Hot Commentary: Finances and Markets

By Jon Nadler , Senior Analyst
Kitco Bullion Dealers Montreal 16 Sep 2008

Good Morning,

As the global financial tsunami rolled westward overnight, markets in Asia fell hard and gold and oil went along for the ride with them as investors raised cash and fled to precious little else. The dollar LIBOR rate fully doubled overnight, marking its largest increase on record while various central banks kept their liquidity-injecting pumps fully open to sedate the frazzled global markets. Questions continue to focus on whether today will be AIG's day of reckoning, and whether that event could ignite a chain reaction. People are making up lists of failure suspects faster than your average CSI forensic investigator. The one question very few analysts appear to have no answer to, is the probability of a global economic slowdown and the certainty that not only will the first trillion of credit loss-related writedowns materialize soon, but that a further trillion might find its way into the toxic waste dump that reckless financiers have created.

Thus, we start today on the heels of a 504 point slaughter on Wall Street, a 605 point cave-in in Tokyo, with crude oil down to $92 and falling, and with a mixed but still resilient dollar; all of them awaiting a word - any word from the Fed about what it intends to do in light of this late summer heat wave in the world of money. In the interim, others offered their own words, ahead of the Fed and found a 'strong' US economy (McCain) or the end to the idea that 'trickle-down' economics is workable (Obama). Events such as these certainly lack no commentators. Commodity guru Jim Rogers said that while gold may well fall to $515-$525, he could be a scale-down buyer of the metal en route to such numbers.

Gold prices fell about 2% overnight but found support at $770 as some physical buying stemmed the margin-call and asset liquidation tide that dove funds and investors out of markets on every continent. New York spot dealings opened with a minor $3.40 gain, quoted at $790 as the dollar shaved gains to 78.54 on the index ahead of what promises to be the most-watched Fed meeting since a year ago in September. Silver opened 6 cents higher at $11.16 this morning. Oil continued to slump, going its own way and skirting $91.35 this morning. Consensus estimates on Fed actions have turned on a giant dime recently, and pundits expect (and some demand) a hefty rate cut by the central bank. Such expectations did not faze platinum which fell to $1189 an ounce, losing $75 on perception that car sales will stall and fail to turn over even with jumper cables being applied. Palladium dropped $6 to $227 per ounce on similar fears.

While we are learning that greed and envy (what else is new?) were at the root of today's spectacle on Wall Street as well as that on Main Street, there are concrete indications that a good dose of arrogance and most of all, denial only aggravated the problem and turned it from a fully preventable one into what appears now to be an incurable one. Jim Cramer railed on a couple of names last night and nailed their portraits to the 'wall of shame' for all to see. A devastating expose from the NY Times' Joe Nocera lays bare the psyche of some of the names you have seen in the news of late. Not a pretty picture:

How can this be happening?

How can it even be possible that we wake up on a Monday morning to discover that Lehman Brothers, a firm founded in 1850, a firm that has survived the Great Depression and every market trauma before and since, is suddenly bankrupt? That Merrill Lynch, the "Thundering Herd," is sold to Bank of America the same weekend?

Just months ago, Lehman assured investors that it had enough liquidity to weather the crisis, while Merrill raised some $15 billion over the last year to shore up its balance sheet. Now they're both as good as gone.

Last week, it was Fannie Mae and Freddie Mac that needed a government bailout. This week, it looks as though American International Group and Washington Mutual will be on the hot seat. We have actually reached the point where there are now only two independent investment banks left: Goldman Sachs and Morgan Stanley. It boggles the mind.

But it really shouldn't. Because after you get past the mind-numbing complexity of the derivatives that are at the heart of the current crisis, what's going on is something we are all familiar with: denial.

Indeed, it is not all that different from what is going on in neighborhoods all over the country. Just as homeowners took out big loans and stretched themselves on the assumption that their chief asset — their home — could only go up, so did Wall Street firms borrow tens of billions of dollars to make subprime mortgage bets on the assumption that they were a sure thing.

[here is the graphic - and we mean graphic version of the bubble that was;

The New York Times > Business > Image > A Primer on the Financial Crisis

But housing prices did drop eventually. And when people tried to sell their homes in this newly depressed market, many of them had a hard time admitting that their home wasn't worth what they had thought it was. Their judgment has been naturally clouded by their love for their house, how much money they put into it and how much more it was worth a year ago. And even when they did drop their selling price, it never quite matched the reality of the marketplace. They've been in denial.

That is exactly what is happening on Wall Street. Ever since the crisis took hold last summer, most of the big firms have been a day late and dollar short in admitting that their once triple-A rated mortgage-backed securities just weren't worth very much. And, one by one, it is killing them.

Take Richard Fuld, the chief ****utive of Lehman Brothers. Last summer, as the credit crisis first gripped Wall Street, Mr. Fuld's firm, which was fundamentally a bond-trading firm, concluded that the problems would be short-lived — and that those firms willing to take big risks would be the ones that would reap the big rewards once things calmed down. So Lehman doubled down on mortgage-backed derivatives — not unlike a Florida condo owner buying a second one to flip 18 months ago.

