August 05, 2007

The Panic of 2007

SOMEWHERE BETWEEN the speculative bubbles of the early-modern era (Tulip Mania, the Mississippi Company, the South Sea Bubble) and the economic disasters of our present advanced age (the Great Depression, the Paperwork Crisis, the Bear Market of 1973-74, etc. etc.) somebody hit upon a great name for a financial crisis: a "panic."

Sadly, this usage has become archaic for reasons I don't entirely understand. Perhaps, long ago, people decided we were living in the modern era -- "Gee, we've got electricity and automobiles and bathtub gin and the shoeshine boy has a brokerage account!" -- and so the word went out that Panics Were Out and Descriptions With Gravitas Were In. After all, if you've got to lose your shirt, would you rather lose it in a panic, where everyone was running around screaming, or something sounding more advanced, like the Asian Financial Crisis?

But still, panics are panics and this latest market hiccup sure seems like a panic to me. It also seems that way to others -- such as Prof Robert Bruner, the dean of the business school of the University of Virginia. He was quoted in The New York Times today in a story on our latest mess.

The Times writes:

Hedge funds, which had been major buyers of complicated securities that financed leveraged loans and mortgages, have also pulled back. Some investors have tried to pull money out of such hedge funds, leading Bear Stearns to stop investors from making withdrawals from three of its funds.

“That is the core of a financial crisis, when too many people head to the exits simultaneously,” said Robert Bruner, the dean of the business school at the University of Virginia.

Mr. Bruner is the co-author of a book on the Panic of 1907, to be published next month, and he sees similarities between then and now. “It was a time marked by the rise of new financial institutions and new financial instruments,” he said. “It marked the end of a period of extraordinary growth, from 1895 to 1907.”

The credit market has changed drastically in recent years, as banks grew far less important and credit rating agencies like Standard & Poor’s and Moody’s became the essential players in the new financial architecture.

Many loans, whether mortgages or loans to corporations, were financed by selling securities. It was the credit agency ratings that determined if those securities could be sold, and deals were structured to meet the criteria set by the agencies.

Those criteria turned out to be very generous. The agencies figured that even very risky loans were unlikely to cause big losses, and so most of the securities backed by loans to poor credit risks could get AAA ratings — the highest available — as long as those securities had first claim on loan payments. Investors bought the securities thinking they were completely safe, and some did so with borrowed money.

Now, however, there is fear even about those securities. The rating agencies are changing their criteria for the loans, and many investors no longer trust the ratings.

The markets are “very panicked and illiquid,” said Mike Perry, the chief executive of IndyMac Bank, the ninth largest mortgage lender in the first half of this year, as he announced plans last week to curtail lending sharply. It is very difficult, he said, to find buyers even for the AAA securities.

All this has happened with few defaults. Mortgage delinquencies are up, particularly on loans made in 2006 when credit standards were very low, but the real problem is that lenders and investors fear things will get much worse.“This is what we would characterize as the first correction of the modern neo-credit market,” said Mr. Malvey of Lehman Brothers. “We’ve never had a correction with these types of institutions and these types of instruments.”

All this has happened with very few defaults. Yeah, that sounds like a panic, all right.

Of course, the real question is what will happen in future. If the gloom-and-doom crowd is right, we're all going to be eating cat food and holding off mobs of angry and desperate citizens as the economy tanks and no one can get a loan to save his life. If they're wrong, however, then the ship will eventually right itself and the credit crunch will ease and the money that has currently flowed out of the market will flow back in. It would be pretty cool, actually, if a whole bunch of money were to flow from expensive hedge funds and other alternative investments back into relatively cheap equities. Jeremy Siegel, a finance professor at the Wharton School, has noted the S&P 500 now has a price-earnings ratio of 16.5 -- and by the standards of history, that ain't bad.

The Panic of 1907 also wasn't all that bad by the standards of history. This was primarily due to the influence of J. P. Morgan, who saved the day and whom investors of the time hailed as a hero on the streets. By early 1908, the ship was once again righted and we would soon see the development of the Federal Reserve System.

It's fair to say Wall Street doesn't have any J.P. Morgans anymore. However, there are a lot of smart people there, and we can fairly make two assumptions about that Wall Street crowd. First, some of them -- and, one suspects, more than one might think -- undoubtedly were clever enough to not buy into all this crap. (They sold it, of course, but they're good at selling crap). Second, all of them are going to do everything they can to avoid losing their shirts in this mess. So we can thus deduce that, no matter how things turn out, Wall Street is going to do everything it can in the meantime to right the ship. We can further deduce that, like all financial crises, that this too shall pass. Thus, in the medium-term and long-term, valuations will probably increase as a result.

For obvious reasons, I should note my scribblings here aren't intended as investment advice, and no one should make a decision without consulting their financial advisers and reading the prospectii and carefully weighing potential risks and understanding that past performance is never indicative of future results. All that said, though, this is a situation that can best be described as interesting, and interesting market situations always offer the potential to somehow, someway make money. So keep a close eye on it. Also, read Floyd Norris' smart story on the whole tempest -- it's a good primer on this whole issue and good business journalism.

Posted by Benjamin Kepple at August 5, 2007 08:45 AM | TrackBack
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