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At 7:30 a.m. in New York, the largest maker of mortgages in the U.S., Countrywide Financial, said it was tapping $11.5 billion in bank credit lines, a sign that it was unable to raise money in financial markets as it had been. This was a development more serious than another hedge fund running into trouble. "When you start talking about Countrywide," said one senior Wall Street executive, "that's kind of America. At the end of the day, we're talking about Mom and Pop and the right to own a home." Just before noon New York time, near the end of the London trading day, the yen suddenly surged against the dollar, rising 2% in just minutes and crushing currency-market players who hadn't anticipated such a sharp move. On the London trading floor of Goldman Sachs Group, phone lines lit up in unison, and some salesmen wielded two phones at the same time. They were shoving and grabbing each other to get in front of traders, and shouting orders to execute trades, according to eyewitnesses. Shortly afterwards, investors began piling into the shortest-term U.S. Treasury securities, which are considered safe because they're backed by the U.S. government. The yield on three-month bills, which had been around 4%, dropped as low as 3.4%, and the gap between yields on T-bills and corporate commercial paper widened sharply. "It was an extraordinarily violent move," said Jason Evans, head of government-bond trading at Deutsche Bank. "It became clear that the market was at a point of distress and expected a response" from the U.S. Federal Reserve. These shocks reflected one of the most perilous days for global credit markets, the circulatory system of the international economy, since the 1997-98 crisis that began in Asia, spread to Russia and Brazil and eventually to the U.S.-based hedge fund Long-Term Capital Management. On Friday morning, following a conference call the previous evening convened by Chairman Ben Bernanke, the Fed blinked. Just 10 days after declaring that inflation was still its predominant worry, the Fed declared "downside risks to growth have increased appreciably" and hinted that it may soon cut its target for short-term rates. In an unusual move, it also encouraged banks to borrow directly from the Fed and made such loans more attractive. In essence, the Fed is following advice that British journalist Walter Bagehot offered in his 1873 book, "Lombard Street," a copy of which Mr. Bernanke kept on a shelf when he was Princeton professor. In times of "internal discredit" -- when uncertainty leads private players to pull back -- the prescription to the central bank is: Lend freely. "A panic...is a species of neuralgia, and according to the rules of science you must not starve it," Bagehot wrote. "The holders of the cash reserve" -- today's central banks -- "must be ready . . . to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to 'this man and that man,' whenever the security is good." The initial reaction of U.S. stock and credit markets to Friday's Fed move was favorable. The interest-rate spread between U.S. government bonds and some riskier bonds shrank slightly, while the Dow rose 1.8%. In early Tokyo trading today, stocks surged more than 3%. It isn't clear yet how many big banks responded to the Fed's encouragement to borrow at what is known as the Fed's discount window. Hard data won't come until the Fed releases its routine tally on Thursday -- unless the Fed or the banks volunteer information. One big bank told the Fed that, though it doesn't need the money and could get it more cheaply, it will borrow $100 million today as a gesture, according to a person familiar with the bank's plans. And one Wall Street firm said it planned to offer collateral to its bank, assuming the bank in turn would offer it to the Fed as collateral for a discount-window loan. Going Back to the Real Begining It began on Tuesday, Aug. 7, in Europe. Shortly after 9 a.m., on the second floor of the European Central Bank's 37-story glass and metal office tower in Frankfurt, the bank doled out 292.5 billion Euros in its regular weekly financing operation. Commercial banks were flush with cash, yet money-market rates -- the interest charged by banks when lending to one another -- were rising. Something was eroding the banks' willingness to lend. On Wednesday, the ECB noticed volatility increasing and credit spreads rising. More money was flowing into safe havens such as two-year German government bonds, and reports of tensions in the commercial-paper market were circulating. By evening, it was clear the ECB had to intervene to keep market rates from rising well above the central bank's previously set target of 4%. President Jean-Claude Trichet and Vice President Lucas Papademos were in touch with Fed officials. With market rates nearly three-quarters of a percentage point above the target, ECB staffers charged with monitoring liquidity met at 8:45 the next morning, about 90 minutes earlier than usual. They recommended that the central bank take the biggest move in its nine-year history -- an unlimited offer of funds to the banking system at its 4% target rate. Members of the Executive Board approved the decision. At 10:26 Frankfurt time, screens across the world flashed the message: "The ECB notes that there are tensions in the euro money market notwithstanding the normal supply of aggregate euro liquidity. The ECB is closely monitoring the situation and stands ready to act to assure orderly conditions in the euro money market." At 12:32 p.m., the ECB announced that it would accept all bids to borrow money made by 1:05 pm. The announcement sent shock waves through the market. At 2 pm, the ECB said it was lending 94.8 billion Euros in one-day funds, bigger even than its initial reaction to the Sept. 11, 2001, terrorist attacks. That night, JP Morgan's senior European economist, David Mackie, said, "For the last few days, people have been worried that [the subprime crisis] would translate to a broader liquidity issue. I think the surprise is that it happened in Europe, rather than in the U.S." In the days that followed, the ECB repeatedly put money into the markets. To a lesser degree, so did the Fed and other central banks. On Friday, Aug. 10, following an early-morning conference call among Fed policy makers, the Fed assured the markets that it would do what was necessary to keep the economy lubricated with cash. By Tuesday, Aug. 14, Mr. Trichet, who was in and out of Frankfurt while trying to take a vacation, issued a statement saying that conditions in the euro zone had gone "progressively back to normal." But that would prove overly optimistic. On Wednesday, a real-estate affiliate of Wall Street buyout titan Kohlberg Kravis Roberts asked investors to accept a six-month delay in repayment on $5 billion in commercial paper. That night, Countrywide notified banks that it was going to draw on its prearranged credit lines, a move hastened by a Merrill Lynch analyst's warning that Countrywide could face bankruptcy. Countrywide bonds plunged, and the price of insurance against a default soared. At one point Thursday morning, it cost $1.1 million per year to buy protection for every $10 million in Countrywide debt. Countrywide's woes posed a particularly severe risk to the economy, officials in Washington realized. It is a major force in the market for jumbo mortgages, those greater than $417,000. By law, the government-sponsored mortgage investors Fannie Mae and Freddie Mac cannot buy these big mortgages. The Carry Trade Unwinds Markets overseas were going haywire too. Until the credit crunch, many investors had engaged in the carry trade, borrowing money in Japanese yen, a low-yielding currency, and converting the yen to higher-yielding currencies such as the U.S. dollar and the Australian dollar. Now, facing big losses, some investors needed to unwind these trades, and the yen shot up in value. So many traders were trying to unload the Australian currency that Australia's central bank intervened to restore order for the first time in six years. In Canada, a group of banks and investors had to rescue faltering issuers of 130 billion Canadian dollars (US$121 billion) in commercial paper. Banks Start Talking to the Fed At one point on Thursday, three big banks -- J.P. Morgan Chase, Citigroup and Bank of America -- discussed with the Fed the possibility of borrowing a total of $75 billion to be used to buy asset-backed commercial paper, mortgage-backed securities and other instruments. Fed officials say they welcomed the creativity. They listened to some ideas without comment, and in some cases explained that the suggestions were outside the Fed's normal legal authority. For several days, Mr. Bernanke pondered options with his confidants. They included the Fed's vice