What a Difference a Simple Rate Cut Makes (NYTimes, 8/18/07)

August 18, 2007
What a Difference a Simple Rate Cut Makes
By JEREMY W. PETERS
As they have so often in the last few weeks, Wall Street traders came to work yesterday braced for the worst. Stock markets in Asia had taken a blow overnight. There was talk that the nation’s biggest home lender might be facing bankruptcy.
And then the Federal Reserve stepped in, with a rate cut for loans to banks and an indication of further action if the economic outlook worsens. In an instant, the despondency gave way to relief.
“The floor was elated,” said Jeffrey Frankel, the president of the Stuart & Frankel Company, a trading firm at the New York Stock Exchange. The Fed’s move, he said, showed that “our system worked.”
It was the beginning of what turned out to be a positive day. The Dow Jones industrial average rose 233.30 points, to 13,079.08, reclaiming a position above the 13,000 mark, which it had given up on Wednesday. The Standard & Poor’s 500-stock index, which had lost its profits for the year earlier this week, got them back and then some. The index climbed 2.5 percent yesterday to stand up 2 percent since the beginning of the year. The Nasdaq composite had its biggest percentage gain since last August, closing up 2.2 percent.
The problem is that no one knows whether it will hold.
“We’re down 300. Then we’re even. Then we’re up 100. Then down 100,” said Theodore P. Weisberg, a trader with Seaport Securities, which executes transactions on the floor of the New York Stock Exchange. “I don’t think anybody is comfortable.”
After Thursday’s session, when the Dow plunged 340 points only to claw its way back to level ground in the final hour, no one needed to be reminded how quickly things can change. And indeed, yesterday morning’s euphoria looked as if it might be short-lived. The market surged immediately after the opening bell, with the Dow soaring more than 300 points in the first few minutes. By 10:45 a.m., those gains had almost evaporated, with the average up only about 60.
Then the downward drift reversed itself, and the week’s trading came to an upbeat end. But as they look ahead, traders are still trying to divine whether the market has merely hit a speed bump or something more serious.
Michael J. Rutigliano, who directs floor trading for the WJB Capital Group, said the initial bounce in the Dow once the market opened was hardly a surprise to him. It seemed investors were looking for any excuse to rally, he said.
“That’s the power that raw emotion adds to the markets,” he said. “The fear has obviously been abated today, but these markets tend to be very emotionally charged. You’re going to see, I think, over the next days and weeks, swings. Because investors need to try to figure out what this all means.”
Stock prices, which are usually reactive to the news cycle, have been hypersensitive lately to anything that might indicate whether more trouble lies ahead for the economy. This week offered investors a multitude of nerve-testing events.
On Tuesday, it was a profit warning from Wal-Mart and sinking earnings from Home Depot that raised concerns about how healthy the American consumer is. On Wednesday it was speculation from Merrill Lynch that Countrywide Financial, the nation’s largest mortgage lender, could be forced into bankruptcy. On Thursday it was a broad stock sell-off overseas, remarks from the Treasury secretary and more concerns about Countrywide.
Then came the Fed’s announcement before the markets opened yesterday that it was easing its lending rate to banks and acknowledging the impact that the credit squeeze was having on the financial markets and potentially on the economy.
Countrywide itself was one of the biggest beneficiaries yesterday, as investors saw relief from its immediate peril. Its stock shot up 25 percent in early trading and wound up gaining 13 percent, to $21.43, as 105 million shares traded hands.
Within the Wall Street firms handling that trading, the recent upheaval is unnerving for even the most hardened veterans.
“I’m old school,” said Peter P. Costa, a senior floor official for Eckhart & Company, a trading firm. Mr. Costa was at the stock exchange for the 1987 crash, the dot-com bust and the Sept. 11 attacks. He said he did not think the current market troubles were as severe as any of those events, but he is taken aback nonetheless.
“You’re constantly talking to customers who’ve been saying, ‘When’s the best time to buy? When’s the best time to sell?’ ” he said. “And it’s hard.”
The market disorder has interrupted what should be the lazy days of August. At times, the workloads can be overwhelming.
“People feel like they’ve worked three weeks instead of one,” said Andrew Frankel, co-president of Stuart & Frankel. “People are exhausted. This volatility is so tiring.”
