Wednesday, October 1, 2008

be careful what you wish for

everyone is placing a lot of hope in this bailout plan to fix the financial system, cure cancer, end global warming and bring prosperity to the downtrodden.

I am not buying it... there are so many philosphical/causation flaws with it I am truly concerned.

some have called for a transparent market for mortgage-backed securities. my response to that is: be careful what you wish for.

first of all, I don't think the market suffers from a lack of transparency. bonds have traded over the counter for decades, with poor transparency. yes, it allows market makers to rip people off by charging large bid-ask spreads, but transparency alone doesnt fix the market. we've had good and bad credit markets before and not many people ever cited transparency. penn central didnt fail because its bonds were traded privately over the counter.

when people look to shell out millions of dollars on stuff, they will figure out the right pricing and brokers will come out of the woodwork to serve them.

I think the problem is actually that the market is becoming more transparent, and the truth emerging is now scary as hell.

I talk to a lot of credit investors... people who plow tens of millions of dollars into different kinds of securities every day. for months, they said there we being innudated with "bid lists" -- big "for sale" announcements from banks looking to unload tons of bonds on their books.

now, months after I heard this, banks such as Lehman, Merrill and WaMu go under because they had "writedowns" and their assets were worth less than they thought. I beleive that the bid lists we saw in the markets over the summer started getting the ball rolling on a new market. and, investor reception was terrible. people were selling stuff left and right, and the prices plunged. that's what killed Lehman, Merrill, etc.

so, for those who call for greater market transparency, I respond: hey, you're already getting it, and it's not pretty.

I also see deeper problems with the gov't trying to create a market for these illiquid assets: they are considered "level 2" or "level 3" assets. that means banks have to be less truthful about their values. basically, they can say: there's no market for these securities, so I can say they're worth x.

here's the problem: what if we actually CREATE a market? we could force level 2 and level 3 assets to become level 1 assets? I fear this could actually cause banks to take writedowns even faster, and ACCELERATE the collapse.... sometimes ignorance is bliss.

another point: these wierd MBS are all different, with all sorts of eccentric features. they were never meant to be traded. they were meant to be held to maturity.

what happens if you take a bunch of stuff that was never meant to be sold and force it to be sold? I think it gets completely crushed in value.

furthermore, credit investors' normal response to wierd, nuanced issues is to demand concessions, meaning higher yields and lower prices. people liked these instruments during the bubble because they gave extra yield. but if they all get thrown on the market at the same time, I fear a blood bath.

imagine you get hired by a company and they force you to spend $100 on an overpriced fake-gold name sign for your desk when you're hired. say for some strange reason, you decide to think it's worth 100 when you make your personal balance sheet.

now say the company decides you need to have fake silver instead of fake gold. they say, don't worry about that $100 you spent -- you can now just turn around and sell your old fake gold nameplate.

under a situation like this, everyone would rush to sell their fake gold name plates and they would all be worth a few dollars, if not a few cents.

this is what's happening in the market now. under the old scenario, there was a compulsion to own exotic mbs. that compulsion was based on the fact everything else was so expensive that they needed the extra yield.

now, it's the opposite. no one wants the extra yield.. people want safety. so the exotic aspects that made those old bonds so attractive are now the same thing that make them toxic. they are now like the fake-gold name plates. creating a market for them will just make them cheaper. this is a different world, with different rules. home prices are falling now. these things only made sense when home prices were going up.

finally, let me say that all the recent "market bottoms" occured when something unexpected happened... the fed rescued bear in march and opened the discount window to ibanks in july. niether was widely expected before it happened... both made stocks bounce.

this time, everyone expects -- and is praying for this bailout to pass. to me, that's very bearish. stocks are no longer pricing in fear, but hope. I am sure it will pass ... but then.. WHAT ABOUT AFTER THAT? people will be praying it fixes the credit market. what happens when it doesnt?

we are going into the debt-based death spiral. it's happened many times before. look at a chart of aig, rhd, leh, etc. its just this time, its happening to the entire economy.

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