17 August 2007

So, you wanna work in finance?



I wanna try and explain whats happening with this ongoing sub-prime lending and credit crisis hysteria as best as I can... but first, let me direct you to this amazing article on Slate the other day which dissects the doublespeak language of Hedge Funds, "How to Speak "Hedgie"... 'twas a brilliant article. They had another good one today, too: "How Do You Inject Money Into the Economy?" Cheers, Slate!

So the Dow has been up and down and all around for the last 2 weeks and if The Times says it's a "crunch in the American credit market" again, I'm gonna freak.

OK, so subprime lending is a general term that refers to the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history. It's basically like yeah we wanna lend you $ so you can invest, even though you're up to your eyeballs in credit card debt. I've heard it explained as crude as this: "Subprime refers to shitty loans given to people who can't possibly pay them off."

So naturally, subprime lending is risky for both lenders and borrowers due to the combination of high interest rates, poor credit history, and murky financial situations often associated with subprime applicants. It's like lending an empty box to someone who's already got nothing.

Subprime lending encompasses a variety of credit instruments, including subprime mortgages, subprime car loans, and subprime credit cards, among others.

Therefore, subprime lending is highly controversial. You can't get blood from a stone, right?

Oh, and the term "subprime" itself actually refers to the credit status of the borrower being less than ideal, not the interest rate on the loan itself.

Opponents have alleged that the subprime lending companies engage in predatory lending practices such as deliberately lending to borrowers who could never meet the terms of their loans, thus leading to default, seizure of collateral, and foreclosure. Dun, dun, dunnnnnnnnnnn!

Proponents of the subprime lending maintain that the practice extends credit to people who would otherwise not have access to the credit market. They want you to play the game, so they'll lend you some balloons... and they win whether your balloon pops or whether it soars to the heavens. Ya hurrd?

So all them mortgages given to people who really couldn't afford them - made even less affordable by high interest, i.e. subprime rates - were subsequently sold, after being repackaged into strange derivative instruments, etc. and bought by hedge funds.



Hedge funds claim these instruments have value, as certified by credit rating agencies. So they can buy stuff - like stocks - with these loans as something like collateral, or rather as proof that they can pay for stocks when called upon to do so (i.e., margin call on futures, etc.)

Guess what? Those mortgages and the CDO's etc. that they were repackaged into have NO VALUE, because Joe Subprime can't make his mortgage payments.

Now the hedge funds are overexposed, they don't really have enough money to
a) justify all the positions they have in the stock market, and
b) pay back all the investors, who are going to come calling now that it's evident the hedge funds are not as solvent as they should be.

So, what do the hedge funds do? They need money, and the mortgage-backed securities they hold are worth dirt. So they sell stocks they're holding. Which drives the market down.

This is bad for investment banks, etc. and they are in a tight spot, since their own stock is now plunging in value - no buyers, lots of sellers - and so they try to prop up the market by buying their own stocks, getting the Federal Reserve Bank to make it easier for investors like them to do so (this is called "injecting liquidity"), and MOST IMPORTANTLY by trying to convince Joe Investor that NOW is a GREAT time to buy because EVERYTHING IS UNDERVALUED NOW and what a SUPER DEAL these stocks are, while trying to keep a straight face.

It won't work, because few people are dumb enough to buy, so all the big players are in a tight spot --they want people to buy, but damned if they're the ones who will go out on a limb. So they sell, but hope somebody else will buy.

BUT, nobody's buying soooo the market plunges.

So, right now if you look at the long-term trends stocks are your absolute best value. Short-term shit and Gordon Gekko wanna-be's in fast red cars, you're all fucked. The bottom has fallen out. But it always does and soon this will all blow over, like it always does, but before it blows over, it'll probably get even worse.

There's also some ish with countries who invest overseas - and they all do - so say a big Co. has a bunch of money in Japan, and they have to yank it all out, now the Yen is gonna shit the bed, too.

As for real estate and mortgages and all that hullabaloo, it means nothing for us New Yorkers - properties here will still be unreasonably expensive. But, outside NY, things will stabilise and houses out in the sticks will go back to being cheap.

I guess it all depends on what your savings are invested in. If it's in low quality, riskier snake oil companies then, well, you're screwed.

If it's in large, high quality companies like GE, Microsoft and Johnson & Johnson, you may lose money over the next few months, but longer term you'll be OK because like I said, it'll settle after a while.

This is turbulence. This is "volatility in the market". Its happened before. Its cyclical.