chairman, Donald Kohn, an economist who was one of former Chairman Alan Greenspan's closest aides; and Timothy Geithner, president of the New York Federal Reserve Bank and a protégé of former Treasury secretaries Robert Rubin and Lawrence Summers. The officials were looking for a maneuver dramatic enough to shore up confidence, while avoiding a cut in the Fed's main interest rate, the federal-funds rate. Mr. Bernanke was still not convinced the economy needed a cut, and some Fed officials feared it might encourage more of the sloppy lending that led to the crisis. The Fed Cuts the Discount Rate They began to look more closely at the discount window. Banks remain well-capitalized and profitable. But they appeared reluctant to provide credit to companies, issuers of commercial paper and even each other, perhaps out of uncertainty over the safety of their customers or their collateral. Eventually, Fed officials agreed to reduce the rate charged on loans from the discount window (to 5.75% from 6.25%) and try to reduce the usual stigma associated with such loans. By making these direct loans to banks more attractive, the Fed hoped to reassure banks that they could borrow if they needed to -- without the usual penalty to their bottom line or to their reputation -- and thus make them a bit more willing to lend in normal fashion. In addition, in its public statement Friday morning, the Fed made what amounts to a vow to cut its target on the federal-funds interest rate if normalcy fails to return. That is the key rate that the Fed normally lowers when it wants to loosen monetary policy. The Fed believed this combination of moves would assure everyone that it was aware of risks to the U.S. economy posed by the market turmoil. Particularly at times of stress, what the Fed says can be almost as powerful a weapon as what the Fed does. So Mr. Geithner, whose job makes him the traditional liaison to Wall Street, turned to a convenient forum, the Clearing House Payments Co., which is owned by a group of banks and operates much of the plumbing of the nation's financial system. To avoid the inevitable headlines -- and comparisons to the 1998 rescue of Long-Term Capital Management, when financial executives were summoned to the New York Fed's fortress-like headquarters -- Mr. Geithner sought a 15-minute telephone conference call. On the call were commercial bankers who work with Clearing House as well as several top investment bankers, among them Zoe Cruz, co-president of Morgan Stanley; James Cayne, chief executive of Bear Stearns; Joseph Gregory, president of Lehman Brothers; and Stan O'Neal, chief executive of Merrill Lynch. Joined by Mr. Kohn, but not Mr. Bernanke, Mr. Geithner told banks about the discount-rate cut and said they could wait up to 30 days, instead of just a day, to pay back their discount-window loans. "We will consider appropriate use of the discount window . . . a sign of strength," said Mr. Geithner, according to a participant. Seth Waugh, chief executive of Deutsche Bank AG's Americas unit, told those on the call that it was important for discount-window borrowing not to be seen as a sign of financial weakness. "You need some safety in numbers," Mr. Waugh said, according to a person who was listening. He said the Fed needed to make clear it "will be there for as long as it takes to restore liquidity." Another banker participating in the call said of the Fed, "What they came up with is pretty ingenious." Investment banks or hedge funds that hold mortgage-backed securities can't borrow from the Fed directly, but they can bring those securities to banks. In turn, the banks can offer the paper as collateral to the Fed for a 30-day loan. The Fed "really wanted to drive home the point that if [bankers] were complaining about not being able to borrow money against liquid, high-quality securities -- mortgages -- we have no more basis for complaint. We were all given a clear message," says this banker. Bond markets on Friday were calmer, although not completely won over by the Fed's move. The price of two-year and 10-year Treasury bonds fell slightly, suggesting demand for these safe investments wasn't as great as before, although the price of three-month Treasury bills rose. The difference between yields on junk bonds and Treasury bonds slipped to 4.48 percentage points, from 4.59 percentage points on Thursday, according to a Merrill Lynch index, in a hint that tolerance for risk was recovering somewhat. These are the kinds of measures that will be watched closely this week, to see whether the destructive cycle of declining confidence and illiquid debt markets has halted. If it doesn't, the Fed will likely cut interest rates on or before Sept. 18, the date of its next scheduled policy meeting.
In both 1987 and 1998, stocks fell sharply starting in July or August and, although markets seemed to stabilize by September, they abruptly plunged again, and didn't come out of their tailspins fully until October. Whether stocks will suffer a similar fate now, or escape it due at least in part to timely Fed action is the big question on investors' minds. In the previous two cases and again this time around, market downturns turned into routs as computer-based stock-trading models blew up in the faces of the investors who used them. The crash of 1987 took place during the original buyout boom, which bullish investors said would keep stock prices high for years. And 1998 was the year Long-Term Capital Management almost imploded, forcing the Fed to step in to calm credit markets. Big corporate buyouts, such as TXU's $32 billion buyout and student lender SLM's $25 billion deal, have formed part of the backdrop to this year's trading. So have battered hedge funds: Two funds at Bear Stearns lost almost all their value after investing in securities linked to low-quality mortgages. ln 1998, the Fed wound up intervening three times, because its first attempt proved insufficient. In 1987, the Fed didn't intervene until after the crash, although when it did step in, it succeeded in stanching the bleeding. This time, as in 1998, the Fed has tried to intervene before things get worse. But unlike Greenspan in 1998, Bernanke has taken a gradualist approach. He has cut the rate the Fed charges to provide cash to the banking system. But he has avoided cutting the more broadly influential federal-funds rate, which governs banks' prime lending rates. A cut in the federal-funds rate would more directly help small borrowers, but the Fed fears it also could rekindle inflation. As in 1987 and 1998, one of the most unsettling aspects of the past weeks' selloff is that stocks are falling and people don't fully understand why. A big reason in each case was the role of computers programmed by people who were supposed to be market geniuses. This time it was hedge funds using mathematical models, whose forced selling contributed to huge market swings and massive trading volumes over the past few days. The hedge funds, many of whose models were strikingly similar, had to unwind unsuccessful trades involving millions of shares after troubles in the mortgage markets bled into the stock market. The sight of unknown sellers using computers to sell millions of shares of many different stocks, while buying millions of shares of other stocks, sowed panic among other investors. "It caused so much mass buying and selling that the market couldn't easily handle it. It was almost like trying to get a stampede of elephants through a small door," says Gordon Fowler, chief investment officer at Glenmede Trust, who witnessed similar breakdowns in computer models in 1987 and 1998. The models on which investors relied in 1987 were known as portfolio insurance. The portfolio-insurance models called for investors to protect themselves from losses by making sales in stock-futures markets if their actual stock holdings fell a predetermined amount. The models, which were based on detailed analyses of market history, didn't take into account what would happen if everyone using these models all tried to do it at the same time. Markets couldn't absorb all the sales demands, and the selling pressure helped cause the 1987 crash. "The models du jour failed in both 1987 and 1998," says William Hackney, a managing partner at Atlanta Capital Management. He remembers being amazed at the stock gains earlier in 1987, despite rising interest rates and inflation. Only later did he realize that people had felt free to behave recklessly because they had "portfolio insurance." Indeed, in all three years, market turmoil was made worse by overconfident investors using borrowed money. The unwinding of all of that leverage, or borrowing, can be brutal because as stock prices fall, investors are forced to sell stocks to pay back their loans, creating a downward spiral. In 1998, the blowup that