolios. Maybe Congress will give them the green light (though this is no sure thing), but it won't be enough to solve all of the problems. (It's just a variation of saying: Don't worry, everything is contained.)
More importantly, the whole notion that Fannie and Freddie should bail out the mortgage sector -- because of foolish behavior on the part of (a) the financial institutions that lent money to folks who could never pay it back if home prices didn't rise 6% annually and (b) the folks who bought a house they couldn't afford, because it just had to go up in value -- is anathema to capitalism.
Gambler Mae
The logical extension of that thought process would be: Let's go buy 100,000 shares of Google (GOOG, news, msgs), and if it doesn't work, we'll get Gambler Mae (the new entity created for all losses) to bail us out; or let's go to Las Vegas and put it all on black; or any other equally absurd examples we could come up with.One of the lingering problems of the Greenspan Fed, besides its legacy of bubble-blowing, is this idea that one should always be bailed out. However, as noted in the past, I believe that the problem is too big to bail out, and therefore it's not going to happen.
Quants on the outs
To bring readers up to date on the latest fallout, a friend called to my attention the problems at Highbridge Statistical Market-Neutral Fund (HSKAX), a quantitatively oriented vehicle that has been getting pounded lately. He thinks other supposedly "market neutral" funds may be doing quite poorly as well.Continued: Another crisis looms
Also, a reader of my daily column who works in quantitative finance wrote to me that "the next chapter of the credit story could be a collapse or outside losses in well-known and respected quantitative hedge funds." Though this hasn't gotten onto anyone's radar screen yet, it could be another hole about to spring in the dike.
On the back of a bank that barfed in Düsseldorf
Turning to losses abroad -- caused by investments here -- when the German bank IKB imploded two weeks ago, it was revealed that they had about $17 billion in subprime exposure and had lost $3 billion. IKB held these structured-credit assets in a conduit, which is a version of a special-purpose entity that banks use to own structured credit. More importantly, conduits are funded in the commercial-paper market. So, in addition to credit risk, it sounds to me like they are borrowing short and lending long, which is always dangerous when your assets are illiquid.Soon, most conduits will be updating their net asset values and rolling their commercial paper. In addition to those two potential data points, it's important to understand that in all likelihood, IKB won't be the last entity in trouble. As my "lord of the dark matter" friend notes, most of these European banks all pursued similar strategies. And I would say that if European banks were involved, U.S. banks probably were, too.
Conduit unbecoming
Meanwhile, a friend in the commercial-paper market (who wishes to remain anonymous) noted: "Yes, spreads have certainly widened on (A-1/P-1, top tier) ABCP (asset-backed commercial paper) conduits from about L - 5 (Libor minus 5) to now about L + 0 to + 3-ish. I think this is generally part of the fear of structured credit you're seeing in the market.With some of these ABCP conduits, a certain opaque nature exists surrounding the nonstandard methods of reporting or the standard definitions of certain asset types. So, one's not always sure exactly what type of collateral exists inside the conduit.
"ABCP has grown very dramatically in the past 15 years or so, and no investor has ever lost money. Hopefully, cool heads will prevail, as most money-market funds hold 50% to 75% ABCP, and banks or financial institutions are obligated to support nondefaulted -- and in some cases even defaulted -- assets in the conduits. So, implications for the financial system are large."
Money-market dark matter?
The moral of the story? As we get further down the road, I think we'll discover that some money-market funds owned commercial paper issued by a conduit whose assets may not be up to snuff. So folks with a lot of assets in money-market funds might want to double-check that they know what's in them.Bottom line: The upcoming weeks should be pregnant with indications of more trouble throughout the whole financial-engineering world. More than a few outfits may discover that the triple-A pieces of paper they thought were worth 100 cents on the dollar are worth only, say, something in the 70s. That will make for a lot of heartache.
At the time of publication, Bill Fleckenstein did not own or control shares of the equities mentioned in this column.