This week, the expression “thank God it’s Friday” took on added meaning. “We need a reprieve,” said Jeffrey Frankel, Andrew’s older brother. “Everybody is happy it’s Friday.”
But come Monday, all bets could be off. “Make no mistake about it,” Mr. Rutigliano said, “if on Monday some unforeseen announcement comes out, the dynamic changes.”

The Fed’s Sudden Action Eases a Logjam in Corporate Borrowing (NYTimes, 8/17/07)

August 18, 2007
The Fed’s Sudden Action Eases a Logjam in Corporate Borrowing
By ERIC DASH
The Federal Reserve Board’s move yesterday to stabilize the credit markets helped to ease the pressure on a mundane but crucial part of the financial markets: short-term lending to corporations.
Borrowing of money short-term — called issuing commercial paper — seized up this week as investors became nervous at the prospect that many of those notes were backed by mortgages that no longer have ready buyers.
“The commercial paper market is the eye of the storm,” said Ed Devlin, a portfolio manager at Pimco, the big fixed-income investment firm. “The reason the Fed is concerned is that there is a real collateral squeeze and issues around funding.”
Until recently, the $2.2 trillion commercial paper market was considered one of the safest places on Wall Street. But over the last few days, many investors have been navigating it like the airport highway in Baghdad.
Yesterday, some of the concerns began to ease. Commercial paper traders called the last week the worst in their career since the 1998 financial crisis that brought down the hedge fund Long-Term Capital Management.
The market is a little-noticed but vital part of the world’s financial infrastructure. And all week, it seemed that one financial bomb after another was exploding.
The rating agency, Standard & Poor’s, warned that it might downgrade a handful of lenders and hedge fund issuers, and Moody’s sharply cut the ratings of nearly 700 subprime mortgage bonds. Countrywide Financial, the mortgage lender, could not sell its notes, leading it to obtain emergency bank financing.
In Canada, two groups of big banks preliminarily agreed to provide $120 billion, in United States dollars, in financing to companies there, amid a global pullback. Even the notes of seemingly healthy companies were priced at higher rates — and had trouble selling.
Commercial paper, essentially a promise to repay a loan within a few weeks to nine months, has served as a major pipeline for corporate financing. Mortgage lenders use the short-term notes to fund their loans before packaging and offloading them from their books.
Hedge funds created special investment vehicles, which purchased the short-term notes to invest in higher-yielding loans — often mortgage bonds — and then used the difference to bolster their returns. And many corporations used commercial paper to finance big share-buyback programs.
Investors in money market funds have found commercial paper a convenient place to park their cash. While some big money market funds may improve their returns if they can invest at the current rates, others may be worse off. But most ordinary investors, bankers and analysts say, should not see much of an impact.
“Investment managers and portfolio managers who deal with hundreds of millions of dollars are very concerned, but the average investor should not be worried,” said Peter Crane, the publisher of Money Fund Intelligence, an industry newsletter. He said there was almost “zero chance” that a money market fund would decline significantly in value.
While the turbulence of the commercial paper market peaked on Thursday, it was still not fully stabilized yesterday.
Investors have grown increasingly scared that the high-grade notes are backed by bundles of subprime mortgages. So much so, they do not trust the credit ratings of many short-term notes — including ones that the major agencies deemed high grade.
About $1.2 trillion, or roughly 53 percent of commercial paper, is backed by pools of assets like home mortgages, credit card receivables and car loans. Over all, some analysts suggested, about half is backed by residential mortgages.
But several said that most investors have no idea of their actual subprime exposure in that mix.
Transparency has been poor. And because of high-octane financial engineering, analysts said, the underlying pool of assets may have been rated as high quality but could actually be backed by riskier stuff.
The widespread uncertainty has frozen parts of the commercial paper market and led to days of turbulent trading. As it reverberates, many players in the financial systems are feeling its effects.
To be sure, many short-term notes are trading — although at record high rates. But as issuers have to come up with cash to roll over, or refinance their notes, they have found themselves unable to do so. That is because the underlying pool of assets is worth considerably less.
