Friday, June 29, 2007

Two Posts I'm not Inclined to Write, but am glad another did

by Ken Houghton

The Epicurean Dealmaker: Marks in the Sand is a good explanation of what happens if you actually mark a levered position to market and find out that your model and the market disagree.

most notable is the coda, which notes the short-term needs of a "long-term" position:
That is one of the instructive lessons from the Long-Term Capital Management implosion: Meriwether and his colleagues were convinced all throughout LTCM's long collapse that the market was irrationally selling into all their positions. They did not want to liquidate because they knew they were right about their portfolio's underlying value. Guess what? In retrospect, they probably were right. But that didn't help them avoid the forced liquidation and takeover of LTCM to meet their Wall Street financiers' margin calls.

A strong stomach won't help you when you've borrowed a lot of money and your broker wants it back.

Contrast this with Brad DeLong's comment at the bottom of the quoted post summarizes the actual economics if the market decides not to call its own bluff:
As long as underlying asset values don't collapse, this is a redistribution: those hedge and other funds leveraged and without liquidity lose big, and those hedge and other funds that are liquid gain big. The caravan moves on, and the returns of those who make it down the California side of Donner Pass look very impressive, with the flesh-stripped bones of the illiquid and their investors scattered near Donner Lake for future archeologists to examine.

Jimmy Cayne is already describing the funds as "a blip on the radar" (per a former co-worker). Rich Marin may disagree. Whether he has company is left as an exercise, though not an academic or intellectual one.

The previous paradigm—Structured Notes—did not end in disaster. But no one was leveraging them.

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The "As long as..." is there for a reason. If defaults trigger foreclosures and if dumping foreclosed houses onto the real estate market triggers a steep price decline in the underlying, we're in big trouble. If not, not, IMHO...
``The real question is, Are there appropriate firewalls between trading desks and captive servicing businesses,'' said Josh Rosner, a managing director at Graham Fisher & Co., an investment research firm in New York. ``If there are not, it would appear to pose real ethical and possibly legal risks in pitting the fiduciary responsibilities of those banks against those investors they have an obligation to.''

Just suppose a large investment bank owned a mortgage servicing company that has been manipulating mortgage payments, not crediting payments, imposing fraudulent fees and forced placing insurance on borrowers for years now in a scheme to trigger those defaults
in order to swell lucrative credit default swaps profit.

Truth of the matter is that all too many 'subprime defaulters' have never missed a mortgage payment.

"Mortgage Servicing Fraud" ~ Read ALL about it because it is a bigger part of this picture than investment bankers are letting on.
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