Some calendar months ago, I wrote an article (published on this site) entitled "A Sub-Prime Economy" and I urge on anyone reading the followers piece to revisit that material, both to see what was incorrect about it, and what was right. In it, I predicted that the gun trigger for fiscal problem would come up either in the word form of an overheating economy, which would drive up involvement rates and end the epoch of easy money, pushing edge companies over the cliff, or, alternatively, that a weakening economic system would fasten up loaning standards, starving weak companies by blocking their resource to working capital, and increasing concern failures. I was wrong.
While even the chronically optimistic must surely now acknowledge that there is a job in the working capital markets, and that it has, in fact, spilled over into equities, the electrical fuse have been lit not by either of the phenomena described, but rather, by the proverbial "tail wagging the dog." That is to state that while the basics of the "Global Economy"—more about that hackneyed phrase below—remain strong, they endanger to be compromised by an absence of entree to credit, hitherto provided by hedgerow finances and private equity sources, with seemingly eternal pools of easy money looking for a home.
Can it be only a few hebdomads ago that the never-say-die cheerleaders for the marketplaces (who, by some charming coincidence, are, for the most part, people engaged in the concern of merchandising securities) were telling us that we necessitate not fear, because the human race was "awash in oceans of liquidity?" Now, cardinal Banks worldwide are intervening almost around the clock to supply needed liquidness to recognition markets.
As for this author, I thought I saw the worm bend about two hebdomads ago, when, in the human face of enormous (and rather scary) volatility in both directions, the folks at Emma Goldman Sachs trotted out Abby Chief Joseph Cohen to state us that the bull was alive and well, give thanks you very much. I had forgotten about Abby Chief Joseph Cohen, and last retrieve her telling us in March, 2000 (the last hooray for the cyberspace bubble) that that, well, the bull was alive and well. Ms. Cohen has, to the best of my knowledge, never suggested publicly that the marketplace might {gasp!} travel down.
Further grounds of a alteration in temper can be establish by anyone who is a regular spectator of CNBC. Gone are most of the smiles, gags and general affability that could always be establish when the outlooks were of an endlessly rising market. Gone is that most bothersome "cowbell" signaling which rang at CNBC to announce any proclamation of short letter in the concern world. And although CNBC is supposed to be a beginning of concern and marketplace news, any regular spectator of its scheduling can have got no uncertainty about the built-in love for bulls and loathing of bears exhibited by its on-air talent. After all, just as Sellers of securities desire us to believe that the marketplaces will always travel up, CNBC's manufacturers understand well that broad, general involvement in the marketplaces (and hence, higher ratings) addition dramatically when the marketplaces are rising. But today, the featured invitee of CNBC before the U.S. Markets opened for trading was none other than Wilbur Ross, the undisputed Dean of Distress. Wilbur is an icon in the bankruptcy/restructuring/turnaround world, and, speaking for myself (I have got spent over 25 old age in this field), I readily admit that Wilbur have probably forgotten more than about this topic than I will ever know.
And yet, his observations on the current disturbance in the marketplaces were succinct and remarkably simple. He noted that: "for the past two years, consumers have got got spent more than than than they have earned, and the authorities have spent more than it have earned (sic)." He pointed out the obvious: that such as a state of affairs cannot go on indefinitely. He attributed some of the recent troubles to what he called the two most unsafe words in the English Language: "Financial Engineering," which, according to John John Ross intends that "someone have figured out a manner to underprice risk." Ross noted that many people had relied entirely, and to their detriment, on evaluations federal agencies and bought merchandises that were designed to sell a "risk ignorant charge per unit of return." According to him, such as a pattern "always have a bad end."
Yet, the purveyors of promised net income will, undoubtedly, go on to state us that this is a mere "blip on the microwave radar screen," and that the indestructible "Global Economy" will salvage the day. If 1 have a memory that ranges back to before yesterday afternoon (not such as a given in an industry whose "captains" are often "twenty-somethings"), one mightiness easily replace the words "Global Economy" for the words "New Economy" that was so prevailing during the cyberspace bubble. One mightiness also easily recognize that the recent and monolithic batch of private equity deals, in which finances get public companies, and finance their acquisitions with either low-cost loans or investor working capital secured by assets of the mark company are (not-so) strangely evocative of the purchase buy-out roar of the late 1980's, so well-exhibited in the movie Wall Street. Those trades certainly came to a bad end.
The difference now, the starry-eyed optimists state us, is that the defaults in these trades are much more than hard to trigger. In fact, some of these private equity trades have got commissariat in which, if the borrower cannot pay, in cash, it have the option of merely issuing more than stock to the lender. That system plant fine, until and unless the borrower is in echt difficulty. It may not be in default, because it reserves the right to publish more than stock (of ever-increasing worthlessness) to its lender. So what have been accomplished? The hazard of fiscal catastrophe have merely been transferred from the borrower to the investors in the private equity deal. To my knowledge, cipher has, as yet, figured out a chemical mechanism to bring forth "junk bond" degree tax returns with "treasury instrument" recognition quality. And yet, the investors in many of these vehicles have got somehow allowed themselves to be bamboozled into thought that person had.
And they were willing to pay astronomical fees for it. Now, of course, many investors are running for the exits, aghast at having actually lost capital! And the "Financial Engineers" are begging the Federal Soldier Modesty to sit in to the deliverance and cut down the Federal Funds rate. Who would profit by such as action? Well, the stock marketplace would likely travel up, at least for awhile. Are the Federal supposed to be in the concern of propping up the stock market? On the other hand, there would almost certainly be run on the already battered U.S. Dollar. The Sub-Prime mess would not be solved by any such as action, as it stands for much more than than a job of less than leading borrowers. It is mostly a job of declining lodging values in a system where there was cherished small equity from the purchasers in the first place. Borrowers who could not afford conventional mortgages bought homes, upon which they set small or no money down, and took on mortgages at teaser rates, which are now adjusting to market.
So who are the victims? Not the lenders. They got their fees and their points. And they got paid again when they "securitized" their loan retentions and sold them on a marketplace newly created and packaged by other "Financial Engineers." Not really the borrowers, either, who got houses without having put option up any equity, and paid (for awhile) low-interest mortgages instead of rent, for a topographic point to dwell which they could not otherwise have got afforded.
But if the Federal plays the function of the cavalry, or the Government embarks upon yet another bail-out plan (anyone retrieve the Savings and Loan crisis?), we KNOW who the victims will be: the taxpayers. We will be called upon to salvage the Banks and the hedgerow finances from the effects of their "Financial Engineering."
The "Global Economy" may well be strong, but the U.S. Economy is two-thirds driven by the true American vice: fanatic consumerism. Once the recognition card game are nearly all maxed out (and accruing involvement at, in some cases, over 30%), and the center social class is no longer able to entree its non-existent home equity (whether because of declining values or tightening recognition standards), consumer disbursement MUST suffer. The first intimations of this are coming from net income warnings from Wal-Mart, Home Terminal and Macy's.
I am certainly a truster in the resiliency and ultimate success of this Country, and we will somehow turn ourselves out of this mess, too, in the long run. But for the shorter term, all the protests of Government spin docs and Wall Street salesmen posing as analysts will not change the simple truth: The Sub-Prime Economy is upon us.
Warren R. Graham
Copyright 2007
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