forced the Fed to act came at a multibillion-dollar hedge fund called Long-Term Capital Management, which had become the dominant player in the Treasury-bond market. In the summer of 1998, LTCM was making highly leveraged bets against Treasury bonds and in favor of other bonds, including those of Russia. Its models showed the risk of losing money that way to be minuscule. When Russia nonetheless defaulted on its debt payments, LTCM faced bankruptcy until the Fed helped persuade a group of banks and brokerage firms to rescue it. For a while, the incident soured many investors on computer models and borrowed money, but with time, new models emerged and began showing large gains. In response, investors pulled billions in investments away from traditional "long-only" money managers, who simply tried to pick which stocks would do best. The latest vogue was for quantitative, market-neutral hedge funds, which were supposed to avoid market gyrations by betting on gains in one large group of stocks, bonds or currencies, while simultaneously hedging their risks by betting on declines in other large groups. "At dinners with other managers, I would hear people talk about how they have 'quant' models, or that they were long-short managers or market-neutral managers. They would look at me like I was a dinosaur," says Hersh Cohen, co-chief investment officer at ClearBridge Advisors, which manages $100 billion in the traditional way, by actively choosing which stocks to buy. "Now I realize that what sounded impressive was not much more than a thing we saw played out in 1987 and 1998," says Mr. Cohen, who managed money during both of those crisis years. Another big lesson of all three years is that it is the debt markets that often pose the biggest threats to stability in the stock market. In 1987, it was rising interest rates that eventually sent stocks plunging. In 1998, it was the risk that the collapse of LTCM could roil the bond markets. Lately, it has been securities backed by high-risk home mortgages that had found their way into a wide variety of investment portfolios. The mortgage securities were so widely held that, when they went bad, they caused credit markets to freeze up, hurting other, higher-grade bonds. As in 1987, huge investment funds used junk bonds in recent years to take over companies once thought too big to be acquired. In 1987 and again this year, the market suffered once buyouts started to face trouble. "My view of booms is that they generate laxity in standards for loans because there is a general sense of optimism. That is what we saw in the late 80s," says Yale's Prof. Shiller. Also supporting stocks in 1987, as well as in recent months, were a strong world economy and healthy corporate profits, which investors expected to last for years. Both times, the sudden stock declines shook those hopes. In all three cases, markets turned increasingly volatile. Sharp drops earlier on proved to be temporary affairs, helping create a false sense of optimism. To be sure, there are also some big differences. One is valuation -- stock prices compared to companies' underlying value. Valuation looked excessive in 1987, with stocks trading at more than 20 times corporate profits. Price/earnings ratios were similarly high in 1998. This time around, the ratios remain in the teens, close to the post-1945 average of about 16. The real excess this time has been in lending markets, where investors bid up mortgage-related securities and junk bonds to unheard-of levels, and where investment banks invented novel bond-like securities. One reassuring difference is that, in the previous crises, problems developed in the bedrock Treasury-bond market. This time, Treasury bonds remain an island of relative tranquility. Another hopeful sign: In both 1987 and 1998, the market's woes were severe but brief. Despite the sharp market drops (more than 36% in 1987, and nearly 20% at one point in 1998), the Dow Jones Industrial Average finished both years with gains. It was up 2.26% in 1987 and 16.1% in 1998, and the S&P500 index was up both years as well. Although memories of the 1987 crash still make some investors shiver, that day -- Oct. 19 -- actually marked the bottom of the bear market. The next day, stocks began to recover, beginning a new bull market. One reason for the quick rebounds was prompt action by the Fed, and another was that the economy avoided recession in both 1987 and 1998. But the fast rebounds led to more excess, and more abuse of borrowed money. The buyout boom resumed in 1988 but went bust in 1989, when a proposed buyout of United Airlines fell through and the junk-bond market plunged. The Dow industrials fell into a bear market in 1990, as recession arrived. The consequences of the post-1998 tech-stock excess were worse: the 2000-2002 bear market. Besides valuation, Fed intervention and the economy, investors need to watch for other corporate and hedge-fund blowups to get an idea what might lie ahead. The longer it takes to work these problems out, the more likely credit and stock-market problems will be to spill over into overall economy, causing a slowdown, or worse, a recession. "When the market does recover, it should recover quickly," more like 1987 and 1998 than 2000, says Burton Malkiel, a Princeton University economics professor. But Prof. Malkiel doesn't think the hedge-fund blowups are over yet. "It is undoubtedly the case that we will be reading about more now," he says. "It is not just the Bear Stearns one and the Goldman Sachs one. Undoubtedly, a lot of those funds were more highly leveraged in some of those investments that now are no longer profitable. A number probably bought mortgage-backed securities that they didn't completely understand."
In the past few weeks, shaky mortgage loans to Americans have emerged in the portfolios of hedge funds, banks and investment vehicles in Australia, Germany, France, Singapore, Korea, China and elsewhere. As a result, investors began looking to pull money out of hedge funds with exposure to the sector. They pulled their money out of other places, too. "Because some of the exotic securities aren't really tradable now, people are getting liquidity by going to other markets" to sell assets and raise cash, he says.
"A massive unwind is occurring," says Tim Krochuk, managing director of GRT Capital Partners, a Boston investment manager. Buying and selling by hedge funds are "pushing those crummy names higher, and pushing names you like lower." The markets' volatility of the past few weeks has taken a toll on quant funds, notably a once-highflying hedge fund at Wall Street's Goldman Sachs Group Inc. Global Alpha, Goldman's widely known internal hedge fund, is now down about 16% for the year, according to people briefed on the matter. The fund manages about $9 billion. Since mid-July, Mr. Krochuk says, shares of companies that quantitative models "screen" as having improved fundamentals have performed worse than the shares of companies whose fundamentals have deteriorated. On Thursday, Standard & Poor's index of pure value companies within the S&P 500 index -- that is, precisely the companies whose shares investors would tend to flock to in times of trouble -- fell 3.4%. The S&P 500 itself fell by a smaller 3%. Even before the selloff, it was becoming difficult to make money using quantitative methods to go long some stocks, short others, and pocket the difference. Earlier this year, Merrill Lynch quantitative analyst Savita Subramanian calculated that the returns managers were generating using long-short strategies were at an 18-year low. Some quant funds have tried to amplify returns by using more borrowed money, or leverage, to invest. But using leverage also amplifies losses, opening up the risk that lenders will demand more collateral for loans. Such margin calls can force funds to liquidate positions. Merrill Lynch strategist Rich Bernstein believes that part of the problem may be that some quant funds didn't put enough history into their models. In the aftermath of the 2000 dot-com bust, volatility increased and value stocks did better than the overall market. But Mr. Bernstein says that that hasn't been the norm historically, and that in previous periods of increased volatility, value stocks actually did worse. "The bubble in 2000 skewed things," he says. "Anybody who built a quant model that was based on just the past 10 years of data probably underperformed pretty badly." But the price moves prompted by quant funds unwinding positions is, in a sense, artificial, and once they've finished their selling and covered their shorts, prices should readjust, says Mr. Krochuk. "Can the market really continue to favor companies that are doing worse? It's just not sustainable," says Mr. Krochuk. "A lack of leverage and patience are going to be very well rewarded."
