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Fire On the Mountain

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Before we issue the all clear it is necessary to understand the root cause of the financial fires.

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The flame from your stage has now spread to the floor
You gave all you had. why you wanna give more?
The more that you give, the more it will take
To the thin line beyond which you really cant fake.

(Grateful Dead)


Fire is a funny thing. We need it to live, cook and warm our homes but if we don't respect the power of the element, it can ruin our lives.

Back in June, I was asked whether the smoke seeping out of the sub-prime space was cause for concern. My response was that the falling trees weren't firewood unless someone was there to chop it up and collect it. Even then, it wouldn't lead to a forest fire unless a match was lit.

The tricky aspect of that juncture, I offered, was that everyone suddenly knew where the wood was. And the wood dealers, the same folks that were quick to realize gains when the underlying assets were appreciating, hoped the spark in the dark wouldn't ignite a blaze that would torch our finance-based economy.

As I watched footage from southern California a few weeks ago, I was struck by one of the reports. Fire departments were snuffing out flames in a particular region before moving on to the next call. A gust of wind then emerged and carried an ember from a neighboring fire back to the area already declared safe, triggering blazes anew.

That imagery stuck with me as it's precisely what is happening in the markets as credit risk spreads through the $500 billion of derivatives that weave together our financial fabric.

I maintain that this is the most interesting juncture in the history of finance. We've been watching a multitude of brilliant fires flash across the landscape as central banks stand at the ready with a hose of liquidity aimed in every possible direction.

In the interest of offering context, I wanted to revisit some of the stories we recently shared while sitting around the campfire.

In August, we walked through the warning flares that were set off around the world.

As we shook sand from our summer shorts, we wondered why the Federal Reserve was trying so hard to avoid the natural business cycle.

After the FOMC reversed course and lowered interest rates, we pondered the implications of dollar devaluation vs. asset class deflation.

Once it became apparent that there were unforeseen agendas in play, we explored those curiously unnatural forces in kind.

And last week, before the most recent witch-hunt began, we explored the haunted homes that littered the Street.

Similar to what we've seen in California, the possibility exists that this past period will move from the front pages to a rebuilding process. After billions of dollars of damage-sunk costs associated with any tragedy-a recovery phase will eventually emerge with lessons in tow.

Before we issue the all clear, however, it is necessary to understand the root cause of the financial fires. While it doesn't change the fact that homes and livelihoods were lost, it may help us understand how and why this seemingly unnatural disaster began in the first place.

Wall Street has long profited from repackaging risk. At the core of brokerage business models, they benefit from the chasm between what people know and what they can charge for advice. This, too, has been a topic of conversation in the past, albeit long before these current issues came home to roost.

Investment banks categorize their investments in three buckets. They are:

  • Type I: Securities that are 'marked to market' or where they could actually sell them according to the last price.
  • Type II: Securities that are 'marked to model' where they could conceivably sell them at a price determined by an analytical model.
  • Type III: Illiquid securities that are 'marked to management'-or prices subjectively determined to be fair value by the management structure of the firm.


As of last quarter, Level III investments at four of the five major investment banks grew 36.7% from $156.4 billion to $215 billion. The one major bank that wasn't included in this reported figure was Merrill Lynch (MER), which has since written-down close to $9 billion dollars in losses.

Two natural questions are therefore begged. One, did it pay to be forthright with regards to disclosure (Stan O'Neal might have an opinion here). And two, what-and where-are the rest of these losses hiding?

I started my career in 1991on the worldwide global equity derivative desk at Morgan Stanley (MS) as the off-balance sheet proliferation began. We were pioneers in the field and during my seven years there, I watched as the largest technology companies in the world-from Intel (INTC) to Dell (DELL) to Cisco (CSCO) to Microsoft (MSFT)-sold massive amounts of downside puts in lieu of traditional buy-backs.

Their motivation was clear-if they were to put the stock, their cost basis would be considerably less than it would be through straight stock purchases. If their short puts expired worthless, the gains weren't taxed as ordinary income. That loophole always seemed strange to me but alas, that's a conversation for a different time.

They played the game because it was playable. And when they lost, they simply swallowed hard and wrote it off.

There was a "range" in which we could mark these positions consistent with where similarly listed options were priced. The spread we assigned to those OTC positions varied and we adjusted our P&L in kind. Management had latitude on pricing (within the "listed" range) such that they could alter performance depending on firm needs.

We did not believe there was anything illegal or unethical in these practices and I am not suggesting with hindsight that there was. It was firm policy and industry standard, albeit a segment of the industry that was widely misunderstood in its infancy. This story serves to encapsulate the hidden risks currently prevalent in the financial complex, albeit with one major difference.

Many of the positions on trading desks around the Street have no listed proxy with which to guide or gauge their valuation. Many Wall Street firms are assigning estimations of where they believe these securities should be trading but as we know, something is only worth as much as what someone else is willing to pay for it.

In a derivative laden finance-based economy, the banks, brokers and other financial service companies simply serve as wicks to the much broader brush. Stocks across a wide swath of sectors derive earnings from financial based operations and that is reason for economic concern regardless of whether the fans are flamed.

The slicing and dicing of risk, coupled with complexity of derivatives, has been cumulatively building during the manifestation of the credit bubble. The key word is cumulative, as the effects have steadily grown as a function of time. It has also provoked a familiar sentiment that just because it hasn't mattered yet, it's not going to matter. The irony would be sweet if only it wasn't so dangerous.

Capital preservation, debt reduction and due diligence remains the path of prudence. We're witnessing a historic transition, both in terms of financial credibility and the socioeconomic mindset as it relates to money. The more you invest in financial literacy and the discipline of risk management, the better you will be serving your future.

For if we've learned anything from recent history, it's that the wind has a tendency to blow both ways.

R.P.


Holiday Festivus is here! Come join us and support the Ruby Peck Foundation For Children's Education at an old-fashioned Southern-style hoe-down in the heart of New York City on December 7th. Click the image below to learn more!

No positions in stocks mentioned.

Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at todd@minyanville.com.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

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