The world, one had to remember, was analog, not digital, in the way it operated. And ‘analog’ actually meant ‘sloppy.’” The Teeth of the Tiger, by Tom Clancy.

We wrote that last month (please visit our Web site and will include it again this month as “sloppy” cannot begin to describe what we have seen lately in the stock and bond markets.

Remember the old adage that the only three things you had to know about real estate were Location, Location, Location! Now you have to add Credit, Credit, Credit and more Credit! And Leverage in many cases involving billions of dollars.

The markets have been extraordinarily sloppy, and frightening, because of U.S. and Global credit policies over the last five years and because the Financial Geniuses have been able to spread the risk from this country to the entire world. And the entire world has bought into it hook, line and sinker!

The banks and Wall Street have developed, and more importantly sold, to the buyer and the seller, mortgages that have at times equaled 100% of properties’ market values at the time they were issued. Often those mortgages did not even require the buyer to include more than his or her name, presumably their real name, although in the end that really wouldn’t make much difference. These were called “No-documentation” or “no-doc” loans. Billions of dollars worth of these mortgages were also sold, where one could not only buy the property at 100% of stated or sometimes overstated value, but also with interest-only payments.

Or, one could buy a 30-year mortgage and pay interest only for two years and then enter into a more conventional financing arrangement at a very high interest rate for the remaining 28 years. These were known as 2/28s and were the rage in 2005 and 2006, particularly at a time when house prices were skyrocketing and interest rates on mortgages were at there lowest in memory if not in history. Subprime loans rose to more than $600 Billion in 2005 and 2006 versus $160 Billion in 2001 when they were primarily used for home-equity loans. Later homes were used as ATMs and offered many of the biggest and “best” bets imaginable.

It was a Win-Win situation for everyone — the house buyer and seller, the real estate agent, the insurance broker, the mortgage broker, the lawyers and the first-time lender, usually a bank. As the business grew, the loans were “packaged” or “securitized” and sliced into tranches where the poorest credits (“junk”) were at the bottom of the pyramid while the highest quality credits (AAA) were at the peak. The ratings agencies often assigned their highest ratings to the entire pyramid.

It is important to understand that this process effectively transferred the risk of owning a mortgage, or a package of mortgages, from the first lender – the bank – to the ultimate mortgage holder – the investor. The investor often does not have a second-party against whom he could make a claim in the event of a default. The investor, as mentioned above, could be anywhere in the world during these halcyon days and could be a hedge-fund, an endowment, a retirement system or pension fund, et cetera, et cetera. Nobody really knows who or where all the investors are, let alone how much money has been invested in subprime mortgages. What is known is that the amount of money involved is beyond a mere mortal’s comprehension. Further, the investor did not and still does not, in the overwhelming number of cases, know or is able to find out the “real value” of his “asset.” Furthermore, the investor in the subprime mortgages no longer had the Fed or deposit insurance to fall back on as before.

Who could have been so naive as to think of a world where house prices would plummet and mortgage and interest rates in general would rise? It was supposed to continue to be just the opposite.

But contrary to conventional wisdom the worm turned, and housing prices have been plummeting while interest rates have been rising. For example: If one bought a home for $100,000 and paid nothing down and “interest only,” what would one expect to happen when that buyer can or will no longer pay the interest only, or pay the higher interest due when the mortgage resets (meaning a higher interest must be paid by the home owner on his interest only, 2/28 mortgage or ARM – Adjustable Rate Mortgage)? The lender paid $100,000 in the beginning, but the house is now worth, say, $70,000 more or less.

The homeowner decides he cannot or will not pay the mortgage or interest on his home where he owes $100,000 on a property that is worth only 70% of that. What happens when that owner sticks his key in the front door and walks away? The bank or lender takes over a loan investment that now carries a $30,000 realized loss. Multiply this situation by an estimated 7,000,000 times in the coming months, and you can see how some people can become upset – like right now! What is happening today is that the lenders, in many cases, are trying to “unwind” or sell their securitized mortgage packages where they have in many cases leveraged themselves by borrowing 7, 8, 9 or 20 times the amount of their cash investment in order to purchase those high interest bearing mortgages.

The most dreaded words in the investment business are NO BID, and that is what is happening now. Potential buyers have either said NO BID, having no interest in buying the mortgages or other assets, or they are offering very low prices that if a transaction occurred at that level would in turn necessitate the hedge-fund’s or other investors’ possibly having to mark down – devalue –their entire investment portfolio.

These investments in many cases had previously been marked to the investor’s “model” – often their cost – rather than marked to the “market.” But that is a different subject for a different day as it brings up the extraordinarily important question of how valid the previous performance records of many “investors” have been since the “real value” of the investors’ assets could have been worth far less than the value stated in their “models.” The validity of performance results in recent years is brought into question. And the conflict is that the money managers, for the most part and to a very large degree, get paid on their performance. We will soon get more evidence as to how much recent years’ performance results have been overstated. The degree of accuracy of reported performance results will be the subject of the SEC’s and other federal and state agencies’ investigations as the story unfolds, and the truth becomes clear.



The U.S. Federal Reserve bank lowered the federal-funds rate to just 1% in June 2003 and kept it there for more than a year. The idea, as told to the public, was to avoid deflation.