The investment banker’s problem was that he was taking out a so-called jumbo mortgage — a loan greater than the $417,000 mortgage that can be sold to the federally chartered enterprises, Freddie Mac and Fannie Mae. The market for large mortgages has suddenly dried up. For months after problems appeared in the subprime mortgage market government officials and others voiced confidence that the problem could be contained to such loans. But now it has spread to other kinds of mortgages, and credit markets and stock markets around the world are showing the effects. Those with poor credit, whether companies or individuals, are finding it much harder to borrow, if they can at all. It appears that many homeowners who want to refinance their mortgages — often because their old mortgages are about to require sharply higher monthly payments — will be unable to do so. Some economists are trimming their growth outlook for the this year, fearing that businesses and consumers will curtail spending. “In the last 60 days, we’ve seen a substantial reduction in mortgage availability,” said Robert Barbera, the chief economist of ITG, a brokerage firm. “That in turn suggests that home purchases will fall further. Rising home prices were the oil that greased the wheel of this engine of growth, and falling home prices are the sand in the gears that are causing it to grind to a halt.” At the heart of the contagion problem is the combination of complexity and leverage. The securities that financed the rapid expansion of mortgage lending were hard to understand, and some of those who owned them had borrowed so much that even a small drop in value put pressure on them to raise cash. “You find surprising linkages that you never would have expected,” said Richard Bookstaber, a former hedge fund manager and author of a new book, “A Demon of Our Own Design: Markets, Hedge Funds and the Perils of Financial Innovation.” “What matters is who owns what, who is under pressure to sell, and what else do they own,” he said. People with mortgage securities found they could not sell them, and so they sold other things. “If you can’t sell what you want to sell,” he said, “you sell what you can sell.” He recalled that the crisis that brought down the Long-Term Capital Management hedge fund in 1998 started with Russia’s default on some of its debt. Long-Term Capital had not invested in Russia’s bonds, but some of those who owned such bonds, and needed to raise cash, sold instruments that Long-Term Capital also owned, and on which it had borrowed a lot of money. It appears that in this case, securities backed by subprime mortgages were owned by people who also owned securities backed by leveraged corporate loans. With the market for mortgage paper drying up, and a need to raise cash, they sold the corporate securities and that market began to suffer. The Wall Street investment banker who wanted a jumbo mortgage had a good credit score. But private mortgage securities are now hard to sell, leading to his problem. In the end, he was able to get a mortgage with a lower interest rate, but it will adjust in five years, possibly to a much higher level. All jumbo lenders have raised rates. Bankrate.com reports that conventional 30-year mortgages cost about 6.23% now, less than they did a few weeks ago, due to a decline in Treasury bond rates. But the average jumbo rate is now 6.94%. The spread between the two rates rose from less than a quarter of a percentage point to more than two-thirds of a point. Jumbo mortgages are most important in areas with high home prices, most notably on the East and West coasts. “In California, it has shut down the purchase market,” said Jeff Jaye, a mortgage broker in the Bay area. “It has shut down the refi market.” The problems with subprime mortgages erupted as home prices began to slip in some markets, making it harder to refinance mortgages. There were reports that a surprisingly large number of loans made in 2006 were defaulting only months after the loans were made. Many of those mortgages had been financed by securities, highly rated by credit agencies, that suddenly seemed less secure than they had. Hedge funds that owned those securities, and had borrowed against them, were asked to put up more money to secure their loans. Two Bear Stearns hedge funds were forced to liquidate, and investors lost everything. Investors shied away from buying new mortgage securities, and several lenders went out of business, unable to finance the mortgage loans they had promised to make. With the credit gears clogged, there has been a sudden lust for cash at many levels of the financial system. Last week banks in Europe and the United States tried to borrow so much money that central banks had to step in to keep interest rates from rising. “What I suspect is that there is a demand for credit by institutions that don’t want to sell the securities they own, because the bids are so low, and the banks are extending credit to them,” said William Silber, a professor of economics and finance at New York University. Fannie Mae and Freddie Mac, the government-sponsored enterprises, can still purchase mortgages and issue securities, guaranteeing that the underlying mortgages will not default. Those guarantees are still accepted by investors, and borrowers who meet their standards still can borrow. But those who want larger mortgages, or cannot make down payments, face a harder burden. Homeowners with adjustable mortgages can refinance them at any time, so long as they qualify for a new loan, so some facing a payment increase may be able to wait it out and refinance later, if the market improves. In past years most borrowers had 30-year mortgages with fixed rates. If such borrower kept his job, he usually could meet the monthly payments, even if the value of the home had declined so much that he could not get a new mortgage. Now, many mortgages call for sharply rising monthly payments after a few years, and borrowers were given loans without regard to their ability to meet the higher payments. Lenders assumed the mortgage could be refinanced, and that rising home prices would assure repayment of the loan. It became common to offer homebuyers loans to finance the entire purchase price of a home. In June, banking regulators ordered that adjustable-rate loans be given only to borrowers who could afford the rate at which it was likely to be reset, meaning that many borrowers would not qualify for refinancings even if their homes had not lost value. Such a rule three years ago might have prevented the crisis, Mr. Barbera said, but imposing it now may worsen the problem.
Investment-grade ratings on 95 percent of the securities in the CDO gave no hint of what was in the debt package — or that it might collapse. It was loaded with risky debt, from junk bonds to subprime home loans. During the next six years, the CDO plummeted as defaults mounted in its underlying securities. By the end of 2006, losses totaled about $125 million. The failed Credit Suisse CDO may be an omen of far worse to come in the booming market for these investments. Sales of CDOs worldwide have soared since 2004, reaching $503 billion last year, a fivefold increase in three years, according to data compiled by Morgan Stanley. CDO holdings have already declined in value between $18 billion and $25 billion because of falling repayment rates by subprime U.S. mortgage holders, Lehman Brothers Holdings estimated April 13. In many cases, investors don't even know that values have dropped. In this secretive market, there is no easy way for investors to find out what their CDOs are worth. The slide of the Credit Suisse CDO points to the critical and little-understood-role played by rating companies in assessing risk and acting as de facto regulators in a market that has no official watchdogs. Many of the world's CDOs are owned by banks and insurance companies, and the people who regulate those firms rely on the raters to police the CDOs. "As regulators, we just have to trust that rating agencies are going to monitor CDOs and find the subprime," says Kevin Fry, chairman of the Invested Asset Working Group of the U.S. National Association of Insurance Commissioners. "We can't get there. We don't have the resources to get our arms around it." The three leading rating companies, all based in New York, say that policing CDOs isn't their job. They just offer their educated opinions, says Noel Kirnon, senior managing director at Moody's. "What we're saying is that many people have the tendency to rely on [the ratings], and we want to make sure that they don't," says Kirnon, whose firm commands 39 percent of the global credit-rating market by revenue. S&P, which controls 40 percent, asks investors in its published CDO ratings not to base any investment decision on its analyses. Fitch, which