Monday, July 16, 2007

Why hasn’t Wall Street reacted to the subprime crisis the way it “should”?

Because the Street has a lot to protect. Note the words “contained,” “suppressed” and “protected” in the Bill Fleckenstein analysis quoted below:

The problems have taken a long time to play out, largely because of what we've recently come to discover but probably could or should have known all along: that the building blocks of the housing ATM — more accurately referred to as structured credit — were created in such a way that these securities were rarely marked to market. Rather, they were allowed to be marked to a model, based on a variety of assumptions. Essentially, therefore, one's assets were impaired only when the ratings companies downgraded them. ...

Fast-forward to last February and March, which saw the implosion of a couple of dozen subprime lenders. Wall Street reacted by proclaiming the problem “contained.” Though I essentially laughed at that sanguine response, now I understand what it meant: Those in the know understood that nothing was going to be marked to market, so the subprime-loan-originator implosion didn't matter.

Next, we saw the blowup of Bear Stearns’ High-Grade Structured Credit Strategies Enhanced Leverage Fund. That happened, in part, because manager Ralph Cioffi had tried to hedge some of its weaker credits with an ABX index that did get marked to market. Thus the fund lost money and was hit with redemptions.

At the time, I said that redemptions were going to force price discovery into the market — although, as Jim Grant so eloquently put it in a recent issue of Grant's Interest Rate Observer — Bear Stearns had a totally different opinion: “Price discovery could wait until the return of blue skies and normal pulse rates. The first order of business was price suppression.”

This price suppression was the outcome folks had hoped for. After all, according to a July 11 article in Bloomberg, Wall Street took in about $27 billion in revenue from underwriting and trading asset-backed securities last year alone. It’s a mighty profitable business that they are protecting.

In other words, until the Street gets as “rational” about sunk costs as classical economists believe people are supposed to be, it’s not going to own up to the size of this problem.