Investor's Dilemma Part II

This is not, by any means, an investment-advice blog, but nevertheless I advised readers back on August 12^th (The Utopia of Usurers) to buy gold coins and mining stocks in case of a market meltdown. That turned out to be pretty good advice; gold is up about $100/oz. since then and mining funds are up 32%, far in excess of market returns. Now, normally gold is not a good investment; in fact, its not really investing at all. It creates no wealth, no jobs, no nothing; gold is sterile. It is really a kind of hoarding, something which reduces the monies available for productive investment. However, in times of uncertainty, in times when there is a suspicion that the government and the market are about to turn the currency into a kind of toilet paper, gold is a defensive measure. In a later column (The Investor’s Dilemma) I attempted to give the reasons for the kind of credit crunch in which we now find ourselves, precisely the kind of crunch that requires prudent men and women to take defensive measures.

At the current moment, the Utopia of Usurers is turning into a nightmare. Some find this very strange, because they can't see why the sub-prime market, such a small part of the economy in general and only a small part of the housing market in particular could cause such damage. But bacterium are small, but they can be deadly; the smallest virus can kill you. And bad loans spread through the market, making seemingly good investments turn sour. How does this happen? The people who make the bad loans certainly don't want to hold them. Instead, the package them up and sell them to hedge funds, pension funds, banks, SIVs, etc, all of whom are trying to get a decent return in a tight market. Bear-Stearns exhibited the greatest chutzpah in this regard by marketing a fund of sub-prime loans, and then selling it short. In other words, they told the individual investors that it was a good deal, while themselves acting on the presumption that it was a bad deal. Nice.

So, how far does the rot spread? The following partial list of sub-prime holders was compiled by Adrian Ash of The Daily Reckoning:

• Public Pension Funds

  • State of Oregon: $475 million

  • City of Detroit: $39 million

  • Teachers Retirement of Texas: $62.8 million

  • State of Missouri: $25 million

  • State of New Mexico: $222 million (and maybe another $300 million)

• Money Market Funds

  • $11 Billion

  • Wells Fargo Advantage Fund: 5% of assets

  • Credit Suisse Prime Portfolio: 8% of assets

  • A.I.M.: $2.64 Billion

  • PayPal fund: $1 Billion

• Mutual Funds

  • Many of these funds are labeled as high-risk mortgage bond funds, but many have such risks without the investors being aware of it.

  • Regions Morgan Keegan High Income Fund: Assets are down from $1 Billion to $420 million. The fund cannot give a market price for its assets, since there seems to be no market for them.

• Private Pension and Insurance Funds

  • Prudential is suing State Street Global Advisors, one of the world's largest fund managers, for failing to mention that it put subprime based derivatives in its “low-risk” fund, causing Prudential an $80 million loss.

  • Unisystems is also suing State Street on behalf of 25 of its employees.

  • Idaho and Alaska are considering suits as well.

• Banks and Brokerage Houses

  • The Banks have lost well over $20 Billion on mortgage-backed instruments

  • Merrill-Lynch is allowing $5.5 Billion for losses, but many think that there is more to come, since they hold $21 Billion in subprime and CLOs.

  • UBS holds about $20 Billion in such instruments

Of course, this just scratches the surface, just a few random reports culled from the news. This doesn't even get near all the hedge funds and SIV's, etc., that were relying on these instruments to make big returns. But it gets worse. These funds are highly leveraged. That is, they put up a small portion of their own money, borrow a lot more at commercial rates (say 5 or 6%) and buy these risky instruments paying 10-12% and pocket the difference. This means that those who lent to them are now on the hook as well. Nor does it count the countless number of investors who bought into these funds because the rating agencies give them high marks in spite of the low quality of the underlying securities.

How do disasters like this happen? As I explained in The Investor’s Dilemma, it happens because there is too much capital chasing too few good investments. When capital concentrates at the top, it has difficulty finding decent returns, and ends up taking greater and greater risks, which are then spread throughout the markets like a plague. The Fed had cut interest rates to 1% and corporate investment-grade bonds were paying peanuts. People came to believe that the real estate boom was forever, and the rating agencies were touting this junk as triple-A.

Folks in the financial intermediation business like to boast that “the free market is very good at spreading risks.” And this is true, but it is not to be praised, any more than Typhoid Mary is to be praised for spreading what she spreads. Fasten your seat belts. By all accounts, we are only 1/3^rd the way through all of the subprime re-sets. It could be an interesting winter and spring.