has 16 percent of the worldwide credit-rating field, says its analyses are opinions and investors shouldn't rely on them. The rating companies apply disclaimers about their analyses. S&P says in small print: "Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision." Joseph Mason, a finance professor at Philadelphia's Drexel University and a former economist at the U.S. Treasury Department, says the ratings are undermined by the disclaimers. "I laugh about Moody's and S&P disclaimers," he says. "The ratings giveth and the disclaimer takes it away. Once you're through with the disclaimers, you're left with very little new information." When it comes to CDOs, rating companies do much more than give them letter grades. The raters play an integral role in putting the CDOs together in the first place. Banks and other financial firms typically create CDOs by wrapping together 100 or more bonds and other securities, including debt investments backed by home loans. Credit-rating companies help the financial firms divide the CDOs into sections known as tranches, each of which gets a separate grade, says Charles Calomiris, the Henry Kaufman professor of financial institutions at Columbia University. Credit raters participate in every level of packaging a CDO, says Calomiris, who has worked as a consultant for Bank of America, Citigroup, UBS and other major banks. The rating companies tell CDO assemblers how to squeeze the most profit out of the CDO by maximizing the size of the tranches with the highest ratings, he says. "It's important to understand that unlike in the corporate bond market, in the securitization market, the rating agencies run the show," Calomiris says. S&P charges as much as 12 basis points of the total value of a CDO issue compared with up to 4.25 basis points for rating a corporate bond, company spokesman Chris Atkins says. (A basis point is 0.01 percentage point.) That means S&P charges as much as $600,000 to rate a $500 million CDO. Fitch charges 7-8 basis points to rate a CDO, more than its 3-7 basis point fee to rate a bond, based on the company's fee schedule. Moody's doesn't publish its pricing for any ratings. "CDOs are the cash cow for rating agencies. They're clearly a gold mine," says Frank Partnoy, a former bond trader, now a University of San Diego law professor and author of a book on the financial markets. That euphoria has blinded investors — and the rating companies — to the true risk of CDOs, Partnoy says. As homebuyers and investors grapple with the subprime-mortgage crisis, many haven't yet realized the extent to which that turbulence is spilling into CDOs. Foreclosure filings in the U.S. surged to 147,708 in April, up 62 percent from April 2006, as subprime borrowers stopped making mortgage payments. As foreclosures increase, the subprime-backed securities in CDOs begin to crumble. Subprime-mortgage securities make up about $100 billion of the $375 billion of CDOs sold in the U.S. in 2006. Investors have little idea how toxic some of these CDOs are, Drexel's Mason says. "We compose CDOs with a bunch of this stuff," he says. "Now we just jack up the risk, jack up the misunderstanding. We're throwing our money to the wind. We now know the defaults are in the mortgage pools and it's only a matter of time before they accumulate to levels that will threaten the CDO market." Ask Victor Ganzi, chief executive of The Hearst Corp. (and owner of the Seattle Post-Intelligencer) why the private New York-based media company bought 20 percent of Fitch Group last year for $593 million and he talks about collateralized debt obligations. "That's where the opportunities lie for Fitch," Ganzi said. Fitch has shot ahead of smaller competitors in the past decade to become the world's third-largest rating firm. Fimalac, the company's owner, has bought up smaller rivals. Ganzi and Stephen Joynt, Fitch's chief executive, say structured finance, such as CDOs, is the fastest-growing source of credit-rating revenue and gives Fitch the chance to compete on level ground with its two rivals, Standard & Poor and Moody's. Hearst eventually wants to buy control of the rating company, Ganzi said. But it won't be easy. Ladreit de Lacharriere, the French investor who controls Fimalac, said he has no plans to sell any more of Fitch. "We're very patient in that regard," Ganzi said. The first CDOs Michael Milken, the junk-bond king, created the first CDO in 1987 at now-defunct Drexel Burnham Lambert, says Satyajit Das, a former Citigroup banker who has written 10 books on debt analysis. Until the mid-1990s, CDOs were little known in the global debt market, with issues valued at less than $25 billion a year, according to Morgan Stanley. Drexel and other investment banks realized that by bundling high-yield bonds and loans and slicing them into different layers of credit risk, they could make more money than they could from holding or selling the individual assets. Investment-grade CDOs that include subprime assets offer debt returns that exceed yields on junk bonds. In May, BBB-rated portions of CDOs — the lowest investment grade — paid 7-9 percentage points above the London interbank offered rate (Libor), according to Morgan Stanley. That amounted to an annual return of about 13 percent, based on May bank-lending rates. Most CDO tranches promise returns at a fixed spread over Libor. That means their value isn't affected by changes in interest rates the way the value of a fixed-rate bond would be, says Arturo Cifuentes, a managing director at R.W. Pressprich, a New York-based fixed-income brokerage that buys and sells CDOs. "CDOs offer you a possibility to invest in risk which you cannot do in any other way," he says. Cifuentes says CDOs have been good for investors and financial markets. Former banker Das wonders why few people are probing the potential dangers for CDO investors. "I think the regulators seem to be fairly sanguine about all of this. The thing that I find quite bewildering is the lack of urgency and focus." He says subprime-mortgage defaults have just started to soar. "The fuse has been lit," Das says. "Somebody should be trying to find where this wire is running to."
The Volatility Index [VIX], which tracks investors' expectations about future stock-market bumpiness, has risen to 22, which is considered reasonably high by historical standards. It was as low as 13 in May, or more than 50% below its average during the past 17 years. The VIX measures future volatility of the S&P500 options that trade on the Chicago Board Options Exchange. Since the end of 2003, the VIX hasn't finished a month above 18 and was as low as 10 this January. Since the fall of 2002, when the current bull market began, the VIX climbed past 20 just eight times. Still, the current 22 level is well below the 44 level the index reached in September 1998, after Russia defaulted on its debt and credit markets seized up. Higher volatility is important because if the market stays this bumpy it likely will affect shares. "If we're looking at sustained uptrend in volatility, investors will require a higher rate of return to get involved in the market, so that will put pressure on prices," says Jack Ablin, chief investment officer of Harris Private Bank. "If you buy something that's bouncing around a lot more it means there's more risk, and you have to be paid for that." Still, the current bout of jitters isn't especially unusual. When the S&P500 fell 6% from its highs in March 2006 -- about the amount the stock market has fallen recently -- the VIX nearly hit 21. When the S&P declined about 8% in June of last year, the VIX approached 24. In both instances, volatility soon dropped and stocks rebounded. Another reason not to focus on volatility when it comes to stocks: It usually is a coincident indicator. When the market goes down abruptly, volatility jumps. In commodities and other markets it serves more as a leading indicator, according data from James Bianco of Bianco Research. Investors should worry about volatility only if it becomes disproportionate to the move in the stock market, Bianco says. "It would be a sign of panic." More worrisome is the lack of trading liquidity, or the ease at which investors can get in and out of riskier bond positions. Trading has slowed drastically for credit-default swaps. There is virtually no activating in collateralized debt obligations, or pools of debt, a key market that has helped financing leveraged buyouts. That lack of buying is important because as much as $300 billion in mergers that have been announced haven't yet been financed, and most of the money for those deals will be borrowed in the credit markets. "That's what's scaring the heck out of people, everyone knows the supply of debt is coming, and the deals won't get done unless the market gets going again," Mr. Bianco says.
