thomast2

The Current Bear Market: Death by a Thousand Cuts

Thanks everyone for all your great comments. As I said, the bottom of this bear market is expected to be around $800 for S&P, similar to Blair's analysis. Kunst, you are right, it is negative "correlation", sorry about the mis-spelling. Thanks again.

Introducing the Minsky Theory - Stability Is Destabilizing

Thank you all very much for your feedback.

Thanks to a reader, I am just aware of that in early 1990s, when MBS appeared, Minsky anticipated the problems they would cause. In his 1992 article titled: “The Capital Development of the Economy and the Structure of Financial Institutions”, Working Paper No. 72, The Jerome Levy Economics Institute of bard College, he wrote:

"The securitization of standard mortgages was a technique by which Savings and Loans and Mortgage companies originated mortgages which were then packaged as securities for the portfolios of holders such as pension funds, life insurance companies, mutual trusts and various international holders. Because of the way the mortgages were packaged it was possible to sell off a package of mortgages at a premium so that the originator and the investment banking firms walked away from the deal with a net income and no recourse from the holders. The instrument originators and the security underwriters did not hazard any of their wealth on the longer term viability of the underlying projects. Obviously in such packaged financing the selection and supervisory functions of lenders and underwriters are not as well done as they might be when the fortunes of the originators are at hazard over the longer term. All that was required for the originators to earn their stipend was skill avoiding obvious fraud and in structuring the package."

Well, even he put it politely at the beginning of the wild MBS era, he pointed out that the fundamental here was the underlying moral hazard issue. And we saw how moral hazard had caused things totally out of control 15 years later.

Why Did the Mortgage Market Go Out of Control?

Thank you all very much for your comments.

Syndicat, you raised an interesting point about MLP. I think it is similar to REIT as a legal structure, but I suspect there are a lot more of tax loopholes on MLP for those private equity senior partners to evade taxes, which is probably the original purpose of setting up MLP. Need more time and research on this.

For Bentra and others, as Billddrummer indicated and well said, most of the price distortion is from the securitization process, which is only about 10 years old with proliferation only in recent years.

During this packaging process, fundamental elements of underwriting get stripped out, replaced with macroeconomic assumptions by the computer model. It is similar to the situation that, instead of buying company stock one at a time after you do research on their fundamentals, now Wall St gives you a basket of 500 companies and charge you a premium, because they claim that, based on Abby Cohen of Goldman, US economy will go on strongly in double digit growth forever.

Unlike equity securities, for mortgage securities, even you know they are mispriced, distorted, overvalued, manipulated, there is no mechanism to do arbitrage to return the price equilibrium, since investment banks at Wall St. controls both the market and the source of those illiquid mortgage securities and their derivatives.

So it becomes an one sided seller’s market, structured finance groups at Wall St. set their price, tell you their value, determine their risk, manipulate its credit ratings, investors don’t have a say on this since it is impossible and too complicated to value them.

The only thing investors can do is to buy high and try to sell higher to the next suckers. This is why you see so many hedge funds are involved in this. At the end of the day, this whole thing is totally a pyramid scam now crumbling, as Bill Gross of PIMCO indicated.

How Quickly Market Sentiment Has Changed

Thanks for your note. I also think it is possible that the business cycle will play out as you have laid out here.