On some notes many issuers have invoked so-called extendable options, which lengthen the payback period from, say, 90 days to six months in an effort to wait for extra time for investors to come back. Others have turned to so-called backstop financing — essentially an insurance policy sold by the big banks and brokerage houses that calls for them to provide funding if the underlying assets cannot be sold. Countrywide, for example, tapped its $11.5 billion credit line yesterday after investors were reluctant to buy its commercial paper. The move allowed Countrywide to stave off selling the underlying mortgage assets at deep discounts.
But the total amount of rescue financing has placed tens of billions of dollars at risk for many of the biggest banks. Most charge nominal fees for the guarantee of liquidity, analysts said, and some banks did not properly reserve for the risk since the prospect of default seemed remote.
Citigroup and JPMorgan Chase, for example, have guaranteed more than $90 billion of liquidity, or about 5 or 6 percent of their total assets, according to a recent Banc of America Securities report. State Street, a custody bank, guaranteed about $29 billion, or 23 percent of its total assets.
In all three cases, their actual subprime mortgage exposure is proportionally small. But other analysts suggest that many big European banks may carry a great deal more risk on their balance sheet.
That has ignited fear that the subprime contagion has spread to the global banking system — and, some suggest, caused the Federal Reserve Board to take action yesterday.
“The Fed is concerned because of the banks’ exposure. The banks are on the hook for potentially tens of billions of dollars,” said Christian Stracke, an analyst at CreditSights, a fixed-income research firm. “That could tighten credit conditions significantly if all that paper is tied up in things that none of the banks want to hold.”

Central Banks Intervene to Calm Volatile Markets (NYTimes, 8/11/07)

August 11, 2007
Central Banks Intervene to Calm Volatile Markets
By VIKAS BAJAJ
Central banks around the world acted in unison yesterday to calm nervous financial markets by providing an infusion of cash to the system. But stocks still fell sharply in Asia and Europe, and in early trading in New York, before they recovered and closed essentially flat for the day on Wall Street.
As in recent weeks, the markets moved in wild swings — sharp drops were followed by steep gains and vice versa — underscoring the uncertainty. Investors weighed concerns that losses in the American mortgage market would deepen and spread against their faith in the ability of a strong global economy to withstand additional shocks.
Hoping to provide some comfort that there is ample cash available, the Federal Reserve made its largest intervention since the markets reopened Sept. 19, 2001, in the wake of the terrorist attacks. The central bank injected $38 billion into the financial system on top of the $24 billion it put in on Thursday.
The intervention steadied the markets — at least for the day. The Standard & Poor’s 500-stock index closed at 1,453.64, a gain of 0.55 point, and the Dow Jones industrial average closed down 31.14 points, to 13,239.54. For the week, the Dow was up 0.4 percent, the S.& P. 500 rose 1.4 percent and the Nasdaq was up 1.3 percent.
The question that remains is just how exposed the financial system and the economy are to losses in the credit markets and the increase in borrowing costs. The answer will set the agenda at the Federal Reserve, which finds itself confronting its first major financial crisis under the leadership of Ben S. Bernanke, who took over last year.
The Fed will be guided by its assessment of how much do banks, hedge funds, pension funds and others stand to lose and whether consumers and businesses will be able to stomach higher interest rates and stricter loan underwriting.
“There are a lot of risks in front of us,” said Liz Ann Sonders, chief investment strategist at Charles Schwab. “Financial crises, in the past, when not accompanied with a recession have been good for the markets.”
But, she added, “if the economic landscape deteriorates much from here, then we are going to have to suffer through a more difficult market period.”
That debate, Ms. Sonders and others agree, will not be resolved anytime soon, which suggests that markets will remain choppy as information about failing hedge funds and mortgage companies dribbles out.
Investor anxiety has been so heightened in recent weeks that days of stability have been shattered by the first sign of trouble tied to the debt markets.
Volatility, as measured by one popular index of options trading, has surged to its highest levels in more than four years, though it remains far lower than it was early this decade and in the late 1990s.
The financial sector has been among the most volatile — stocks there fell by as much as 1.7 percent during the day, only to climb as much as 1.1 percent before closing little changed.
