Michael Campbell
Sun
To borrow from the late, great George Burns, “Gracie, we have a problem.” The big question is: When it comes to the losses in the subprime (read low-quality) mortgage market, no one knows just how big the problem is.
I love the quip that analyst Denis Gartman offered up when the first significant losses in the subprime mortgage market were reported in February. Gartman, in anticipation of more problems to come, told his investors to hold on to their money because “there is never only one cockroach.”
Since that time, the cockroaches have been scurrying out of the deep dark corners — the likes of Bear Sterns, France‘s AXA, Japan‘s Shinsei Bank, Germany‘s IKB Deutsche Industriebank, plus several hedge funds in the U.S. and Australia.
The monster cockroach that triggered Thursday’s massive stock market sell-off came courtesy of France‘s biggest bank, BNP Paribas, which announced that it was suspending client withdrawals from three of its investment funds with a face value of $3.79 billion US.
The problem is that the lack of liquidity in the subprime market makes it impossible to reliably determine the asset values of the funds, so Paribas put an end to withdrawals.
This is just the kind of uncertainty that the market abhors, and it encourages investors in other mortgage-related funds to withdraw their money before their funds are frozen.
The fact that just a week earlier the bank’s CEO had said that the firm’s exposure to the U.S. subprime market was “absolutely negligible” lends credence to the fear that no one knows the extent of the problem.
Even companies themselves don’t know their exposure, because billions of dollars in low-grade mortgages were repackaged and sold to hedge funds, mutual funds and institutional investors around the world.
What’s ironic is that in 2005, when BNP Paribas Asset Management launched two of the now-frozen funds, the bank declared that these kinds of mortgage-backed securities “have lost their exotic status and entered the mainstream of fixed-income investing.”
In other words, these high-risk investments had taken on an aura of respectability, which aided their proliferation. Last year alone, Wall Street issued $773 billion US in mortgage-backed securities.
What’s amazing is that anyone paying attention is surprised. The massive increase in debt levels and the complacency surrounding the risks being taken made the whole situation like a game of musical chairs. Analysts and investors knew the music was going to stop, the only question was when.
Well, the “when” seems to be now, although central banks in the U.S. and Europe seem bent on letting the party go on with the infusions of billions of dollars into the system.
To be fair, the Federal Reserve is caught between a rock and a hard place. It can’t allow a panic liquidation to take place, which would end in a nasty recession, but by trying to alleviate the problems by pumping money into the system, it is sowing the seeds of a bigger problem down the road.
In November, 2002, I wrote in this space that the massive decline of the U.S. dollar and accompanying hard-asset inflation were inevitable as then-Federal Reserve governor and current chairman Ben Benanke declared that they had an invention to prevent Japanese-style deflation, and it is called the printing press.
Since that time, every panic has been met with the printing presses running full speed, with a lower U.S. dollar and higher hard-asset prices the obvious results.
My bet is that unless some really ugly surprises come out of the subprime woodwork, they will be able to pull it off, but not without some gut-wrenching gyrations for some investors.
Significant damage has been done, and a sober reassessment of risk should take place.
Michael Campbell’s Money Talks radio show can be heard on CKNW 980 on Saturdays from 8:30 to 10 a.m.