Big mistake. Ever since then, Lehman has had a terrible time admitting the magnitude of its mistake — or properly pricing its securities. As mortgage derivatives became increasingly toxic, they also became increasingly illiquid. So firms were left to set their own "mark-to-market" price. And just like so many homeowners, they kept pricing their securities higher than they should have.

Earlier this year, for instance, when the hedge fund manager David Einhorn was making his public case against Lehman (he now refuses to talk about the firm), he stressed his belief that Lehman was valuing its securities too high. He turned out to be exactly right.

Every time the market was roiled — especially after the Bear Stearns collapse — every firm on Wall Street had to re-mark their securities to reflect the new reality. That's why you saw firms taking billion-dollar write-off after billion-dollar write-off, long after they thought they had taken care of the problem. And it is also why the write-offs will continue now that Lehman is bankrupt.

"Selling begets more selling," said Sean Egan of the independent bond-rating firm Egan-Jones. And yet, even as they lowered the value of their mortgage-backed securities, firms like Lehman had still priced them too high. Back when he was talking publicly about Lehman, Mr. Einhorn used to cast Lehman's mark-to-market pricing as an act of dishonesty. I tend to think it was more like wishful thinking. Either way, the result was the same.

A week ago, even as the government was bailing out Fannie and Freddie, Mr. Fuld went off to seek new capital — something Lehman desperately needed to shore up its decimated balance sheet — from the Korea Development Bank. Why did those talks break down? Because Mr. Fuld wanted more for Lehman than the Koreans thought it was worth. He simply couldn't face the reality that his firm wasn't worth what he thought it was.

Now look at his next-door neighbor, John Thain at Merrill Lynch. To be sure, Thain owned a better house — although Merrill Lynch also had billions in toxic securities, its bread-and-butter is its brokerage arm. It is fundamentally a gatherer of assets, not a bond-trader.

But there is another big difference between the firms. Unlike Fuld, who had run Lehman since 1993 and is the architect of the modern Lehman, Thain had been at Merrill Lynch just since December, when he was brought in to stanch the bleeding. He didn't have the same pride of ownership in Merrill that Fuld had in Lehman. That is why he was willing to sell $31 billion worth of mortgage-backed derivatives for 22 cents on the dollar in late July — far lower than many firms had been pricing those securities.

And that is also why, seeing what had happened to Bear Stearns, Fannie and Freddie, and Lehman Brothers, he took the pre-emptive step of selling Merrill Lynch to Bank of America. In the process, he got $50 billion for Merrill's shareholders. True, that was half of what Merrill was worth a year ago, and a once-proud name is about to be swallowed up by a commercial bank. But he also got $50 billion more than Fuld got for his shareholders — and being sold is a lot better than being liquidated.

It is unlikely that the worst is over. The market Monday dropped more than 500 points, and the government is now trying to keep AIG from going the way of Lehman Brothers, even asking Goldman Sachs and JPMorgan to make some $75 billion in loans available to the struggling insurance giant. And then there's Washington Mutual. And then ... well, who knows where it will end?

[more pictures, same landscape:]

The New York Times > Business > Image > A Failing System

Clearly the government is no longer willing to put the taxpayers' money at risk to save firms that took on too much risk buying securities that they didn't understand. As painful as it is to see Lehman employees lose their jobs, that is probably a good thing. That is the final parallel that exists between the housing market and Wall Street: the issue of moral hazard.

For over a year now, many Wall Streeters have complained about government efforts to forestall foreclosures, saying that it would create the expectation that everyone should be bailed out, and that consequently no one would learn important lessons about the dangers of taking more risk than they could handle. Besides, they added, the housing market was never going to improve until housing prices found their natural bottom. And that wouldn't happen until the government stopped trying to prop up housing prices.

But in truth, you can say the same of Wall Street — it won't learn any lessons, either, until firms that took foolhardy risks start to fail. One reason Lehman could not find a buyer over the weekend is because potential buyers were insisting on the same kind of taxpayer guarantees that the government had given JPMorgan when it bought Bear Stearns, or when it took over Fannie and Freddie. That's the essence of moral hazard. When Treasury Secretary Henry Paulson refused to do so, the potential buyers went away.

With the government refusing to prop up Wall Street anymore, maybe now mortgage-backed derivatives will find their natural bottom. Something to look forward to, I guess."

Nervous trading and wider swings will define the action - much as they have in previous sessions. US CPI fell in August, driven by slumping energy values. Let's see if that leaves the Fed still looking wise in cutting rates at the risk of reigniting the former trend. Gold remains vulnerable to the asset liquidation trend and may not be able to overcome it, or the free-fall in crude oil as it heads to the $80's range. Then again, one really bad news item could have the $800 mark being taken out in a blink. Right now, a less likely probability in the wake of what we have seen thus far. Gold pundits/speculators beware of Mr. Fuld having lived in denial. Not a good example to follow.

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