Shares of Countrywide Financial, the nation’s largest mortgage lender, and Washington Mutual, the sixth-biggest lender, opened sharply lower after both companies said they were facing a harder time selling loans and could potentially have problems raising money.
While those stocks recovered much of their losses for the day, they are both down significantly for the year.
A common pattern has been a surge in trading late in the afternoon, around 3 p.m., that has often sent stocks higher, as it did yesterday — though on some days, like Thursday, the move has been just as sharp on the downside.
Richard X. Bove, an analyst at Punk Ziegel & Company, noted the trend in a recent note to investors and suggested that the reason was strong buying from portfolios that use computer models to buy and sell quickly, a practice known as program trading, or a foreign source like the investment arm of the Chinese government.
“We are talking about such a sizable amount of buying and volume goes up and stocks react strongly one way or the other,” Mr. Bove said. “What I have trouble with is trying to figure out where it’s coming from.”
But he acknowledges that the pattern will probably not last long, because as sophisticated traders figure it out they will jump in on the other side to profit from the trades.
Using data from the New York Stock Exchange, Ms. Sonders of Charles Schwab estimates that program trading accounted for about 40 percent of all trades on the Big Board in recent days, up from the 30 percent range earlier this year.
“That’s why we are getting these swings, this is professional- to-professional trading,” she said. “This is money that has a time horizon measured in minutes.”
Indeed, there is evidence that the average individual investor has not been a big player in recent days.
Flows into mutual funds that specialize in American stocks were essentially flat for the week that ended on Wednesday, according to AMG Data Services. But investors put $36.2 billion into money market accounts, the largest weekly inflow this year. Investors often put cash into money market funds, which earn more than savings accounts, that they eventually plan to invest in the market.
It is not surprising that individuals are sitting on the sidelines, given the sharp moves in the market. Yesterday, for instance, all three major American indexes fell immediately after the opening bell, and at one point the Dow Jones industrial average was down 212 points. By noon, stocks were on the rebound and the indexes were briefly in positive territory, then declined. The Nasdaq finished at 2,544.89, down 11.60, or 0.4 percent.
“You can’t invest into a market that does that,” Mr. Bove said. “You have a better chance at making money on the craps table than in this market.”
Treasury prices were little changed yesterday. The 10-year note fell 9/32, to 99 18/32 and the yield, which moves in the opposite direction from the price, rose to 4.81 percent, from 4.77 percent on Thursday.
Earlier, stocks in Japan, Hong Kong and Australia dropped by more than 2.5 percent. The benchmark Kospi in South Korea fell 4.3 percent, the biggest decline since June 2004. Most major European indexes plunged by 3 percent or more.
In both Asia and Europe, fears about the American housing market prompted investors to sell assets and forced commercial banks to reel in credit lines.
Central banks around the work stepped up efforts to slow the losses. The Bank of Japan added liquidity for the first time since the market problems began.
The European Central Bank injected money into the system for a second day, adding another 61 billion euros ($84 billion), after providing 95 billion euros the day before. The Federal Reserve yesterday added $19 billion to the system through the purchase of mortgage-backed securities, then another $19 billion in three-day repurchase agreements.
In Washington, Treasury Secretary Henry M. Paulson Jr. spent the day in what his aides said was hourly contact with the Fed, other officials in the administration, finance ministries and regulators overseas and people on Wall Street — where until last year he had worked as an executive at Goldman Sachs.
“We’ve been in touch with our colleagues in other agencies and among the financial regulators and are monitoring the situation carefully,” said Michele Davis, the Treasury Department spokeswoman. “Beyond that, we are not commenting.”
As investors in Asia sold off assets considered relatively risky, like Philippine stocks, they bought those considered safer, like Japanese government bonds. Asian currencies like the Thai baht also retreated against the dollar and more liquid and stable currencies like the yen.
“Everyone’s been talking about a credit crunch, and not surprisingly it turned into one,” said Jan Lambregts, head of Asia research at Rabobank.
While Asian banks did not seem to be directly affected, he said, “the main problem is we don’t know who is bearing the losses, and that kind of uncertainty is creating the situation that we’re in right now.”
Wayne Arnold, Steve Weisman and Jeremy W. Peters contributed reporting.

