In Memory of Long Term Capital

It was great before the storm began. On July 23, 1998, the Nasdaq composite had recently broken through 2000. Technology and the "new" Internet stocks were rocking. There was great cause for enthusiasm and investing had almost never been better.

But quietly, in the background, rumors began to circulate about a fabled hedge fund, euphemistically called Long Term Capital Management - staffed with Nobel Laureates in economics no less - that was having trouble with its "black box" quant style of investing. Hundreds of billions ($) were on the line. A quiet retraction of prices for financial stocks suddenly turned into a tsunami that brought the Nasdaq down 500 points (-25%) in a month; the last 300 in four days.

The Nasdaq rebounded, putting in an impressive counter-rally for 300 points by the end of September (+28%). But then another terrific slide in early October dropped the index -350 points to an intraday low of 1375.

Yet as quickly as this fever began, Long Term Capital vanished into history. After the last big drop that final Monday morning, cooler heads prevailed on Tuesday and the markets never looked back. When all was said and done, the numbers for the economy turned out to be okay for the quarter, the worst fears about LTC's overall effect on the financial world never came true, and growth accelerated anew.

The point I am making is back then the news-driven saga of the Clinton impeachment trial and Long Term capital gripped the investment world like a hurricane. Sensationalism sells. In the space of a few short weeks Merrill Lynch dropped 40%, Citi lost 55%. Washington Mutual fell 40%. The biggest banks and brokerages in the world went on sale, just like they're doing today. Wildly successful tech stocks like Microsoft and Yahoo loss 25-30% in a matter of days. Does any of this sound familiar? The only sectors having a truly difficult time this quarter are the banks and the homebuilders. Delete their losses from the overall mix and earnings for Q3 come in slightly up to 7%, rather than flat to slightly down.

When you look at the sub prime mess, you have to ask yourself , "Who is defaulting on their sub prime loans?" The people who are driving our economy, taking it to new heights? A BIG no.

Unfortunately, it's families with poorer credit from the margins of our society who wanted a piece of the American pie (their own home), and who wouldn't qualify for a home loan under normal credit requirements. Low income workers do not bring down the largest economy in the world. This is an isolated financial incident that's spread globally because these loans were sold globally.

Like all participants in a bull market with eternity in their headlights - families or flippers bought homes they couldn't afford, with money they didn't have, from bankers who packaged and collateralized the loans in ARMS (adjustable rate mortgages), and who then sold them to investors who shouldn't have bought them. I think part of the levitation in the real estate market 2005-06 was from sub prime buyers desiring to enter the market at any cost; and from mortgage brokers accommodating them. The double whammy for foreclosed families is now they must enter a rental market that is sky high as a result.

To wit, what does sub prime have to do with Google (GOOG), Microsoft (MSFT), Yahoo (YHOO), Apple (AAPL), Amazon (AMZN), Hewlett-Packard (HPQ), Intel (INTC), Broadcom (BRCM), Dell (DELL), Applied Materials (AMAT), RIM (RIMM), Nokia (NOK), VMWare (VMW), etc. and all the thousands of stocks in the domestic and emerging world that are doing ok? Not much. Is sub prime affecting the energy industry, the large cap techs, or the growth in emerging market? Again, no. Tech stocks went through their speculative mess 7 years ago and now they are the strongest financial stocks out there. They have globally diversified holdings, practically NO debt, and the falling dollar is magnifying their profits.

The banks are repeating the same stupid mistakes they made with sub prime S&Ls in the 1980s twenty years ago. By its very nature, the selling of debt to low income families is a parasitic profession - the sole purpose is to put responsibility on the lendee at a higher % rate, not the lender, in order to get a "safe" but steady rate of return by doing NOTHING.

The only creativity involved in the lenders' methods was the cleverness behind the CDOs and the "resets" of the adjustable rate mortgages that lay underneath them; and the only ethical solution two years later is to give those strapped homeowners a break at lower % rates - and thus fix and quantify their loss (to the banks) - by writing off that portion from the bank's books. I don't think it's any coincidence that the loan industry got the Feds to rewrite a bankruptcy law that had been in existence for decades to protect consumers from times like this.

I guess they figure they can get more for the homes at a foreclosure auction instead of letting homeowners (i.e. "risk") stay in their homes. After all the baloney from the U.S. president (Katrina liar) this summer about "doing something" to keep families in their homes, little has been done to effect that. Countrywide (CFC) had to be shamed by consumer lawsuits and public demonstrations outside its corporate offices to keep their word - to do something about resetting a fraction of their ARMs.

I find it amazing too that the great bubbleonian - Alan Greenspan - whose "free lunch" interest rates fueled this incredible mess - is so eloquent of late on the newswires.

But maybe as investors we should be grateful that Wall Street's sheeples are gobbling up Barrons' and CNBC's fuel-driven fires with such aplomb. Some very nice buying opportunities are presenting themselves in their wake. I am newly long WaMu (WM), Citigroup (C), Merrill Lynch (MER) and CountryWide Financial (CFC).

For a more realistic view of the current malaise, see " The Credit Crunch and Other Myths", by Dick Green from Briefing.com.

Comments

[Uncle Bill:]

Your market knowledge is very limited. When the market as a whole falls, the riskiest issues -- techs -- will fall the most. That's why they're the riskiest. Dismissing the banks and brokers because they only represent a portion of the market is a fatal mistake. The stock market follows the banks and brokers; check the charts. Just in the last couple weeks have the analysts taken off their buy ratings. You will soon see that the entire economy has been dependent upon new construction for the past five years, and now that's come to an abrupt halt. The whole foundation of risk taking by hedge funds was built upon the knowledge that CDOs would fund their operations. That business is bust. Those stocks you bought will be much lower in six months.

2007 Nov 12 08:38 AM

[daver:]

When banks can no longer lend because their capital is impaired one may very well enter a period where everything slows down. Businesses and individuals that are actually good risks and in the past would have gotten credit no longer have access. In the end this hurts all aspects of an economy as credit is a key component driving growth. I would be a bit more cautious here - you may see a slow down in the sales of many retail items as consumers retrench. You may see a slowdown as businesses also retrench and cut back due to more expensive or a lack of access to capital.

2007 Nov 12 09:02 AM