Summary
Hedge fund losers are going to begin appearing. The crisis atmosphere in the markets will spread further. But this asset class does have a downside valuation floor. Hard-core rigorous analysis is identifying major trading opportunities in the current crisis. The bigger longer term opportunity is already starting and creating new money vehicles to capitalize on the improved pricing and discipline in the market.
Analysis
·This article rightly celebrates the wins of the hedge funds who bet short on the current subprime mortgage crisis. But there is counter-party to every trade. Figuring out who are the losers in the current crisis is where the big longer term money will be made. The shorts have bet on this cycle’s inflection. But what is more profoundly happening is an industry restructuring.
·The losing hedge funds are only now beginning to report their performance, after they have been shopping looking for better pricing indications in the midst of the market meltdown. When the figures are in, I suspect we’ll find that some of the supposed hedge funds were not in fact that hedged. The losses will certainly reduce risk-bearing capacity on the street. But what about the second order effects? Will New Century declare bankruptcy now that its liquidity lines have been turned off? Will investors be spooked and withdraw funds. Will there be a rush for the exits at some funds, as the article suggested almost happened? Could we see a contraction of certain sectors of the hedge fund industry, or the CDO sector? Certainly the investment banks are all feeling it now, on the trading floors and in their treasury departments for holding the risks on balance sheet; and it’s being reflected in their share prices. How far will the contagion spread? The strain on the consumer is already beginning to be seen in various other sectors, as individuals are normally more likely to go into arrears on their unsecured than on their homes. Thus delinquencies are already being seen in subprime auto and pay day loans (anecdotally). Surely, it is also being felt in credit card and subprime oriented consumer banks. Rationally, spreads are widening out in those sectors. But spreads are also widening in commercial mortgage backed securities, even though their fundamentals haven’t changed. The general risk-bearing capacity and system liquidity is being reduced as nervousness increases. The volatility index rises. Where will it stop? Is the nervousness about excess liquidity also behind the sharp drop in emerging markets? The great global euphoria from recession recover was behind the money multiplier and related liquidity expansion that drove down the risk premium. Is that euphoria now over or being tempered? What would that do to the pricing of capital in the economy? Is not this second-order effect on the markets actually far greater in ultimate impact than the direct impact of reduced construction employment? For one, I don’t think this scenario will go so far as to cause a hard landing and a 33% probability recession. It will be contained and absorbed. But the effects will certainly be felt on the margin and in specific sectors for a long time to come.
·The sense in the markets now is one of panic, rumor and conjecture. But now is the great opportunity for rational analysis to prevail. These residential real estate asset values do have an intrinsic floor based upon the historic affordability norms. This downside valuation sets a floor. From that the financial asset values can be marked to hypothetical market. Securitization residual values can be set. CDOs can be valued. Subprime lenders and banks can be valued; and impacts on investment bank share prices can be seen. One can identify those over-sold and under-sold in the current crisis. It’s time for calm and fast analysis to be done.
·Now is basically the eve of the death of the subprime mortgage banking industry as we know it. But, also as the article began to allude to, now is the time to begin to position for the rebirth of a new and better industry that will be reborn to continue to fulfill the positive function of helping lower income households own their own home. Just as happened post-Katrina in the insurance industry, new funds are already being formed to originate and underwrite and securitize new vintages, but on much stricter criteria and with much better pricing of risk. I know of various teams that are putting together distress funds, servicing platforms, new originators, etc. The phoenix is already beginning to rise from the creative destruction in the classic economic cob-web cycle of boom and bust. This is where big long term money will be made.