Small-Company Stocks At the start of 2000, the typical retirement investor held $1 in small-capitalization stocks for every $16 invested in large, blue-chip shares, according to Hewitt Associates, the employee benefit research firm. But by July this year, that ratio had shrunk to just 1 to 3.6, as investors chased hot-performing small-cap stocks — and as those shares grew faster than the broader market. This portfolio allocation may be putting investors in a precarious position. “The sword cuts both ways,” said Greg Schultz, a principal at Asset Allocation Advisors, a financial planning firm. Though small-cap stocks tend to climb faster than blue chips in a market upswing, they also tend to lose ground more quickly in a market downturn. Since the start of July, large stocks, as measured by the S&P500 index, have fallen 3.8% while small stocks in the Russell 2000 have lost 5.7%. And there’s another reason to fear overexposure to small stocks: many savings institutions — those traditionally classified as savings and loans — are small-cap companies, and many of them have been buffeted by the mortgage debacle. In fact, a recent analysis by Morningstar showed that while 67% of large-cap stock funds have some exposure to these savings institutions, 88% of small-cap funds are so exposed. And this financial industry group has been among the worst-performing so far this year, down nearly 18%, on average. Financial Sestor Stocks No sector of the economy is more vulnerable to the current mortgage crisis than the financial services industry. And no sector accounts for a larger slice of the S&P500 index. At the end of last year, financial companies represented a record 22.3% of the S&P500. That was up from 7.5% at the end of 1990. To be sure, there was never a bubble in this sector, as there was in technology in the late 1990s. Financial stocks in the S&P500 now trade at a lower price-to-earnings ratio than the broad market. That was certainly not the case for tech in 1999. But there is still a potential problem, if only because the sector represents such a wide swath of the market. If your domestic stock portfolio mimics the broad market, more than one-fifth of your holdings are in this sector just as this credit crisis is unfolding. Emerging-Market Stocks Despite its lack of exposure to the domestic mortgage crisis, the average diversified emerging-market stock fund has lost 16.4% of its value over the past month. That’s more than the average financial sector fund has lost. That is to be expected. Some folks will flee risk in general because they don’t understand what’s going on. Investors’ have had a five-year love affair with emerging-market stocks. But eventually the performance of emerging-market stocks will slow and return to historical norms. And when that happens, the emerging markets will be affected in their own right. Though emerging-market stock funds have produced enviable annualized gains of nearly 28% over the past five years, investors forget that these same funds lost money in five of the six years from 1997 to 2002. Now, the average investor in a 401(k) retirement plan holds only 1.3% of his or her assets in emerging-market equities. “But the average can be very deceptive,” said Pamela Hess, Hewitt’s director of retirement research. Of those 401(k) participants who invested any of their money in the emerging markets, Ms. Hess noted, the typical allocation is 16.4%, according to a study Hewitt conducted last year. In many cases, investors may have started with a much more modest exposure to emerging markets, she said. But by failing to rebalance their accounts in recent years, some investors allowed their allocations to this and other risky asset classes to explode. The concern is now this: Will those risky assets blow up investors’ portfolios now that the market has a new-found aversion to risk?
On the other hand, this is the third spike in stock market volatility in a little more than a year — the last one began at the end of February. In the two previous cases, the market’s roller-coaster ride, while frightening, proved rather short. So this might not be the best time to drastically overhaul your asset allocation strategy by reducing your exposure to stocks. But when it comes to managing your portfolio, you don’t have to make major long-term adjustments to your mix of stocks and bonds to damp the gyrations in your investments. Sometimes, all it takes is a periodic rebalancing of your portfolio, back to your desired mix of stocks and fixed-income investments, to smooth out the bumps. To be sure, making a major and permanent shift to a much more conservative asset allocation strategy can make a real difference in your overall risk profile. For instance, over the last half-century, the worst one-year stretch for a portfolio of 60% stocks, 30% bonds and 10% cash was a loss of 24.1%. That occurred in the 12 months that ended in September 1974. By comparison, the worst one-year loss for a more conservative mix — 40% stocks, 40% bonds and 20% cash — was just 15.5% during the same period. Yet to achieve this lower risk, you would have to give up a decent amount of gains. In this case, the switch in asset allocation strategy would have reduced your average annual returns to 8.3% from 9.2%. For some investors, that may be too significant a loss of potential returns to consider. So the asset manager T. Rowe Price recently posed a different question. Can you significantly reduce your exposure to risk simply by rebalancing your portfolio once a year, rather than permanently reducing your exposure to stocks for the long run? The answer turns out to be yes. Say you started investing at the end of 1984, in a portfolio consisting of 60% stocks, 30% bonds and 10% cash. And further assume that you never rebalanced this portfolio back to that 60-30-10 ratio. Instead, you did what a surprisingly large percentage of individual investors do: you let the market take your investments for a ride. Through the end of June, this strategy would have earned an average annual gain of 11.1% since 1984. Now, had you started in 1984 with the same strategy, but this time rebalanced your portfolio annually, you would have earned nearly as much on your investments: 10.7% a year, on average. But at the same time, that portfolio would have been 18% less volatile, based on standard deviation, according to T. Rowe Price. The buffering effect of rebalancing might have been enough to let you sleep better at night. Unfortunately, a vast majority of individual investors fail to rebalance. According to a new study by Hewitt Associates, the employee benefit research, only 18% of workers who invested in a 401(k) retirement plan rebalanced their portfolios last year. This is about in line with historical trends, as only 17% of 401(k) investors rebalanced their accounts in 2005 as well as in 2004, according to Hewitt. The fact is, whether or not you tweak your mix of stocks and bonds, the market will do it for you — though maybe in a way you won’t like. Over the long term, stocks — which are much riskier than bonds — tend to outperform bonds. So “if you rely on inertia and don’t rebalance regularly, over the long run, you’re going to end up with a bigger allocation to stocks than you started with,” said Christine Fahlund, senior financial planner at T. Rowe Price. But rebalancing is not just about resetting your mix of stocks and bonds. You should also consider periodically resetting the types of stocks you own. For instance, Mr. Stovall notes that over the last five years, many of the best-performing areas of the stock market have also been among the most volatile. Those include the basic materials, telecommunications and technology sectors, all of which have a “beta” of more than 1.0. (Beta measures the tendency of an investment to go up or down, relative to the market.) On the other hand, two of the lowest beta sectors in the market — health care stocks, with a beta of 0.6, and consumer staples stocks, at 0.5 — have been the market’s worst performers over the past five years. One way that investors might consider rebalancing the stock portion of their portfolios is to “gravitate toward areas with lower volatility, like health care and consumer staples, while avoiding those highly volatile areas that have already done exceptionally well,” Mr. Stovall said. Another way to rebalance is simply to take your new money and invest it in areas that many investors have ignored in recent years, like large-capitalization domestic growth stocks and stock funds. The notion of buying stocks amid a market storm may seem unappetizing. And some investors may decide simply to wait to see whether this is a short-term sell-off or the start of a real correction. But keep in mind that if you have not rebalanced your portfolio for several years, chances are that you probably have more equity exposure than you intend. Moreover, you are probably overexposed to the most volatile types of stocks. So some rebalancing may be better than no action at all.