If you work in finance or on The Street, you might lose your gig, especially if you're a big dog. This is the time when big dogs get taken for walks, not the little guys, not the bottom-feeders, you're all safe. They'll need you here later when the market levels out. But in the meantime, you can kiss that year-end bonus goodbye and chances are that Christmas party will probably be moved from the Waldorf to a phone booth on 41st and Park.

Best quote I heard was: "America sneezes, and the whole world gets a cold". Basically, that's the deal.

Thank you and goodnight.

Please, I welcome your insight and comments.

Read:
Bloody and Bloodier: The subprime-lending crisis is worse than you think, and could crush financial and real-estate markets for years.
By Mad Money Jim Cramer

ADDENDUM:

All abstract markets (stocks, bonds, derivatives, etc.) are basically just big experiments in psychology. They work on self-fulfilling prophecy.

If everyone thinks the Dow will keep climbing forever, the damn thing will. But once someone gets the jitters, and spreads them around, everyone wants out and, sure enough, the bottom drops out. The problem is figuring out whether people are only temporarily freaked out or actually permanently freaked. Hint: they don't know yet -- they're waiting to see what everyone else does.

The stock market right now is starting to reflect the fact that people are worried that tons of debt has been issued to a bunch of dolts.

People bought houses that they couldn't afford and wrote checks their ass couldn't cash (I love that term, its timeless), Oh, and companies borrowed against bad business models, and banks lent them this money without even charging them the right kind of interest rate to reflect the risk or checking to make sure they weren't total deadbeats...

The economy has been flashing the danger signal all year as a bunch of signs that slightly lean times are coming all kind of went off. But recently, it all came to a head when some big players - hedge funds and private equity funds - started being unable to get money because banks were running out of it. Read "Crunch all you want, we'll make more" from earlier today.

Banks were tapped pretty hard to begin with and now economic conditions have made it difficult for people who took bad debt to make payments on it. This is a "credit crunch" - banks are so laden with crappy loans to deadbeats that aren't generating cash flow that they can't even lend it to JoeyTony with 850 Credit Score.

The worst part is, your mortgages and car loans that you aren't paying back get bundled up into big stock-like thingies called MBS securities. Hedge Funds, Mutual Funds, and Investment Banks buy a bunch of these and "collateralise" them - put them up as the payback if they can't put up their debts - to use them to take out loans.

So now, if the Hedge Funds screw up and get in trouble, the stuff they used to justify the big loans THEY took out isn't worth anything to the banks anymore.

Hold onto your hats as we'll have to pay the piper for a little while. That said, the world won't end (just yet) and stocks remain good long-term investments.

3 comments:

Anonymous said...

The NY Mag article Cramer wrote explaining his freak out is actually very detailed and informative and he makes an incredible amount of sense.

Even I saw this coming and I only took college-level Economics.

http://nymag.com/news/businessfinance/bottomline/35813/?imw=Y

In general... expect massive finance industry layoffs (with many who don't have golden parachutes).

Expect little to no bonuses this year.

Expect much of the disposable income that the finance industry pours into NYC disappear.

Now trickle that downward since NYC economy is very much tied into the service industry and the people who provide those services.

Expect housing prices to fall.

Expect people failing to meet their credit loads.

Expect an overall downturn in the economy.

Also expect hipsters to actually get jobs since looking dirty won't be cool anymore when you really don't have parental money to wash with.

Anonymous said...

The subprime problem breaks down like this: "Subprime" refers to a borrower who has crappy credit or who is almost borrowing more than they can afford.

Many of the Mortgages they are getting are structured to have small payments in the beginning but these can get much larger later on as interest rates change, etc.

From the start, these loans are risky and now a lot of people can't afford the payments.

Now switch to the business side.

Most "subprime" lenders are not normal banks. This means that they don't have the money to lend and must get it from somewhere else....Wall Street.

They get their money by selling these big investment products called "asset-backed securities" to investors on Wall Street.

Normally these are safe investments because they are "backed" by Mortgage loans.

But since a lot of the loans are going bad, people are loosing money.

As a result, most Wall Street investors have pulled back their money...and the Mortgage companies are screwed because their business model depends on these investors.

The effects of this situation have rippled through the markets, scaring investors and banks alike.

As a result, there is less money available in the credit markets and this is bad news for everyone. All businesses need credit.

Got that?

Anonymous said...

This was very good
You should write one of those "for dummies" books with all this random stuff you write and know about.
I will buy a copy