Pack Mentality Among Hedge Funds Fuels Market Volatility (NYTimes, 8/13/07)

August 13, 2007
Pack Mentality Among Hedge Funds Fuels Market Volatility
By LANDON THOMAS Jr.
On Wall Street, there is a rage against the machine.
Hedge funds with computer-driven or quantitative investment strategies have been recording significant losses this month.
The managers of these funds are the products of the trading desks of the big investment banks, like Goldman Sachs and Morgan Stanley, both of which have investment operations that use computer models.
The cross-fertilization has raised fears among some analysts that it is not only the hedge funds that are being hit, but the trading desks at the banks as well.
“These guys all know each other, and they all have the same strategies,” said Ernest P. Chan, a quantitative trading consultant who has done computer-driven research at Morgan Stanley and Credit Suisse. “They came from the same schools, and they get together for drinks after work.”
As the quantitative system has come to underpin the investment approaches of some of the largest hedge funds, its use has grown sharply.
Moreover, bankers and investors say, the strategies employed tend to be not only duplicable but broadly followed — the result being a packlike tendency that has helped increase market volatility and, for some hedge funds, has led to losses in the last month.
Wild swings in stock prices have become the norm as fears about the mortgage securities market have expanded into the broader markets. Last week, the Dow Jones industrial average was sharply higher on Monday and Wednesday, only to drop 387 points on Thursday, eventually ending the week about where it began.
A common thread has often been a rise or fall in prices late in the day, a pattern that many analysts attribute to computer models, which are driving a much larger volume of the trading.
Mr. Chan said this predilection for lemming-style buying or selling from investors using similar computer models could turn what would normally be a market setback into a wider contagion.
“If all the models say buy, who is going to say sell? There is just not enough money on the other side,” he said.
The problems of these quantitative funds mirror those of the hedge fund industry as a whole — many funds have seen sharp declines in the last couple of months as the credit markets have dried up. Some quantitative funds could potentially have their worse year on record.
Despite the large sums of money involved, ranging from $250 billion to $500 billion, according to industry estimates, the club of quantitative investors is a small, exclusive one that bridges the trading desks of investment banks and some of the country’s largest hedge funds.
One might call it six degrees of quantitative investing.
Clifford S. Asness, who has a Ph.D. in finance from the University of Chicago, is the founder of AQR Capital Management, a quantitative hedge fund that, according to investors, has had a 13 percent loss so far this month.
Mr. Asness is also a founder of Goldman Sachs’s troubled Global Alpha fund, which controls about $9 billion. The Alpha fund has suffered an 11 percent reversal this month, giving it a decline for the year that is approaching 30 percent, sparking speculation that Goldman would liquidate the fund. Goldman calls the speculation “categorically untrue.”
On a smaller scale, Tykhe Capital, another hedge fund that uses quantitative techniques, was down 19 percent in August. The founders of Tykhe are from D.E. Shaw & Company, the giant hedge fund that manages $35 billion via a broad reliance on quantitative, as well as other, strategies and whose founder, David E. Shaw, who has a Ph.D. from Stanford, originally came from Morgan Stanley.
Hedge funds as a whole have grown exponentially and now manage about $1.7 trillion, more than double the amount five years ago.
In one respect the swoon of these computer-reliant funds is the result of managers, who are faced with a deluge of investor money seeking accelerated returns, using their models to make higher risk market bets by following day-to-day trends. It is an approach that seems to run contrary to the original philosophy underlying a quantitative approach, called statistical arbitrage.
Narrowly defined, statistical arbitrage involves a fairly straightforward investment strategy, like the rapid-fire buying of one stock and the selling short of another so as to use the computer’s speed to identify and make money from even the most minute price discrepancies. Such a strategy will generally provide liquidity to the market by buying stocks on the way down and selling them short on the way up. In so doing, it provides a dose of calming, computerized sang-froid to markets in the grip of panic or euphoria.
But such strategies rarely promise high returns, so quantitative investors have broadened their computer models to include strategies for investing in more risky areas like mortgage-backed securities, derivatives and commodities.
“You can build a computer model for anything that is tradable,” Mr. Chan said. To some extent, that explains the outbreak of losses in these funds.