Asset allocation and market timing are closely related. Market timing refers to jumping into and out of a single asset class in the hopes of participating in rallies and sidestepping declines, like what the domestic stock market experienced last week. Asset allocation is market timing applied to more than one asset class. The extremes in the asset allocation debate are well known. At one pole are those who believe that successful market timing is impossible over the long run, and that it never makes sense to alter a portfolio on the basis of beliefs about the various asset classes’ relative attractiveness. The only occasions on which those allocations should be shifted are when an investor’s life circumstances have changed. At the other extreme are those who believe that, not only is successful market timing theoretically possible, it is not all that difficult in practice. As a result, investors should be willing to make large and frequent changes to how much they allocate to each of the asset classes. In their new study, the researchers explored the middle ground between these two extremes. In particular, they were interested in how an investor might behave if he believed that, while the future course of the markets was not completely random, the extent of any predictability was still quite small. As Professor Wachter put it in an interview, such an investor “is skeptical of the market timers’ claims, but not dogmatically so, and therefore willing to modestly alter his asset allocation when the evidence in favor of doing so is particularly compelling.” While conceptualizing this nondogmatic skeptic may be relatively straightforward, actually modeling his behavior is complex. To do that, the researchers resorted to a branch of statistics championed by the Rev. Thomas Bayes in the 18th century. His theory shows how to update probabilities in light of new information. It allowed the researchers to quantify the skepticism of their hypothetical investor and then to estimate how his beliefs would change from time to time as the markets either did or did not live up to previous forecasts. An example: Imagine an investor whose default asset allocation is to be 65% invested in domestic equities and 35% in bonds. Imagine further that this investor uses only one stock market timing indicator: the stock market’s dividend yield. If this investor believes that market timing is impossible, his allocation to domestic equities will always be 65%. If this investor is a believer in market timing, he would currently have only 23% of his portfolio allocated to domestic equities, because the stock market’s current dividend yield is so much lower than the historical average, suggesting an overvalued stock market. What would be the current allocation to domestic equities for the middle-of-the-road approach? It would be 40%, according to Professor Wachter. The proof of the pudding is in the eating, of course. Consider what the researchers found upon calculating the track records of the three approaches to asset allocation that they studied, each of which relied on just the dividend-yield indicator to switch between domestic stocks and short- and long-term bonds. Over the 33 years beginning in 1972 and ending in 2004, the middle of the road portfolio outperformed those at either extreme in the asset allocation debate. The midddle of the road beat market timing by an annual average of around 10 percentage points and beat the strict asset allocation portfolio by an annual average of around one percentage point. Wachter cautioned that she and her co-researcher couldn’t say for sure whether the same conclusion would hold for other market-timing tools. But she did say they reached similar results for the one other market-timing indicator that they examined — the yield spread, which is the difference between the yields on long- and short-term bonds — and she says that she would not be surprised if the same conclusion held for many other market-timing variables as well. These results might strike investors as counterintuitive. If a little market timing is good, shouldn’t a lot be better? The reason it isn’t is that even when a good market timing system is right more often than wrong, those wrong times can be disastrous to those who bet on it too heavily. The investment implication is clear: While not dismissing market timing, don’t bet all-or-nothing on it, either. Monthly Employment Stats
Health care employment grew by 36,000 in July, with gains of 9,000 jobs each in offices of physicians and in hospitals and 8,000 in home health care. Over the year, health care employment has expanded by 377,000. Employment in social assistance continued to trend up in July; the industry has added 99,000 jobs over the past 12 months. In financial activities, employment rose by 27,000 in July. Credit intermediation and related activities added 11,000 jobs over the month, offsetting a decline of a similar mag- nitude in June. Over the month, employment continued to grow in insurance carriers and related activities (+6,000) and in securities, commodity contracts, and investments (+4,000). Over the year, these industries have added 42,000 and 32,000 jobs, respectively. Within professional and business services, computer systems design and related services continued to grow, adding 15,000 jobs over the month. Business support services employment also rose in July (+9,000). Temporary help services employment continued to trend down (-7,000); this industry has lost 52,000 jobs so far in 2007. Employment in food services and drinking places continued to trend up in July (+22,000). Job growth in this industry has averaged 29,000 per month in 2007, about the same as the average monthly increase in 2006. Over the month, wholesale trade employment continued to increase, while retail trade employment was unchanged. In the goods-producing sector, employment changed little in both manufacturing and construction in July. Manufacturing has lost 175,000 jobs over the past 12 months. Since its most recent peak in September, employment in construction has fallen by 75,000. In July, the average workweek for production and nonsupervisory workers on private non- farm payrolls decreased by 0.1 hour to 33.8 hours, seasonally adjusted. Average weekly hours and overtime hours for factory workers were unchanged over the month. The index of aggregate weekly hours of production and nonsupervisory workers on private nonfarm payrolls fell by 0.1% in July to 107.7 (2002=100). The manufacturing index was unchanged. Average hourly earnings of production and nonsupervisory workers on private nonfarm pay- rolls increased by 6 cents, or 0.3 percent, in July to $17.45, seasonally adjusted. This increase followed gains of 7 cents in both May and June. Average weekly earnings were little changed over the month at $589.81. Over the year, average hourly earnings rose by 3.9% while weekly earnings rose by 3.6%. The downturn in housing has hurt employees of financial institutions. So far this year, the financial industry has announced nearly 88,000 job cuts, 164% more than through the end of August in 2006, according to Challenger, Gray & Christmas. Of this year’s cuts, 41% are directly related to the mortgage and subprime lending markets. (David Gaffen, WSJ 8-21)
Quick Facts, Stats & Opinions ETFs Get a Tough Market Test Eleanor Laise, WSJ 8-19 While investors shouldn't make decisions based on short-term performance figures, the recent volatility has given many ETFs their first test run through turbulent markets and offers some important insights into ETF investing. Roughly one-third of the ETFs now on the market were launched in the first seven months of this year, according to State Street Global Advisors. While the Standard & Poor's 500-stock index dropped roughly 9% in the month ended Aug. 16, many ETFs produced double-digit gains or losses. The top and bottom performers include a number of "leveraged" ETFs, which magnify market movements. The UltraShort Russell MidCap Value ProShares ETF, for example, which aims to produce twice the opposite of the daily performance of the Russell Midcap Value Index, posted a 29% market return in the month ended Aug. 16. Among foreign stock ETFs, iShares MSCI Brazil Index Fund lost 24%, while the far more broadly diversified SPDR S&P World ex-US fund lost 12.6%. Even ETFs that appear quite similar on the surface produced substantially different returns during this volatile period. Consider China-focused ETFs. The iShares FTSE/Xinhua China 25 Index ETF, which holds stocks that trade on the Hong Kong Stock Exchange, dropped 13.9% for the month, while the PowerShares Golden Dragon Halter USX China Portfolio, which holds stocks of U.S.-listed companies that get most of their sales from China, fell 17.4%. Recent ETF returns show that investors must pay close attention not only to the index an ETF tracks but to the weighting scheme it employs. While many indexes and ETFs weight stocks by market value, some ETFs weight all holdings equally or by "fundamental" factors such as price/earnings ratio. That can make a big difference in investors' returns. The market-cap weighted iShares S&P 500 Index, for example, lost 8.1% over the past month, while the Rydex S&P Equal Weight lost 10.4%. Nationwide, about $500 billion in so-called hybrid ARMs are scheduled to reset over the next 18 months, with an average increase in monthly payments of 30%, according to the investment bank JPMorgan Chase. However, most subprime borrowers already are stretched financially and may not be able to make higher payments. On top of that, this year's adoption of tougher credit standards by mortgage lenders - and stagnant or falling house prices in most areas - are making it hard for those borrowers to qualify for new loans. The result, according to Mark Zandi, chief economist at Moody's Economy.com in West Chester, will be a surge in defaults this year and next that could cost investors in securities backed by subprime and other risky mortgages more than $100 billion. The accompanying rise in foreclosures is adding to the record supply of houses on the market, putting further pressure on an already weak housing market, Zandi said Thursday. (Harold Brubaker, Philadelphia Inquirer 7-29) The S&P 500 companies are collectively at less than 