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The Greatest Bait And Switch Of All Time As the market’s volatility continues it's important to keep a close eye on what's going on and why. In order to do that, we're going to revisit our Market IQ column, written on August 16, 2007, in which we reported on a conversation between a Dallas hedge fund manager and an acquaintance at a wedding reception. In retrospect, this might have been as crucial a moment in the market's current history as any. We got a forwarded e-mail in mid-August, from a mutual fund manager friend who thought that we might find the communiqué' from the hedge fund manager "interesting," and we did. As we wrote on August 16th: 'The fund's name is Hayman Capital Partners, and the managing partner J. Kyle Bass sets forth an interesting story. Bass says he spoke to someone at a wedding that was being held in Rose, Spain, and here are the salient points of the story as he heard it from the well connected source: 1. Big money, "U.S. insurance companies and pension funds," stopped buying subprime paper in 2003, and were looking to unload the stuff in a profitable manner. 2. According to the note, the only pools of money around the world with enough capital to buy up the seemingly never ending supply of U.S. paper were "mainland Chinese banks, the Chinese government, Taiwanese banks, Korean banks, German banks, French banks, (and) UK banks." ' Bass described the foreigner's thirst for U.S. paper at the time as "virtually insatiable." So Wall Street obliged them. According to Bass, his wedding conversation partner described the mechanism used by Wall Street as the CDO (Collateralized Debt Obligation)-Mezzannine mechanism, in which subprime loans, with BBB (ie junk) ratings, were packaged into the same securities as prime (AAA) mortgages on which the mortgage holder actually paid on the loan. This is how it worked, according to Bass's wedding party confidante: "Through the alchemy of Mezzanine-CDOs. With the help of the ratings agencies the Mezzanine CDO managers collect a series of BBB and BBB- tranches and repackage them with a cascading cash waterfall so that the top tiers are paid out first on all the tranches – thus allowing them to be rated AAA. Well, when you lever ONLY mezzanine tranches of Subprime RMBS 10-20X, POOF…you magically have 80% of the structure rated “AAA” by the ratings agencies, despite the underlying collateral being a collection of BBB and BBB- rated assets..." In fact, due to the ratings given these bundled CDO's, most of the buyers holding these securities were marking them as being worth 100 cents on the dollar, while in fact, Bass correctly predicted "these tranches of mezzanine CDOs will fetch bids of around 10 cents on the dollar." More compelling is what Bass wrote next: 'The ensuing HORROR SHOW will be worth the price of admission and some popcorn. Consequently, when I hear people like Kudlow on CNBC tell their viewers that the Subprime problem is “contained”, I can hardly bear to watch.' So what has started to unfold, it seems, is Bass's "HORROR SHOW," as reports surfaced on 1-21, that the Bank of China, is going to have to write down an additional $300 million in, you guessed it, subprime exposure, above the amount that it has already reported as having written down. And if you're looking for more clues as to what's next, think of this, as well espoused by Bass: "The key reason the Subprime problem exists as it does today has to do with the wanton disassociation of risk inherent in the machine that churns out Subprime loans. Unlike the S&L crisis of the 1980s, the mortgage lenders of today aren’t taking their own balance sheet risk when underwriting loans. These brokers get paid for quantity REGARDLESS of quality. The balance sheet risk is transferred through three entities in less than 90 days from origination. The originator will originate ANYTHING he can sell to a whole loan buyer to pass the hot potato on. Whole loan buyers are simply the aggregators of loans at the Wall St. firms that aggregate, package, tranche, and sell as quickly as they possibly can to the clueless buyer. This transference of risk is the crux of the Subprime situation. Just think about it…if you were a 20-something making mortgage loans in California using someone else’s balance sheet and being paid per loan (with no lookback to performance of the loan), how many dubious loans would you underwrite?" What's Next? It seems as if we may be merely at the beginning of the exacerbation phase of the problem. First, we saw some selling by hedge funds and other entities that were saddled with the smelly subprime loans. These sellers, along with some Wall Street investment houses that got stuck with some of their own bad paper, have at least written down their losses, although, some may still have some to report. What's next is the paper that got dumped on Bank of China, and other global financial players. What's left is the stuff that got dumped on unsuspecting suckers who now have nowhere to run except for the exits with anything that is liquid in order to cover their losses from bad decisions. Think about this. If Bass' story is true, and so far we've found no reason to think that it's not, this phenomenon started in 2003, when the U.S. big money houses figured out what they had on their hands and stopped buying up the bad paper. Yet, the subprime problems began to surface in 2007. That means that from 2003 to probably early 2007, the insurers and the pension funds unloaded as much paper as possible on the unwary. Yet, at the same time, Countrywide, Washington Mutual, and who knows who else, continued to write subprime loans, while Wall Street repackaged them and sold them to somebody. And here is the key statement. If the U.S. wasn't buying most of the stuff, somebody else was. And that somebody was likely foreign money, with a good portion of it likely to be China, and perhaps oil producers, the only entities with excess capital from the recent economic expansion. In other words, what we've seen so far might be the tip of the iceberg, since no one knows how much bad paper was peddled around the world until the bottom fell out of the market in 2007. Conclusion Two key developments have become evident . One is obvious, the U.S. stock market has fallen significantly. But as the SocGen problem, and the issues with regard to the Bank of China recently highlighted, the waters of the subprime crisis are increasingly murky. The other was not so obvious to the casual observer, until very recently. And that is that all global stock markets, including China, are now starting to fall in tandem. In fact, even as U.S. markets seem to be trying to stabilize, foreign market are starting to show significant weakness. More important is the fact that gold, oil, and foreign currencies are also starting to fall, which is a sign that sellers are now starting to unload what they can, which is what is liquid. When liquid assets are being unloaded, despite what the fundamentals are suggesting, you've got something else going on. And that something else is a huge global margin call. When something like this takes hold, it can take quite a while for it to see its way to conclusion. We couldn't have said it better than Mr. Bass. What we've got going on is your basic “HORROR SHOW.”
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