With many of these new assets being highly illiquid and with the funds themselves having used considerable amounts of borrowed money to enhance their returns, losses have been magnified as worried investors have demanded to pull their money out.
In a letter to investors this week, James H. Simons, the founder of Renaissance Technologies, the most highly regarded of the quantitative funds, gave voice to what he described as “unusual” market conditions. Mr. Simons, who received a Ph.D. in mathematics from the University of California, Berkeley, acknowledged what a difficult month August had been, with his RIEF down close to 9 percent for the month.
For an investor who reportedly earned $1.6 billion last year and whose flagship Medallion fund had an average annual return of over 30 percent since 1988, it was a surprising reversal.
“We cannot predict the duration of the current environment,” Mr. Simons wrote. “But usually such behavior causes first pain and then opportunity. Our basic plan is to stay the course.”

Shaky Markets Prompt Rumors of Who’s in Trouble (NYTimes, 8/10/07)

August 10, 2007
Shaky Markets Prompt Rumors of Who’s in Trouble
By JULIE CRESWELL
The global stock and bond markets these days seem to be playing a giant game of hide and seek.
In this version, played on a global field, investors are scrambling to discover which banks, hedge funds or public companies are holding potentially hundreds of billions of dollars in bad loans and subprime-related mortgage securities that are imploding.
On any given day, traders are exchanging rumors of a hedge fund that has blown up or a Wall Street brokerage firm that has incurred losses in subprime or other mortgage-related securities, creating a frenzy and a whipsaw of trading activity in the stock and bond markets.
So far, most rumors have turned out to be unsubstantiated and untrue. Still, exposure to and losses from subprime and other mortgage-related securities are being revealed, slowly, in all corners of the world.
Yesterday France’s largest bank, BNP Paribas, stopped withdrawals from three of its asset-backed securities funds, saying it could no longer value them accurately because of problems in the subprime market in the United States.
Also yesterday, the insurance giant American International Group revealed that it held $28.7 billion in subprime securities, but that given its size, it was not under any pressure to sell the securities at a loss.
Already the turmoil in the mortgage market has led Germany’s central bank, the Bundesbank, to bail out a bank, IKB Deutsche Industriebank, that held subprime investments. Several hedge funds in the United States, four in Australia and at least four additional funds in Europe have either closed or halted investor withdrawals as they sort out the value of their subprime and other mortgage-related investments.
In reaction to the growing losses on subprime mortgages and related securities, the European Central Bank stepped in yesterday morning and provided $130.2 billion in emergency loans to European banks while the Federal Reserve injected $24 billion in liquidity into the United States banking system.
Capital markets have undergone periods of extreme turmoil and lack of liquidity in the past. In 1998, the credit markets virtually froze up after the hedge fund Long-Term Capital Management buckled and Russia defaulted on its debts. Many investors dumped mortgage securities into the market and prices tumbled.
Yet, the nervousness seems more intense given the amount of leverage, or borrowed money, that had been made available to hedge fund investors in the subprime and mortgage arena. The use of borrowed money, along with the sheer size of the mortgage market, should only worsen investor losses.
“This is a market that has grown tremendously in the last five years,” said Professor Stijn Van Nieuwerburgh of the Stern School of Business at New York University, “and whereas a lot of the mortgages were previously held by banks, now, particularly with subprime mortgages, they are held by a lot of new players who are essentially just getting used to them.”
Last year, Wall Street firms issued $773 billion in mortgage-related securities, up from $217 billion in 2001, according to the Securities Industry and Financial Markets Association.
Yet trying to ferret out which one of these relatively new players will be the next to report big losses on subprime or mortgage-related securities, whether they be an Asian bank or American hedge fund, is difficult.
Unlike investors who hold large stakes in publicly traded American stocks, and must report those holdings to the Securities and Exchange Commission, no central government agency or private organization tracks who may be holding subprime or other mortgage-related securities in any detail. (The United States Treasury does track broad foreign country holdings of American mortgage securities.)
“I don’t think any of the regulators have a handle on where the net exposure of subprime is,” said Christopher Whalen, managing director of Institutional Risk Analytics, which builds risk systems for regulators and auditors.
Mr. Whalen said the situation was worse in Europe, where even less public data was available.
