Sunday, August 19, 2007

Subprime timeline

Let me repeat: the meltdown is not a black swan event. Many predicted it long ago. See my post from 2005 (lots of details on CDO pricing, copula, how hedge funds could make a short term profit by taking on default risk).

From the Times:

All through last year, Jim Melcher saw the signs of a rapidly deteriorating American housing market — riskier mortgages, rising delinquencies and more homes falling into foreclosure. And with $100 million in assets at his hedge fund, Balestra Capital, he was in a position to do something about it.

So in October, as mortgage-backed bonds were still flying high, he bet $10 million that these bonds would plunge in value, using complex derivatives available to any institutional investor. As his gamble began to pay off in the first months of 2007, Mr. Melcher, a money manager based in New York, plowed the profits into ever bigger wagers that the mortgage crisis would worsen further, eventually risking some $60 million of the fund’s money.

“We saw the opportunity of a lifetime, and since then events have unfolded on schedule,” he said. Mr. Melcher’s flagship fund has since doubled in value, even as this summer’s market turmoil cost other investors billions, forced the closing of several major hedge funds and pushed the stock market down 7 percent since mid-July. This week, Mr. Melcher is heading to Paris for a vacation with his wife.

The extent of the turmoil has stunned much of Wall Street, but as Mr. Melcher’s case makes clear, there were ample warning signs that a financial time bomb in the form of subprime mortgages was ticking quietly for months, if not years. ...

...On Friday, the Federal Reserve was forced into a surprise cut of the discount rate it charges banks to borrow money, a move that steadied shaky stock and credit markets and reassured investors, bankers and traders who were reeling from a month of market turmoil. And for the first time, the Fed bluntly acknowledged that the credit crisis posed a threat to economic growth.

“Until recently, there was a lot of denial, but this is a big deal,” said Byron R. Wien, a 40-year veteran of Wall Street who is now chief investment strategist at Pequot Capital. “Now the big question is: Will this spill over into the broader economy?”

The answer to that question will be revealed over the coming months. But the cast of characters who missed signals like the rise of delinquencies and foreclosures is becoming easier to identify. They include investment banks happy to sell risky but lucrative mortgage debt to hedge funds hungry for high interest payments, bond rating agencies willing to hope for the best in the housing market and provide sterling credit appraisals to debt issuers, and subprime mortgage brokers addicted to high sales volumes.

What is more, some of these players now find themselves in a dual role as both enabler and victim, like the legions of individual borrowers who were convinced that their homes could only keep rising in value and were confident that they could afford to stretch for the biggest mortgage possible.

“All of the old-timers knew that subprime mortgages were what we called neutron loans — they killed the people and left the houses,” said Louis S. Barnes, 58, a partner at Boulder West, a mortgage banking firm in Lafayette, Colo. “The deals made in 2005 and 2006 were going to run into trouble because the credit pendulum at the time was stuck at easy.”

Oddly, the credit analysts at brokerage firms now being pummeled were among the Cassandras whose warnings were not heeded. “I’m one guy in a research department, but many people in our mortgage team have been suggesting that there was froth within the market,” said Jack Malvey, the chief global fixed income strategist for Lehman Brothers. “This has really been progressing for quite some time.”

A nice timeline below (larger original here):


Anonymous said...

if there has been a black swan event, it would be the way subprime troubles spread to quant long-short equity land -- presumably b/c someone was dabbling in both markets and had to delever. or at least that seems to be one theory.


steve said...

Yes, one story is that funds had to sell whatever liquid assets they had to make margin calls on leveraged credit investments.

But equities are near all time highs; the market is nervous and looking for reasons to correct negatively. Fragility of sentiment isn't necessarily due to hedge funds.

Another thing I've heard is that huge amounts of money are coming into the equity vol market from the fixed income side, totally swamping the usual players. The fixed income guys are long vol (buying puts?) and the equity guys keep selling it.

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