Mr. Greenspan said in August 2005, six months before retiring: “History has not dealt kindly with the aftermath of protracted periods of low risk premiums.” But what the Fed, i.e. Mr. Greenspan and Mr. Bernanke, did not foresee was the deluge of capital pouring into the U.S. from oversees. The effect was to keep our banking system awash with capital. Interest rates remained low, at least lower than they should have been, in our opinion. Mr. Bernanke has referred to foreigners putting their reserves into U.S. Treasury obligations a “global savings glut.” The Drudge Report as recently as July 20th stated: “Foreigners put more money into American stocks and bonds in May than in any previous month in history.”


Risk still exists although it is not mentioned in polite company and certainly not on TV.

In other words, it has taken seven years and two months for many of the averages to get back to where they were in the halcyon “dotcom” days — the craze that exploded in March 2000. Not surprisingly, there are now a number of other excesses that are sources for legitimate concern.

The U. S. economy seems to be coming in for the much desired “soft landing” and global money supply is at a level never seen before. However, continuing problems in housing and with the extraordinary financial leverage used globally by Hedge Funds and Private Equity groups could scuttle today’s market euphoria.

And we have not even mentioned the Leveraged Buy-Out Crowd and Private Equity folks out there who may have to be funding up to $500 billion under these conditions to complete their previously announced deals. There are many on that very large hook for $500 billion.

Again we would like you to note the following relevant comments from the Financial Times.

On November 7, 2006, the Financial Times carried an article titled “Big buy-out collapse ‘inevitable.’ “The collapse of a large buy-out is ‘inevitable’ and could ultimately pose a threat to the stability of the UK economy, Britain’s main financial watchdog warned yesterday as it became the latest national regulator to turn its attention to the private equity industry.” “The US justice department also recently launched an inquiry into potential anti-competitive behaviour among US buy-out houses.” There is currently a short-term approach and speculation in the financial sector in general that is bad for the economy. It must become more sensible. When you see groups buying one company after another and then another, you start to ask questions….” “The default of a large private equity-backed company is increasingly inevitable….” “Such defaults would have negative implications for lenders, purchases of the debt, orderly markets and conceivably, in extreme circumstances, financial stability and elements of the UK economy.

The results of a financial blow-up – or melt-down – will affect the US markets and ultimately the economy, just the same as in the UK and elsewhere in today’s Global Economy. In other words, each of us would be negatively and seriously affected.

Also note from the Financial Times on May 3, 2007 an article titled “NY Fed warns on hedge fund risk.” The first sentence began: “The risk hedge funds pose to the global financial system has reached levels by some measures comparable to those just before the Long Term Capital Management fund imploded in 1998, the Federal Reserve Bank of New York said yesterday.” “The bank’s study is the latest contribution to a debate that has seen regulators and analysts express concern over the risks and leverage taken on by hedge funds, the private investment vehicles that are increasingly influential in financial markets. The hedge fund industry has mushroomed in recent years and now accounts for an estimated $1,500bn ($1.5 trillion to us Americans) of investments.

The following is a quotation from “Et Tu, Paribas? (Review & Outlook) on the Opinion page of the August 10th Wall Street Journal:

What’s becoming clearer by the day is that we’re watching the unraveling of a global real estate financing bubble. The U.S. subprime market is the heart of the problem, but financial innovation has spread the risk around the world in a way that wasn’t possible a generation ago. Long-term assets – real estate – have been financed by hedge funds with short-term debt instruments, and the amount of the debt now exceeds the value of the collateral in these subprime investments. Somebody is going to have to swallow the difference….”

We will be the first to admit that we are unable to call market highs or bottoms. Imagine the markets to be like a pendulum that when at rest its “real” or “true” fixed point (or value in this case) is at 6 o’clock. Bull markets always overshoot to the upside, for example to 9 or 10 o’clock and bear markets to the downside, for example to 3 or 2 o’clock.

We repeat we are not in the “gloom and doom” business — just the opposite. Nevertheless, the above articles and comments are from eminently respectable sources that we take very seriously in view of our experiences having spent careers in the investment business in excess of 110 years. It is part of the struggle to Preserve Capital as well as to make money, and we have learned over those years that one of the best ways to “make money” is to keep from loosing it.

The tip of the Iceberg: If what has happened to Bear Stearns (two hedge-funds holding more than $20 billion of assets just several weeks ago requiring $1.6 billion – the numbers are still vague), Goldman Sachs (its Global Equity Opportunities Fund needing a $3 billion cash infusion after a 30 percent loss of its value last week and its flagship formerly $10 billion Global Alpha fund down 27% for the year as of last Friday, June 10th) and KKR, can such problems crop up anywhere else or with different forms of financial instruments? Take a guess. And keep in mind, while these players are not exactly warm and cuddly, they probably have had the most experience working with many of the “smartest” people inhabiting these non-eleemosynary intuitions.

The problem is years of unwise credit expansion and unwise use of leverage with the result that the Chickens are now Coming Home to Roost. The Trillion dollar question is how many Chickens are coming home and how long they will be staying.
John W. Hamilton
August 16th, 2007