17 times their earnings for the 12 months through June, according to data from Standard & Poor's. The last time the S&P 500 regularly traded below 17 times reported earnings was in 1994 and 1995 -- before the late-1990s stock-market surge. The index's eight-decade historical average is 16 times reported earnings. (Jonathan Clements, WSJ 8-11) Many have fretted that the Federal Reserve will cut interest rates dramatically and thus usher in another credit bubble that will only postpone (and inflate) current credit problems. Bianco Research says there’s little evidence that the Fed has done this in the past. “The chain of causation may frequently go the other way,” they write. “Increases in the federal funds rate may induce selloffs in equities more often than selloffs in equities induce a lowering of the federal funds rate. (David Gaffen, WSJ 8-21) Hedge Fund / Private Equity News Briefs As hedge funds hit by market upheaval are being forced to cover their short positions — buying back the stocks they were betting against — they’re helping stand the market on its head. Stocks that quants like to short are being buoyed as hedge funds cover their shorts, while higher-quality fare is getting left behind. This month through Thursday, S&P 500 stocks with the highest short interest have seen a big uptick in trading volume, relative to July, and these highly shorted stocks have beaten the least-shorted stocks by 1.3 percentage points, according to TFS Capital LLC. Among small-cap stocks, the effect is even more pronounced: Highly shorted stocks in the small-cap Russell 2000 Index beat the least-shorted stocks by about 12 percentage points this month through Aug. 16, TFS found. For TFS, the numbers add up to a gloomy market forecast. “It’s not a show of strength if the only people buying are buying to cut their losses,” says Kevin Gates, co-manager of TFS Market Neutral and two hedge funds that use similar strategies. (David Gaffen, WSJ 8-21) With a couple of big name hedge funds already falling by the way side, markets watchers say the average annual industry failure rate of 8% may double by early 2008. “This year is going to be the worst we’ve ever seen in terms of number of funds having problems, worse than 1998,” John Mauldin of Millennium Wave Investors told Reuters. “There has been such abated growth in this industry,” Randy Lampert of Morgan Joseph said, “that there is bound to be some consolidation and the more marginal funds will be washed out to the side.” Closures will come not only because of poor performance and lost assets, but also as investors take a second look at secretive hedge funds and decide it’s time to reduce their exposure, especially pension funds, which are greatly concerned about risk and volatility. If that occurs, it would reverse a trend that led to a nearly 70% growth of pension assets in hedge funds in 2006. Most likely hurt hardest among the hedge funds will be those HFs with less than $1 billion in assets under management, and, as Reuters notes, even though the largest 100 hedge funds in the world handle two-thirds of the assets, it’s the smaller ones, which produce the healthiest returns, that may be the first to go. Lawrence Glazer of Mayflower Advisors predicts that this year will see the worst drawdowns since 2001 with “more exotic strategies like the black box traders who rely solely on computers being affected most.” (Hedge Fund Daily 8-21) Competition for deals among private equity professionals has become so fierce, that the average firm has had to make an average of 49 bids while completing only 13 transactions, according to Grant Thornton. Despite the competition, 90% of those surveyed for the quarter Grant Thornton Corporate Finance Private Equity Barometer say they expect deal volumes to increase or remain at the current level in the next 12 months, with 87% seeing the value of the deals either increasing or remaining constant. The areas of greatest interest to private equity in the next 12 months, he noted, are business services (73%), healthcare (47%) and financial services. (Hedge Fund Daily 8-08)
The convergence of hedge fund strategies is quantifiable. It was detected in a study completed earlier this year by Nicole M. Boyson, an assistant professor of finance and insurance at Northeastern University; Christof W. Stahel, an assistant professor of finance at George Mason University; and René M. Stulz, a professor of finance at Ohio State University. A copy of their study, “Is There Hedge Fund Contagion?,” is at http://ssrn.com/abstract=884202. The professors focused on months when there was a particularly big loss in one of the many categories of hedge funds. In an interview, Professor Stulz said he and his co-authors found that during those months, all hedge funds, regardless of their category, had an unexpectedly high probability of losses, too. A number of factors have caused this convergence, according to Lawrence G. Tint, an investment consultant and retired vice chairman of Barclays Global Investors. These include “the sheer number of hedge funds, the huge amount of assets invested in them, and the enormous amount of leverage that they employ,” Mr. Tint said. Another is a fee structure that provides hedge fund managers with “an intense incentive to capture the last little inch of competitive advantage,” he said. Hedge funds are structured and regulated in ways that give them wide latitude to pursue profit opportunities wherever they find them. Mr. Tint says he suspects that some hedge fund investors will be surprised that their funds lost money because of problems in the subprime mortgage arena. That’s because those investors have been falsely assuming that, just because their funds focused on completely different strategies — commodities, for example — they have no exposure to the subprime mortgage market. “There are today so many interconnections between hedge funds that, on the surface, pursue quite different approaches, that even a minor perturbation in one corner of the market causes everyone to run in the same direction,” Mr. Tint said. Another factor that contributes to rapidly spreading losses, or contagion, among hedge funds is the proportion of their holdings invested in assets that cannot be readily sold. Hedge funds are attracted to such illiquid assets because their expected return is often higher than that of liquid investments. But that higher expected return carries a price: it makes it harder for the funds to raise money when credit becomes tight. One expert who has worried for several years about the risks caused by hedge fund illiquidity is Andrew W. Lo, a finance professor at the Massachusetts Institute of Technology and director of its Laboratory for Financial Engineering. He is also chief scientific officer at the AlphaSimplex Group, a hedge fund management firm in Cambridge. Hedge funds do not generally divulge their holdings, so the extent of illiquidity must be measured indirectly. Professor Lo does this by measuring the degree to which hedge fund returns move in the same direction from month to month — a statistical pattern that some call return persistence. This is a telltale sign of illiquid investments, he argues, because their valuations typically are updated infrequently — say, once a quarter or once a year. In such cases, hedge funds have to make a number of assumptions when coming up with how an illiquid investment performed in a particular month, and they may simply extrapolate it from past returns. This will have the effect of making an illiquid investment’s month-to-month returns appear to move in the same direction. In an interview, Professor Lo said he began noticing as early as five years ago that return persistence was becoming more prevalent in hedge funds, and that it has become even more so since. As an example of how this measurement could have been used as an early warning signal, he refers to Amaranth Advisors, the hedge fund that failed last September. The particular trade that caused huge losses for that fund, and eventually led to its closure, was a complex derivative involving natural gas futures contracts. Professor Lo said that this derivative appeared to become quite illiquid in mid-2006, as evidenced by a big spike in its return persistence. This indicated a marked increase in vulnerability for hedge funds invested in it, according to Professor Lo. It turns out, however, that relatively few hedge funds were invested in that derivative, so the ripple effects of Amaranth’s failure were relatively mild. But that was something of a lucky break, Professor Lo said. Today, the odds are higher than ever that losses in a remote corner of the financial markets will spread quickly across the hedge fund world. Professor Lo likened his warnings about hedge fund illiquidity to those of a weather forecaster pointing out that a forest has become extremely dry and vulnerable to fire. “Such a report can’t be used to predict when a spark will actually trigger a rapidly-spreading fire,” he said, “but it does tell you that it has become significantly more likely to happen at any time.” Random Thoughts Some of my net buddies have written that they are playing with the idea of buying the now beaten down shares of MREITs, usually holding paper on commercial property, or the preferred shares from those companies. I wish them luck. But playing with that idea is playing with fire. And being a late baby boomer, I know what happened to folks who played with FIRE. Jimi Hendrix - choked on vomit after drug overdose - wrote "Let me Stand Next to Your FIRE". Jim Morrison of the Doors - died of drug overdose - wrote Lyrics to "Light My Fire". Keith Moon, drummer for Who - choked on vomit after OD on pills - this band also had a song called "FIRE". Janis Joplin - died of drug overdose - her song Kozmic Blues contains the words "There's a fire inside of everyone of us". Ronnie Van Zant - Lynard Skynard leader - died in Plane crash - the band's song "One More Time" contains the line "I know I'm playin' with fire / I get burned everytime." Every famous rocker from my childhood/adolescence who had an early death had a 'fire' connection. Thus, I ain't playing with fire. I can learn lessons vicariously. Home Page Previous Factoid Top Sites
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