Sunday, September 21, 2008

Apocalypse Now

This is a stub to mark the financial meltdown that occurred last week.

In a previous post The Party's Over I suggested the art market was going to contract over the next few years. According to Crain"s New York Business, the Spreading pain will cost 90,000 jobs

Retailers will be hit hard, particularly those in the luxury sector, as out-of-work Wall Streeters trade down to mid-tier stores from upscale ones. And brokers are steeling themselves for a slowdown in leasing by luxury retail tenants. They are preparing to lower rents in order to lure tenants into their expanding portfolio of empty spaces.

“Consumers react to news,” says Matthew Katz, managing director of AlixPartners, an advisory and consulting firm. “Certainly the events of [last week] were enough to provide some shock.

It is possible, even likely that money will continue to flow into the very high end of the market in an attempt to redeploy assets. This has happened in the past and I believe it was partly the reason for the success of the Damian Hirst auction recently. Regardless how this plays out, it seems fairly clear that the other sectors of the market will feel the pressure.


Hans said...

"“The point everyone misses,” wrote economist Robert Chapman a decade ago, “is that buying derivatives is not investing. It is gambling, insurance and high stakes bookmaking. Derivatives create nothing.”1 They not only create nothing, but they serve to enrich non-producers at the expense of the people who do create real goods and services. In congressional hearings in the early 1990s, derivatives trading was challenged as being an illegal form of gambling. But the practice was legitimized by Fed Chairman Alan Greenspan, who not only lent legal and regulatory support to the trade but actively promoted derivatives as a way to improve “risk management.” Partly, this was to boost the flagging profits of the banks; and at the larger banks and dealers, it worked. But the cost was an increase in risk to the financial system as a whole.2"

worth reading:

George said...

Most people fail to realize that most investments are a form of gambling, risk taking. So I won't argue that point.

Derivatives have a function in modern finance. They allow one party to moderate the risk on their side of the investment. When the price of oil goes up, it was the producers who sold for future delivery as the prices rose. It was the users who bought in order to maintain their supply of oil at a known price. Speculators traded both sides of the equation and add liquidity, they increase the contract volume and moderate brice behavior.

Most of the complaints against derivatives are misplaced, or made by those with outdated ideas about modern finance.

There is a very basic problem which capitalism is being forced to reconcile. At the extremes of price behavior the normal functioning of free markets becomes distorted by fear or greed. In another era we might have been able to live with the excesses that result but the world economies are so interconnected that this is no longer an option. It needs to be dealt with in order to prevent the condition we find ourselves in today.

zipthwung said...

back in 2007 when everyone (harpers and you for instance) was all, "subprime's looking a bit bumpy," you said there were measures to be taken, and I didn;t pay attention, really - though I now have a small amount in a mutual fund (and I cashed some in at the wrong time, though not much)

I;m hoping this dealio wont last past feb, it will all come roaring back to like 12000 n the Fotune 500 and life will be grand.


Blogger zipthwung said...

I'm a man of means by no means....

Sub-prime. I didn't know or think about what it meant, not being in the market for a loan nor having any money to play the market with.

Sub prime. Below good. Not the best.

But very favorable for loan sharks.

I must say this whole bundling of loans together into bonds seems a bit abstract to me - like set theory. When you pull the strings at either end someone is left holding the bag.

Or not, I don't know what I'm talking about.

Oh yes, art, well that's all good.
October 6, 2007 11:31 AM

Hans said...

Zipthwung, it's really not very difficult to understand what is going on, when you know this:

"U.S. banks getting more than $163 billion from the Treasury Department for new lending are on pace to pay more than half of that sum to their shareholders, with government permission, over the next three years.
The government said it was giving banks more money so they could make more loans. Dollars paid to shareholders don't serve that purpose, but Treasury officials say that suspending quarterly dividend payments would have deterred banks from participating in the voluntary program."


Best regards

George said...

There are good loans and bad loans, most lenders know they will have a certain number of loans default and set aside a certain amount of money in reserve to account for this.

Bundling loans = bundle ten loans of similar quality together and divide by ten. The new bundled loan now represents 1/10 of the bundle elements so that if one loan defaults the loss is 10% not 100% (in theory)

This isn't in principle a bad idea, it does reduce risk IF certain prudence is used in making the original loans. At the end of the real estate bubble (world wide not just the US) riskier loans were made on property which at the market top, turned out to be overvalued. This became a problem.

The real problem lies somewhere else, in the derivative instruments called CDO's which essentially are like a bet on whether or the loans will default or not. These were used as "insurance" by the bundled loan holders. They bought CDO's which would pay off in the event the loans defaulted. The writers of the CDO's took on the default risk but as long as the real estate markets held up, writing CDO's was like printing money, profitable because no one cashed in.

Enter the speculators, who bought and sold CDO's primarily as a bet on the real estate market. The writers (hedge funds, AIG etc) raked in the dough on the front end assuming nothing bad would happen. Speculators, bought CDO's because they thought the real estate markets would decline and the CDO's would pay off. The bets would pay off $20-$30 to $1. This essentially is nothing more than gambling.

These markets were totally unregulated by the Bush administration Treasury Secretaries. "Unregulated" means that NO ONE knew how many CDO's there were, or how solvent the issuers were (could they pay off). NO ONE really knew how all these trades interlinked, who the counter-parties were, so in some cases financial institutions might have clients who would go broke issuing CDO's and the financial institution would have to absorb the loss because their client defaults on the account.

As the CDO's mess started to unwind, the brokerage houses lost money both on their CDO and bond bundle holdings and also due to counter party defaults. As a result, everyone got very skittish and began to pull money out of any institution which looked like it might be in trouble. When someone withdraws capital from a financial institution, they have to come up with the capital. Banks don't have cash just sitting around, it's loaned out or invested. So the banks had to sell bonds, investments and other financial assets in order to meet the redemption's.

Selling into a weak market forces prices down and a negative spiral was created which could and did bankrupt certain financial institutions. So we saw them fail one after another until the Treasury department finally stepped into the pile and started shoveling.

The problem became one of trust, the lending institutions didn't trust each other enough to make loans and the credit markets froze up. This meant that not only was it impossible to borrow money with a loan but that the commercial paper market froze solid. Commercial paper is a short term lending instrument, usually 3 months or less, so less time risk and a cheaper way to borrow. Commercial paper is used to finance the day to day business of the world and this became the critical problem.

As a result of all this, the world economies essentially stopped for a month, and this is causing all the wold economies to enter a slowdown or recession. The recently announced declines for the US GDP were fairly sharp BUT only account for September before the crisis hit bottom, so I expect the next report will be even more severe.

All of this has scared the shit out of the consumer who has totally stopped spending on anything other than essentials. I saw a graph of consumer confidence recently, the drop is the most severe ever recorded and frankly scary. In the end everything will work out but I don't know where the end is.

Hans, the Fed lending and the bank dividends is more complicated an issue than it appears on the surface. If the dividends are cut, the stock prices will decline and that will reduce the banks equity portion of their capital reserve requirements which means they will need to borrow more money. Catch-22

zip email me, the offer for a drink still stands.

out for the day, going to MOMA