Furthermore, because of accounting rules, some holders of these mortgage-backed securities do not have to own up to or recognize any losses until they actually sell them.
But these days, trying to value certain subprime securities or the more complicated collateralized debt obligations, or C.D.O.’s, which are pools of mortgage securities, is difficult as well.
Unlike stocks that trade openly on exchanges and whose value can easily be determined at any point of the day, mortgage-related securities and C.D.O.’s change hands behind the scenes via individual bids and offers made on trading desks across Wall Street.
And while, typically, billions of dollars of securities can move in and out of these markets with great ease, in recent weeks trading in mortgage-related has seized up because Wall Street firms are reluctant to buy or sell them, many traders and portfolio managers said.
Trading in C.D.O.’s has become a “standoff” said James L. Melcher, president of Balestra Capital, a New York-based hedge fund.
Jokingly, Mr. Melcher said the attitude of some investors in C.D.O.’s seems to be: “I am dancing here. Don’t bother me about this iceberg we have hit.”
If there is an upside to the mortgage meltdown, some analysts said, it may be that because these securities are held by so many investors the pain will be spread among many market participants instead of taking down a large single financial institution.
Indeed, two rating agencies, Moody’s and Standard & Poor’s, said this week that the large American investment banks face modest risks and manageable losses because of subprime-mortgage losses.
“The good news is that the losses will be widely distributed across the different owners of these pools of securities,” said Stuart A. Gabriel, a finance professor at the Anderson School of Management at the University of California, Los Angeles.
“The bad news,” he said, “is because of the difficulties in valuing these mortgage pools and the high levels of uncertainty and panic that have set into these markets, we have a situation where there is a severe lack of liquidity in the mortgage market and that has created an extremely dangerous situation for our economy and the global economy.”
Eric Dash and Vikas Bajaj contributed reporting.

A New Kind of Bank Run Tests Old Safeguards (NYTimes, 8/9/07)

August 10, 2007
News Analysis
A New Kind of Bank Run Tests Old Safeguards
By FLOYD NORRIS
A few generations ago, savers responded to financial panics with runs on banks, and even healthy institutions could fail if they could not raise enough cash quickly enough.
For a long time, that all seemed to be safely relegated to the past. But now the runs are back — and this time the targets are not banks but the securities that have replaced them as the prime generators of credit in the new financial system.
“Our current system of levered finance and its related structures may be critically flawed,” said William H. Gross, the chief investment officer of Pimco, a mutual fund company. “Nothing within it allows for the hedging of liquidity risk, and that is the problem at the moment.”
This problem has plagued the United States at regular intervals. The Panic of 1907 was halted only when the banker J. P. Morgan persuaded banks to stand together and halt the string of closings by lending money to threatened institutions. That led to the creation of the Federal Reserve, as Congress recoiled from the notion that the country’s financial health had relied on the wealth and wisdom of one private citizen.
Then the Depression, with a wave of bank failures, led to the establishment of deposit insurance. With that, savers became convinced that they need not worry about the health of their bank, and bank runs vanished.
But a new financial architecture emerged in the last decade — one that relied more on securities and less on banks as intermediaries. With the worth of those securities now being questioned — and no equivalent of deposit insurance — some who financed the securities want their money out, a fact that has created the 21st-century equivalent of a run on a bank.
Left to deal with the run are the institutions that were created to deal with the old system’s problems — notably the central banks like the Federal Reserve and the European Central Bank. But, in contrast to their close involvement with the banking system, these banks have little regulatory oversight of the securities that are in trouble and may not even know who is holding them.
At the heart of the new system was a decision to have loans financed directly by investors, rather than indirectly by bank depositors. Investors, ranging from hedge funds to wealthy individuals, had confidence in the arrangement because most of the securities were blessed as very safe by the bond rating agencies, like Moody’s and Standard & Poor’s.
The highly rated securities pay relatively low interest rates, but until now there were many willing to own them or to lend money to those who did own them. But there is no reason to hold them if there is any question about their safety — just as there was no reason to keep deposits in a bank that was facing a run amid rumors about its safety.
