Thursday, April 17, 2008

The Markdown

I've been saying that the pricing in the markit indexes are ridiculous, and that those prices are overstating the risks:

Yesterday, Bloomberg finally came around and said the same thing saying it has become a monster:

"Swaps Tied to Losses Became `Frankenstein's Monster'
By Neil Unmack and Sarah Mulholland
April 15 (Bloomberg) -- The credit-default swap market has become a lesson in being careful what you wish for now that Wall Street has taken $245 billion of losses partly tied to such exotica.

Rather than dispersing risk and lowering borrowing costs as former Federal Reserve Chairman Alan Greenspan predicted, the contracts have exacerbated the debt crisis. What was intended as a way for lenders to protect against defaults spawned a market covering $45 trillion of bonds and loans where no one knows how much is traded and speculators who bet on deteriorating credit quality end up forcing that reality.

Some credit-default indexes have morphed into what Wachovia Corp. analysts led by Glenn Schultz call ``Frankenstein's monster'' because they now often drive prices in the so-called cash bond market, rather than the other way around. Fearing a repeat of losses, banks are refusing to support new indexes that would allow investors to wager on everything from auto loans to European mortgages, reining in a market that's about doubled in size every year for the past decade.

``The indices are just trading on their own account with no relationship whatsoever to an underlying cash market that's ceased to exist,'' Jacques Aigrain chief executive officer of Zurich-based Swiss Reinsurance Co., said at a March 18 insurance conference in Dubai.

Lack of Support
Markit Group Ltd., the London-based index provider, said banks last month shelved plans for indexes intended to allow investors to speculate on the $200 billion market for bonds backed by U.S. auto loans because of a lack of dealer support. Indexes on European mortgages and U.S. Alt-A loans, or mortgages made to borrowers a step above subprime, were also postponed.

``The last thing the securitization market needs is another no-cash-upfront instrument that people can use to knock the markets about with,'' said Andrew Dennis the London-based head of the asset-backed debt syndication group for UBS AG of Zurich."

Institutions are trying to load up in the REO market, and nobody seems to be able to put deals together at the prices that they have agreed on. Which means prices have to go higher. Which means housing losses are overstated. Which means those short hedge funds that profited from the marking of their shorts to the crazy marks that these indexes reflected profits gains are just as phantom as a mark as a peak housing valuation at the top of the market. Here the homeowner took the gain with his home equity line of credit! But now you've gone from a peak to a trough in housing pricing because 40% of the sales are foreclosures!

But now the banks, the distressed sellers of the foreclosure property, are now thinking twice about parting from their REO inventory at these prices.

Look at the chart halfway down in the next link detailing the drops in California in one year!

Foreclosure resales - houses sold after being foreclosed on continue to dominate many inland neighborhoods. More than one out of three Southland homes that resold last month, nearly 38 percent, had been foreclosed on at some point in the prior year. This time last year such sales were only 8 percent of the market. At the county level, foreclosure resales ranged from 28.8 percent in Los Angeles County to 56.4 percent in Riverside County....

In recent months, foreclosure resales typically sold for about 15 percent less than other homes in the surrounding area. When these foreclosure resales dominate a market, accounting for more than half of all sales, they tend to tug home prices down by an extra 5 to 10 percent when compared with communities where foreclosure resales are less common.

The NY Times talked about the billion dollar payday these hedge funds reaped.

Hedge fund managers, those masters of a secretive, sometimes volatile financial universe, are making money on a scale that once seemed unimaginable, even in Wall Street’s rarefied realms.

One manager, John Paulson made $3.7 billion last year. He reaped that bounty, probably the richest in Wall Street history, by betting against certain mortgages and complex financial products that held them...

Even on Wall Street, where money is the ultimate measure of success, the size of the winnings makes some uneasy. “There is nothing wrong with it — it’s not illegal,” said William H. Gross, the chief investment officer of the bond fund Pimco. “But it’s ugly.”

The richest hedge fund managers keep getting richer — fast. To make it into the top 25 of Alpha’s list, the industry standard for hedge fund pay, a manager needed to earn at least $360 million last year, more than 18 times the amount in 2002. The median American family, by contrast, earned $60,500 last year.

Combined, the top 50 hedge fund managers last year earned $29 billion. That figure represents the managers’ own pay and excludes the compensation of their employees.

Does anyone find it ironic that these folks making billions and billions of dollars, have done it on bets that the average Joe cannot make, and with pricing that isn't transparent that doesn't reflect the actual values?

Remember Warren Buffett's interview with Becky Quick of CNBC last month?

Here's part of it:

QUICK: But we're going to start off with a question about derivatives, because Joe, you brought this up earlier. You were talking about those comments that Mr. Buffett's made in the past about these being weapons of financial mass destruction. And Warren, you said you had a couple other thoughts on derivatives.

BUFFETT: Well, you know, the ways you get into trouble in markets is doing things you don't understand, and then doing them with a lot of borrowed money. And derivatives combine those things. And--but the really important illustration that has never gotten picked up on much was that a couple of years ago Freddie and Fannie got into big trouble, billions and billions and billions of dollars of--that they had to restate. Now, Freddie and Fannie had auditors like everybody else, but they also had a government agency called OFHEO that had 200 people in it whose sole job was to oversee Freddie and Fannie. Two hundred people going to work every day, and those people did not pick up at all on all of these problems that Freddie and Fannie had. I mean, they were looking at complex financial instruments, you know, all kinds of swaptions and all that sort of thing. The auditors didn't pick up on it, but more important, 200 full-time--they didn't have to think about General Motors, they didn't have to think about AT&T. They had two companies to think about. And they issued a report later on telling about the failing of all--everybody else.

QUICK: Mm-hmm.

BUFFETT: But it shows you--when things get that complex, you're going to have a lot of problems. And CDO squared--I figured out, on a CDO squared you had to read 750,000 pages to understand the instruments that were underneath it.

QUICK: Oh, my gosh.

BUFFETT: Yeah. Well, you start with the RMB, that's the residential mortgage-backed securities, and that would have 30 tranches. And then you'd take--and that would be a 300-page document--you'd take a tranche from each one of that and create a CDO, 50 of those times three--300, you know, it becomes 15,000. Then you take a CDO squared with 50 more, and now you're up to 750,000 pages.

QUICK: You have to read through it.

BUFFETT: And the mind can't comprehend that. What people did comprehend was that the fees were terrific in selling them to the people.

So you have 200 auditors looking over Fannie and Freddie's books, and they can't find any problems, although the problems amount to the tens of billions of losses that weren't recognized.

Now you have hedge funds booking tens of billions of gains, but the auditor doing their books now knows what they are doing!

Today IBM announced blow out earnings after the close. A few weeks back, we were told that IBM's earnings would be punk because financial service firms would be cutting back, and that their business would be slow since Oracle's was. And Friday the world was coming to an end because GE missed.

Whoops. The story changed! I guess that's the difference between stocks and derivatives. We have transparency and liquidity in the pricing of stocks.

Of which you have neither in derivatives.

Wait until this bull market unravels the bears who've booked these billions of profits on these derivative positions of which they haven't closed!

But then, they've already taken the profits on the marks!

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