Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [69]
Ralph Cioffi, a senior managing director of Bear Stearns Asset Management and a former colleague, had seen the segment and gave me unsolicited feedback.“You sounded good,” he said,“and you looked mahvelous as Billy Crystal used to say.”When his leveraged hedge funds failed a few months later, I wondered if he had listened to the content.
In early February 2007, the shares of aggressive subprime mortgage lender, New Century Financial Corp., then the second largest subprime in the United States, plummeted after it alerted that it was short of cash. London-based HSBC Holdings Plc, the largest bank by market value in Europe, unexpectedly reported that it had $1.8 billion of losses due to subprime lending.2
Bear Stearns’ fixed income research gave the horrific news a positive spin indicating that the worst might be over and recommended customers go long—the opposite of Jim Melcher’s short money-making position.3 ResMae Mortgage Corporation went bankrupt on February 13, 2008, the day after Bear Stearns Fixed Income Research issued its report. ResMae was selling assets for mere pennies on the dollar.4
By the end of February 2007, New Century was trading at around $15 per share, after its share price fell around 50 percent during the prior three weeks. Rumors circulated that the lender was in its death throes. Perhaps Bear Stearns didn’t get the memo, even though it had a “longstanding”5 relationship financing New Century’s mortgage operation. On March 1, 2007, Scott R. Coren, a Bear Stearns stock analyst, upgraded New Century, saying that $10 per share would be the downside risk, if New Century needed rescuing. About a week later, New Century announced it had probably been unprofitable during the last six months of 2006 and needed to restate its earnings. Lenders yanked their credit lines. In April 2007, New Century filed for bankruptcy, joining more than 100 failed mortgage lenders. Countrywide, the nation’s largest mortgage lender, also showed signs of strain.
Hidden leverage threatened the global markets. Many hedge funds used CDOs’ artificially high ratings as an excuse to leverage their “safe highly rated” investments. It is an extremely risky proposition. Debt purchased near full price has little or no price upside, but there is a lot of room for the price to go down when things go wrong. Combine that with leverage, and you have a very risky strategy.
What if prices drop because everyone finds out that the assets are overrated? What if prices drop because of defaults by overextended homeowners, defaults due to a collapse in housing prices, or permanent value destruction due to fraud? There is no other income to give you upside potential, and a leveraged position has no hope of springing back. If a fund does not have gobs of liquidity in reserve, investor capital is quickly wiped out. Investors take a stomach-churning toboggan ride straight down risk’s icy slope. Creditors that lent the fund money to buy assets are lucky if they do not lose money, too.
Most of us use high degrees of leverage when we buy a home. A homeowner might buy a $1 million dollar home and mortgage $900,000 of the purchase. If the price drops to $950,000, the “homeowner” loses $50,000 of his initial equity of $50,000, or 50 percent of his equity. If the price drops to $900,000, the “homeowner” loses all of his initial investment. If a bank forecloses on the $900,000 mortgage, it does not even break even after fees. If the price drops below $900,000, the bank’s cushion of the first loss taken by the “homeowner’s” $100,000 is gone, and the bank, the creditor, will not get the full amount of the loan paid back. Some of the mortgage loans made in 2006 and 2007 had zero money down, were made against aggressively appraised homes, and defaulted almost immediately. The investors in the hedge funds are like the homeowners