A result has been a freezing up of markets for many securities that, it turns out, were critical to the free flowing of credit. The problem first gained widespread attention when two hedge funds run by the brokerage firm Bear Stearns collapsed and a third Bear Stearns fund had to suspend redemptions as investors sought to get out even though there was no evidence that the fund was in trouble.
“The third Bear Stearns fund announcement was the key,” said Robert Barbera, the chief economist of ITG. “You have to believe that in the hedge fund and mutual fund complexes, there is a decision that is building that says, ‘I want to hold some Treasuries to have a cushion if I see redemptions.’ ”
The basis of the system was a belief that securities backed by bad credit could be very safe — so long as there were other securities that would suffer the first losses that came from defaults in pools of subprime mortgages or of loans to highly leveraged companies.
So far, none of those highly rated securities have failed to make their interest payments on time, but that fact is not enough to make anyone want to buy them. The rating agencies have downgraded some securities, and they are tightening their standards for new ratings.
Early this week, stock market investors around the world tried to reassure themselves that nothing was really wrong, and financial stocks bounced back after suffering sharp declines last week. Analysts argued that profits remained strong, as does world economic growth.
On Tuesday, the Fed declined to lower the federal funds rate, saying that despite financial market volatility and a decline in the housing market, “the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.”
But that comforting outlook did not help the credit markets recover, or persuade anyone to buy the newly questioned securities — at least at anything like the prices people had assumed. No one wants to sell the securities at very low prices — and in many cases they have borrowed heavily against them. So the markets have dried up.
Yesterday, BNP Paribas, a major French bank, said it could no longer value three investment funds that it managed, whose assets had been invested in highly rated securities that were backed by dubious mortgages.
“The complete evaporation of liquidity in certain market segments of the U.S. securitization market,” the French bank said, “has made it impossible to value certain assets fairly, regardless of their quality or credit rating.”
Adding to the problem is that the questionable securities are widely owned and sometimes have been repackaged to form the basis of other securities. European banks and funds own paper tied to subprime mortgages, and it is not clear who else does, or how investors will react.
Banks that are worried about their own liquidity decided this week to increase their reserves, which they can do by borrowing from other banks. Loans on such rates rose as a result of the added demand. Both the federal funds rate — the rate on loans of reserves between American banks — and the London Interbank Offered Rate leaped sharply yesterday.
The Fed — which conducts monetary policy by focusing on the fed funds rate — was forced to inject money into the system to bring the rate back down to its targeted level. And the E.C.B. lent almost 100 billion euros ($130 billion), to European banks.
If the current panic is just that — unreasoning fear — then such cash infusions may be able to let the new financial system weather the storm. Money can be lent to those owning the dubious securities, obviating the need to sell. As they eventually turn out to be good, the loans can be repaid and all will be happy.
On the other hand, if many of those securities turn out to be as bad as people now fear, some of those loans will not be good, and there may be more financial failures.
Yesterday, stock prices fell in Europe and kept declining in the United States, amid speculation over what other owners of the securities might surface as having problems. But American stock prices remain well above the levels they fell to in February, after a sudden drop in the Chinese stock market, and many stock investors still think all will work out acceptably.
The central banks, while clearly crucial to dealing with the loss of faith in the new financial system, lost influence under that system. Loans could be arranged by nonbanks, not subject to bank regulators, and the regulators were hesitant to impose rules that would not apply to all lenders. The lenders sold securities to finance mortgages that let people borrow at rates that — temporarily — were far lower than the Fed envisioned. That delayed the impact of the Fed’s attempts to raise interest rates in 2005 and 2006.
“That is important because it means the decline in the housing market is likely to continue,” Mr. Barbera said. If the American economy does continue to weaken, the Fed may feel forced to reduce interest rates sooner than it had expected, even if that move threatens to hurt the value of the dollar.
Prices in the futures market for federal funds show that just a few weeks ago investors thought there would be no Fed easing this year. Now they seem to think such a move is highly likely, and some expect it as early as next month.
But the Fed’s influence is limited when lenders are suddenly risk-averse. “The impetus of lowering interest rates may not help, if they don’t let you borrow in the first place,” said Kingman Penniman, the president of KDP Investment Advisors.
The new financial system is not the one the Fed was created to deal with, but it is the one it must try to handle.