Thursday, September 18, 2008

fixed income

The closing bell marks the end of another tumultuous day on the markets. I check my computer screen. As a welcome change, there's actually a smattering of green instead of the usual sea of red I have become far too accustomed with in the last several months. Still, the volatility is stomach-churning. An example of some tickers I'm following ... TCM: +1.22% ... QUA: +18.76% ... POT: -2.20% ... OIL: -3.47% ... G: -6.68% ... RY: +7.24%.

In these times of economic distress, maybe it's best to just focus your mind on other things. Like going to the greenhouse and photographing the tiny, one centimetre flowers of a Portuguese Squill. Lund, Sweden. (2008).

In the three-and-a-half years starfish and waffles has been online, I've never had much desire to write about the financial markets. Part of it was refusing to mix work with life. Most of it was not wanting to bore you to tears.

But these are extraordinary times. In the twelve years I've been embroiled in the markets, I've never seen anything like this. The undulating intra-day gyrations. The household names - Lehman, Merrill, AIG - vanishing virtually overnight. The unprecedented government and central bank intervention. The outright panic selling.

In essence, this is the economic crisis which started on Main Street. Too many US homeowners, who never had the wherewithal to be buying homes in the first place, figured out the hard way that the culture of "consume now, pay later" - meant that they actually did have to pay later. Imagine that. When they couldn't come up with the money, the greedy bankers - who were driven by their short-term, quarterly cycle of reporting and annual bonuses - were forced to foreclose, leaving these lenders with heavy financial losses and collateral with rapidly shrinking value. With such non-performing assets (loans), the banks had no choice but to call in loans and curb lending in other businesses, putting a freeze on the industrial, manufacturing and service sectors, which already were struggling to compete effectively with lower cost, offshore competitors. To cut costs, these companies announced layoffs affecting the very homeowners who just lost their houses. With no job and no home, no money was spent, further plunging the economy to greater depths.

Further up the chain, investment banks who bought up the questionable mortgages from the banks, collateralized them, and sold them (with fees, of course) to institutional investors acting on behalf of their respective clients (who were greedy in their own right, always pushing for that extra bit of return without a real understanding of risks) were getting sideswiped by the credit crunch as well. A seize-up in the liquidity required to run their everyday operations meant they, too, were in danger of violating the terms of their obligations and commitments. The problem was, there were a lot of such commitments, especially in large derivitative contracts - with notional value in the trillions of dollars - and suddenly, all of their counterparties were at risk.

With good reason, the authorities couldn't risk having the entire financial system collapse. Knowing full well that the troubled lending and investment banks needed equity capital to keep liquidity in the system from freezing, there had to be a way to prop up the share prices of these struggling financial firms so they had a hope of raising the necessary capital with minimal dilution to existing shareholders. And, as such, two things happened. First, the US government would announce a massive bailout package for the quasi-public Fannie Mae and Freddie Mac, who had their fingers on at least 50% of the outstanding mortgages in the United States. Second, the powerful Securities and Exchange Commission made it illegal to short sell the very financial firms that were in trouble.

The next morning, the hedge funds - those secretive, investment funds for the rich that so effectively circumvented normal securities regulations - were sent in a tizzy. See, being as clever as they were, the hedge funds had known for awhile that the lending and investment banks were in trouble, and they ruthlessly sought to profit from it. The winning trade: short the banks (borrow the bank shares, and sell them on the open market, hoping to buy them back at a lower price) and go long (buy) into commodities such as oil and metals and agricultural products, whose prices, reflecting normal supply and demand, had been heading up steadily since the turn of the millennium. However, the actions of the US authorities meant that the hedge funds were forced to unwind the winning trade and buy back the bank shares they had shorted. To finance that this, they had to sell the commodities they had previously invested in, sending commodity prices tumbling.

For awhile, the authorities' plan worked like a charm. The hedge funds unwound their trade, and the share prices of the banks went up as summer progressed. Unfortunately, the US lending and investment banks were having trouble finding anyone who wanted invest additional equity capital into their tenuous balance sheets.

And, finally, this month, time had run out for some of the financials who had been in the most precarious situations. Fannie Mae and Freddie Mac were completely nationalized by the US government. Independent investment bank Lehman Brothers declared Chapter 11 bankruptcy. The American Insurance Group, the world's largest insurance company, required and $85 billion emergency lifeline to stay afloat, leaving the US taxpayer owning 80% of the company. As I type, investment bank Morgan Stanley and savings and loan bank Washington Mutual are frantically searching for investor to provide them capital for mere survival ...

Ok, so the above was an outrageous oversimplification based on some of the stuff I've been reading the last little while. But you can sort of see why the situation is looking bleak, and the sensationalist financial press is wasting no time in calling it the worst financial crisis since the Great Depression. I don't really know whether or not this is true, but I do know for the individual investor who has worked to scrape together some hard-earned savings, the last little while has been a rough, humbling experience.

There's an old adage in the business which goes something like this: "markets can stay irrational longer than you can stay solvent." In times like these, fundamental valuation and rational thinking tend to go out the window. Someone in the theatre has screamed "fire!" ... and now everyone is rushing for the exits. And the results - all of those red, negative numbers - aren't pretty for those left holding the bag.

Speaking personally, I suppose I've been at this gig long enough that I should've known better while it was all happening. But, as they say, retrospect is always 20-20. You live, learn, and see another day to live again.

So, at this point, is it worth holding on, or is it time to just throw in the towel? This is a good question. But my inclination is that this storm, too, shall pass. Even though the US housing market is in shambles and Europe is mired in recessionary conditions, something tells me that the upwardly mobile - i.e., the growing middle class - in populous places such as China, India and Brazil will be the counterbalancing saving grace. To state the obvious, those who are new to the middle class buy things like cars, appliances, and houses - and, this, will be good for the world economy.

Eventually, markets should act rationally once again. And, just maybe, this is something you can take to the bank.


  1. So long as the supply and demand of Sugar Crisp are doing well. All is well

  2. Good point. Let me tell you, the editor sure is relieved that all seems normal in Sugar Crisp market. (^o^)